War In The Valley: Apple vs. Google

The Monday Note covers the intersection between media and technology and the shift of business models. It is jointly edited by Frédéric Filloux, a Paris-based journalist and Jean-Louis Gassée, a Silicon Valley veteran currently general partner for the venture capital firm Allegis Capital in Palo Alto. Their column appears on CBS News.com each Monday.

This is the Valley and its cozy relationships. By which I mean executives and directors sitting on one another's board, competitors enjoying the same directors, venture firms "sharing" their partners around portfolio companies. For example, besides Eric Schmidt sitting on both Apple's and Google's boards, we have Arthur Levinson, head of Genentech, a director of both companies. Or partners at Sequoia (a very successful venture capital firm)
 sitting on boards at YouTube and Google, which might have help a successful "exit," that is the sale of YouTube to Google.

Back to Apple, there are also lingering allegations of a no-poach agreement, one by which the companies agreed not to hire each other's workers.

Closer to home: Be, Inc., the operating system company I founded with a few friends from Apple and elsewhere. For a while, one of our investors (and director) also sat on Microsoft's board. Microsoft executives were investors in his firm and we ended up with Bill Gates (indirectly) owning a piece of Be. Ah well… That was a decade ago, the statute of limitations ran out.

The SEC (Securities and Exchange Commission), the stock market regulator, has become more aggressive in watching out for companies engaging in collusive behavior through cross-directorships. See here.

Back to Dear Leader's words: Google enters more of Apple's core business.

The first thing to notice is more. Indeed, the reason we all think Eric Schmidt's resignation was overdue is two years old, almost: it's called Android, Google's smartphone OS, directly competing with Apple's iPhone OS. In 2007, it isn't clear yet that smartphones are the next PC, only bigger, the iPhone just starts shipping. But, a year later, in 2008, the competitive picture is now sharply drawn. Android is the most dangerous competitor for the most important component of Apple's present and future profit streams, the iPhone ecosystem.
So, what is the more that broke the cross-directorship? Without a doubt: Google's Chrome OS, with a strong dash of Google Apps.

To explain, let's take a trip inside Google's strategy.

By now we know what Google Apps are: applications running on computers in Google's cloud and served to desktops, laptops and netbooks through a browser. No need for desktop applications. Nice. As long as you have a Net connection.

Enter the second stage of Google's strategy: we need to keep these Google Apps running even when the Net is unavailable. If we do this, we conquer the Office world, we become the next Microsoft, only better.

No magic required to achieve off-line functionality for Google Apps, all the required components are available. Today's personal computers have lots of memory, 1Gb of RAM minimum, and lots of hard disk storage. Further, most personal computers already have a Web server inside. (Geeks know where to look for httpd.exe or httpd.) Now, if we, Google, discreetly download the App code inside the personal computer, under the cover of a browser extension, what do we have? A microcosm, a small scale replica of the server and application software in our cloud, only now neatly tucked inside the personal computer. Really. Slick, simple, stealthy, a Trojan Horse against Microsoft. Or Apple.

The local replica of the server-based set-up isn't so easy for Microsoft to counter: Google has tons of money, can and does influence Web standards in ways Microsoft can't match. Further, unlike Microsoft, Google doesn't have a legacy (Office) business to protect.
Great, but how does this threaten Apple? Isn't my enemy's enemy my friend? Aren't Google and Apple natural allies against Microsoft?

Unless, of course, Google is the next Microsoft. Microsoft competes with Apple because it supplies the software engine for PCs fighting with Macs. Now, Google competes with Apple because it supplies the software engine for iPhone competitors and, tomorrow, for n-books. On the surface, these "cheap", "limited" n-books don't compete with Apple's more expensive machines. A recent survey gave Apple an astounding 91% market share for personal computers costing more than $1,000. Consumer computers, that is, we don't have numbers for Enterprise purchases. But Steve Jobs knows what always happens: the low-end machines start as a crack in the wall; later, they acquire more of everything and, if the higher-end incumbents don't watch out, the lowly machines, the n-books, take over.

(If you want to absorb the enormity of the iPhone's business, go here, this is Apple's Q309 10-Q filing, numbers for the quarter ending in June 2009. On page 26, Apple discusses its Revenue Recognition policies. Sparing ourselves the detailed parsing, iPhone revenue isn't "recognized" (recorded) when the devices are sold, it is spread over the life of the agreement and/or according to the period of time in which features will be added by software upgrades.

