Thinking in Reverse

Google recently removed an ad blocker called Adblock Fast from the Google Play store. This product was designed to work with Samsung's mobile Internet browser, which operates on Samsung Android phones.

Apple permits ad blocking on iOS. Apple has also publicly announced its commitment to user privacy, stressing its efforts to keep user data on the iPhone rather than gathering this data in an Apple cloud database. Some worry that Apple's machine learning and AI efforts could suffer, since data can be better analyzed in the cloud than on the device itself. 

Google's recent ad blocking decision reveals the benefits of "thinking in reverse." Rather than looking at how Apple could be hurt by forgoing user data and permitting ad blocking, think about how Google could be hurt by an advertising business model that forces it to: (1) gather and deeply analyze user data; and (2) serve up ads that users can't block. Google's model may facilitate machine learning and AI while creating a permanent competitive disadvantage when it comes to ads.

The author owns stock shares of Apple.

Xiaomi and Apple

Background

As an Apple investor I think a lot about Xiaomi and whether it's a threat to Apple. Xiaomi's smartphones run MIUI, a forked version of Android. Google Play and Google services are banned in China, at least in large part. So in China MIUI works with: (1) Xiaomi's own services, including contacts, calendar, SMS, notes, photo album, etc., very similar to Apple and Google services; and (2) Xiaomi's own app/content store called Mi Market. Xiaomi services include a cloud storage/syncing service called Mi Cloud. Outside China Xiaomi smartphones come with Google services and the Google Play store pre-installed, per the Android license agreement. So outside China MIUI works with Google services and the Google Play store. Google's absence inside China, its presence outside China, and the mandates of the Android license agreement have effectively forced Xiaomi to adopt two strategies: vertical integration and proprietary services inside China and a more horizontal/modular approach outside China.

Michael Porter calls a company that tries to implement more than one strategy a "straddler," and that's what Xiaomi appears to be. The problem with straddling is that it makes it more difficult to create a unique set of activities with trade-offs and good fit across activities. Xiaomi is trying to improve its proprietary services, and its vertical integration inside China, at the same time it's expanding internationally with a modular approach that requires it to pre-install Google services and Google Play per the Android license agreement (this agreement apparently requires Android OEM's to pre-install Google services in international markets where Google services are available, like India). See post titled Acquisitions, Rivalry, and Strategic Trade-Offs. As a result, Xiaomi must ensure MIUI integrates well with its own proprietary services (inside China) and with Google services and Google Play (outside China).

Analysis

Some of Xiaomi's Chinese products bear a close resemblance to Apple products. China has more relaxed IP laws. This makes vertical integration easier, at least in terms of Xiaomi's in-house design and manufacturing. This kind of imitation is more difficult outside China, where IP laws are more stringent. One question is whether Xiaomi can develop the design capabilities needed to create useful products that sell well outside China, while still complying with international IP laws.

A lot of Xiaomi's China success is based on: (1) low price; (2) design similarities between its products and Apple's; and (3) a unique, proprietary ecosystem similar to Apple's. These three strengths go away, or are weakened, when Xiaomi tries to sell products internationally. When competing internationally, Xiaomi loses at least part of its low price advantage because it has to pay IP licensing fees. IP laws also make it more difficult for Xiaomi to sell Apple-like designs. And international pre-installs of Google Play and Google services make it more difficult for Xiaomi to market/sell a unique, vertically integrated ecosystem similar to Apple's. Outside China Xiaomi looks a bit like Samsung -- an Android player that uses pre-installed Google services/content and is stuck in the mid to low end market. Undifferentiated competitors stuck in the middle typically get squeezed by high end, differentiated vendors and by low cost, undifferentiated vendors. See Concepts page and discussion of Michael Porter.

For now it looks like Xiaomi is going to sell (1) vertically integrated, Apple-like products in China and (2) modular products with standard Google services internationally. This gives Xiaomi two activity sets to manage, with one set based on no Google services and a closed, proprietary ecosystem and one set based on Google services and a more open ecosystem.

These two approaches don't really complement each other, and they're driven by different priorities. In China, where Google services aren't pre-installed, Xiaomi can freely pursue vertical integration, focusing on improving its ecosystem and moving upmarket to compete with Apple. Xiaomi recently introduced some fairly expensive smartphones for the Chinese market.

