Which is best: hardware, software or services?

Apple’s recent margins are nothing short of spectacular. It’s hard to convey just how remarkable 47% gross margin and 39% operating margins are. For a company that sells hardware these are simply unheard-of numbers.

The best way I can illustrate this is by comparing Apple’s operating margins with those of two other platform-based companies, Google and Microsoft.

Microsoft invented the software-as-a-business model and, as software is easily reproduced, their margins are phenomenal. The gross margins are typically in the 80% range for software. Overall, the company had higher R&D and SG&A expenses so their operating margins are a more modest 37% on average. However, Apple managed to exceed this value even though it has the disadvantage of actually having to build things made of atoms.

Google also has led a charmed life free of inventory and factories. Its operating margins have been however hurt by investments needed to sustain the infrastructure for indexing the internet. That means that their margins have hovered around 33%.

As the chart above shows, Apple has been creeping up on both these benchmark companies with exceptional operational leverage and, as of this last quarter, overtaken them.

The reason Apple is able to do this is that its iOS businesses are extremely profitable and, as those businesses grow in absolute terms and relative to its other businesses, the overall margins are reaching into the stratosphere.

The impact of iOS on Apple is shown in the right-most two charts below. The difference in growth relative to these other great companies makes Apple all the more impressive.

But the temptation is to compare the “core” business models and ask which is best: hardware, software or internet services. It would seem that hardware is winning, suddenly getting the best margin and best growth–a dramatic reversal with prior technology business dogma.

However, it would be a mis-reading of what allows Apple to succeed. Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services. It’s the first, and only, company to do all these three well in service of jobs that the vast majority of consumers want done.

  • “Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services.”

    Agreed. And while Apple hasn’t always gotten each of these right or well integrated, they’ve been making incremental improvements all the way along and in the past few years with the addition of a well integrated iOS universe things have tipped.

  • Luis Alejandro Masanti

    “It’s the first, and only, company to do all these three well in service of jobs that the vast majority of consumers want done.”

    Maybe the only reason is not hardware/software/service.
    Just “customer satisfaction”…

    (And, of course, to be able to do the last, Apple integrates the first three.)

  • “Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services.”

    It’s hard to pin down exactly what makes Apple so successful: 

    – Some things seem unique to Apple (Steve Jobs’ genius, a fetish for design, etc.), 

    – Some things seem so obvious as to be trite (great management, supply train, etc.). 

    – Some things seem obvious but are routinely ignored or dismissed out of hand (a laser focus on providing a superior customer experience, a fanatical devotion to the concept of simplicity, etc.) 

    But some parts of Apple’s success are obvious, non-trivial, understood as being important, not unique to Apple but also almost impossible to duplicate or copy. “Integration” is one of those things.

    Any large company could have created integrated products and an integrated ecosystem that was comparable to what Apple has, if they had been willing to devote the same amount of time, resources, effort and attention to the matter. But no one has chosen to do so.

    Integration is not unique. But Apple’s level of devotion to it is.

    • nangka

      the main reason others don’t (want to) do it is because of the focus on numbers – sales & profits for the next quarter.

      apple’s focus is to create great products, and experiences.

  • r.d

    So Horace are you writing an article on Android number coming out of the Oracle Trail.
    They seemed different from the activation #s.  Seem strange that no one has highlighted them.

    any comment on Tax story. There is big difference between 24% and 9%.
    It seems strange that Apple didn’t point that out.  I guess they don’t want to open their tax form.

    • I’m looking at the Google data. It will take some more time to complete and there is a large overhang of data from Apple’s quarter to process as well as the entire phone industry. On the question of taxes paid, I assume Apple is obeying the law.

      • r.d

        question about tax had more to do with effect on margin.
        basically forbes article is saying that tax paid this year is
        estimation on last years profit.  It is troubling that NYT can
        get away with such an bold face lie without Apple calling 
        them on it.

      • I also assume that, but that ceases to be a discussion-ender when Apple (and similar companies) take a role in writing the law. There are serious questions of corporate citizenship at issue. Not that the Times’s focus on Apple isn’t disingenuous; it is.

    • ChKen

      IMO, the Forbes blog was wrong. He says the tax rate was calculated on the wrong year.

      Anyhow, the NYTs article was inflammatory by headlining it as “sidestepping billions”. Most of it is about millions, not billions. There’s the tax California misses as Apple manages its cash in Nevada. That might be about $30m given Apple makes so little on its US cash. Then there’s the R&D credit which amortized is only $27m a year. There are plenty of other companies taking far larger R&D credits, particularly in software and gaming software. Probably an order of magnitude larger. Then there’s income shifting to Ireland, which lowers Apple’s foreign tax rate, but if Apple pays the balance of its US taxes on that income, it’ll be tax shifting, and not tax sidestepping.

      The 9.8% differs from Apple’s 24% because Apple gets to defer/accrue taxes on its foreign income. My disagreement with the NYTs article is over that, as it’s the crux of their “sidestepping billions” headline. I presume Apple will pay that accrued tax unless they restate their accounts and say they won’t repatriate 60% of their foreign profits.

