Microsoft and Cool

Growing up in the 1990's and the early 2000's, I recall Microsoft being the omnipresent company making Windows and thriving off its enterprise business. There was nothing remotely sexy about it. Even at a young age, I found the design of Microsoft's software to be stale and unimaginative, catering solely to function. Being raised in an immigrant family with little discretionary income, all I had to play with were old Windows PC's that were hand-me-downs from various friends and family members. My fascination with tech started with Windows NT, followed by Windows 95, Windows 98, and finally my last version, Windows XP. It was shortly before the release of Windows Vista that I had all but abandoned the Microsoft ecosystem, and turned to Apple.

There wasn't anything in particular that made me switch to Mac OS; it was a combination of many small deal-breakers that together made for a very frustrating Windows experience. First there was the bloatware that came preinstalled with practically every PC. Then there was the general disregard Microsoft had for aesthetic. Before I bought my first Mac, I never used OS X before, but I always found it to be more appealing from the screenshots I had seen. Moreover, Windows was never playful, and it always felt like it was made primarily to please enterprise. That's because it was.

Things began to improve with Windows 7, but it was the Windows 8 design language that finally made Microsoft value design and appeal. Although Windows 8 was a colossal failure, in my eyes it was what solidified the shift of Microsoft. I still do not know exactly where Microsoft is shifting, but it feels like the right direction.

If you've followed me on Twitter these last few weeks, you would know I called Microsoft out for its purchase of Accompli Mail and Sunrise Calendar. I have since changed my thinking. My mistake was in assuming that the goal of both purchases was to eventually turn a profit from these apps. This line of reasoning was reinforced by the constraints of my business school education: a company buys another company when it believes the return on that investment will exceed the return of the next best investment. You already know I'm a big fan of examples, so let me illustrate my previously faulty logic.

Let's say you own a company and have $1B of unused cash lying around. It would be foolish to keep it locked down at a bank, since the interest rate you would be earning would be negligible. Instead, you can invest it in the stock market and earn roughly a 10% return every year, or $100M. Alternatively, you can invest the $1B in the R&D of a potentially new product, which by your estimates will earn $500M in year 1, $800M in year 2, $1B in year 3, and $1.2B in perpetuity. Financial analysts would discount the cash flows of this potential project in year 1, 2, 3, and so forth, in order to calculate the total return of this product. If the return is greater than the original $1B investment, it may make sense to invest in this project. But what you really want is for the total return of this product to exceed the return of the next best investment, which is the $100M you would earn from the stock market. Of course, this example is a simplification of reality, but hopefully the point is made.

Using this logic, I assumed that the rumored price of $200M that Microsoft paid for Accompli, and the $100M they paid for Sunrise, that they would expect to earn a greater return than the cost of the investment. In other words, I implied that Microsoft believed that the $300M they spent on these acquisitions would provide a greater return than the cost. This thinking was largely incorrect.

It was incorrect because my assumptions were all wrong. I assumed that the goal of these acquisitions was for Microsoft to make money on them over the future years. After all, why would you spend millions of dollars on something that won't actually make you any money? Given this assumption, I reasoned that Microsoft will not actually make money on these products, since few people would be willing to spend money on an email or calendar app. Microsoft was paying millions of dollars for two apps that won't actually bring them any profit in!

For as much writing I do about the inability of spreadsheets to calculate the complete financial ramifications of a business, I still made the same mistake that many analysts do. In reality, Microsoft was investing not in the profitability of Accompli and Sunrise, but it was investing in the future of Microsoft.

Goodwill is what accountants and financial analysts use as a plug-in variable for everything they can't measure. It is fairly easy to asses how much the laptops, desks, and other equipment of the business are worth. The same goes for the liabilities of a business. But the worth of intangibles such as patents, logos, employees, brand recognition, and customer data is as close to the definition of guesswork as can be. We simply don't know how to put a concrete value on such touchy-feels things. There is no Craigslist for intangibles, and so we do not know their exact worth. What we do know is how much we are willing to pay for them. Accounting students spend a whole semester learning how to calculate goodwill on an acquisition, but in general terms the calculation is very basic. Goodwill = what you paid - what something is worth. If you paid more for the business than it is worth, you have goodwill. Congratulations - you now know more about goodwill than 99.99% of the population (and probably more than most accountants)!