Outside China Xiaomi won't be able to pursue a unique, closed ecosystem -- it will have to pre-install Google services per the Android license agreement. To the extent this agreement allows Xiaomi to install its own services, Xiaomi will have to compete with Google Play, slowing international consumer adoption of Xiaomi services.

For these reasons Xiaomi's outside China strategy/activities will have to focus on something other than differentiation through unique, vertically integrated products. The company may have to move downmarket internationally, driving down costs so it can sell mid to low end smartphones in places like India and Brazil. This puts Xiaomi in a strategic "straddle," trying to: (1) move upmarket with mid to high end products and a differentiated strategy in China (while ignoring international IP laws); and (2) move downmarket with low cost products and an undifferentiated strategy elsewhere (while following international IP laws). This seems like a tough challenge.

Xiaomi must also make MIUI function well inside and outside of China while avoiding any conflicts or customer confusion arising from Xiaomi's proprietary services and Google's pre-installed services.

China and non-China strategies could lead to one of two outcomes: (1) one or more Xiaomi products that attempt to satisfy both strategies -- something that's differentiated for China, like a typical mid to high end product, but still international IP compliant and low cost to make, and can therefore be sold in places like India and Brazil; or (2) two Xiaomi product lines, with one line focused on mid to high end differentiation in China and one line focused on low cost, international affordability. This second approach could lead to a very broad product line, making great product design more difficult.

Inconsistent strategies and/or too many products can make it hard to compete with focused competitors that have one uncompromised strategy centered around a limited number of products, clear priorities, unique activities, and great activity fit (e.g., Apple).

It's difficult to predict the future. It will be interesting to see how Xiaomi does.

The author owns stock shares of Apple.

Learning to Survive and When to Move Up and Down the Value Chain

Relevant Concepts from Christensen and Porter 

Clayton Christensen says incumbents can normally address sustaining product improvements, even product breakthroughs by new entrants, by simply co-opting or acquiring the entrant's business. See The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003). If a company is acquired only for its resources (people, products, technology, or market position) then it can be safely integrated into the acquiring company's business. Id. If a company is also acquired for its processes and values -- its ways of making decisions, getting things done in a timely and cost effective way, and company culture/priorities -- then it should be operated as a separate entity since integration may destroy the processes and priorities that make the company successful. Id.

Christensen also says it makes sense for a company to move to adjacent links of the value chain when the company's link becomes too commoditized or unprofitable. Christensen says companies should try and skate to where the money will be, or those chain links that aren't yet good enough and therefore aren't yet commoditized and low margin. Id.

Blending a little of Christensen with Michael Porter, Porter says companies should compete to be unique. See Concepts page and discussion of Michael Porter and post titled Acquisitions, Rivalry, and Strategic Trade-Offs. So Porter might say it makes sense to acquire an adjacent link of the value chain when the acquisition gives the company a more unique set of activities and improves activity fit, making the company's value chain link(s) more defensible and harder to duplicate.

Costs and Benefits of Value Chain Moves

It's important to consider the costs and benefits of any move to an adjacent value chain link. When a component manufacturer, for example, moves up the value chain and also starts assembling final products that incorporate the component, it may lose component business from the final assemblers who were previously its customers. This outcome is less likely if the component is priced attractively, but it's still a risk -- companies don't like helping or giving business to competitors. This is why Samsung has started losing some of Apple's semiconductor business. Samsung went from making smartphone semiconductors to also making smartphones, competing more and more directly with Apple, one of Samsung's semiconductor customers. Apple is now ordering more chip components from TSMC, which is a pure chip foundry. TSMC's willingness to stay squarely in place, in its component manufacturing value chain link, has become one of its key competitive advantages.

There's also the risk of a final assembler moving down the value chain and entering the component manufacturing business. This outcome is unlikely so long as the component business is lower margin -- and therefore less attractive -- than the final assembly business.

As this discussion illustrates, any time a company moves into new parts of the value chain it creates new rivals and new competitive pressures. This can make partnerships more difficult. It's easy for companies in different parts of the value chain to partner (e.g., Apple and TSMC). Partnering is more difficult when companies share one or more value chain links (e.g., Apple and Samsung).