Spreadsheet pathologists have untangled the mess, they've separated new 'spread' revenue from units just shipped from dollars flowing from earlier shipments. They arrive at an approximate $850 'unspread' revenue per iPhone.

Now, turn to the 10-Q's page 30. For the 2009 quarter ending in June (Q3): 5.2 million iPhones for a recorded revenue of $1.689 billion. This amounts to $324 recorded per iPhone.
Now, try instead the 'unspread' $850 per iPhone and you get $4.4 billion, compared to $3.3 billion in Mac sales.

This in less than two years, just a beginning as iPhone distribution reaches more countries, with only one current model. Perhaps this is why Apple is no longer Apple Computer. Certainly, this is why Apple worries about competitors for its largest and fastest growing money machine.)

A new Microsoft attacking both iPhones and Macs. And, unlike Microsoft, with free software. That's what Apple sees in Google.

But, wait, there is more!

Apple's business model is bound to change. In plainer English: Until recently, Apple's profits were built on hardware sales. Everything else, system software or iTunes music revenue only mattered as a way to buttress hardware profits. For example, when iTunes came out, analysts expressed concern that music margins were thin or negative. So what? iTunes's sole role is to prop up iPod and iPhones margins. Apple talks up its software, operating system and applications, spends hundreds of millions of dollars in development and generates modest or no direct revenue from it. It's all in the service of Mac and iPhone sales and profit margins. That's the picture so far, fast becoming the past.

With the iPhone, Apple hasn't just broken into a new product category, it has shouldered its way into a new world of service revenues. Legally call it the way you want, the difference between the retail price of an iPhone, $199, and the pathologists' number, $850, is a service revenue. According to other dissectors, the manufacturing cost of an iPhone would be about $179. So, the retail price covers the product cost, all the margin comes from the service revenue rebated by AT&T. That's a business model change - and for the largest business unit.

But this is just the beginning.

Going back to iTunes, let's consider its micro-payment system. Not the only one on the Net: I just spent $.45 on Amazon for a Cecilia Bartoli aria, neatly ending up in my iTunes library. Both very smooth, in plain view but generally unremarked, perhaps because they works so well. I can't wait to see if and how Apple and Amazon will cooperate on e-book sales.

In the meantime, why would Apple let Amazon MP3 sales "get into" iTunes and why would they fight Palm's attempt to sync their new Pre smartphone with iTunes? Amazon makes iPods a little nicer. Perfect, forget the "missed" iTunes revenue. Palm is trying to make an iPhone competitor look better. No way.

Today, Apple "sells" a lot of free products via iTunes: free university courses on video, free apps on the App store. The latter must be a money-losing operation, so far. More than a billion downloads, about half of which are free, will generate a "low" multiple of $100 million dollars in net (30% of gross) revenue for Apple. Figure out people costs, a large organization to manage the (sometimes frustrating) approval process, add the infrastructure costs, servers and their servants and you'll see the App Store will never compare with the $600 profit par iPhone.

The App Store helps that big number and may or may not make a little money on the side.

Now, Apple has developed an infrastructure, a micro-payment system - and an appetite. If and when some kind of tablet surfaces, it will be an opportunity to be the channel of choice for entertainment and, let's use the ugly word, infotainment content: games, e-books, videos, newspaper and magazines, if they bite the bullet and demand payment. In a way, this would be the "Kindle-done-right", with apologies to my dear Amazon friends, really: color screen, touch interface, Apple software and UI, Apple retail stores…

Apple could become a distributor and micro-payment agent for goods and services going way beyond you can get on an iPhone, think screen size, or a MacBook, think everyday mobility/ubiquity, weight and size. In the process, Apple could rake in substantial monthly profits (not revenue, we don't eat from revenue). Perhaps not as much as the $25/month over 24 months equalling $600 for the contract life of an iPhone, but good enough for a multi-billion dollars business nonetheless.

This is the type of business Google threatens with Chrome OS for n-books, advertising subsidies and its CheckOut payment system. Business is war. (In a future column, I'll get into Google's potential weaknesses in this conflict.)

The Monday Note is off next week. We'll be back August 23.

By Jean-Louis Gassée and Frederic Filloux
Special to CBSNews.com