This post is long, so I have listed the main points below:
- The inevitability of losing market share on its device jeaopardize Apple's main future asset – the popularity of its iTunes service
- Apple and Steve Jobs are masters in "hype management"
- Most innovative companies go through what I call a Hype Cycle, as they have many high risk ideas which they try to push through to a market that does not accept it at first. The "break-through" nature of such a product or service is so surprising to everyone that the company who does it commands a premium, until competitors and imitators can catch up, and consumers become less awestruck
- A Hype Cycle consists of four stages:
- Reflection: Bottom of the cycle, relatively quiet, and a non factor. The most profitable use of time for an innovator as they are filled with both a desire to succeed and time to really think about the best way to do it.
- Buzz: Idea(s) begin to get popular amongst loyal customers and industry insiders. The "Old Guard" starts to take notice, but usually does nothing
- Excitement: The Buzz turns to genuine excitement as the product or idea goes mainstream overnight. Like Google, Nintendo, and iPod – it becomes the standard by which its competitors will be based upon – both in English language terms and in market terms
- (Pre/Post Hype): Pre Hype is when a company must deal with the pressure of doing it again along with being the farthest most profitable phase – Reflection. It is usually before a new product or upgrade and usually is very anticipated and very disappointing. Resulting in Post Hype – where you are ridiculed on your way down towards reflection to start again. Sometimes a great innovator can overdeliver and go back to the Excitement phase, but with every trip back, disappointment becomes more and more inevitable.
- Apple saw this happen back in the early days and understands it.
- Big breakthrough events generally come with very little hype, and the iPhone has plenty
- Therefore Apple is using the Hype they are getting to mask the early Buzz on Apple TV (in some form) and establish a relationship AT&T for this. They are in effect liquidating their hype – which really has no value as it is just price inflation, and using it to make its competitors stick around and try to compete, while Apple maintains its hold as a media outlet in the future and gets a head start w/ AT&T on the Apple TV
The iPhone will appear to be a glorious failure on most accounts. But before I go any further let me say, I believe that Apple is a great company and I am not just being my usual negative self. More so, I think that they not only have no other choice, but they will benefit more through failure than through success. I also will disclose upfront that I own Apple and so do my clients (at a very low cost basis at that). Unlike, some of the iPhone haters (mostly admirers) who have been all over the financial porn network these past few weeks, I know Apple. I had an Apple Computer when Apple's were not cool or very good - growing up and learning to use a computer on one. I also bought an iPod when nobody else had one - and it doesn't look like the one you have. I am not saying this to brag but to show that I understand the way they operate. I am not the foremost expert, but I know more than many people who love to talk about Apple these days. I know that that may not translate into anything that is meaningful, but they are just as likely to be wrong. Owning a Mac during the beginning stages of the internet was akin to buying a Sega Saturn and then having Playstation come out. The lack of software and hardware left me with nothing else to do but get to know the little guy. My, how it has grown.
That being said, the last electronics purchase I made was a Sandisk Sansa. I love my iPod, and the two hours of battery life I still have left was not the reason I made the purchase. Instead, it was because I fell in love with another old friend - a little program called Napster. As an avid music fan, the $50 dollar a month that Napster gives me the opportunity to save as well as the privilege to explore 2.9 million songs makes the iTunes look like a rip-off - and in fact that is what it is. However, it is not just cost alone that has me staring at that little cat in the headphones instead of a partly chewed piece of fruit when I listen to my music (Good to have you back pal). Napster is a better platform than iTunes and Apple, not to mention the fact that the Sansa is no better, no worse than an iPod and much more affordable. Apple will lose all of its iTunes revenue it does not compete on price, or find away to give music away for free. If you have noticed, I appear to be getting off course from the iPhone - it is not me simply rambling again - it is intentional. Apple's success as the runaway EPS growth train that could depends on the eventual earnings they will receive from iTunes and its derivatives of media outlets. The iPhone is their means of accomplishing this.
Obvious right? Apple completely redefines itself (as it has done many times prior) with a new device and go after to the likes of Nokia, Verizon, and Motorola as they did with Sony and Microsoft, breaking down industry norms and earning a nice chunk of change along the way. They will do that, but not with this device or with this industry. This is instead a tactic to strategically position themselves for their next big thing - Apple TV. The genius of it all will soon be revealed I will proceed to show why I believe the iPhone will flop, why it doesn't matter, and how Apple plans on being in your living room smiling after it is all done.