When a company moves to an adjacent value chain link, it must consider the competitive response of companies in that adjacent link, and whether damage from this response outweighs the benefit of higher margins, more unique activities, and/or better activity fit.

I'd argue that component makers with low cost business structures are usually well-positioned to move up the value chain, even if it means they might lose business from final assemblers that buy their products. That's because a component maker moving up the chain, operating with a low cost business structure, has already experienced intense competition at the component level and is well-prepared to deal with competition from final assemblers, even if it means losing some component orders.

A component maker moving into a higher margin assembly business can also profitably sell the final product to end users at a lower price than unintegrated final assemblers. That's because the component maker can get the relevant part at cost, while the unintegrated final assembler must buy the part at a marked up price from a separate supplier. This phenomenon gives component makers moving into final assembly a pricing advantage -- their cost of goods sold is lower, meaning they can sell the final assembled product at a lower, more competitive price.

Acquiring at an Attractive Price

From an investing perspective, one powerful rationale for making an investment (or acquisition) is when the upside is large and the downside is small, or what investor Mohnish Pabrai calls "heads I win, tails I don't lose very much." See The Dhando Investor, by Mohnish Pabrai (John Wiley & Sons, Inc., 2007). Pabrai believes the markets often undervalue businesses with uncertain future outcomes. For this reason he looks for businesses with:

(1) high uncertainty in terms of possible future outcomes (which often creates an undervalued situation);

(2) high returns if things go well; and

(3) minimal losses if things go poorly.

Id. Pabrai especially likes businesses with low cost operating models, which is consistent with Porter's comments on generic strategies. Porter believes there are four viable generic strategies: differentiated and targeting a broad market; differentiated and targeting a niche market; low cost and targeting a broad market; and low cost and targeting a niche market. See Concepts page and discussion of Michael Porter. Competitors typically don't want to get stuck in the middle, selling an undifferentiated product that's not low cost to the middle of the market. That's because they lose business to: (1) low cost, undifferentiated competitors who can beat them on price; and (2) high end, differentiated competitors who can beat them on quality, service, and product features.

If you accept Pabrai's reasoning, it makes a lot of sense for large incumbents to acquire threatening new entrants as early as possible, before the entrant grows prohibitively expensive. Uncertainty over a new entrant's future can help keep the acquisition price down.

Acquisition Criteria

In light of the principles above, acquisitions can be evaluated in terms of the following criteria:

(1) Does the acquisition move the company into an adjacent part of the value chain that isn't yet good enough and therefore isn't yet commoditized and low margin? Do the margin benefits outweigh any damage to the company's existing business?

(2) Is the acquisition needed to defend/strengthen the company's existing link(s) in the value chain because:

(a) the entrant has a breakthrough, sustaining technical improvement/innovation (which might only require a resource acquisition followed by integration of the acquired company); or

(b) the entrant has a breakthrough, disruptive business model (which might require acquisition of the company's resources, processes, and values and operation of the company as a separate entity).

(3) Does the acquisition strengthen the company's existing link(s) in the value chain by leading to a more unique set of activities with better fit across activities? See post titled Acquisitions, Rivalry, and Strategic Trade-Offs.

(4) Can the company be acquired cheaply enough -- due to future uncertainty -- that the financial upside is large while the financial downside is small?

Western Digital

Looking at a real world example, Western Digital ("WD") seems to satisfy a lot of the criteria discussed above:

(1) WD acquired Hitachi Global Storage Technologies ("HGST") to get a better foothold in a sustaining technology, enterprise flash storage. HGST subsequently acquired sTec, another enterprise flash storage company. These moves strengthened and defended WD's existing value chain link, hard drive manufacturing/storage.

(2) HGST recently acquired Skyera, which makes all-flash arrays and accompanying software systems for enterprise storage, effectively moving into an adjacent value chain link. All-flash arrays and related software should provide WD/HGST with a higher margin business than the manufacture of hard drives and flash memory. This acquisition also seems to give WD/HGST a more unique set of activities with the possibility of good fit between Skyera's activities, assembling all-flash arrays, and WD/HGST's activities, manufacturing flash memory and hard drives.

The caveat here is that WD is now in direct competition with some of its former customers, companies like Dell and EMC. Hopefully WD has weighed the costs and benefits of this kind of competition, ultimately concluding that the benefits of higher margins and more unique, tightly integrated activities outweigh lost partnerships and component business.

