Monday, November 19, 2012

Soft stance on patents would cost Apple's shareholders hundreds of billions of dollars

A few days after its settlement with HTC, Apple's stock price fell to the lowest point in six months. I'm not attributing the latter to the former. Licensing is the ultimate solution. But Apple is in a strategic situation in which it simply can't afford to soften its stance. This weekend, an article by Agence France Presse accurately noted that "Google's Android is eating Apple's lunch", and the question is what strategy Apple has to fend off Android. Patent enforcement must play a central role in that strategy.

There are so many people who have invested in Apple, and so many analysts who kept extrapolating past results into a future that actually looks far more challenging than promising, that any caveat concerning Apple's mid-term to long-term prospects is unpopular and elicits heat, not light. I'm not against Apple, and definitely not against anyone who owns Apple stock. I just want to put the patent situation into the wider and ultimately decisive context of shareholder value.

Apple's market share is on a tailspin

One example of those "heat, not light" reactions is that people claim Apple's primary problem is supply, not demand, sometimes pointing to long queues in front of Apple's official stores. This supply-not-demand-is-the-problem argument is downright moronic. There may be some room for optimization in Apple's supply chain, and maybe more room now than there was a year or two ago, and an organization the size of Apple can probably keep itself busy for many years just trying to optimize internal and external processes -- but I have yet to find even one person who bought an Android phone or tablet because an iPhone or iPad was sold out somewhere and they couldn't wait a week or a month for their next phone. Have you ever met one?

The queues in front of those stores merely reflect hype, which is as fickle as it is fragile. There may be long lines of people, but as Samsung indicates in some of its commercials, people are making much ado about stuff they can simply buy across the street. What's the unique selling proposition, in a technological sense, of an iPhone or iPad? There is none. There really isn't even one unique iOS feature that can be considered a driver of demand and that you can't find on some Android devices, too. If the long lines were driven by some features exclusively available on Apple's devices, they'd mean a lot more.

The only kind of exclusivity that you get by buying an Apple gadget is that you can say: "I own an iPhone." Or: "I own an iPad." That is: "I'm hip. I'm cool." If Apple were in the fashion industry, or the luxury car industry, that would be enough. The perceived value of those products is mostly about positioning. It's not about what you get, but about who you are, compared to who your neighbors or colleagues are. But the number of people who base their phone or tablet purchase decision on this kind of consideration is limited.

In the luxury goods industry, a small market share is not only acceptable. It's even indispensable because a Ferrari or a Rolex with a high market share would be a Volkswagen or a Swatch, even with the same objective characteristics. But in the technology sector, there are certain dynamics that make it very difficult to prosper in a high-price niche, and there's really no historical evidence of a significant number of consumers being willing to pay a premium, just for positioning (in other words, for the brand), if not for functionality, or network effects, in the absence of a lock-in.

Apple is strategically losing market after market, segment after segment, to Android. First it was the phones. Now it's also losing the tablet game. In the U.S., Apple is still doing relatively well, but that's only one major market. In China, Android has a market share of 90%. That's not just dominance. That's superdominance. In Spain, it's at 85%. That country has its economic woes, but we're still talking about a significant Western European economy. And in Germany, the largest European economy, Android's installed-base market share is now above 50%, while it was at 10% two years ago. Here's an article published by Focus, a leading German magazine. It's in German, but you just have to look at the two charts. The first one appears to indicate that Apple's market share remained stable, but the article says that even Apple has lost market share in Germany. It has actually lost a lot if you simply take the numbers from that chart and throw out Symbian -- considering that Nokia itself is no longer positioning Symbian against Android and the iPhone, at least not in a market like Germany, that makes sense. Ont hat basis, Apple has lost dramatically. I live in Germany and a vast majority of the people I know use Android, not iOS. I even know people who were considered die-hard Apple "fanbois" (I know it's a controversial term) but switched to Android over the last couple of years. Two years ago, it was a platform only for the nerds.

