Apple, Microsoft at Same Tipping Point

See Apple’s  latest moves on this Tipping Point here.


Rapid developments in smartphones and the emergence of Netbooks would suggest that Apple-AAPL and Microsoft-MSFT are reaching tipping points in their respective industries. However, the probability of when and the nature of the Tip may be different. But first before considering anything else, lets take a look at each company’s financial condition:
Both from Google Finance and Reuters

Apple Financial Strength

Company Industry Sector S&P 500
Quick Ratio (MRQ) 2.36 1.81 2.21 1.16
Current Ratio (MRQ) 2.38 2.21 2.63 1.41
LT Debt to Equity (MRQ) 0.00 18.45 22.53 77.98

Apple Profitability Ratios

Company Industry Sector S&P 500
Gross Margin (TTM) 34.34 10.39 17.47 40.78
Gross Margin – 5 Yr. Avg. 31.83 30.55 43.17 40.31
Operating Margin (TTM) 18.99 4.11 4.12
Operating Margin – 5 Yr. Avg. 15.40 8.08 15.06 17.78
Net Profit Margin (TTM) 14.70 3.11 2.69 8.99
Net Profit Margin – 5 Yr. Avg. 12.15 5.54 9.72 12.26

Apple Management Effectiveness

Company Industry Sector S&P 500
Return on Assets (TTM) 13.34 3.11 2.54 7.81
Return on Assets – 5 Yr. Avg. 13.96 6.32 8.57 8.46
Return on Investment (TTM) 20.44 4.98 3.69 10.86
Return on Investment – 5 Yr. Avg. 21.57 9.87 12.09 11.46
Return on Equity (TTM) 24.47 6.76 4.61 25.41
Return on Equity – 5 Yr. Avg. 24.00 11.68 13.93 20.64

This is Microsft Results

Microsoft Financial Strength

Company Industry Sector S&P 500
Quick Ratio (MRQ) 1.55 2.70 2.21 1.16
Current Ratio (MRQ) 1.59 2.79 2.63 1.41
LT Debt to Equity (MRQ) 0.00 9.27 22.53 78.31

Microsoft Profitability Ratios

Company Industry Sector S&P 500
Gross Margin (TTM) 80.42 17.45 17.47 40.69
Gross Margin – 5 Yr. Avg. 81.69 58.18 43.17 40.23
Operating Margin (TTM) 34.61 5.33 4.12
Operating Margin – 5 Yr. Avg. 34.46 22.38 15.06 17.74
Net Profit Margin (TTM) 27.80 3.78 2.69 8.88
Net Profit Margin – 5 Yr. Avg. 27.86 14.50 9.72 12.22

Microsoft Management Effectiveness

Company Industry Sector S&P 500
Return on Assets (TTM) 25.89 3.32 2.54 7.75
Return on Assets – 5 Yr. Avg. 17.26 10.54 8.57 8.44
Return on Investment (TTM) 39.45 4.90 3.69 10.79
Return on Investment – 5 Yr. Avg. 23.53 15.03 12.09 11.43
Return on Equity (TTM) 50.01 6.32 4.61 25.34
Return on Equity – 5 Yr. Avg. 26.46 16.49 13.93 20.62

But perhaps the most telling numbers are the amounts of Cash each operation generates per year:

Cash flow Cash QTR Cash 2008 Cash 2007
AAPL Cash from Operating Activities in $MM 3,938.00 9,596.00 5,470.00
MSFT Cash from Operating Activities in $MM 9,152.00 21,612.00 17,796.00

Both companies are huge cash generators and outpace their respective industry and the S&P 500 in their overall financial performance and strength in a number of highlighted categories. In some respects both Apple and Microsoft are peas in a pod with no long term debt, huge advantage in gross and operating margins versus their competitors and stellar returns on assets and equity. There are some differences: Apple pays no dividend while Microsoft does and while Apple has good margins Microsoft has massive ones. But it is important to note that because neither company has any long term debt and both generate huge amounts of cash, they are hardly financial invalids. So both are financially in a strong position to address any market problems. And so they may have to.

The Market Problems are remarkably similar in some respects. Both companies are under margin pressure because of the economic contraction that will see sales of PCs having its worst drop ever, down 12% from 2008 according to Gartner. At the sametime, Apple and Microsoft are now starting to wage serious marketing campaigns against each other – and price is a big factor. But of even greater impact is that the one PC market that is growing spectacularly Netbooks, is drawing down sales of laptops and notebooks. But the rise of Netbooks stands to hurt both Apple and Microsoft in more than in margins. Each suffers in its own way.