Because WD/HGST makes one of the key components -- flash memory -- used in Skyera (now HGST) all-flash arrays, its cost of goods sold for all-flash arrays will probably be lower than the cost of goods sold for incumbents like Dell and EMC, giving WD/HGST an all-flash array pricing advantage and putting them in a good competitive position.

(3) WD/HGST has positioned itself as a low cost manufacturer of tiered storage for a broad market, selling low cost hard drives and flash memory to consumers and enterprises. This is one of Michael Porter's four viable generic strategies.

How Competition Teaches

There's a great blog post by Professor Bill Barnett, who teaches at Stanford University's graduate business school. In a post titled The Red Queen Barnett argues that competition teaches and "causes organizations to learn." Barnett says that over time an organization facing rivalry will outperform and out-innovate a monopolist, because an organization with strong rivals must continue improving and innovating to survive.

In this sense, rivalry should make at least a few industry competitors stronger over time (i.e., the ones that survive). This, in turn, may make it more difficult for new entrants to upend the industry with a sustaining technological improvement or disruptive low end or new market product/service. Western Digital and Seagate, for example, have engaged in years of brutal competition in the hard drive industry -- they're now the only companies left making hard drives (a very attractive duopoly). Intense competition has taught them how to survive, both through low cost business structures and through strategic acquisitions of threatening new entrants. Industry rivalry has sharpened Western Digital and Seagate's strategic knowledge and operational skills.

The caveat to Barnett's article would be that industry rivalry isn't good if a company lacks the knowledge and ability needed to adapt and survive (consistent with Porter's comments on the destructive impact of too much industry rivalry).

The author owns stock shares of Apple and Western Digital.

Surviving Competitive Attrition

There seems to be a repeating cycle in the life of successful breakthrough products. These are: Phase One: The introduction of the breakthrough product followed by a "headstart" growth period with little industry rivalry/competition (e.g., the iPhone or Apple Watch).

Phase Two: As competitors catch up with the technology contained in the breakthrough product, and try to participate in the growing market created by the breakthrough product, industry rivalry increases. Industry growth is sufficient to sustain competitors even if their products lack sustained differentiation or a low cost competitive advantage (e.g., Samsung smartphones). See Concepts page and discussion of Michael Porter.

Phase Three: As industry growth slows competitors with sustained differentiation try and grow sales by moving downmarket (through market segmentation), while companies with a low cost competitive advantage try and grow sales by moving upmarket. Companies without sustained differentiation or a low cost competitive advantage are eventually forced out of the market (e.g., Samsung). As competitors drop out rivalry decreases.

When a company introduces a new product it must make sure the product has either: (1) some element of sustained differentiation (like Apple's iOS and the Apple ecosystem); or (2) is produced through a low cost, trade-off based approach that's difficult for competitors to match. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Without sustained differentation or a low cost advantage, a competitor will get squeezed out of the market during phase three. This happened to Samsung and Sony in the PC business and is currently happening to Samsung in the smartphone business. With smartphones, Samsung probably made a mistake trying to compete in the mid to high end market with an undifferentiated Android product instead of making a strong, early commitment to a low cost approach. During phase two this strategy works (when the industry is rapidly growing), but it stops working during phase three.

One downside of pursuing a low cost advantage is that many low cost approaches seem to get matched by at least a few hyper-efficient competitors. Dell originally had a low cost advantage in PC's, but this advantage has been largely matched by Lenovo, HP, Asus, and Acer, leaving these companies stuck in a price-driven modular battle that makes it difficult for them to invest in meaningful product innovation (which makes them vulnerable to technological breakthroughs by integrated companies like Apple). See posts titled "Business Models That Facilitate the Creation of New Products" and "How Outsourcing Can Destroy a Company."

Michael Porter notes that operational effectiveness ("OE") is typically matched over time, and does not constitute a unique long term strategy. For this reason, any company pursuing a low cost strategy should focus on trade-off based activities that competitors can't or won't match (regardless of OE improvements these competitors eventually make). See Concepts page and discussion of Michael Porter; post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

The author owns stock shares of Apple.

