Why Apple "Outsources" Applications and Services

I believe Apple's business model is based on hardware profits, rather than profits from apps and services, because expensive hardware creation and the accompanying creation of Apple's OS and iOS are uniquely suited to the resources and capabilities of a large, well-funded company. 

Unlike hardware, the creation of apps and services doesn't normally require large capital outlays. And the best apps don't come from just one company or person -- they come from thousands of highly creative developers working alone or for small developer companies. Rather than compete against a large mass of highly creative developers -- by hypothetically trying to sell profitable, proprietary apps -- Apple instead offers its own apps/services at breakeven and allows developers to capture the profits from apps and services (with the possible exception of Beats Music, which Apple just purchased). This approach allows Apple to embrace and benefit from the creative efforts of thousands of developers -- creative efforts which Apple could not match in-house. It also allows Apple to embrace large, best-in-class service providers like Facebook, Twitter, and Google (to the mutual benefit of the service providers and Apple). When Apple feels it needs more control over an important service to enhance integration, ease of use, and the end user's experience, it takes steps to make the service proprietary (e.g., Apple Maps and Beats Music).

This may ultimately be the problem with Xiaomi's business model -- by relying on profitable apps and services rather than profitable hardware, Xiaomi makes the development of proprietary in-house apps/services the priority, when this kind of work should logically be outsourced to thousands of creative developers. Rather than embracing independent developers so that it can offer end users creative, best-in-class apps and services, Xiaomi puts itself in direct competition with developers.

The author owns stock shares of Apple. 

Acquisition Rationales from "The Outsiders"

Just a short post based on a book I'm currently reading called The Outsiders, by William Thorndike. The book discusses capital allocation processes followed by some of the greatest CEO's, including Warren Buffett and John Malone. The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012). Based on Chapter 9 of the book, titled "Radical Rationality," a good way to look at Apple's prospective Beats acquisition is whether proprietary Beats Music streaming will: (1) enhance the customer experience; and (2) help Apple defend its long term competitive position.

The answer to these two questions appears to be yes. A high quality, curated music streaming service will enhance the average user's experience, especially given Apple's ability to integrate streaming into iOS/OS across all Apple devices.

Apple also needs high quality music streaming to defend its long term competitive position as a leading distributor of music content. iTunes music, and downloaded music ownership, is not the long term future in a world of fast, ubiquitous broadband service. Fast broadband makes music streaming far easier and more convenient than music downloads (leading to much more efficient music discovery and acquisition), and these advantages should drive ubiquitous music streaming.

A proprietary or well-integrated streaming service also enhances the unique, differentiated nature of Apple's ecosystem, thereby reducing two of Michael Porter's five forces, rivalry and buyer power. A Beats acquisition therefore appears to make good strategic sense.

The author owns stock shares of Apple.

M&A, Apple and Beats, and the Downsides of Asymmetric Competition

Christensen's Thoughts on M&A Clayton Christensen says the main reasons to do an acquisition are: 

(1) acquiring resources that permit a company to meaningfully differentiate a product and thereby increase price; 

(2) acquiring resources to increase scale and efficiency, so that costs can be distributed over more customers or more resources (e.g., acquiring an adjacent oil field so that existing fixed assets/costs can be utilized with two fields instead of just one, or buying a company to acquire customers in the same geographic area so that fixed shipping assets/costs can be distributed over a larger customer base); and

(3) acquiring a simpler, more affordable business model, and then operating the new model as a separate company (with the expectation of significant future growth and future upmarket product moves). See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011); also see Concepts page and list of sources and recommended reading.

With resource-based acquisitions (reasons one and two), the acquired company's resources are integrated into the acquiring company’s existing operations. In the course of integration the processes and priorities of the acquired company typically disappear. 

With a business model-based acquisition (reason three), Christensen says the acquired company should generally be operated as a separate entity from the acquiring company. Otherwise the acquiring company can end up destroying the processes and priorities that make the acquired company’s disruptive business model unique and profitable.

Christensen says the most compelling reason for an acquisition is the opportunity to pursue a new business model, which can often be a source of tremendous future growth for the acquiring company. Resource-based acquisitions can produce a one time bump in profitability, but are usually not long term sources of future growth. 

Christensen says that companies often overpay for resource-based acquisitions, but that companies should be looking for, and paying more for, opportunities to acquire new business models. Because of growth prospects, new business model acquisitions are worth far more than the typical resource-based acquisition. See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011).

Apple and Beats

Apple’s prospective acquisition of Beats seems both resource-based and business model-based. This kind of acquisition would give Apple new resources in the form of Beats Music and Beats headphones, including algorithmic search, human curation, contracts and relationships with the music industry, headphone design/engineering/manufacturing, and the Beats brand. 

Beats Music would also give Apple a new business model very different from iTunes, in the form of profit-based music subscription/streaming services. Apple makes iTunes and its other services available at close to break-even so it can sell highly profitable hardware. If Apple acquires Beats — or more specifically Beats Music -- it’s acquiring a profit-based music subscription/services model. 

