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Sundararajan: More Problems Ahead for Apple

Arun Sundararajan, Associate Professor, New York University's Stern School of Business
Friday, 25 Jan 2013 | 12:04 PM ET
Apple Store NYC
Getty Images
Apple Store NYC

All eyes are on digital titan Apple this week. Despite quarterly profits of over $13 billion, the recent success of the iPad mini, and seemingly strong growth rates for both the iPhone and iPad, the share price is off more than a third from its pre-iPhone-5 launch high of over $700, and the company has shed over $200 billion in market cap over the last five months. Could this merely be the extreme volatility often associated with the digital sector? Or perhaps the expectations of Apple's investors have evolved to mirror those of iconic founder Jobs, demanding nothing less than perfection from the company?

(Read More: El-Erian: Solving Wall Street's Apple Puzzle)

This market reaction is not just an aberration. There are more stormy waters ahead for Apple, whose success is largely rooted in a tumultuous, yet determined history that gave it a massive head start a decade ago as the digital landscape became consumer-centric. Granted, this early edge has led to an impressive array of short-run technological barriers to entry and a tremendous revenue stream today. But the lead is dwindling and the barriers are fading. To keep its spot on top, Apple will soon need to participate in the imminent creative destruction of its revenue model. This calls for caution.

"This market reaction is not just an aberration. There are more stormy waters ahead for Apple." -Arun Sundararajan, NYU's Stern School of Business.

Historical Headstart

Today's age of "consumerization" of information technologies, in which radical innovation is driven by the needs of consumers rather than organizations (think mobile devices and social media), is a stark contrast to the business-centric 1980's and 1990's. The lone contrarian of these decades, Steve Jobs bet his company's future on making his products easy to use and easy on the eye. He rode against a trend of vertical specialization by doubling down on both hardware and software development while investing heavily in usability and attractive industrial design. That era belonged to the corporate-focused Dells and Microsofts, while Jobs' relentless pursuit of his vision nearly bankrupted the company he founded.

But Apple survived, even if only barely. And at the turn of the century, consumerization gained traction. Electronics giants like Sony grappled with a digital-resistant corporate culture and erstwhile technology leaders like Microsoft tried to reorient their massive organizational engines towards home users. Meanwhile, Apple was ready for this transition, armed with two decades of consumer experience, a charismatic founder and exceptional marketing prowess. We fell in love with the iPod and started organizing our music on iTunes. As the only company at the time truly capable of melding hardware and software into an eye-catching and user-friendly mass-market platform, Apple owned us.

(Read More: Apple Suppliers Slammed, but Experts Say Buy)


Apple Lost Its Genius?
Without a dividend boost, a monster buyback or a deal for something that makes the company more social, explains Mad Money host Jim Cramer, the stock might go from a growth stock to a value stock.

Stormy Waters

The press over shipping delays, earnings growth and mapping snafus distracts from more fundamental future challenges. Apple has lost its absolute dominance over design. For the first time in smartphone history, the most anticipated device of the year will not be an iPhone, but Samsung's Galaxy S4. Last year, what analysts missed in the Samsung patent victory was a critical moment of transition: over time, Apple will need to rely increasingly on inherently volatile intellectual property protection to beat the competition, and not the vast superiority of design and capabilities it has cruised on over the last decade.

This challenge is compounded by the growing popularity of streaming services like those offered by Amazon, Netflix, Pandora and Spotify which will soon jeopardize Apple's massive hardware revenues, currently well over $10 billion a month. See, while it's not impossible for us to port our iTunes-specific digital music and video to a new platform, it isn't easy or convenient either. Thus, in the world of digital media ownership that has immediately followed the CD and DVD, Apple aficionados who contemplate new generation Android-powered phones and tablets can feel "locked-in" to iDevices by their media libraries.

This market power that Apple derives from control over the "rendering interface" of digital media feeds their ecosystem and hardware upgrades, and is of far greater strategic importance than their annual $13 billion in iTunes content revenue. But this source of leverage dissipates as subscriptions to massive media libraries delivered over faster networks become the future norm, whether or not Apple's current efforts to develop a streaming service within its ecosystem succeed.

The impending transition from device-intrinsic to cloud-based is oddly familiar; we've seen Microsoft's market cap more than halved (even without adjusting for inflation) as the source of value for computer users moved away from installed software and towards the platform-agnostic Web over the last decade. Frankly, Apple should understand this threat better than anyone. They were a prime beneficiary of that recent shift as millions of newly-minted digital consumers have chosen the Mac over Windows for their Internet-heavy computer use.

And Apple's impending challenge is exacerbated by the fact that they actually don't enjoy the kind of "applications barrier to entry" that safeguarded Microsoft's monopoly in the 1990's. (After all, most popular iPhone applications are free and have an Android version.) Further, Microsoft didn't have a competitor quite as powerful as Google, the creator of much of the technology that powers the cloud.

(Read More: What's Wrong With Apple? It's Not What You Think)

Looking Ahead

Before we rush for the lifeboats: Apple has a lot going for it, and I fully expect it to sustain its 12-figure annual revenues in the short-run. There is little to be gained from an immediate radical shift in strategy. But the massive head start from its unique heritage is running out, and our cloud-based future will rapidly weaken the market power from its early dominance of the digital consumer space.

To stay on top over time, Apple will have to engage actively in the creative destruction of the very revenue model that sustains it. They will gradually have to sacrifice the device lock-in afforded by iTunes. And if that's not hard enough: Apple must also willingly depart from their comfort zone of the last three decades if future generations of digitally savvy consumers seek convenience and choice over usability and design.

Success with such radical transition seems unlikely. History has taught us that even when market leaders foresee such a shift in the digital landscape that might render their business model obsolete, they simply can't step out of the cozy confines of catering to their profitable core customers and invest heavily at the fringes. Perhaps Apple will be the exception, reinventing itself yet again (like IBM did in the 1990's), and regaining the ground it has given up since last Fall. After all, this is the company that taught us to think different.

An economist, Arun Sundararajan is Associate Professor and NEC Faculty Fellow at New York University's Stern School of Business. His research studies how information technologies transform business and society, with a recent focus on networks, privacy and digital institutions. Follow him on Twitter @digitalarun

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