Apple Watch: Segmentation vs. Skimming

Apple is segmenting the market early with the Apple Watch, offering different product versions and prices right up front instead of using a single product to skim the high end and then moving downmarket with additional versions later on. This approach allows Apple to take full advantage of the technology head start they have with the Apple Watch. If software/hardware integration gives a new Apple product a big head start over competitors, why not take full advantage of that head start by segmenting the market and locking up market share (rather than skimming the market and making it easier for competitors to break in with a late entry)? Segmentation makes even more sense given Apple's ecosystem lock-in: if a new product helps lock people into Apple's closed ecosystem, it makes sense to get the product into the hands of as many people as possible as early as possible.

With the original iPhone segmentation probably wasn't possible. Apple didn't have the supply chain and capital infrastructure needed to meet the huge demand that market segmentation might generate. Enter Tim Cook, the supply chain expert, ramping up capital expenditures and leading the development of multiple iPhones and Apple Watches.

Limited market segmentation -- I'm talking just a few product versions, not the Samsung approach of dozens of product versions -- helps Apple: (1) reduce the threat of new entrants (one of Porter's five forces); and (2) avoid exposure to low end disruption. See Concepts page and discussion of Clayton Christensen and Michael Porter. Single product skimming encourages low end entrants. Limited market segmentation discourages low end entrants without sacrificing product focus.

The author owns stock shares of Apple.

Reducing Rivalry by Staying Focused

One of Michael Porter's five forces is industry rivalry. Rising industry rivalry often leads to price-based competition and commoditization of competing products. Companies in an industry can reduce rivalry by: (1) pursuing a unique, hard-to-duplicate strategy;  (2) competing on non-price elements like quality, features, service, and brand image; (3) targeting different market segments with different mixes of product/price (thereby expanding the total market pie); and (4) forgoing the goal of market dominance or market leadership. See Concepts page and discussion of Michael Porter. Companies that compete based on the same product dimensions often end up engaged in price-based, zero sum competition. Companies that pursue sales growth and market dominance by broadening their product range increase the number of competitors they have to face, which increases long term rivalry and makes future corporate partnerships more difficult. In pursuing growth, these companies often compromise the unique strategies and product qualities that made them successful in the first place.

When you look at the technology and e-commerce industries, it's hard not to notice Amazon and Google's ambitious pursuit of market dominance. Google wants to dominate search and data collection to drive ad revenues. It tries to do this through proprietary Android, which is a combination of the Android Open Source Platform ("AOSP") and Google Mobile Services ("GMS" services include Google Play, Gmail, and Google Maps). OEM's that want to use the Android brand and GMS services must agree to limit any efforts to fork proprietary Android. Some major OEM's, like Samsung, sell phones with proprietary Android, which ensures Google gets the search/user data. Google also sells Nexus hardware, which runs proprietary Android, to ensure it gets search/user data.

In pursuing market dominance, however, Google has dramatically increased rivalry with other major tech players. Google's development of Android angered Steve Jobs and pushed Apple away from Google services: Eric Schmidt left Apple's board, Apple created Google Maps and started using Bing as the default search engine on iOS, and Apple has basically started trying to disengage itself from direct use of all Google services. And now bare-bones AOSP, which can function as a mobile operating system without GMS services, is coming back to bite Google: more and more low end OEM's are using AOSP alone, without GMS services, which prevents Google from gathering search/user data.

In pursuing market dominance of data collection and search -- through Android and the Nexus line -- Google has created a fragmented, intensely competitive smartphone market consisting of: (1) an openly hostile Apple, which is actively trying to move away from Google services; (2) a few major proprietary Android OEM's like Samsung (that seem to be exploring proprietary Android alternatives like AOSP and Tizen); and (3) lots of small AOSP-OEM's that provide Google with no search/user data.

While a highly competitive, fragmented market may ensure Google has access to at least some search/user data, the long term outcome of increased rivalry/fragmentation seems to be declining search/user data for Google, which indirectly depresses Google's ad prices. And over the long term, AOSP puts Google in a data collecting competition with every competing search engine (like Baidu), every competing email/mapping service, and every competing digital storefront that resides on an AOSP mobile phone.

