Operations Strategy of Apple Inc.

Already, we can see Tim Cook is changing Apple.  In contrast to Jobs’ rare

appearance before the press and analysts, Cook took the opportunity to discuss

Apple’s business strategy at the recent Goldman Sachs’ Technology Conference.

When questioned about the future of the iPhone, Apple’s largest revenue stream,

Cook underscored that smartphones only represent 9% of the global handset market

and even within smartphones, 3 out of 4 customers bought something other than

Apple.

Apple manufacturing partners and practices have also come into the spotlight

following the unprecedented disclosure of their supply chain partner audit combined

with the hiring of a third party employment practices review agency.  Most recently,

Apple invited ABC Nightline into their primary supplier Foxconn.  In

increasing increments, Cook is making Apple more accessible.

In the past, his operational expertise has been a perfect counter to Jobs’ legendary

product instincts and will serve Apple this year.  What we won’t learn in 2012 is

whether Cook can plant the seeds for a new platform in the years beyond.  It’s a no-

brainer to assume Apple Labs is cooking away.  There just won’t be much evidence

in 2012.

What we can expect is that Apple will continue to get paid for the integrated

value they deliver.  Apple products initially cost more than most competitors.  They

win by tightly integrating hardware and software for a superior user experience. 

Many would argue Apple’s integration provides a lower aggregate cost as well.

Apple 2012

2012 will be dominated by the following four themes, all targeted at cementing users

and developers into Apple’s lush, walled garden of peerless user experience:

1. Scaling all operations (manufacturing, retail, Internet) to meet global demand

2. Rapid expansion in China and developing economies

3. New product form factor:  Apple TV

4. Apple’s iCash Mountain Problem

1. Scaling:  Flawlessly Synchronizing Billions of Transactions

With revenue greater than $46B in the fourth calendar quarter of 2011, any

conversation about Apple strategy has to begin with the challenges of scale.  The

iPhone and iPad have plenty of runway left for growth as does Apple retail, but as

numbers grow, so do the consequences of the smallest hiccup.

Meeting demand for hundreds of millions of annual units requires flawless execution

across the supply chain, distribution and with their manufacturing partners.   We’ve

become so accustomed to high tech products that it’s easy to forget what a shortage

of a single component can do.  When floods struck Thailand last fall, it disrupted disk

drive supplies for nearly six months.

Last year, Apple sold 156 million IOS-based devices (iPhone, iPad and iTouch) which

is more than the 122 million Macs sold since its 1984 introduction.  In Tim Cook’s

own words, “the trajectory is off the charts.”

Geometric growth plays to Cook’s strengths.  In fact, if there’s a hallmark to Apple’s

business strategy in 2012, it begins with leveraging his unique competencies.

2. China…and other developing countries

Any conversation about scaling quickly turns to Apple’s China opportunity.  Focusing

just on iPhone, Apple currently sells it exclusively through China Unicom (196 million

subscribers).  This is slightly less than the combined subscriber base of Verizon

Wireless and AT&T.  But in a country of billions, it doesn’t compare to China Mobile’s

616 million subscribers. It’s no surprise that Cook visited China Mobile this past June.

As important as Apple’s innovation machine has been for the developed world, 2012

success in China and emerging economies will be fed by incremental product

improvements.  They may be combined with creative cost and/or pricing strategies

that subsidize purchasing much like Verizon and AT&T has for U.S. iPhone

customers.  With rapidly growing middle classes, one might consider market access

more important in the developing world than ground-breaking innovation.

And the above doesn’t account for iPad or iTouch.  Apple’s Asia Pacific sales (minus

Japan) grew approximately 200% last year and account for 20% of Apple’s total

revenue.  Add in an expanded global retail presence and there’s not much that

stands in the way of superior revenue growth in 2012.

3. Next Platform Form Factor:  Apple TV

The speculation regarding an Apple “next generation television” has evolved

significantly.  According to Cook, the current Apple TV hockey puck has been a

“hobby” product.  Shortly before his death, Steve Jobs told biographer Walter

Isaacson that he had finally figured out TV.  True or false, there are several reasons

why flat screen TV’s make sense for Apple:

1. Market size & headroom for premium pricing: The global market for flat screen

displays is over 77 million units and grew 15% last year.  Apple needs large

markets like this to move the needle even if they only appeal to the high end of

the market.

2. Platform expansion via form factor: Just as the iPad is essentially a larger iPhone,

an Apple flat screen will enlarge the form factor again.  It will leverage

technologies such as Siri for a new control interface.  Facetime will evolve into

home video conferencing, likely enhanced by motion sensing technology that

automatically follows action. As connection speeds improve, iCloud based

recording (currently limited by upload speeds) and playback (available today) will

be incorporated.

3. Apple ecosystem lock-in: Just as Frito-Lay thinks about the “share of stomach” it

captures with drinks and snack foods, Apple seeks “share of screens” be it on

Mac, iPod, iPhone or iPad.  Just as salty snacks drive you to drink more soda,

Apple TV will leverage device interoperability via iCloud.  Apple TV widens the

moat that keeps competitors away while fertilizing the soil in land of Apple.

