Saturday, November 2, 2013

Apple And The Renaissance Of Hardware Monetization

As the moderator of the Braeburn Group discussion community, I am in constant contact with members of our global network of independent analysts. For the active participants in the Braeburn Group, Apple analysis is its own form of a virtual full contact sport. 

Since the release of Apple’s September quarter results and December quarter guidance earlier this week, discussions about Apple’s revised revenue deferral program and management’s decision to provide OS X upgrades and copies of the company’s Keynote, Numbers and Pages productivity applications free to iOS device and Mac owners have reached a fever pitch. Tracking Apple’s new deferred revenue program and its impact on each quarter’s results has its own challenges. Determining the rationale of foregoing revenue on OS X upgrades and sales of the company’s productivity apps is a sub-plot for conversation. 

In this post I won’t go knee-deep into the analysis of Apple’s financial results or the fiscal impact of the company’s strategic decisions mentioned above. I reserve financial analysis for my Posts At Eventide blog. What I will mention in this post is a concept I’m calling Apple and the Renaissance of Hardware Monetization.  

Apple’s New Deferred Revenue Scheme
During the September quarter conference call with analysts, Apple announced the company has increased the revenue deferred on each iOS device sold to as much as $25 and increased the revenue deferred on each Mac sold to $40. The revenue deferred on each iOS device sold will be recognized over 24 months and the revenue deferred on each Mac sold will be recognized over 48 months from the time of sale. 

iCloud image courtesy of Apple

The justification for the increase in the amounts deferred on iOS device and Macintosh PCs is to better reflect the value of software and services provides to device owners at no additional cost and to reflect the value of the implied guarantee Apple provides to consumers they will receive free OS upgrades over the anticipated economic life of the devices they purchase. 

Accounting rules require the deferral of revenue at the time of a device's sale when enhanced features and functionality are provided at no additional cost at a later date. From an accounting standpoint, Apple’s decision to defer revenue is sound and justified. The amount of the deferred revenue on each unit sold reflects management’s estimated value of the OS upgrades, software and services Apple plans to distribute to the device owner following the date of original purchase. 

Keynote, Numbers and Pages
I am an active user of the Apple’s productivity apps. Keynote and Pages are excellent products and iCloud integration provides for seamless workflow across all of my Apple-branded devices. Under Apple’s product and services model, I can access, create and edit Keynote, Numbers and Pages documents on any of the devices I carry and I can drive presentations using the company’s productivity apps at any time from my iPhone, iPad or Mac. I also use Numbers exclusively in my analysis work. I’ve adapted to Numbers because of the way Apple’s spreadsheet solution integrates with Keynote and Pages. While in my view Numbers is an application in need of active development, I use it almost exclusively because of the seamless integration with Keynote and Pages and anywhere access to documents via iCloud.

A Bit of PC Industry History
When the original Macintosh debuted in 1984, it revolutionized the PC industry and sparked the desktop published revolution. At the time of its release, it came equipped with Apple-sourced software that allowed Mac owners to create documents and express creativity in ways not previously available to personal computer owners at the time.

In partnership with Adobe Systems, which developed the PostScript language, Apple created a lucrative market for premium-priced PCs that changed publishing forever. Unknown to many, Microsoft Excel was originally a spreadsheet solution for the Mac. 

Apple thrived following the release of the Macintosh because the company monetized the hardware. Although software and the unique operating system Apple developed for the Mac were essential for success, hardware monetization through premium-priced Macintosh PCs, was the source of the company’s financial success and profit margins on the Mac were enviably high. 

In 1988 I purchase a Macintosh PC and an Apple-branded dot matrix-style printer for my office at a cost of over $3,000. Today, in non-inflation adjusted dollars, that same $3,000, now 25 years later, can purchase a 27” iMac, an iPad Air and an iPhone 5s on a subsidized contract with $500  remaining to cover much of a year’s cellular services contract for the iPhone through AT&T. The prices for personal technology products, both nominally and relatively, have fallen dramatically over the past quarter century.

Over the past 25 years, Microsoft created a global empire by suppressing or commoditizing the cost of computing hardware in favor of rich prices and premiums for computing software and services. Today, Apple, despite the dramatic drop in cost of personal technology products, has the highest gross margin among PC and handheld device makers on the planet. Apple commands rich premiums through the wedding of hardware, software and services and by not licensing it operating systems to low-cost device makers. Apple’s approach to the market is the antithesis of Microsoft’s market model.

Apple and The Renaissance of Hardware Monetization
By choosing to forego the revenue generated from the sales of operating system upgrades, the revenue generated from the sales of Keynote, Pages and Numbers and by offering iCloud services at no cost to device owners, Apple is again upending the digital device markets through the delivery of valuable software and services at no cost to consumers. Consumers also obtain an implied right to receive future software and services enhancements over the anticipated economic life of the Apple products they choose to buy.

Active and often spirited discussions about Apple’s deferred revenue model and the company’s strategic decision to offer services, software and future operating system upgrades at no cost to device owners will continue to rage among members of the Braeburn Group. But there’s no disagreement among members of our global network of independent analysts that Apple will continue to drive innovation and continue to increase the value proposition of the company’s products.

Apple’s approach of wedding the company’s hardware, operating systems, software and services in a complete package for  consumers while providing OS, software and services upgrades for free over the anticipated economic life of each device sold is a winning strategy for today and tomorrow. 

Apple is crafting a renaissance of the hardware monetization model and this renaissance will provide enhanced value to consumers while rewarding the company with higher unit sales volume and greater profits over time.

Robert Paul Leitao