      The Sullivan paper which the NYTs cites, seems to think Apple should apply US taxes to more than 30% of their global income since the products are designed in the US. He proposes 50 or 70%, which would mean paying 2.4 or 4.8B more. It’ll be a moot point when Apple repatriates

  • obarthelemy

    “Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services. It’s the first, and only, company to do all these three well in service of jobs that the vast majority of consumers want done.”.

    IBM was/is doing that in the business segment.Apple is the IBM of the consumer space. IBM gradually moved away from commoditized hardware. Apple seems to be doing the same already with pro desktops. What will happen when the rate of innovation in the mobile and tablet segments slow down too, and prices and interoperability start to matter more ?

    • Modern smartphones will 5 years old later this year and tablets are two years old. Most of the growth is yet to come and innovations in software and services for mobile computing are in their infancy.

      • obarthelemy

        I wonder. How long did it take for the PC market to slow down, and value compatibility/operability/users’ habits rather than new features ? With much of that transferring over to the Mobile market, what more can be done ?
        Indeed, what has been done recently ? Higher DPI screens ? voice search / control / AI ? Payments ?
        I recently came across my shoebox of retired Palm Pilots, and realized I’m not doing much more today on my smartphone than I was doing 10-15 years ago with them: PIM, emails, music, video, ebooks. RSS and Web blossomed in the mean time, even the latest T3 could never browse tha well, though I think there was a competent RSS client. And I got a 3G instead of wifi connection, but really, if the T3 could browse and sync, I might have put it back in service just for kicks.
        The one thing missing is a camera.

      • The PC market took about 30 years to slow down.

      • famousringo

        If we want to compare this with desktop computing, this is 1989. The mobile equivalent of Windows 95 hasn’t even shipped yet.

    • oases

      Growth isn’t essential. If a wonderful business throws off lots of cash every year then that is sustaining even after termination of industry growth. And if you’re a mega company already equal to let’s say 10% of the World’s economy, what more could you ask for?

      • obarthelemy

        I never mentioned growth. Commoditization is about margins, mainly, also differentiation and innovation. The danger in a mature market is that innovation is scarce, and pressure gets put on price, and compatibility with users’ skills and other IT toys.
        My opinion is that there already isn’t much innovation in the mobile market, the last big one was the full-touchscreen phone ?

      • oases

        That’s when having a monopoly comes in handy. Allows you to ignore pricing pressure. It all turns on whether Apple can get AppStore hegemony.

  • Dick Applebaum

    “Microsoft invented the software-as-a-business model…”

    Horace… minor quibble here, but the “software-as-a-business model” existed long before Microsoft, Apple or Google even existed.

    For example, in the early 1970’s IBM had several popular software packages including:  CICS, IMS/DLI, BOMP…  I worked at the IBM Palo Alto Systems Center (PASC) that did market support for these applications.  At one time, in the 70’s, we got some numbers that there 30,000 CICS installations.  CICS was leased to customers at of $3,000-$6,000 per month….

    So… $3,000 x 12 x 30,000 == $1 Billion and change per year.

    There were other companies selling software for Maimframes and MiniComputers prior to the introduction of the MicroComputer.

    While Bill Gates and Paul Allen may have created a software business around BASIC for MicroComputers — Many (including me) would assert that VisiCalc, the first spreadsheet, was responsible for the large scale, disruptive acceptance of MicroComputers by businesses.

    VisiCalc sold for $79 a copy.

    • I still think that Horace is right on this.  In your example of IBM, software was still just a side business centered around selling the system of components; mainframe; terminals; software.  Software was a business model but not THE business model.

      MS is the first long term successful company to have software be THE business model.  There were other companies that made some change along the way, from Ashton-Tate, VisiCalc, WordPerfect and Borland for example, but they were not long term entities.

  • Luis Alejandro Masanti

    One (late) question: Isn’t RIM/Blackberry a hardware/software/service integrated company?
    Which one is the difference with Apple?
    Is RIM focused in the user? No. It is focused in the buyer, the IT manager!

    • RIM was and is an integrated offering. The job of messaging they began with was a powerful source of growth and income. As that became commoditized, the company did little to move into the next jobs.

  • If you take out the iPhone with its outsized margins from Apple’s portfolio, there is nothing exceptional about the company’s margin structure. No amount of integration will cause Apple to make 40%+ margins on unsubsidized iPads, Macs, iPods, and other iProducts.

    • Adamthompson3232

      Wow. Ridiculous point. But, hey, if you remove advertising from Google’s revenue they’ve got almost nothing left. Another ridiculous point for sure but why not point it out.

    • Indeed. The integration must be applied to new jobs to be done. Integration on commoditized activities is a liability and that process of commoditization is never-ending and relentless and few companies survive the shift. I would disagree however with the claim that there is nothing exceptional about ex-iPhone margins. Competitors were never able to match any of those product category margins and the choice of categories to compete in is non-trivial.