Apple and Netbooks

Apple gets hurt by the rise of Netbooks in two ways. First, Apple’s iPhone is under more margin pressure than ever before because of the entry of several feature-rich players (think Google Android, Palm Pre, Rim Blackberry among others) into the smartphone field. But all the smartphones are now under attack by the swift rise of Netbooks whose more of everything comes in the category of lots and lots(full keyboard, bigger screens, huge hard disk drive, much faster processor – see all the details here) and now more choices of OS and Net providers) – and all for the cost of 2.5lbs or a lot less and $299-800 or a lot less when bought on a two year plan with Verizon or AT&T. Some CTIA Telcomm show chatter is suggesting $0 to $50 signup deals being offered from wireless providers by 4th quarter 2009.

But Netbooks also hit on the broader Notebook/Laptop markets which in turn have been cannibalizing the desktop PC market. As the NYTimes coverage from both the business and the technology side show, the Netbook is having huge disruptive effects on the PC marketplace. Netbooks currently are the fastest growing PC sales with 39 Million projected for this year rising to 139 million by 2013 according to ABI research. This is a back-to-the-PC-future annual growth rate of nearly 33% per year. And if Netbooks get a strong pick up from Wireless vendors some analysts are suggesting the growth rate will be even larger. But the big fly in the ointment is the cannibalization factor – sales take awayas from desktop PCs and full size laptops and notebooks. HP says its is only 20%, but others believe that number is too low.

Clearly Apple, whose laptops and desktops are already premium priced, has potentially a lot to lose if the Netbooks take off. But others argue that most Apple machines are used for CPU intensive multi-media and photo processing work which the current crop of Netbooks are not so good at. So the argument goes that except for users downsizing to Netbooks for Office and web browsing, Apple is protected. However, the iPhone certainly has a competitor in Netbooks whose only missing ingredient is touch screen operation – otherwise Netbooks dominate the iPhone in hardware specs … and with Google’s Android as the OS, could quickly match the software prowess of iPhone.

Even more telling is that the price of some lowend Netbooks approach those of iPods say nothing of iPhones – but the Netbooks screens and speed and hard disk capacity far exceed both the iPhone and iPod. So Apple will have to a)lower prices on the iPod and iPhone and/or b)sell iPods more agressively on foreign markets – currently 80% of Apple total sales come from North America and Europe.

But the handwriting is on the wall. Apples vaunted margins will be coming under pressure up and down its product lines in the coming rise of Netbooks over the next 3-5 years. Even an Apple entry into the Netbook space is complicated by the fact that it will be me-too except for touch screen and possible Wireless capability. Yes Apple iTunes, App Store and customer loyalty will help. But clearly the 25% annual growth rate in sales for the past 5 years as well as margins are in jeopardy as swift change will force quick and sweeping decisions at Apple – something that may be on medical leave.

Microsoft and Netbooks

Microsoft’s executives were right – Vista is a dog. But that is not the only problem facing Redmond. The IE browser continues to lag way behind four other browsers in speed, features, and standards support – and that deficit is taking its toll : now showing up in dwindling market share numbers and developer desertions. There are servers side problems as well. Windows Server 2008 even with the new Azure version (dedicated to Web processing) can’t put Microsoft.com ahead of 60% of all other websites in performance. Also the Business division just will not make its growth targets established 2-4 years ago. Apple is pounding Zune. Nintendo Wei is an unexpected game market innovator and dominator. Google is pounding Microsoft Live Search. Fortunately Sharepoint, Windows Server and SQL Server are doing very well thank you.

And then Netbooks arrive on the scene. At first it looked like a marketing ploy had erased that problem. When originally introduced into the market, all the major Netbooks used Linux. But some hackers got Windows XP to work on their Netbooks and that prompted a clever play from Redmond. Windows XP which had just been forcibly retired from service in June 2008 suddenly found itself resurrected and available for Netbooks – and sure enough the market went Microsoft. Redmond claims 96% of Netbooks currently sold use Windows XP. Yet in the last quarter of 2008 Microsoft saw some disturbing declines in Windows client sales. Redmond is admitting that Netbooks as well as the economic downturn is a factor. Estimated cost of Netbook XP is $20-35 to OEMs but was double that for desktops. So there must be some real margin pain associated with XP on Netbooks for Microsoft.

