February 8, 2013 (1:30 pm)
A SUBWAY RIDE. If you live in New York, you know that there’s not much to do while riding the subway except listen to music and look around at the other passengers. While on the subway last night, we were looking around… per usual. It’s always interesting to look around at the types of devices other passengers are using. Since the vast majority of riders commute to and from work everyday, we all share similar habits. Last night, we noticed that most passengers in our packed subway car had Apple’s ear bud headphones on. Not a surprise, given Apple’s enormous popularity here.
NYC LOVES iDEVICES: What was somewhat surprising, though, was that we didn’t see a single iPhone 5 in the mix. There was a small iPod (couldn’t tell which one) and one new iPod Touch. There were a couple of iPhone 3G’s, which we easily recognized by the rounded aluminum back. And there were a ton of iPhone 4/4S’s – too many to count. But no Samsung Galaxy S3’s or iPhone 5’s! Aside from phones, there a few kindles being used by seated passengers and a couple of iPads (no mini’s that we could see).
This seems like a lot of useless information, other than the fact that New Yorkers seemingly all went to the Apple store together at one point to buy these devices. A friend remarked that this must be bad news for Apple, since nobody wanted to upgrade to the iPhone 5. Rationale argument.
But we view this differently. As we’ve discussed in the past, it’s all about the…
ECOSYSTEM. Apple’s ecosystem is an important advantage that many investors and analysts seem to dismiss. All they care about is how many iPhone’s did Apple sell last quarter, and how many will they sell next quarter?? Investor’s worry that Apple, as a hardware manufacturer, may end up like Palm, Dell, HP or RIMM (now Blackberry). Once they stop making the coolest, freshest devices that work like “magic” compared to competitors, their current users will simply jump ship.
But that’s an incorrect (and really lazy) assumption. Investors and analysts that believe this logic are simply not doing the necessary research to understand the long-term implications of the ecosystem advantage. For Apple’s current users to switch to a different operating system (i.e. Android, Windows or Blackberry), they would incur significant switching costs. These costs come in the form of direct monetary expenses as well as time. We’ll discuss both. But suffice it to say, Apple has them locked into the “i” ecosystem.
COSTS. Direct monetary expenses come in the form of all the digital content users have already purchased on their iDevices. Have you purchased a song, TV show, movie or book on iTunes? The answer is probably “many”. When you leave the iOS ecosystem, you lose them. Further, and perhaps more significantly, have you downloaded any paid apps? Have you made any in-app purchases? You’ll lose them, too.
Then there is the loss of time, and subsequent frustration a user will face. Think about all the contacts and notes you’ve taken on your phone. And the photo stream you set up with your friends and family. And all of the documents saved and stored in the iCloud? If you switch to another system, that all (even your contacts) becomes inaccessible. Not to mention the hardware compatibility and airplay features. Do you have an Apple TV? No longer would you be able to use your phone as a remote control, or stream content from it directly to the TV. And those speaker systems and alarm clocks that sync with your phone lose a substantial amount of usability.
LONG-TERM USERS. So switching to another OS is clearly not as easy as the media makes it out to be. As hardware features become commoditized, users may not feel the need to buy the newest iPhone the minute it is released. Instead, they are happy to wait until their two year contract is up before upgrading. Because the software is the same, or at least substantially the same. We all know that upgrading from the iPhone 4S to the iPhone 5 is not the same as upgrading from an old feature phone to any iPhone. But as more and more users become initiated into the Apple ecosystem, the more long-term value Apple creates. For all the reasons we mentioned, switching to a competitor’s device is something most users will avoid unless they’re extremely unhappy with the phone. It’s simply not economical. While they may not purchase each new iteration of the iPhone, they’re very like to purchase a new iPhone every 24 to 36 months. And that gives Apple a recurring revenue stream (both in terms of each successive iPhone purchase as well as all the content and apps purchased through Apple in the interim). We view all of those passengers on the subway with older iPhone’s as part of this future recurring revenue stream.
Investor’s are laser focused on incremental device sales from quarter to quarter, but are ignoring the recurring revenue stream opportunity that Apple has created. It’s a good thing that management has not.