4. Innovation Bluebird: Borrowing from Donald Rumsfield, the biggest unknowable

that we know today is that Apple’s legions of independent apps developers will

provide something surprising.  The causal gaming phenomena of Angry Birds

didn’t exist before mobile apps. TV will offer a new and much larger landscape in

which to play.

5. Hardware opportunity: As important as iTunes, mobile advertising and iCloud

may be in Apple’s future, they currently constitute a thin sliver of overall revenue

and profits.  For now, the route to growth remains hardware.

But Apple TV will face challenges.  First are the flat screen incumbents.  LG,

Samsung and Visio have not been sleeping and will quickly counter Apple’s moves at

lower price points.  They will most likely scale Google’s Android interface; perhaps a

long shot might be Microsoft.  Assuming Apple pushes Facetime as a family video

conferencing play, you can bet that competitors will counter with a similar feature

based on Google Voice or Microsoft’s Skype and Kinect technology.

The second and more troublesome foe will be current content producers and

distributors.  After watching Apple iTunes disrupt music distribution, pricing and

margins, movie and TV studios as well as cable, satellite and phone companies will

be very wary.  If you need evidence of their strength, just look at Neflix’s recent

struggles (see Netflix at a Crossroad).

Can Apple drive the same disruption through television that they did in mobile

phones?  Without question, Apple will make good money but we won’t know if it’s

only a good business or a more serious disruption in 2012.

4. Apple’s iCash Mountain Problem

Do you recall the mountain of cash Donald Duck’s rich uncle Scrooge McDuck

possessed?   Tim Cook has a $100B mountain and it’s rapidly growing.  Far beyond

what’s needed for a rainy day, Cook cannot continue to ignore it.

Declaring a special dividend to return some to stockholders is simple but hardly

strategic.  Technology acquisitions like the 2008 acquisition of P.A. Semi which

brought the iPad’s ARM processor in-house will continue, but they don’t dent the

bank.

The current maelstrom of patent lawsuits in the mobile space suggests that Apple

will ultimately use some to settle issues much as Google did with its acquisition of

Motorola Mobility.

Similarly some will go to addressing market expansion issues such as the current

licensing spat between Apple and China’s Proview regarding use of the iPad trade

name in China.  Or Apple could follow Amazon’s Kindle strategy and subsidize

hardware pricing to lower entry price.

The problem is none of these strategies drain more cash than is coming in. The

obvious next question is what if Apple pursued a large acquisition?  This raises three

significant challenges, at a minimum:

1. Regulatory:  As the most valuable company on earth, regulators in all

geographies would scrutinize any deal for monopoly concerns.  It’s hard to think

of a large technology acquisition that wouldn’t cause concern.

2. Cultural fit: Strong cultures exclude rather than include.  Add in Apple’s penchant

for secrecy and try to name an asset of scale that would naturally fit in the Apple

world.  I can’t.

3. Assimilation capability: Companies such as Cisco that have a track record of

acquiring and assimilating large entities; Apple has never done so.  Starting with

a big bite would be challenging.

Having said this, Apple could acquire an infrastructure capability outside of

traditional tech that enriched the breadth of Apple’s ecosystem.  For example, what

if Apple acquired a financial services player?   Blend Apple’s mobility

hardware/software, advertising and iTunes to offer an electronic wallet with Apple’s

legendary ease of use?

Apple could buy a “no-name” bank and quietly use their existing financial

infrastructure to leverage its 200 million iTunes customers and software expertise

into an Apple iWallet.  In the midrange, they could look at Intuit ($17B market

capitalization) though that might raise regulatory flags.  Alternatively, they could go

big, buy Mastercard ($50B market capitalization).

Stepping outside the technology arena would reduce regulatory monopoly concerns

while leveraging Apple’s technology, branding and retail expertise.  Going big

doesn’t directly address the cultural fit and assimilation issues but neither does it

require much in the near term.  Mastercard is a well-run, growing firm.

Please take above for what it is: an example to illustrate a strategic choice versus a

fully vetted alternative.

This graph originally appeared in a Bernstein analysts report on Apple and was included in a Fortune blog post (Is Apple suing Samsung — and tooling up its factories?, Nov 15). As you can see, Apple has been dramatically increasing its capital expenditures, particularly outside of retailing. For 2012, they are expected to spend north of $7 billion on top of what they spend on their retail arm. Note that this is very much in line with what we discussed in our previous post on Apple’s operations. They bet big on technology that lets them have distinctive products. With their limited product line and high volume, they can make commitments that other tech firms may shy away from. It also means that (if they are right) other firms are going to be hard pressed to catch up if Apple has locked up a large amount of supplier capacity.

Summary

Apple’s business strategy 2012 has three elements:

1. Leveraging momentum with scale

2. Expanding the walled garden geography and IOS foundation

3. Investing in new directions:  new product platform innovation and cash

If we were playing poker, the first two elements are cards that are face up.  The third

is not.  And that’s the bet we’re waiting to see.

Srikant Patra

B309051

EEE(8th Sem)