The Hype Cycle and the iPhone
Apple and Steve Jobs have always been artful at creating hype - whether it be a cinematic Super-Bowl Ad reminiscent of "2001: A Space Odyssey", or their brilliant means of keeping the iPod appearing fresh for years - when it never really changed much at all after it really took off. They understand that they have a very young, wealthy, hip, and more importantly loyal base of consumers and they orchestrated some of the most brilliant marketing campaigns of this century. What they are doing with the iPhone is no different, if not more brilliant. If it all goes right, they will come out of the businesses' most disappointing product launch ever (in line with their own Apple Newton, the Motorola Rockr, and Microsoft's Windows 98 - XP) relatively unscathed and in the position to try for the next big thing. This is because they understand the concept I call "Hype Cycles".
Great innovators like Apple, who have to compete in a global creative economy usually, go through Hype Cycles. The products and ideas they introduce usually break down barriers. These cycles are first deemed worthless by the mainstream, then shrugged off during their early rise to speculation, but eventually explode into a new phenomenon seemingly overnight- at which point imitators come in to take eat away at their returns. Due to the impossibility of predicting future cash flows innovative firms invest spend their capital on projects that pretty much MUST have a much lower IRR (%) than business as usual in some cases negative. In turn sometimes they essentially invest capital in an overvalued idea when they should sell it, because by the "rules" of corporate finance that would be a very stupid thing to do. Most innovators will make that mistake and are lucky enough to live to see another cycle. They usually don't do it twice.
A Hype Cycle goes through four distinct phases: Reflection, Buzz, Excitement, Hype (Pre/Post). Usually, when an idea is new, it is a quiet period where the company is essentially a non-entity in the business - either because they are new or they have fallen so far from grace. During this time they are spending tons of money on R&D, and investing their capital in few very risky ideas with great conviction and attempting flawless execution. I call this the "Reflection" phase. It is the bottom of the cycle, where the quality and dept of ideas are very valuable. A company knows that they must innovate in order to survive and that it is essentially "do or die" - especially for the CEO. If they do indeed begin to take off, then the next period is the "Buzz" phase. Their investment is beginning to take off and they are beginning to generate some chatter. This is usually fueled by product loyalists and people who are somewhat trendy. This period is usually somewhat brief because Buzz travels fast and is quickly converted into "Excitement".
The Excitement Phase comes right around the peak of the cycle. Companies who caught on during the buzz stage are beginning to come out with products on some wide scale and the company's product becomes a household name or even a vocabulary word. During the excitement phase, "Google" became search the web, "Nintendo" became video game system, and "iPod" an mp3 player. Depending on the nature of the business and product being sold, this time period could be somewhat extended as they are earning profits and the product is so fresh, it still has some shelf life to go. During this period the company becomes the fixture of the industry involved if not of ALL industry in general. Due to the unbelievable success they have realized, they are put under enormous pressure to continue - by both their costumers and by competitors/imitators. In turn, they must walk a very fine line as not to allow the imitators to capture the excitement and profits, but still woo the market who has deified them as the next [Insert Last Big Company to be in the same shoes].
Once they are faced with increased pressure they have entered the "Hype" period of the cycle. This period should contain as the peak, but also a sharp part of the downside. Usually, it is defined by enormous expectations and inevitable disappointment. Hype can work a company on the way up and against on the way down, creating Pre Hype and Post Hype. Pre Hype is usually very positive and Post Hype quite negative. It is essential expectation and disappointment. It is usually consists of a huge run and a larger fall as a result of the company being talked up by those who didn't really know it and down by those who did not as well. If it is truly a great innovator, those who understand the company will not be telling you to load up before a major product rollout/rollover as this and most certainly won't tell you to sell after it dropped because it was being artificially inflated by hype. Companies can stay mid phase for a few events and releases, however. Good innovators, such as Apple, can actually deliver during one or two Hype phases causing them to temporarily avoid meltdown but creating another Excitement and Pre Hype Period. Every renewal of Excitement is accompanied by rampant inflation expectations of their earnings from their existing business- "resulting in "too much hype". Rarely does a company survive the second time around without scars. The growth has left them without an ability to think through another Reflection Period - coincidentally the one thing they need most. The idea has no more intellectual equity left and they are forced to spend great amounts in marketing in order to inflate the hype - devaluing their product or idea further until reversal is almost guaranteed. They burn a ton of cash in efforts to protect the idea than in just allowing nature to run its course and going out to find another one.