The Windows-Mac history

I've heard this argument before: no matter how well Android does, all that matters is Apple's sales and margins. And some point to the fact that the Mac is doing well despite Windows having a much greater market share and many Windows PCs selling at prices well below that of a Mac. Those who make this point ignore that because of the problems the Mac had in a "Wintel" world, Apple was on the verge of bankruptcy and was saved by a Microsoft investment. If history repeated itself, Apple would at some point need a lifeline from Google or Samsung.

Compared to Android, Windows is, regardless of market share in a given segment, much less of a threat to Apple, for two reasons.

First, it's distinguishable. No one who sees Windows 8 will confuse it for iOS. But Android, especially the way it's marketed by Samsung, is a clone. IBM allowed the PC to be cloned, and it probably did so for antitrust concerns (based on its experience with the mainframe antitrust decree). For some time, IBM was still able to sell its PCs at higher prices and margins than the makers of "IBM PC compatibles". And it tried to be innovative. I remember I bought a ThinkPad notebook in the 1990s. But the PC business never contributed a lot to IBM's bottom line, compared to the mainframe and other truly profitable business areas, and in 2005 IBM sold it to Lenovo. There really isn't any indication that a company can be worth hundreds of billions of dollars if low-price clones of its flagship products are available.

The second (and no less important) point about Android and Windows is that Microsoft has a business model that is more similar to Apple's. Microsoft's business model may move even closer to Apple's. At any rate, two major players can coexist in a given market if both want to really make money on products, not just advertising or content sales. But the current landscape, with the aggressively-priced new line of Google Nexus offerings (built by different manufacturers) and the Kindle Fire, suggests that Android has even moved past a "free" business model to "less than free". Here's an article by a top-notch venture investor that already described in 2009 another Google business model as "less than free". Apple can't even sustain its margins if it has to compete with "free". How can it compete with "less than free", unless there's a unique selling proposition beyond branding?

Apple's primary challenge: sustainability

Financial analysts generally attach too much importance to past performance, even in highly dynamic markets. And in Apple's case, there are some short-term issues. But the stock market is at least somewhat concerned about Apple's future. Otherwise, a company with such a high growth rate would not have a price-earnings (PE) ratio that corresponds to little or no growth.

The actual derivation of a valuation is more complex than this and consists of a weighted average of expectations for different periods. But if you look at the bottom line, the market believes Apple's long-term value is at a level with its current financial performance. Considering that Apple will likely still experience very significant growth in 2013, this means that the market sees considerable risk in the sustainability of Apple's sales and margins. If you believed that Apple would still grow at the current rate for a couple of yeras and would then be able to stay at that level, you would get all of that growth for free today.

Apple's current stock price is not comparable to dotcom bubble valuations, when companies with annual sales of a few million dollars were worth hundreds of millions. I even remember a company that had annual sales of about $1.5 million, went public, and on the day of its IPO was valued at more than a billion dollars. Apple's numbers are real. But those numbers may nevertheless be ephemeral.

Apple's business lacks the most important characteristic of other large tech companies that sustained annual profits in the category above $10 billion over many years: an entrance barrier. Dozens of companies are selling Android devices. Most of them aren't making any serious money with them; only Samsung is. But they all have an Android license (or use it on open source terms), enough engineering resources to put the thing together, and they can pay some Chinese company to manufacture it for them. For a new platform to be launched now, the challenge would be to get traction with the developer community. But Android has solved that problem. There's no shortage of Android apps. And while some of Apple's customers will remain loyal because they would have to repurchase their favorite apps and their favorite digital content after switching to Android, Apple increasingly has to compete with Android devices even when its own customers buy their next device. It can command a somewhat higher price, but it can't charge twice as much as the competition, and those subsidized Nexus and Amazon devices are going to push prices down, down, down.

There's no reason why the operating margins on smartphones and tablets should in the mid term be much greater than those on desktop and laptop computers, or cars.

