Apple: Why Free Software Makes Perfect Mathematical Sense

By Michael Comeau  OCT 24, 2013 9:30 AM

Apple is sacrificing a tiny bit of profit for a whole lot of competitive advantage.

 


During Tuesday's iPad-centric event, Apple (NASDAQ:AAPL) dropped a historic bomb on the technology industry, and it's got nothing to do with Retina displays or motion co-processors or fingerprint-resistant oleophobic coating.

No, Apple's big news was that it was cutting the price of a good deal of its software to zero.

Going forward, operating system updates, including the upcoming OS X Mavericks from Apple, will be completely free, as will the company's iLife and iWork suites.

As you'll learn, Apple is giving away a tiny bit of dough for a whole lot of strategic advantage going forward -- if you can think long-term.

Apple's Tiny, Meaningless Sacrifice

Let's take a look at Apple's revenue breakdown from the June quarter:



As you can see, the iTunes/Software/Services segment accounted for 11.3% of revenues.

But let's look at what's in that category. Apple notes that it includes the following: revenue from sales on the iTunes Store, the App Store, the Mac App Store, and the iBookstore, and revenue from sales of AppleCare, licensing, and other services.

And in fact, in its most recent 10-Q, Apple noted that for the first three quarters of the 2013 fiscal year, 58% of segment revenues came from iTunes. That leaves 42% of the segment (or 4.7% of total revenues) to divide between AppleCare, licensing, and software, including OS X, Final Cut, iWork, iLife, and Aperture.

So what is Apple giving up here?

Not much -- maybe 2% of revenues at the most.

And What Is It Gaining?

Apple issuing free software is about one thing and one thing only: winning a long-term platform war against the Microsoft (NASDAQ:MSFT) Windows and Google (NASDAQ:GOOG) Android/Chrome ecosystems.

Back in 2010, I discussed why supposed iPhone killers should focus on targeting iTunes, which served as the glue of the Apple world:

iTunes has evolved from a piece of music-management software into something that 1) manages all your media, contacts, and appointments and 2) activates, syncs, and backs up the iPhone/iPad.

In other words, iTunes is now the personal operating system for millions of people, giving them a good reason to stay within the Apple ecosystem. When you buy a new Apple gadget, you plug it into your computer, and voila -- iTunes updates everything and you’re ready to go, no thinking or effort required.

It’s the most comprehensive piece of plug-and-play software on the market, blowing away the likes of Microsoft’s Zune ecosystem and BlackBerry (NASDAQ:BBRY) Desktop software.

So the theme here is simple -- iTunes is the glue holding Apple together, and the piece of the puzzle competitors need to focus on if they want to hurt Apple.

No Apple product is an island, because each one cleanly ties together as part of an overall strategy -- get the people inside the house, and slam the door behind ‘em.

Apple clearly emphasized inter-device software compatibility at the iPad event.

For example, you can start producing a song in GarageBand on the iPhone, then seamlessly finish it up on a Mac or iPad.

Now let's talk about consistency across platforms. Microsoft is running tablets with two different operating systems, and there are even more versions of Android in the wild.

Meanwhile, as it stands now, two-thirds of eligible Apple mobile devices are running iOS 7.

Why?

Because Apple exercises total control over its hardware and software, and iOS 7 is free.

And making OS X updates free means the same will be true for Mac users. Why Does This Matter?

First of all, it makes developers' lives easier, which means Apple keeps its status as the number-one priority in the mobile software world.

Secondly, and more importantly, it helps ensure a predictable, unified customer experience. If you can use one Apple device, you can use them all -- the next step here is to somehow fully combine OS X and iOS, though that's probably a ways off.

Meanwhile, popular Android devices like the HTC (OTCMKTS:HTCXF) One and Samsung (OTCMKTS:SSNLF) Galaxy S4 can offer vastly different user interfaces because of their respective customizations on top of Android -- which is actually a compounding of the existing issue of having so many different versions of Android out there.

Now obviously, Android is absolutely crushing it from a market share standpoint, but who's really making big money in Android phones?

Last quarter, Google's own Motorola posted an operating loss of $248 million on revenue of $1.18 billion.

HTC's sales are collapsing and it's fighting rumors that it's shutting down production lines.

And the jury's currently out on the mighty market leader Samsung, which has admitted to feeling pressures in high-end smartphones, but is doing okay overall because of its strong semiconductor business.

Apple's strategy of charging premium prices for access to an easy-to-use platform is the least worst, and therefore the best.

Forget 2013

I don't think Apple making software free means much in 2013 beyond some measly decline in revenue and earnings.

But it is important for 2023 and 2033 and beyond.

Apple is not fighting for current market share or seeking to take on competing products one-on-one. If Apple was worried about market share this quarter or next, the new iPad mini with Retina display would not be $399.

No, it's using free software to get people accustomed to a simple, unified Apple user experience with all products working seamlessly together -- something that offers an incentive to pay up.

Whether that's superior to Windows or Android/Chrome is a matter of opinion. But it seems like a good way to keep people inside an expensive walled garden, right?

And as I showed above, Apple can't possibly be making serious money from this stuff, so mathematically, it's a good trade-off.

So Will I Soon Be Dumping Microsoft Office for Apple's iWork?

Most likely not. Serious Office users, particularly Excel junkies, are very unlikely to leave for even a free iWork any time soon. Most (if not all) of that crowd is running Windows, and Office is just too integral to too many people's existing workflows. So in many cases, switching over to a Mac to run a different productivity suite is just not realistic .

And for the non-serious users already on Macs, I would assume Google Docs has already picked much of the low-hanging fruit.

But think about this: Apple may be looking to simply get the next generation of kids hooked on using iWork instead of Office.

To me, the biggest long-term bull case for the iPad is the fact that babies like them so much:



The same could be true for software.

After all, why did Windows win the PC wars? One big factor was the fact that people knew how to use Windows from their work computers.

So maybe kids that grow up using Apple-only software, like the individual iWork and iLife apps, will grow up to only use Apple products because that's what they know.

Maybe that's nuts, but for less than 2% of revenues, it's worth the bet.

Does This Mean Microsoft Has to Cut Software Prices Too?

My opinion couldn't be less interesting: The answer is not yet, if at all.

Price isn't the only factor in platform choice, and in any case, Windows PCs start at significantly lower prices than Macs. Plus, many PC users only upgrade software when they buy new systems; they don't just purchase every update. So it's not clear that Microsoft has to immediately react.

And as I noted above, it won't be easy to get people with existing Windows-based workflows to switch just because one part of the Apple system is now free.

Nonetheless, Apple is making a not-so-subtle attack on the Office Empire, which accounts for a whopping 32% of Microsoft's revenues and 61% of its operating profit.

That certainly can't be welcomed by the folks in Redmond, and it will be interesting to see if and how they respond -- especially since they want to move to a subscription-based model with cloud products like Office 365, which starts at $5 per user, per month for small businesses.

But at the end of the day, this isn't a huge issue just yet -- Apple's PC market share is still pretty tiny, and battling Office with the Apple-only, unfamiliar iWork is no easy task, even if it is free.

In 2023, it may be another story, though.

Also see:

Three Investing Experts on Apple's Many Smart Decisions... and One Mistake
 
Apple Inc. Rekindles Its Rivalry With an Old Foe

At Apple, Investors Still See Evolution, Not Revolution


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