Weekend Reading #11
This is the eleventh edition of our weekly newsletter, Weekend Reading, sent out on Saturday 6th April 2019. Sign up here and receive a copy each week direct to your inbox.
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Of apples and mandarins: The new smartphone paradigm.
Apple’s recently announced pivot to services has been covered ad nauseam, but we believe the majority of commentators are missing the point. To borrow from the marketing gods of Cupertino, here at Three Body Capital it’s our job to Think Different.
The superficial story goes that after a period of cognitive adjustment, “Tim Apple” aka Tim Cook and colleagues now recognise that over-dependence on iPhone sales poses an existential threat to the future of the company and are racing to reconfigure their business model. In this narrative, the wholesale pivot to services isn't about revenue diversification. It’s about survival, plain and simple.
But there’s another story to be told. A story about you and me, how competing ideological systems are vying for control of our data, our money and our time. Viewed through this prism, Apple is doing something remarkable – it’s becoming the go-to smartphone service provider for people who value their privacy.
The iPhone generates two-thirds of Apple’s revenue, but developed markets are saturated with premium product. So, like all good western behemoths, Apple has looked to the Chinese “hypermarket” for growth. But the iPhone is simply too expensive to scale further in Emerging Markets. Even at the lower end of the market, the entry-level iPhone XR costs around ¥1,000 more than competing devices. It’s 2019, smartphones are commodities and Apple can’t compete on price. Increasing the weighted average price of your best selling product by 23% in the face of sky-rocketing competition and a saturated market has turned out to be one of Apple’s few really poor moves.
What is true for China and India now will soon enough spread to developed markets too. The glory years of bumper hardware unit growth are over, weighing on Apple’s share price and disrupting the supply chain. This leaves Cupertino needing to figure out a way to grow revenue from existing customers in developed markets. Hence the push into services.
The great copycat.
Apple is known as the great innovator, but this time it’s late to the party. Chinese tech companies have been offering a diversified portfolio of services for years. Alibaba and Tencent have already mastered engagement through bundling. And smartphone maker Xiaomi has been pushing the “ecosystem” model for some time, driving down gross margins on its phones to a maximum of 5% and getting people hooked on cheap phones and premium services.
Still, this is some change for Apple. This bold recasting of a long cherished business model is going to have implications for its customers, shareholders, suppliers and of course, its competitors. A company that started life as a desktop computer manufacturer is now in the game of financial services, news, music, video, gaming, cloud storage, health – you name it. Who knows what all this means for Apple’s hardware business, but considering the superior unit economics of leasing services to consumers, it’s conceivable that Apple will one day “do a Xiaomi’ and make its handsets (almost) free to customers, contingent on a minimum monthly spend on Apple services.
The new model certainly has many benefits. It enables Apple to grow in saturated developed markets. It can scale in Emerging Markets. And it can mitigate disruption to its supply chain caused by volatile US/China trade relations, with The Great Game introducing political and economic complexity that is hard to navigate over long business cycles.
Is this a masterstroke of strategic insight? Or a panicked response to the challenge of exporting an inflexible business model to the merciless theatre of emerging markets? Whatever you believe, it has to be one of the boldest pivots in corporate history. We don’t know how large the ship’s turning circle will be, but luckily for Apple it has a huge head start, a $237bn cash arsenal and a deep reservoir of brand equity that has the potential to facilitate its full-scale transformation into a services business.
Welcome to the ecosystem.
To borrow another killer tagline from a company we greatly admire, Apple is “eating the world” of consumer technology by rolling out deep, native integrations of core services with iOS – things like banking, healthcare, entertainment, even education, all packaged up and provided as-a-service.
Apple doesn’t just think different. It is different. It is, in fact, not a hardware company, or a software company, or a media company, but an ecosystem that generates, monetises and recycles user data in a positive feedback loop par excellence. This is an almost unassailable moat. No wonder then, that moat aficionado Warren Buffett is up to his eyeballs in AAPL.
Here at Three Body Capital we believe (like most people) AI is going to be a huge value generator for the global economy. The challenge is identifying companies for which AI can make a material difference to profitability in the near term. We call this “Real AI”, and Apple presents a HUGE opportunity to buy this theme, with its ability to drive user engagement by applying machine learning to large datasets gathered over decades of hardware dominance.
Furthermore, Apple’s ecosystem enables it to occupy a unique positioning amongst consumer tech companies. It can do privacy better than anyone else.
As people spend more and more time online, the liminal space between data and identity is becoming increasingly blurred. For some time now, Apple has been attacking the privacy angle, as consumers become more informed, more engaged and more outraged about how their data is collected, stored and monetised. Apple is perfectly positioned to benefit from this shift in the way users manage their data.
There are 3 types of privacy. The first is communication privacy (nobody snoops on you). The second is individual privacy (you have control over what data is shown to you). And the third is information privacy (you have control over your data). Apple’s ability to standardise user identity enables it to integrate all three and deliver the holy grail of personalisation and privacy, turning big data in relevant data. Whereas Google needs to track your identity everywhere as they use big data to customise the advertising experience, Apple is able to curate and customise on device, engaging users whilst preserving their privacy through integrations. No other company on earth is able to offer privacy and convenience – this is Apple's unfair advantage.
A key battleground.
Apple Card, Apple Arcade and Apple TV+ might not seem that innovative, but they are touch points in a holistic nexus of user interactions within a closed ecosystem that guarantees user privacy whilst disintermediating a plethora of third party service providers. Less Finance 2.0, more Privacy 2.0.
Here at Three Body Capital, we believe that divergent ideologies are creating hard choices for investors, companies and consumers. In the battle between individualism and collectivism, privacy is going to be a key battleground. An American model that emphasises individual liberty is rubbing up against the Chinese way, built around large scale social coordination and the optimisation of user experiences at the expense of personal and collective freedom.
All players in “The Great Game” will be forced to choose between competing worldviews as the existing trust architecture is disrupted. Seen in this light, Apple’s focus on services might be less of a pivot than people think. It might, in fact, be a calculated strategy to forge a new kind of consumer experience in which people no longer have to choose between personal liberty and convenience. And that's a new paradigm for the smartphone.
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