(By Michael Holt, CFA) The list of once-great consumer electronics companies is long. Brand loyalty is largely dead, forcing hardware manufacturers to compete on features and price each product cycle. This makes it difficult to sustain a leadership position. Temporary advantages are easy to identify--namely the number of available applications and first-mover advantage on tablets. More relevant and meaningful to a sustainable competitive edge is how a firm applies software to establish user switching costs that will pull customers from one generation of devices to the next. The heart of Apple's (AAPL
) strategy is to create a bond with the user that transcends device cycles.
The mobile phone market is full of cases where a dominant position proved fleeting. Motorola (MMI) hit a home run with its RAZR product cycle, but after a couple of years, it stumbled. More important, there was nothing that compelled RAZR customers to purchase the RAZR2, so they didn't. One stumble at Motorola was enough to send customers fleeing to competitors.
The smartphone market is not immune to this trend, as Research in Motion's (RIMM) circumstances vividly demonstrate. Hardware companies must compete for the consumer's attention with the latest and greatest gadgets, and design expertise alone does not convey a sustainable competitive advantage. Vendors are instead turning to software to create a sticky bond with the end user. Failure to keep pace in design and software has crippled RIM, and Apple will have to overcome these same challenges to avoid a similar fate.
Inability to respond to changing market conditions can trigger a catastrophic loss of customers from one device cycle to the next. The story of iPod unit sales shares some similarities with Motorola and RIM, but it has two key differences. First, Apple largely maintained its share even as demand for stand-alone portable music players declined, reflecting decay in the market, not in the firm's products. Second, Apple was able to capture much of its base by offering the device that was cannibalizing the demand. For many iPod-wielding consumers, the ease of transition from the iPod to the iPhone was a material selling point. The Apple family of devices has maintained its momentum.
Building a Moat With Software
To prove its economic moat, Apple must demonstrate that it has locked-in customers, rather than wager on the product development team's ability to hit home runs on every product launch. This lock-in is established by the software. A Dell PC is easily replaced with a Hewlett-Packard PC, but for decades the user will probably be running Microsoft's (MSFT) Windows software. Apple is replicating what worked for Microsoft, minimizing the risk of losing customers between product cycles by using software to connect the user to an ecosystem of applications and content spanning multiple devices, creating a relationship that transcends the useful life of any single device.
Apple's focus on usability over technology will deliver the masses. When the original iPhone was launched in 2007, it ran on the abysmally slow EDGE network in the United States. Nonetheless, the device began winning customers despite superior 3G transfer speeds on competing devices, because Apple delivered a device that a nontechnical user could operate without an instruction manual. Even today, Apple's latest phone, the iPhone 4S, offers less cutting-edge technology, yet it continues to pull new customers into the Apple ecosystem.
The heart of Apple's strategy is to create a bond with the user that is more powerful than any given device cycle. Current momentum and execution should deliver many years of customer acquisition, but Apple is building a moat around software that locks in customers. Given the loss of visionary leader Steve Jobs and growing competition from Google (GOOG), Facebook, and Microsoft, we believe Apple will not be able to sustain its leadership by delivering great design. Great design and execution enable Apple to build its customer base, but it is the firm's software that makes it difficult for consumers to switch to another device.
Historically, moving your contacts from one phone to the next was a mild inconvenience. But as users adopt smartphones, the expanded functionality leads to a transition that includes importing music, photos, video, applications, and other services that never existed before. Therefore, the transition from feature phones to smartphones is the critical point for driving customers into the Apple ecosystem.
Apple will have its setbacks, but it is beginning to deliver software and services that should help it navigate future challenges with its customer base intact. The true test of the moat is not how sales are when products are at peak public perception, but rather what happens to the customer base when flops occur. Just as Microsoft easily weathered the fallout from Windows Vista's incredibly negative reception, Apple is positioned to retain its customer base through challenging times. In contrast, product launch missteps were the beginning of the end of Motorola's temporary dominance.