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Why total net profits are not conserved

When cellular phones emerged in the 1980’s wireline phone service was excellent. Penetration was at 99 percent in the United States and prices had never been cheaper. The industry was deregulated and phone companies were competing fiercely over long distance calling plans. In contrast, the new cellular phones were not “good enough” on the basis of what was considered necessary for making critically important phone calls.

Sound quality was poor, coverage was spotty and battery life measured in minutes. But they allowed a whole new consumption model of communication to emerge. They allowed a caller to call a person not just a place. Over time, this simple value proposition caused a powerful profit formula to emerge. That formula led to extremely rapid improvement in the quality of the network and devices that connected to it.

It caused such a cataclysmic change that twenty years hence it became possible (even natural) for consumers to “cut the cord” and abandon wireline communications altogether. The “excellent quality” wireline industry was dead to be replaced by the “good enough” wireless industry.

One consequence of mobile telephony was increased consumption. Voice call minutes increased dramatically because calling could happen anytime from any place. While overall consumption increased, landline use decreased. Then came messaging of various types. Forms of communication enabled by cellular networks that simply did not exist before with landlines.

As a result there were vast pools of profits available to telcos that seemed to appear out of nowhere. SMS and data plan income was beyond anyone’s ability to forecast in the 1980s.

The same phenomenon is happening with smartphones. Consider a proxy measure: operating profits from mobile phones since the iPhone launched, illustrated below.

Although Apple went on to capture 75% of the profits, it did so from a vastly expanded profit pool. A similar picture emerges from an illustration of revenues:

Another way to visualize the evolution of the market is to look at the combined price, profit margin and volume areas for the fourth quarters of 2009, 2010 and 2011.

Scanning from top to bottom, you can see how volumes grew, revenues grew and profits both grew and were re-allocated among participants (each colored pixel in the charts above is equal to about $1 million.)

These charts illustrate that there is no “law of conservation of profits” in any market as long as there is sufficient innovation. This is because the there is no “law of conservation of value created”. If value is presented, buyers will gladly trade cash for it. Conversely, if there is no value-generating innovation, growth stops and competition reduces to a zero-sum game.

One of the most exciting aspects of disruptive growth is that although it tends to transfer profits from incumbents to entrants, it also grows the size of the overall market. Sometimes the growth is significant.

  • http://wmilliken.livejournal.com/ Walter Milliken

    I don’t know if you’ve got the data, but showing a simple smartphone/featurephone split for the total market charts (profit and revenue) might be even more compelling to show how adding value can grow the market.

    Another variant would be average handset price over time, which factors out changes in market size, but shows how the change in value proposition affects the individual buyer.

    By the way, add me to the list of people who want a different legend description of the colors in the vendor area charts, rather than “solid/opaque”. I’d suggest “light color” and “dark color”.

  • Guest

    (“cut the cord”)

  • Anonymous

    Thanks for another great article. The only thing I wanted to point out is that it should be “cut the cord” not “cut the chord”.

    • http://www.asymco.com Horace Dediu

      Thanks. Fixed.

  • gbonzo

    Do you see the iPhone as disruptive? If so, in what way?

    Certainly not low end disruption against other phones. Maybe new market disruption? Are there other categories of disruption?

    Or was the iPhone just better than the competition?

    • addicted4444

      The harder question is, in what way was the iPhone NOT disruptive in the mobile space.

      As far as disruptions go, the iPhone disrupted at least the following:

      1) The carrier-manufacturer power relations in the US. Nokia was never able to enter the US market because the carriers never wanted them in. Nokia stands a much better chance now.
      2) The idea of what a cellphone is. A cellphone was no longer just a calling/texting device. It was now a portable computer.
      3) It possibly (not entirely sure about this) was the driver of getting newer cell phone technology. I really doubt we would be seeing LTE being rolled out so fast if it wasn’t for the iPhone, and iPhone like devices, because phones prior to that never consumed that much data.
      4) It made real, and mass market, a completely new human->device communication interface. It is the greatest advance in input interfaces since the mouse.
      5) It massively changed the value of a phone in a consumer’s mind. Suddenly consumers were willing to pay a lot of money for their phones (as evidenced by the growing profit/revenue pie) as opposed to simply getting the cheapest they could find.