I'm aware of only one computer hardware business that has rock-solid, sky-high margins: IBM's mainframe business. There's some migration away from mainframes, but it's limited by the fact that an estimated $5 trillion ($5,000,000,000,000) of legacy code developed for the mainframe platform is such a huge investment that customers are willing to pay IBM, the only mainframe maker left, huge prices. Apple doesn't benefit from a lock-in of such proportions. The price differential between an iPad Mini and a Nexus 7 is enough for most users to repurchase on a new platform the apps and the content they need.

For now, the average selling price of the iPhone and the iPad (apart from the newly-launched iPad Mini) appears stable. It may still be stable in 2013, but I can't imagine that it will still be near its current price point in two years, unless Apple decides to just milk the installed base and those who pay for the coolness of owning an Apple product. In the current market, Apple can grow without sacrificing profitability (again, with the iPad Mini being a separate issue). That's because there are still so many people switching every day from a dumbphone to a smartphone -- but most of those who do so now choose an Android phone, not an iPhone, and now Android also has traction in the tablet market (for the reasons explained further above, I focus on Android in this analysis since other platforms that are more distinguishable from Apple's but based on a similar business model are not as much of a threat to Apple's own business).

The reason that Apple is still growing, at its high margins, has a lot to do with the enormous momentum from years past, and the transition from dumbphones to smartphones that Apple triggered. But there are countries in which smartphones and tablet computers already have a fairly high market penetration, so Apple's problems with market share won't be covered up forever by the growth of the overall market. And in those markets in which there are the most exciting growth opportunities, such as China, Apple has been marginalized by Android and it's hard to see how it will ever reverse that trend.

The only entrance barrier that can make Apple's financials sustainable is intellectual property protection

Apple will continue to innovate. It has to. And since HTC's CEO talked about innovation in his statement on the Apple-HTC settlement, it's obvious that Tim Cook couldn't give the impression of Apple being less committed to innovation. But the likelihood of Apple coming up with another innovation of iPhone or iPad proportions is very limited. Over the last few years, there was more evolution than revolution when it comes to iOS.

Apple redefined the market, but how can it best benefit from the paradigm shift it brought about? I can't see any better and more realistic answer than intellectual property protection.

In this context I don't want to take a position on whether it's desirable, from an innovation policy point of view, that patents are valid for up to 20 years in a fast-paced industry. There are some who argue that patents in this field should be short-lived. Judge Posner is not even sure that patent protection is needed at all in certain industries. I may comment on these policy issues on some other occasion, but here I want to focus on what the rules are today, not whether they should be changed.

It took Android only a few years to beat Apple's platform in pretty much every country on this planet, and in pretty much every market segment. Apple's continued innovation efforts didn't prevent this from happening. If Apple had been less innovative, the problem would be even bigger, but it's big enough despite Apple's best efforts.

In another few years, Apple won't even be a top five company in the industry unless it manages to fend off Android -- not in terms of thermonuclear destruction, but at least Apple needs to force Android companies to come up with their own innovations in some areas and make distinguishable products. Microsoft has delivered proof that one can compete in this market without simply copying Apple.

Apple's primary shareholder value concern must be to extract the greatest possible returns out of the revolution it brought about. And it's clear that continued innovation -- however important it may be -- does not come close to the 20-year term of protection that the patent system offers. Patent enforcement can be slow, and the drop-out rate is high, but Apple stands so much to lose that it has to do what it takes to prevent copying.

Business is not a popularity contest

There are some commentators who say that patent enforcement results in "blowback" and may lead customers to buy non-Apple devices. I don't see any serious indication of this being a major problem. Those who criticize Apple for its IP enforcement are mostly the ones who would never buy an Apple product anyway. Many of them have an ideological bias in favor of open source.

Even if it was a significant problem, Apple still wouldn't have an alternative. Of course, Apple should never say in public the things that Steve Jobs told his biographer about a "thermonuclear war". But what is the greater threat to Apple -- some people's objections to IP enforcement or the fact that lower-cost clones of Apple's products are available everywhere?

To innovate is not a strategy. It's great. It's important. But again, that's not what is called "strategy". Strategy is really about leveraging an organization's strengths and dealing realistically with its weaknesses in order to compete successfully.