Instead of creating a vehicle (AOSP) that increases OEM rivalry and makes it harder for Google to collect the data needed to drive ad revenues, Google could have reduced rivalry and increased data collection by partnering with major OEM's (Apple, Nokia, Blackberry, Samsung, etc.) at the outset. Google could have offered all smartphone OEM's integrated Google search and Google Maps. Apple integrated Twitter services into iOS -- maybe something similar could have been worked out with Google (I realize I'm speculating here). This approach still would have allowed Google to capture significant user/search data. Instead of working with major OEM's to reduce rivalry, however, Google increased rivalry through proprietary Android, the Nexus line, and AOSP.

Amazon also seems bent on market leadership/dominance, which is increasing rivalry and direct competition with companies like Apple and Google. With the help of AOSP, Amazon has started selling Kindle Fire tablets and phones to ensure it can sell profitable digital media and e-commerce (similar to how Google is using proprietary Android to ensure access to search/user data). In 2013 Google responded with Google Shopping Express. Apple has responded by bolstering its iBooks effort, and by partnering with streaming movie companies like Netflix.

Because Apple was already selling digital media/content through iTunes, Amazon's rivalry with Apple may have been unavoidable. What's clear, however, is that Amazon's ambition increases its rivalry with other tech players, often making it infeasible for them to partner with Amazon. Imagine if Amazon had successfully negotiated partnerships with Apple and Google. The Google Play store and Google Shopping Express may never have developed. Apple might have passed on iBooks altogether (along with other forms of digital media). Amazon could have stayed focused on profitable digital media and e-commerce rather than saddling itself with a subsidized/break-even hardware business.

Regardless of what might have been, there's no question that the blind pursuit of market dominance incentivizes competitors to defend themselves. These competitors often end up developing alternative offerings that increase industry rivalry. Rising industry rivalry increases price-based competition.

A company can reduce rivalry by staying focused, by competing to be unique, and by deepening integration around a job-to-be-done. See posts titled "Acquisitions, Rivalry, and Strategic Trade-Offs" and "Avoiding Disruption by Integrating Around a Job-to-be-Done." To date Apple has largely done this: with the possible exception of the iTunes store, Apple has stayed focused on creating integrated, easy to use computing tools. Apple moves up and down the value/supply chain only when it helps the company deliver a simpler, more seamless computing experience for end users. While the digital media on iTunes is arguably outside Apple's core hardware/software business, iTunes was necessary to create an integrated, seamless user experience for the original iPod. Interestingly, Apple may be moving away from downloaded/owned iTunes music, in favor of streaming through a Beats Music subscription, because it improves the end user experience.

Apple's focus on integrated computing tools has allowed it to avoid unnecessary rivalries, making it easy for Apple to partner with software developers, service providers, and music/media content providers. These partnerships have helped make iTunes, the App Store, and the iPhone a success. The challenge for Apple is to maintain this focus going forward.

The author owns stock shares of Apple.

Why Apple Can Target the Mid-Market

Apple's proprietary OS and iOS give it sustained product differentiation, as noted by Ben Thompson at stratechery.com. It's very difficult if not impossible to copy an operating system due to its complexity (despite other companies, like Samsung and Xiaomi, copying Apple's UI style). Michael Porter's four generic strategies are: differentiated and targeting a broad market; differentiated and targeting a niche market; low cost and targeting a broad market; and low cost and targeting a niche market. See Concepts page and discussion of Michael Porter.

Competitors typically don't want to get stuck in the middle, selling an undifferentiated product that's not low cost to the middle of the market. That's because they lose business to: (1) low cost, undifferentiated competitors who can beat them on price; and (2) high end, differentiated competitors who can beat them on quality, service, and product features.

But what Apple seems to do is take the high end market and then take the mid-market. And it can comfortably do this because it has sustained differentiation through OS and iOS. This differentiation means that low cost competitors can't compete with Apple based solely on price. So Apple can put a mid-market ceiling on low cost competitors by dropping price, selling both mid-market and high end products (and letting low cost, low margin competitors put each other out of business through price-based competition).

And Apple is already at the differentiated high end, so other high end competitors are a de minimis threat if Apple also decides to offer differentiated, mid-market products.

The author owns stock shares of Apple.