    • Anonymous

      The iPhone was the first sophisticated touchscreen smartphone. It disrupted the whole area of mobile tech. Many others are following where Apple led. Again.

    • http://www.asymco.com Horace Dediu
      • gbonzo

        That was insightful. Thank you.

  • http://pulse.yahoo.com/_KEVQDCIMSOI6AFXXFFS5ZFFWBA PeterK

    Horace,

    I wonder if you can cast your analytical eye on Apple’s disruptive *method of supply*. I believe they will be delivering over 1B devices per year in the near future. 

    Isn’t what it takes to develop a 1B+ supply chain of highly valued items disruptive in itself? And what of 2, 3, and 4B devices they will produce if Apple thrives over the next 10 years or so?  

    Also, due to the very few models they make and the ‘beehive’ accelerated teamwork, their engineering/design/R&D team may only double from 25,000(?) today to 50,000 in the next 10 years. (Whereas, the retail team might go from 30,000 to 150,000 employees in that 10 years.)

  • Andreas

    Great charts and thank you for sharing this data, Horace.

    I still think that this profit and revenue growth was simply captured from adjacent industries and *not* created by Apple. Looking only at phone vendors does not show this. Because the smartphone is a multi-purpose device it draws in profits and revenues from:

    - camera makers
    - navigation device makers
    - the PC market (eg delaying buying a new notebook as some tasks are moved to the smartphone)
    - music players
    - game console makers (e.g. look at nintendos profits and tell me this is not something apple captured)
    - PDAs (ask Palm for their profits)

    Overall, I will go out on a limp here and say that iPhone/iOS destroyed revenues and profits and focused them on a single company. This is because a multi-purpose device is more efficient to create and operate than all these single devices. This efficiency makes the iPhone, overall a low-cost disruption being a worse phone, worse camera, worse game console etc. but being overall cheaper to buy and manage than all the single devices.

    • Argletom

      You beat me to it.  Maybe the “law of conservation of profits” needs to be assessed over a broader range of products and services.

    • Anonymous

      It’s not a worse camera or game console, though. It takes a couple of steps back for some people, but for most it is all hundreds of steps forward.

      Overall, an iPhone 4S is the best point-and-shoot camera ever made. Period.

      I think what you are seeing is hardware devices becoming apps. That is the natural order.

      • Andreas

        “Worse” in the disruptive sense of being worse along established, mainstream performance attributes. In the case of pocket cameras this would be megapixels and picture quality. I guess few pocket camera makers regarded the iPhone as a threat when it was launched.

      • Wesley Hsu

        I’ll agree re the 4S and go a step further: the consumer camera industry will be dead in two years. High end pro SLRs will keep Nikon and Canon alive, but medium players like Sony, Samsung, and Panasonic, will abandon their digital camera divisions except as component makers for smart phones. Fuji will join Minolta, Olympus, and Pentax in the afterlife. 

        The images possible with a 4S and 30 seconds of app-tapping surpass what a Canon G11 and 15 minutes of Photoshop used to do. 

    • http://wmilliken.livejournal.com/ Walter Milliken

      I agree, somewhat. However, I think there are at least some users — myself at least — who actually didn’t buy products in those other industries, but are happy to buy a multifunction device that eliminates the need for single-purpose devices and provides extended functions at a very low cost.

      In fact, I didn’t even want a cellphone until the iPhone came out, because I didn’t actually want a mobile phone, it was the mobile computer aspect *with* a phone that was a compelling value for me. I didn’t own either a navigation device or a game console, and my old digital camera was 3Mpix and hardly ever used (too much trouble digging it out and making sure it had a charged battery). The iPhone *did* replace my old Palm V and my iPod, though.So it’s not clear exactly how much it’s cannibalizing other products, and how much it’s selling to new users in those markets.  I suspect I’m not the typical case, but I suspect it’s not uncommon. In any case, I think there’s an argument to be made that it presents a much better value than a bunch of single-purpose devices, and it’s not just because the total price is cheaper.

      • twilightmoon

        I would say the person that owned all of those devices was San edge case and most people owned only a couple. Also the people that owned none and got an iPhone are an edge case (excluding very young buyers just coming into the market).