Strategically, there is no way -- absolutely no way -- that Apple can win a popularity contest with Google unless Apple gives up its business model and adopts Google's, in which case it would be a smaller Google, also in terms of market capitalization. Most consumers look at Google as a benefactor who gives them some great online services for free -- by the way, this blog is also being hosted by Google. And most of these people don't have the sophistication to understand that Google, too, is profit-oriented, and that it's not doing this pro bono, and that its business model has a number of problematic implications if one thinks the issue through. Besides Google's services, there are also its contributions to open source -- and one can view those critically at a closer look, but few people understand open source business models and licensing issues. People hear that Google doesn't charge for Android, and they're grateful.

Steve Jobs did what what he thought was most beneficial to Apple, and didn't listen to people who told him about popular sentiment or analyst consensus or anything like that. He did what he believed in, and most of the time he was right. The biggest mistake Apple could make, not only in connection with patents, is to try to play a game that Google will always win because consumers love "free" and "less than free" business models.

Thermonuclear destruction of Android is unrealistic. Differentiation and independent innovation are, however, achievable at least to a significant extent, as Apple's litigation with Samsung shows, even though it's still in the early stages. Since its business model won't ever be more popular than Google's, it has to view this the way Ronald Reagan explained his Cold War strategy: "We win. They lose." But it obviously wouldn't want to tell this to the courts, or in public.

Consumer blowblack is a non-issue compared to what's at stake. There's also a risk of regulatory and political blowback.

In the antitrust context Apple benefits from its limited market share. It certainly doesn't have a dominant market position right now in smartphones and it's losing market share too rapidly in the tablet computer market to be considered dominant in that field. Any antitrust theory of an abuse of a dominant market position (through patent enforcement) would therefore face the challenge of defining a relevant product market. "Tablets with rounded corners" are not a relevant product market for the purposes of competition law because even if Apple had a monopoly on rounded corners, there's no reason why tablets can't have other corners. It would also be difficult to define multi-touch technologies as a relevant product market -- possible, but difficult, given that there are so many multi-touch solutions, including patented ones, out there besides what Apple has invented. Apple could defend itself pretty well against any antitrust challenge, and even if regulators imposed fines, it's doubtful whether they would be able to defend such a case in court.

Political intervention through new patent legislation is another scenario. Again, I'm not going to comment on particular political positions in this post, but it's a fact that there are certain calls and proposals for reform. I believe that patent troll lawsuits are a much bigger reason for those calls than Apple's patent enforcement against Android. But even if Apple had to fear that its own actions would allow others, such as Google, to convince politicians of radical reforms, it should just take its chances anyway. Last year's U.S. patent reform was the first one in about 50 years that Congress was able to agree upon. The next one probably won't take another 50 years, but these things take a lot of time, and certainly years, with the outcome usually being a compromise that won't change much. Even if it did change much, Apple would in the meantime have leveraged the current framework to the best of its abilities.

Are there signs of Apple softening its stance?

None of what I wrote above was meant to imply that Apple is getting soft on patents. There are only two recent events that raise the question of whether this is the case. One of them is the HTC deal, and I'll talk about it in more detail below. Too little is known about that deal to draw a conclusion.

The other one is Apple's correspondence with Google regarding arbitration. There are no unknowns about that one because the letters were filed with a court. Those letters are tactical. They're just about looking good in front of judges and regulators. The name of the game is that either party wants to appear constructive. Apple wants to defend itself against Google's standard-essential patent (SEP) assertions in court and would have a credibility problem if it came across as an unwilling licensee. Google wants to obtain injunctions against Apple, and it wants to avoid antitrust intervention, so it also has to pretend to be willing to solve the problem.