      • Yes, competitors in PC, tablets, mp3 players haven’t been anywhere close to 30% margins in those product categories – and there’s no question that Apple is an exceptional hardware player. But in the software space, which is your analysis in this post, 30% doesn’t look exceptional vs Google or Microsoft. The interesting question to tackle is what causes iPhone to earn outsized margins? Is it the operator subsidy? That’s the only thing I can point at that’s really different between say, and iPad and an iPhone. iPad is just a really big phone that isn’t sold w/ a 2-yr contract through a MO.

      • The money does come from operators, but the question should be why they are so willing to part with it. I try to answer some of this question here:

      • Agreed – operators need to monetize their 3G infrastructure, and smartphones are their friend in that. That doesn’t answer a question though of why iPhone is so much more profitable than an iPad.

      • The iPhone is more profitable than an iPad because an iPhone leads people to spend loads more on service. When consumers went from not paying for TV (broadcast) to paying for TV (cable) they went from paying zero per month to paying $100 per month. What is the value of such a customer to a cable operator? What would he pay for a set-top box that made this cash flow possible? Is that set top box maker going to make a huge margin? If he sold the same assembly of components separate from service it would not fetch nearly as much.

      • I like the TV analogy, but shouldn’t it apply to iPads as well? 3G iPad is a great consumer of MO data, probably an even better consumer of MO data vis-a-vis the iPhone. 

      • What is MO data?

      • Mobile Operator data packages – the 1-2-5 GBs that subscribers pay $15-30-50/month in the US.

      • iPads are rarely used with cellular data. Although the majority have the capability, most people don’t activate the network.

      • I would disagree that the iPad is better for mobile data consumption. In my observation of the way normal people use mobile computing, the pocket factor is a huge advantage. Maybe a 3G iPad user might consume more bandwidth, but the frequency of use and subsequent value to the user has been far greater with the iPhone. It always being in your pocket or purse is a tremendous advantage. 

      • r00fus

        I have several 3G iPad owners in my family – many of them bought it just for the “flexibility” of 3G data, which is pre-paid. 

        Some of them never even use the 3G ability.  Others use it only when they are taking trips (ie, once in a few months they’ll get a minimum data plan).

        I’d bet mobile data for an average iPad is lower than with the iPhone… even assuming we’re simply talking about mobile-enabled (3G) iPads.

  • Tim F.

    Next landmark event: surpassing MSFT’s gross profit margin!

    (I don’t know if I think that sort of efficiency/desirability can be achieved, but you’ve got to have goals.)

    • r00fus

      It would be possible if Microsoft really feels the pinch from iPad or the mobile market in general – People still (today) want MS Office, but not everyone wants Windows.  Tomorrow, even Office may be extraneous for a device.

      When Microsoft’s monopoly falls hard on it’s face, their profit margin will fall – and Apple will be there to pick up the crown.

  • capnbob67

    Great stuff as ever but wouldn’t it have been more useful to align the product colors for revenue with the colors for operating profit? It would then be a little more obvious how profit aligns with revenue.

  • joelypolly

    “Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services.”While this is technically the result I wouldn’t call it the winning formula.

    Apple is the most valuable company in the world because of its single minded pursuit of user experience that has pushed it into creating the hardware, software and services around a product. Apple makes technology accessible but technology isn’t really what they are selling, they are selling solutions to problems and technology is the delivery vehicle.

  • JohnDoey

    I think the missing link here is the change in how software is delivered:

    – 1990’s — 3rd party physical media (too bulky, many other problems)
    – 2000’s — 3rd party downloads (too insecure, too technical for most users)
    – 2010’s — 1st party preinstalls with 1st party network upgrades and optional 1st party app store

    … so if you want to be a software company now, you have to make your own hardware, because the hardware company is managing the entire software stack on the device, or soon will be, or will soon be out of business. The hardware company is therefore basically a software company now. Apple puts iOS on an iPad in the same way that Microsoft puts Windows on a DVD. Both are $399. Both are 1 of hundreds of millions of copies. Same kind of high-margin make one and then make hundreds of millions of copies scale.

    App Store has 3rd party developers, but the apps are installed by the 1st party hardware vendor. All of the software on an iPad is installed by Apple, including Web apps, which install via Safari/WebKit. Apple is not only a software company, they are the ONLY software company for all iOS users.

  • None of the above.  The true value is in being able to create a System that composes a seamless mix of software, hardware AND services.

    Ask Apple.
    Ask Amazon.

    “Apple is the most valuable company in technology (and indeed in the world) because it integrates hardware, software and services.”

    This goes to what I have been saying on this site for well over a year.  Apple is a systems company and they arrive at value through the strength of a system on not individual pieces.

    • Jeffrey

      systems company…great explanation

  • Apple does not actually manufacture the hardware itself. If you had to factor in Foxconn’s numbers, the margins would be lower.

  • Pingback: Apple: Q2 Thoughts | Monday Note()

  • Nice conversation,Your idea for this topic is amazing.

  • Pingback: Master Apple puts quality before commodity()

  • Pingback: Apple puts quality before commodity | ccnew()

  • Pingback: 複製 Apple 的三要件:好軟、好硬、好服務 | TechOrange()

  • Pingback: Apple puts quality before commodity | Insight with Passion()