But now the Netbook game has taken a nastier turn for Redmond. Google has enterd in the Netbook market with its Linux version, Android. And HP, Dell and Asus among other are biting. Ubuntu and Xandros who are already on some Netbooks are offering spiffed up versions for new Netbooks. But the crucial element is that 39 million Netbooks will be sold this year – and price will have a big impact to all vendors. And at an estimated cost of $3 for the Linux versions versus $20-35 for Windows – and you have the definition of major margin pressure for Microsoft.

And there is another factor playing out here. A lot of the vendors want to add their own special software and added features to their Netbooks. With all the Linux versions being open and Google having an official API and APP Store already for Android, OEMs and software developers will have some very appealing choices. Now Linux will be offering a)free and unfetterd access to source code (contrast this with Windows XP)and b)in the case of Android a marketplace for their goodies and b)from some names that have built up strong brand trust for consumers and developers alike. Finally, there is the MindScape factor – Open Source in the downturn is getting strong mindshare simply because of its many economies. Google itself has positive developer mindshare – contrast this with what the problems in Vista, IE and Web development have done to the Microsoft brand for superior developers environ.

So Netbooks may be the same tipping point that Google+Mozilla+other browser vendors have been for IE in the past 3-4 years -slowly eating away IE marketshare such that IE has declined in Europe to less than 50% market from a high of 90% just 4 years ago. Can the same happen for Windows ?

Microsoft has the cash and also its own developers that want to deliver best of breed. But it also has two major problems: all of its major software brands are undergoing major repair/refurbishment work and for whatever reason, Redmond developers may want to deliver but something is in the way. IE8 and Vista are telling examples of less than stellar delivery. Perhaps the mandate to have everything run best in Windows is getting in the way. Others mention internecine warfare among competing Redmond development teams. Still others mention the long underwater drought of Microsoft stock options – a key pay component at Microsoft. Whatever the cause, Microsoft’s track record on recent software development is mixed at best and Vista at worst.

Summary

Both AAPL and MSFT will have margin challenges associated with Netbooks. This is inevitable. PC have long been sold with too much computing power for most users and many common tasks. At the same time both mobiles and Netbooks have inevitably prospered from Moore’s law which has doubled their capacity for the same price every two years or less. Also the idea of OLPC and then the reality of the Asus EEE delivering light-in-weight, long-lasting-in-power and very mobile computing for 1/3 price or less …. and suddenly not 10’s of thousand but millions of users had their machine. Now add Wifi, phones, and games to these handy beasties and it is as if smartphones/PDAs had come up to PC scale – and so the markets seem poised to change yet again.

For the past 30 years the two charismatic companies and their leaders, Apple with Steve Jobs and Microsoft with Bill Gates danced around each other in seeking to lead the PC industry and more broadly IT innovation. Apple and Steve Jobs first appeared to have the lead in innovation with the Lisa and Mac. Then Bill paid Steve the highest of IT compliments and copied most of Apple’s ideas with Windows – and after 3 years and 3 tries got the breakthrough that lead to Redmond leading in marketshare and dollars by wide margins over Apple. Lately Steve and Apple have started to catchup with 25% growth while Microsoft grows at low single digit rates. And Apple leads again in innovation, particularly in the consumer Smart-gizmo marketplace. But Microsoft continues to lead in software, market share and raw revenues plus ROI.

Some have argued that the major PC players from Bill Gates thru Mitch Kapor to Steve Jobs were the beneficiaries of astoundingly fortuitous circumstances(see the book Accidental Empires). However, It appears that the next phase in the PC and thinking electronics evolution will not see the usual sequence – one of these two companies leading the way with the other following closely behind. Rather, both companies will have to react to market forces not totally under their control as neither will have first-starter advantages in the fas growing Netbook market. Both companies are already experiencing the first signs of inflexion on their Financial Statements, particularly Microsoft. Both companies have leadership questions – with Bill semi-retired to charity and Steve tackling tough health issues. How both companies handle the Tipping Point problems presented by the rise of Netbooks, connectivity to them and information truly at your fingertips – this may well define the future relative position of the two firms in the marketplace and the ultimate legacy of the two leaders.

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