Apple's proposed parameters would ensure that arbitration wouldn't be disadvantageous for Apple compared to a regular federal lawsuit, but Apple wouldn't give up anything. Google's proposal isn't serious. Google would actually prefer that a German court set a worldwide FRAND rate, but if there's going to be U.S. arbitration, it wants "baseball arbitration" which would guarantee that the outcome would not be a FRAND rate either way. Depending on the parties' offers, the outcome could be way below FRAND, or way above FRAND -- pretty much a gamble. Apple's position is that it offers about $1 per device, and Google's (Motorola's) 2.25% position corresponds to more than ten times that amount. In baseball arbitration, it would be "either-or", instead of the actual FRAND rate. Just proposing baseball arbitration is a FRAND violation, at least philosophically, if not legally. By the way, in actual baseball arbitration involving non-free agents (meaning players that have to continue with their team), a team can't even offer too low a salary. But in a FRAND case, you would need a whole arbitration proceeding just to determine the minium amount the licensee would have to offer and the maximum amount the patent holder would be allowed to demand. It's ridiculous.

Maybe the parties will adjust their positions, especially Google, but for now the arbitration-related correspondence doesn't mean that anyone's getting soft.

The more complicated question is what the Apple-HTC deal means. As I said further above, licensing is the way forward, but there are three unknowns here: reasons, restrictions, royalties. In that order.

Even if Samsung's initiative brought to light some more information on the terms of the Apple-HTC deal, the most important part is actually not what they agreed upon but why Apple decided to let HTC off the hook instead of continuing with its lawsuits, which had been delayed but weren't lost. The decision has almost certainly been driven by a multiple considerations. If battle fatigue, concern about blowback etc. had played any role, Apple shareholders would have to be very concerned that the company isn't doing what it needs to be doing, which is to defend its crown jewels against copying and to engage in uncompromising rent-seeking based on the breakthrough innovations it brought to the world under Steve Jobs. I wish to repeat here that I'm not taking a position on what the reasons have probably been, but just going analytically over the various permutations and possibilities.

The reasons underlying Apple's decisions are more important then the terms since the HTC deal could have been driven by unique factors. Simply put, if the reason was primarily that HTC is no longer a priority target, that wouldn't apply to the Samsung case or the dispute with Google's Motorola Mobility. Another possible factor is that the deal with HTC drives a wedge into the Android ecosystem and could make sense as part of a broader divide-and-conquer strategy. But someone who buys an HTC phone now is more likely to buy a Samsung product than an Apple product in the future -- it's all about the competing ecosystems.

The second unknown R: restrictions. This is precisely why Samsung wants Apple to lay the cards on the table and show the HTC agreement to the court. A deal with a low royalty rate but far-reaching restrictions would be much more valuable to Apple than a deal with a high royalty rate and no restrictions.

The third R: royalties. This is a distant third if the amount is limited. The lifetime value of a customer to Apple is in the many hundreds if not thousands of dollars, and no one would pay Apple a royalty that really offsets the cost of losing a potential or actual iOS user to the Android ecosystem. Even a limited amount can help Apple to fight price erosion. There is speculation that HTC is paying $6-$8 per unit. I have no idea if the number is right, but if it is, then the amount is meaningless in strategic terms. It's not an amount that really solves Apple's problems in competing with Android. Patent licensing costs could be a challenge to the Android ecosystem, but there's only a limited number of patent holders that will collect per-unit royalties. Smaller patent holders will content themselves with a lump-sum payment. Many patent lawsuits are nuisance lawsuits, brought only in hopes of settling for a price below the cost of a proper defense. Obviously, major operating companies would want a running royalty of some kind (percentage or fixed amount), but there aren't too many companies of that kind. I believe Nokia is in a good position to collect per-unit royalties from Android device makers just like it's already getting paid by Apple. Any rumors relating to Microsoft's patent deals also suggest that licensees pay a per-unit royalty. There may be a few other right holders who will go for such deals, but no one stands more to lose from Android than Apple, and that's why Apple needs to be particularly demanding.

I really don't want to take a position on the probabilities of different scenarios. Some more information may become available. I just wanted to outline the criteria by which to judge such information if and when it does become available -- or the conclusions that could be drawn from one's own assumptions of what the Apple-HTC deal is like and why it was done.

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