Business Models That Facilitate the Creation of New Products

A company with a business model that incentivizes and facilitates the creation of well-designed new products can avoid disruption indefinitely. Integrated Versus Modular Business Models

Apple's business model is based on hardware profits. To grow these profits -- and survive -- Apple has to create innovative new products. To create innovative new products, Apple makes sure it controls the key technologies and integrates the key functions of design, engineering, and manufacturing. As a vertically integrated company, Apple can create almost any piece of computing hardware it wants, creating new product categories, moving upmarket with sustaining improvements, or moving downmarket with simpler, more affordable versions of existing products. Companies that do this can avoid low end or new market disruption indefinitely -- they just keep creating new stuff, squarely addressing different jobs that need done.

Modular companies that assemble standardized components have to rely on component manufacturers to innovate. When a standardized component becomes good enough, additional improvements to the component won't drive additional sales for the company that uses it. HP and Dell's PC businesses have struggled, at least in part, because Windows 7 and existing Intel chips are good enough for many people. And because they aren't vertically integrated, HP and Dell lack the design, engineering, and manufacturing resources and processes needed to create attractive new computing devices. They're basically stuck in the low to middle end of the PC and tablet markets, selling standardized, modular devices based on different chipsets and different versions of Windows, Android, and Chrome OS.

Another drawback with modular assemblers like Dell, HP, Lenovo, Samsung, and others is that their reliance on standardized, modular components often leads to bad design. Because they're putting together modular components, their design options are limited -- they have to operate within the parameters of the standard components they're assembling. And if you're a modular assembler competing with other modular assemblers, you have to at least match your competitors' technical specifications. So to compete, modular manufacturers end up abandoning good design principles, often using components that overserve the job that needs done or putting too many features into the final assembled product. This ultimately results in: (1) poorly designed, undifferentiated products and price-based competition; (2) little to no meaningful new product innovation (just immaterial improvements to things like screen resolution or "speeds and feeds"); and (3) the kind of industry-wide overserving that developed in the Wintel PC market.

And that's exactly the kind of market that's ripe for disruption by an integrated competitor. An integrated company isn't stuck with standardized components and cut-throat, modular style competition, so it can design products based on the job that needs done and avoid overserving. The outcome is frequently a simple, beautiful product that happens to be more affordable than many overserving, modular alternatives (e.g., Apple designing the simpler iPad as an alternative to laptop PC's).

The Importance of Business Model Incentives and Resource Scarcity

Google and Facebook have ad-based profit models. With the acquisition of Nest, Google may be shifting toward a hardware-based profit model (as noted by Horace Dediu at asymco.com). To duplicate Apple's ability to efficiently create new hardware products, Google will probably have to vertically integrate thousands of design, engineering, and manufacturing activities. And that's not going to be easy. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs."

Some people see an ad-based profit model (Google or Facebook), or a business model based on tremendous scale and operational effectiveness (Amazon), and think the relevant company is a safe, monopoly-type business with predictable, growing earnings. But as Horace Dediu at asymco.com has noted, ad-based models may lose traction as Internet usage starts growing less in developed economies, which have higher personal incomes, and starts growing more in developing economies, which have lower personal incomes.

Additionally, when a company's business model doesn't really depend on the periodic creation of new products, it's not going to be as good at developing them. A company focused on collecting user data and churning out profitable ads, such as Google or Facebook, or trying to efficiently grow retail sales volume, such as Amazon, isn't really focused on creating entirely new product categories -- these companies are focused on improving the efficiency and performance of the dominant, profitable business models they've already established, whether it involves data collection, ad targeting, or operational effectiveness.

Clayton Christensen has noted that disruptive new products are generally developed in a context where resources are scarce. Most startup companies with a disruptive idea have scarce resources, so they have to be impatient for profit. That's because they need early profits to fund ongoing product sales and development. Early profits also test whether the product is truly disruptive, appealing to new and low end markets. Without resource scarcity, and the need for early profits, a company can keep wasting time, talent, and money on a product that lacks the market appeal to sustain itself. See Concepts page and discussion of Clayton Christensen.