    • davel

       Andreas,

      Great analysis.

      Thanks

    • Wesley Hsu

      I remember a friend in 2004 using rubber bands to bind his iPod to his Nokia phone because he couldn’t keep track of both of them separately. I made a joke about investing in rubber bands, which goes to show how badly I missed the insight.  

  • Andreas

    I work at an ISP also selling an “internet” based telephony service designed to replace the old fixed-line phone service for businesses. This morning we had a similar thought as in the first two paragraphs.

    Our customers freak out when our phone services has a short hickup, but when their mobile phone service is away for a couple of minutes they shrug and try again later..

    Andreas

    • Anonymous

      That is the difference between wired and wireless. If you have wires, you’re expected to be more reliable than wireless.

  • Sam Wallentin

    The conclusion is applicable to the introduction of three way catalysts by Saab and Volvo in the seventies (particularly in the us) and the introduction of Freon free refrigerators by Foron in The early nineties (particularly in Germany). Just to broaden the perspectives here.

  • Pingback: De mobiele telefoon producenten hebben nog niets geleerd | |

  • Michael Held

    Would be interesting to compare how the revenues and profits migrated from the 80s landline providers to mobile carrier (some are the same I guess) and what is now redistributed between infrastructure provider and platform owner. The bundling of voice and message into billable packets must sooner or later end I suppose.

  • Damon

    It graph of price and operating profit per phone sold is excellent.  But its key is wrong.

    The way it is now, newcomers (and even those of us who have seen it before) have to figure out for themselves the correspondence between light/dark colors and profit/expenses.  Every time I look at this graph, I guess wrong, catch my error (because negative values don’t make sense for operating expenses), and finally arrive at the correct meaning.The problem is that the words used to describe the colors–”solid” and “opaque”–mean pretty much the same thing when it comes to colors.   Improved pairs of words would be “transparent”/”opaque” and “transparent”/”solid”.  But “light”/”dark” would probably be the clearest descriptions to use.

  • http://nmuppala.wordpress.com Nalini Kumar Muppala

    For the last three charts, static pictures make it hard to visualize and follow the story. Short of a full movie or a Flash-only google widget, a motion chart or even an embedded widget with three pictures that can be “moused over” will help. Have you explored any such tools?

    • http://www.asymco.com Horace Dediu

      Yes, stay tuned.

  • Ozzie903

    For addressing many of the issues raised in the present discussion, I think it is better to consider the iPhone as a mobile computer that performs many functions — one of which making phone calls. It competes with phones, but it also competes with cameras, calculators, game players, gps units and so forth. 

    In short, the smartphone — whether Apple’s or that of another company — is a completely different product category than mobile phones, which BOTH overlaps other products and provides services never before available to the consumer-on-the-go.  

    In the first instance the smartphone cannibalizes other product categories, while in the second it creates new value (and profits) by empowering the user and making him/her more productive.  One other productivity gain from smartphones is the result of integrating many different functions/services in a single model.  These are synergies. 

    Inasmuch as total revenues and profits generated by smartphone makers is vastly larger than those of feature phones — both today and in years past — one must conclude that smartphones are responsible for vast gains in convenience and productivity for customers rather than cannibalizing the feature phone segment. 

    Moreover, since ‘new services’ and ‘synergies’ (rather than cannibalization) are responsible for such a large share of the value provided by smartphones, it is not surprising that the company with the best integration between software and hardware (i.e., Apple) is ‘winning’ the contest.  It explains why the makers of feature phones can’t effectively compete with smartphones simply by lowering their prices. 

    This analysis suggests that ongoing/future improvements in services and synergies will be necessary to drive further adoption of smartphones and shorten upgrade cycles.  Prettier phones or improved technical specifications that don’t deliver more computing services to the customer are far less likely to succeed in the marketplace.

    This is consistent with Horace’s ‘no conservation of profits’ theme. 

  • http://www.ivpcapital.com/blog Michael Elling

    Useful data.   Apple thinks more digitally, with a vertically complete (not integrated) approach to ecosystem, than any company on the planet.  2007 was like 1987 at the start of the WinTel revolution.  The carriers (and vendors) are being disrupted and need to rethink their business models.  http://bit.ly/AzWLF3