At this point Apple finds itself it that position in regards to portable music. They were able to reinvent their product enough during the Excitement Phase and use iTunes as both leverage and a revenue source in order to prevent the idea and "iPod" brand into becoming what it is an mp3 player. I had a Sony Walkman when that first came out, but never remember having to have a Walkman after a while. A Panasonic or something of equal quality was more than sufficient. There are many mp3 players out there on the market and quite frankly as a whole they very competitive if not more so. Microsoft's Zune Player is supposed to be amazing, and Samsung and Creative Labs have come up with the same thing. At the very beginning, the iPod was innovative because of its functionality and practicality. The first iPod was not the object of superior design and beautiful simplicity that the later models were. Then they innovated with smaller iPods and video iPods with the competitors always one or two steps behind. Since no steps have occurred the last 1.5 years, the competitors have caught up on everything but brand recognition, and in my opinion, Apple does not exhibit significantly higher hardware quality than Microsoft, Sandisk, and Samsung - who are all great companies as well. My Sandisk Sansa looks just like a Nano and Apple can no longer design its way to differentiation without sacrificing simplicity.
Therefore the only advantage Apple has is that all those people who have iPods can't get there music anywhere else at a cheaper price than on iTunes. They know that they have commanded a premium for years because of this artificially creating a market for something that should not really even exist as a service. Music is commodity in its simplest form, and many of the people who are paying $1 a song on iTunes used to be charged nothing by one of iTunes's biggest competitors, Napster, who by the way is starting to generate some "buzz". On top of that, Sansa recently came out with a portable that downloads music through its Wi-Fi capability off of Yahoo Music Service - also $15 a month. Microsoft Zune has Wi-Fi "sharing" capabilities and on its second generation, plans to turn it into a "iTunes meets Napster" where users can purchase music online or on the go and share it with others as well - especially when coupled with rumors that Google may buy out Napster and the usual Microsoft and Yahoo rumors. Sirius and XM have also put out portable versions of their radio players where users can record live radio and download songs they like for a price. This brings us to the last group moving in on Apple's music business - the cellular phone companies. The LG chocolate offered by Verizon and many other phones now come as an mp3 player where people download music from their services for prices in line with Apple.
All this does not appear to bode well for Jobs and company. Last time Apple was in this position, they went down the wrong path. When Apple was a budding young computer company, they did not foresee the fact that the machine would be commoditized, but the software was essentially service with high barriers to entry and the source for growth. Microsoft took the other side of that trade, and both Apple and IBM shared the pain. In turn, Apple's failed (albeit brilliant) attempt to introduce a PDA ten years before its time with, when Palm was still just a restaurant on 2nd avenue to those on Wall Street, showed they understood this concept and the ideas of portable computing. They held on to that insight, waited for Microsoft cease innovating (some will say it never innovated in the first place but Office is great and Office 2007 is surprisingly excellent) and parlayed the idea into a major payday.
Nintendo journeyed down the same path. Their mistake to believe that the kids they designed the NES, Gameboy, and SNES for in the late 80's and early 90's would be an identical market in the 1990's and 2000's. They went on to design cartoony, childish, but enjoyable games and found themselves with a very active, but niche market and increasingly upped their bets with the Nintendo DS - an odd portable with some success, and now have won many of them back with their Wii - transitioning from a Buzz into a major Excitement Phase. All the while its competitors have been in an extended Hype period and went complex instead of simple. The first day of their simultaneous release, you could not find an Xbox 360 anywhere, but Wii's were plentiful, as video game fans who wanted to get the Xbox could not, and upon hearing some buzz on Nintendo's "new" controller decided to give the simpler, more competitive priced product a chance. You now can not find a Wii anywhere but X-Box's and PS3's are plentiful. In that an important lesson can be learned. A company can not get caught up in its own hype, because usually it has competitors beginning to generate some buzz - as Apple is seeing now.