You can see Google and Amazon doing this, at least to a degree, with: the subsidized/break-even Kindle Fire; the break-even Nexus products; Google's lackadaisical approach to the Motorola acquisition and to Motorola's hardware; and the high end Google Pixel (which doesn't even qualify as a low end or new market disruption). Because Google has a dominant, highly profitable ad business, while Amazon has a dominant, profitable retail business, neither company has to deal with resource scarcity. As a result, both companies are willing and able to continue subsidizing break-even hardware. Analysts looking at Google justify this by saying that Google uses subsidized hardware to collect data for its profitable ad business. Analysts looking at Amazon justify it by comparing the Kindle Fire to a storefront (which may arguably be true, although Amazon's customers already have an optional Amazon app storefront on most tablets and smartphones). The bottom line is that neither Amazon nor Google is strongly motivated to focus on disruptive new hardware that performs a specific job well, because their business models don't depend on profitable hardware sales.

Apple shares at least some of this motivation problem, since past product successes have provided it with abundant resources, especially cash. Apple doesn't have to deal with resource scarcity, so it must be vigilant in saying "no" to unfocused product ideas that don't squarely address jobs that need done; unfocused products waste time, talent, and money that could be productively used elsewhere. The big difference between Apple and companies like Google and Amazon, however, is that Apple depends on profitable new hardware to survive. Hardware isn't a side-game, so despite its resources Apple is still strongly motivated to design any new device around a job that needs done, which increases the odds of market success, prevents overserving, and often results in more affordable products that appeal to new and low end markets.

Maybe that's what Steve Jobs meant when he counseled others to "stay hungry, stay foolish" -- namely, to avoid complacency, and to keep creating well-designed products that squarely address important jobs. A good business model facilitates and incentivizes this effort.

The author owns stock shares of Apple.

Coupling Great Innovation with Great Design

To be really successful, an innovative product must be well-designed.  Great design is what leads to iconic products and a great brand.  And rapid/iterative product innovation without great design makes the customer a "test dummy" and risks brand damage. When product iteration is too rapid, it makes effective product design more difficult, because the best product design requires care, thought, and time.  It takes product designers time to study and fully consider how a product will be used.  Focus on just a few products makes it easier for great designers to devote the time and care needed to create iconic products that create true brand value.

And great design doesn't equate to a premium price tag.  In Marc Newson and Jony Ive's recent November, 2013 interview with Charlie Rose, Newson noted (and Ive concurred) that thoughtful product design increases accessibility, often through greater simplicity, ease of use, and affordability. Newson and Ive stressed that good design simplifies and reduces objects to their essence, eliminating anything unnecessary or superfluous.  A spacesuit is the ultimate in product design, because everything is essential, everything is necessary.  And Ive noted that great design doesn't "wag its tail in your face" -- instead, it disappears and seems "inevitable."  Newson went on to note that the best objects transcend the issue of functionality versus aesthetics because they just "kind of are the way they are," and don't seem like they could be any other way.

In today's marketplace lots of companies come up with innovative new products, or make rapid, iterative, and innovative improvements to existing products.  Samsung and Google come to mind, with a steady stream of new products and services.  But how many companies really focus on marrying great innovation with great design?  Apple comes to mind, with its focus on perfecting just a few products.  

When great innovation is coupled with great design, you end up with simple, accessible, well thought-out products that don't overserve users.  These kind of products really stand out -- and often become iconic -- because so many companies are pumping out a steady stream of new products that are technically innovative but aren't thoughtfully designed.  It's hard for designers to create iconic products when they're working on too many new products at once, or when they're facing short cycle times with rapid product iteration.

And most companies probably don't prioritize industrial design the way a company like Apple does -- they often make design compromises to achieve a certain profit margin, or to ensure an efficient and cost effective engineering/manufacturing process.  Apple seems fairly unique in its willingness to let industrial design dictate so many aspects of the final product, as noted in Leander Kahney's recent biography of Jony Ive.  Over the long haul, Apple's no compromises approach to industrial design may be a significant competitive advantage over companies that don't prioritize design to the same degree (e.g., Samsung, Google, and Amazon).  

A couple weeks ago I posted an article on how Apple co-opts adjacent component businesses when the relevant component still isn't functionally "good enough."  See post titled "Why Apple Co-opts Adjacent Component Businesses" (11.6.2013).  But the other reason Apple probably does this is because they see an opportunity to improve a product's design by making it simpler, easier to use, and more affordable.  They co-opt technologies -- like sapphire glass, fingerprint readers, and liquid metal -- that eliminate design constraints and lead to simpler, more accessible designs.

The author owns stock shares of Apple Inc.