If you apply Christensen’s recommendations, Apple should run Beats Music as a separate company to insure the survival of the processes/priorities that make Beats Music a unique, profitable business model. If Apple tries to integrate Beats Music into iTunes and makes it a break-even service (kind of like iTunes Radio), then Apple may derail the innovation and unique processes/priorities that make Beats Music a profitable service.* (see Addendum below).

Conversely, it should be fairly easy for Apple to integrate profitable Beats headphones, and headphone resources, into its existing business, possibly as a sub-brand. Beats headphones are just profitable hardware, which is identical to Apple’s business model of selling profitable hardware.

The Downsides of Asymmetric Competition

The prospective Beats acquisition highlights one of the fundamental downsides of asymmetric competition, where a company gives away one product at break-even to generate profitable sales from a related product (e.g., Amazon selling Kindle Fires to sell profitable electronic content, Apple giving away services to sell profitable hardware, Google giving away hardware to drive data collection and sell profitable ads). At some point the product or service being given away becomes pretty crappy/mediocre, despite the indirect benefits of driving profitable sales of a related service/product. 

With the Beats acquisition, Apple is: (1) addressing the weaknesses in a break-even iTunes product and (2) taking advantage of technological improvements in music discovery, curation, and streaming (faster broadband, expert curation, the future possibility of high quality streaming audio, etc.). The Beats acquisition allows Apple to "catch up" in music services. But the underlying reason Apple has to catch up is because break-even, asymmetric products/services like iTunes often trend toward mediocrity over time, especially relative to products from motivated competitors who are trying to create simpler, profit-based alternatives (like Beats Music).

Some of Apple's services have become mediocre or overly complex/cumbersome — iTunes especially -- because profits aren’t needed for the service to survive. Apple’s hardware provides the profits needed to sustain iTunes. For Apple this is often a strength: Apple is famous for a functional structure rather than a product division structure, meaning the company has "one P&L" and can offer proprietary, break-even services to increase the profitability and "stickiness" of Apple's hardware and overall ecosystem. The downside is that there’s no direct incentive to make meaningful upmarket improvements to break-even services/products, since the whole point of an upmarket improvement is to improve profit margins. See Concepts page and discussion of Clayton Christensen. When the product or service is an asymmetric giveaway, profits aren’t critical and neither are improved profit margins.

Another downside of any asymmetric giveaway, regardless of enhanced ecosystem/product stickiness, is that the giveaway product tends to stagnate over time, since continued product innovation and improvement aren't needed for the product to survive. A company selling a profitable competing product is highly motivated to out-innovate a company giving its product away, and is also motivated to make upmarket product improvements that make the giveaway product an inferior or obsolete choice (as Beats Music is arguably doing to break-even iTunes, and as the iPad is arguably doing to the break-even Kindle Fire).

And this is what’s really interesting about Apple’s reported purchase of Beats and Beats Music. Beats Music is excellent — and improving -- because Beats must build a profitable user base to survive. If Apple successfully operates Beats Music as a separate, profitable service, it may start trying to generate profits from other Apple services. Apple may reduce the number of giveaways and start trying to create proprietary, profitable services that are really good and worthy of upmarket improvements. 

It makes sense for Apple to insist on a profitable service when a break-even service that was formerly good enough (like iTunes) becomes inferior or obsolete due to technological advances that permit a better solution to a job that needs done (in this case simple and convenient music discovery, curation, and streaming). 

When a break-even product/service is no longer good enough due to technological advances, a profit-based business model can help inspire the innovation and upmarket improvements needed to create a better, more competitive offering. By applying profit-based business models to hardware and services that have become inadequate, or aren't yet good enough, Apple can make its services as strong as its hardware.

* Addendum (added 5/21/2014): This article assumes Beats and Beats Music are profitable business models or will become profitable business models. Financial statements for Beats aren't publicly available, so there is no way of verifying this assumption.

The author owns stock shares of Apple.

Apple, Beats, and the Value of Curated Experiences

In a world of information and data overload, security problems, and privacy issues, curated experiences like the ones offered by Apple gain value over time -- first with the App Store and now possibly with Beats Music.

Jimmy Iovine, one of the founders of Beats, refers to algorithms as a "utility." The quality of Beats Music seems to prove the value of going beyond algorithms by adding expert curation. Compare the search results of Beats Music to those of Pandora or Spotify. Art collections are curated, and music is an art form. With Beats Music Apple may again be positioning itself at the intersection of technology and the liberal arts.

Expert curation also increases in value as the drive for advertising revenues adulterates the quality of algorithmic search.

Michael Porter notes that companies should compete to be unique rather than competing to be the best. See Concepts page and discussion of Michael Porter. If Apple consumates a deal with Beats, it will be competing to be different/unique through a proprietary, curated streaming service (Beats Music) that differentiates the iPhone from its competitors. For this reason Beats is worth more to Apple than it is to its co-founders, Dr. Dre and Jimmy Iovine, as a stand-alone company.

And mobile headphones, mobile sound quality, and music streaming/discovery/curation are still areas that aren't yet "good enough." Additionally, while there are various ways to measure sound, sound quality/appeal is ultimately subjective. This works in Apple's favor, allowing it to avoid product comparisons based on speeds and feeds -- Beats products are unlikely to ever overserve.

The author owns stock shares of Apple.