Archive | 1:21 pm

vertical integration of design and post-pcs

9 Apr

The news that Apple has been building an RF/baseband team is a great reminder about how cool vertical integration of intellectual property design can be as design and final manufacturing continue to fracture.

I wasn’t a business strategy wonk growing up, I was too busy writing software, so my first view of vertical integration in manufacturing, contract manufacturing and white-label manufacturing came during the mid- and late-90’s at Microsoft while working with PC OEM’s on the troubling issue of “low-cost consumer PCs.” OEM’s were in a price war that was driving their margins into the dirt and were giving Microsoft (the $70 Windows software license) and Intel/AMD (the $50 CPU price) grief over those parts of their cost as well as trying to figure out how to differentiate their products. We were helping key OEMs prototype different special-purpose uses for the Windows operating system which could be sold with new high-volume consumer products under a lower licensing cost to hit the <$300 retail price point. (This effort and some of our prototyping was one contributor to the initial XBox.) I was fascinated to learn details about how much PC OEM’s had outsourced manufacturing (and some forms of the hard intellectual property design) to foreign white-label manufacturers. Some small players had literally outsourced everything but their logo, their sales staff, and their direct-mailing lists. It was clear even then that they were not differentiable and fully doomed. Others, like Dell, were still doing final customer-specific options assembly and industrial/mechanical (particularly pluggable component) design but were no longer designing much of their printed circuit boards (PCBs). The more I learned the more this seemed like a difficult-to-defend position without unique software capabilities to differentiate the clearly commodity hardware. PC OEM’s had no brand-exclusive content.

One PC OEM that stood out and then led me down the rabbit hole of game consoles was Sony, who I learned was an extremely vertically oriented company – at one point it probably built the trucks that dug the sand and copper to be carried by its ships to its factories to be turned into glass and magnets for TV tubes to be carried again by its ships to markets around the world. Sony’s vertical integration experience in many different CE devices from Walkman to CD players to stereos to TVs taught it how to manufacture Playstation One consoles cheaply and then to radically reduce their build costs each year over the life of the console. It was using this technique in PCs and notebooks as well, delivering the most appealing and smallest PCs and commanding the highest margins for a time (though the PC OEM war of specs and hundreds of configurations dilute and defeat many of these advantages). Studying Sony’s’ Playstation and PC/notebook businesses as well as their various content business illuminated two important things for me which may seem at odds, but they are not: (1) vertical integration of hardware intellectual property is critical for differentiation, though the actual manufacturing can be carefully out-sourced if possible, and (2) Software differentiation (content) is the even more important differentiator. Ironically for Sony, it was the fact that even the strongest advantages of their vertical integration and their deep investment in hardware intellectual property for consoles wasn’t enough to keep ahead of the price-performance trajectory of commodity PC CPUs and GPUs. (It’s good to see them embracing the PC ecosystem and focusing on exclusive content now.)

Which brings me back to Apple, who clearly learned more lessons than everybody else combined from the PC OEM wars. Lessons about how differentiation matters, how intellectual property design must keep its distance as far as possible from manufacturing, and most importantly how to prevent a cross-over threat from another ecosystem.

In the classic PC/notebook space, Macs continue to use many off-the-shelf PC parts (ethernet chips, CPUs from Intel, memory), but their deep investment in industrial design and consumer-important features like thinness, lightness, screens and longevity require expertise and investment in the intellectual property of PCBs, glass, mechanics, aluminum, manufacturing, just to name a few. They use the intellectual property of hardware design to make their products unique and their exclusive software clinches the deal, allowing them to keep their margins high.

More interesting still, though, is the mobile, Post-PC or “Internet Of Things” space. Here with iOS and ARM-based in-house-designed CPUS Apple’s overall vertical integration strategy is just shockingly impenetrable for the foreseeable future. Post-PCs will be small, highly-capable, full of sensors, network-connected, power-sipping, and accessible to developers. Apple’s environment is all this, and is particularly strong in low-power. At this point Apple just lacks dedicated in-house designers of displays, touch-screens and batteries, though they appear to have long-term investments and future capacity contracts with their key suppliers and manufacturers. They don’t actually own the team which designs the graphics processor (Imagination Technologies, creators of the PowerVR GPU) though there is evidence of a deep investment & long-term contract. I suspect there must be a right-of-first-refusal or right-of-first-purchase in place. (I still don’t understand why Imagination hasn’t been bought by somebody, they are an amazing company who understand low-power better than just about anybody).

Android plus off-the-shelf hardware from the non-Apple ecosystem of ARM CPUs, GPUs and baseband controllers are nearly price-competitive, but already at the cost of very slim margins for all the intermediaries (increasingly for the medium- and high-end, this is just Qualcomm). Apple building custom baseband chips will mean Apple has fewer intermediaries and so pays less (it would likely pay $20-30 less per device using in-house baseband, or 10% less of its fully-loaded bill of material), and I’m guessing they will continue to outperform on power-consumption. Qualcomm will feel pressure from OEMs to further reduce prices and power-consumption, leading to lower margins and less ability to invest long-term. This is the aspect of the strategy which prevents an ecosystem cross-over – living in the same ecosystem as your competitors, retaining exclusive content, as in PCs and notebooks, but being able to do cutting edge intellectual property investment in literally every component with no exceptions. By bringing the hard intellectual property design of the very same ecosystem in-house and securing inexpensive manufacturing there simply is no competitive price-performance curve for competitor to cross over.

I shake my head at the genius of not just managing your supply chain but literally eating every bit of intellectual property designed within it except the lowest margin manufacturing. I see no offensive strategy capable of cracking Apple’s Post-PC lead at this time. Perhaps (I hope not) anti-trust will eventually be used, but it’s really more a waiting game for Apple to stumble and slow their pace of innovation.