If a company goes through this product Hype cycle which I contend most innovative companies do, they eventually come back home - the Reflection Phase, where they, well, Reflect. A company like Apple, or Nintendo is conscious of what happens and why. They have thought about their failures extensively and swore not to let it happen again. They know that while disappointment is inevitable, it does not have to be permanent or even last another product cycle - especially a company like Apple with many different products and businesses. Instead, they embrace the ultimate failure, and USE the hype and the market to their advantage. They seize this opportunity to liquidate their idea or innovation, monetize whatever value is still left in it and use the proceeds to go ahead with the new ones when they still have a large market capitalization. In essence it allows them to operate perpetual state of Reflection, annuitizing their product launches into periods of buzz and increasing the possibility that they will have something in the pipeline for when the next idea is no longer generating earnings. An innovative company is much more valuable when it is thinking than when is doing. If a company like Apple is doing too much, they are losing money - even if they are earning it. They in turn use the Hype of the old product to mask the buzz on the next product as much as possible, as they are a huge target for competitors. An innovator usually has tons of goodwill on its balance sheet, as it invests heavily in Intellectual Property through R&D Expense. This goodwill accrues during the early phases and is hopefully realized during the later phases. Therefore as they start to eat way at the goodwill from one idea, they should begin no a new idea - but make the market believe that they are gung ho on the first. This gives competitors the illusion of market cap that can be captured, but usually a Competitor is so focused on that, they don't realize that the market cap is eventually akin to a buying a put on Apples stock, when you try to get in and then see it slowly drift further and further out of the money.
This brings us to the i-Bluff. A good innovator knows the unpredictability of innovation, and in today's economy, the pursuit of innovative brilliance is much like a fixed limit poker game. When you have been playing your best hands all night and are the biggest stack at the table with a decent amount of people still playing, the longer you play, the more likely you will probably exhibit a return to the mean and quite possibly beyond. Your large stake allows you to muscle some people out of the hand and earn a little more money over time. If you stay around, you're bound to be caught in a bluff as the players wise up, or get lucky, as you start to lose. Your attempts to muscle become less and less apparent as people begin to wise up or get the money to stay on and see the turn and river cards - eventually outdrawing your 4 7 off-suit. This can sometimes put you on "tilt" resulting in stupid bets you otherwise wouldn't make. (Those who have played cards have had this happen to them numerous times and it never ends up well).
Therefore you are faced with two decisions, to keep playing or get up, and if you keep playing - when do you stop? If you get up right away, then you may lose out on a couple more hands that you can get out due to the substantial chip count you have accumulated and the last minute money it could bring. So what if you stay for 1,2,3... more hands. Well, if it was real poker, you would really be no better, no worse in the long run. But if you are Apple, your decision is clear. You decide to lay down one more big bluff - with the intentions of leaving immediately afterwards. You lay it down when your chip total is high and the table's desire and ability to call your bluff is at a low - since you've proved them wrong every time prior. Then you get out, take your profits, and let them play out the rest of the night. The best part of it all is, if you are Apple, and playing at a table with numerous good players - you want to leave early as possible and keep them playing as long as possible. Therefore not only can you afford to make a huge bluff since you have more than double the stack, before you make that bet, you know that the any money in their hands should give them a false sense of victory that what they are doing is the going to benefit them long run and prolong the game - but you know the longer they play the more they should come out even, but still down compared to you. So instead you take their money and leave them to fight over what, they will find to be nothing.
Before leaving the casino, Apple, instead sits down at a blackjack and plays a few hands with some other big shots - Time Warner and Cablevision. Fortunately, the dealer is AT&T, and Apple begins hitting blackjack like crazy. It's no surprise because they are in cahoots. After all, AT&T is getting a great deal by Apple DECIDING to roll out the iPhone there. Apple essentially monetizes its otherwise worthless hype into plenty of 2 year+ contracts for Cingular, which is owned by AT&T. By indirectly selling the hype to AT&T, Apple is takes a risk free move into the Cable world. This is because over the last few years, AT&T has been making a huge push towards the confluence of internet, TV, and Telephones. They have been laying wire and buying companies. Something tells me that the little Apple TV box is a diversion – put out to lead any competitors in the wrong direction, like those who make set top boxes. After playing media through the Nintendo Wii, and hearing about the poor quality of the Apple TV, the idea of Apple TV as it will be know being that little stupid cheap box will sound absurd and stupid – and that is their intention. Apple is getting into the cable business with AT&T, who up until now has not been in the business either, and needs something to get in and get in big. Apple will probably design a cable box that they run, organizing all types of media to go through their iTunes (or i-Tube?) Service and AT&T will pay it to do that. In turn, they will offer their music and television media for a subscription value much less than the $100 going rate – bringing a tone of business in to AT&T, who is happy to have it. Now the dumb idea of the video iPod makes sense - start the relationship with the broadcasters before anyone else gets involved, and use a product that is not going to last much longer as a means to test it out. Then, while everyone is looking the other way, liquidate the brand through putting out a phone - and get a head start on the next step of online media. Brilliant.
I wouldn't be surprised if they have an ace up their sleeve – possibly a video game system.