Understanding the concept of goodwill, we can return back to Microsoft and its latest two acquisitions.

As I have alluded to earlier in this post, Microsoft was actually purchasing the intangible element of coolness when it acquired Accompli and Sunrise. Microsoft was also purchasing relevance, social, and trendy. Although it may seem insane for a company to spend hundreds of millions of dollars on such vague and immeasurable terms, these are actually investments that aim to convert Microsoft from being an enterprise dinosaur to a modern creature. Most of Microsoft's success in the past came from what its users did at work: Outlook for email, Microsoft Office for documents, SharePoint for collaboration, and Windows for the ecosystem. But when these users came home, they used consumer-grade products from Apple and Google since the user experience was better, and many features were free. As a result, Microsoft's blinding focus on enterprise lost many consumers to non-enterprise software.

Accompli and Sunrise are acquisitions to win back these non-enterprise users. Although Accompli is heavily geared toward productivity and scheduling, it is a well designed (but by no means perfect) app that also caters heavily to non-business users. By purchasing it, Microsoft was able to please enterprise users by offering them a great iOS mail application and please consumers by providing them with a great general email application.

Sunrise, a calendar app with social integration (Facebook, Foursquare, etc), is Microsoft's attempt to please consumers even further. Before the acquisition, Sunrise had millions of users. Now they belong to Microsoft. It is possible, of course, that Microsoft will lose these users through bad updates to the app, but I remain confident this will not occur.

So where exactly is Microsoft shifting - to consumers, enterprise, or both? My bet is on both, judging from the recent acquisitions. But what is most promising to see is the newfound focus on design and cool by Microsoft. For a company that never prioritized these two attributes, it is impressive to see them pivot so quickly. With both acquisitions, Microsoft purchased a huge cohort of younger users (like me) who have previously abandoned Microsoft products or have never used them before. If they don't mess up, there could be another generation of Microsoft users.

Disrupting the Innovator's Dilemma

It seems Clayton Christensen has become the Michael Porter of the third millennium, having his book, The Innovator’s Dilemma (TiD), quoted in all sorts of articles, talks, and even other business publications. You can’t read a single WSJ or NYT article without seeing the word disrupted. Companies go out of business because they are disrupted by more innovative businesses. Products and services kill other products and services because they are so disruptive to them. A company even disrupts itself when it releases a new product that improves on the old one. Everybody is being disrupted everywhere, all the time.

Some Background

If you aren’t familiar with Christensen’s law, it is this. There are two types of technologies defined in his framework: sustaining technologies and disruptive technologies. In order to be as accurate as possible, I will quote his own definitions for these technologies.

“Most new technologies most improved product performance. I call these sustaining technologies…What all sustaining technologies have in common is that they improve the performance of established products, along the dimensions of performance that mainstream customers in major markets have historically valued.”

From the next paragraph…

“Occasionally, however, disruptive technologies emerge; innovations that result in worse product performance, at least in the near-term…Disruptive technologies bring to a market a very different value proposition than had been available previously. Generally, disruptive technologies underperform established products in mainstream markets…Products based on disruptive technologies are typically cheaper, simpler, smaller, and frequently, more convenient to use.”

So now you have a basic understanding of Christensen’s ideas. I still encourage you to read The Innovator’s Dilemma, since it shares many interesting ideas, but for our purposes, you are ready. 

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Opportunity Cost

One of Christensen’s fundamental contributions is quite profound. To summarize, it goes something like this. Management of a company doesn’t think about the disruptive, low margin technologies nearly as much as they do about higher margin technologies, since by definition, low margin products are not as profitable. 

As Christensen himself admits, a company becomes successful in the first place from the processes, values, and ultimately products it created in the past. Since the goal of most companies is to be profitable, they must create profitable products. Profitable products are usually more expensive, provide more features (value) to the buyer, and/or carry with them an element of prestige. According to TiD, these very same products are ripe for disruption. Thus, companies should avoid being disrupted by instead investing in disrupting themselves, before somebody else can disrupt them. 

This all sounds great until the realities of the real world come in. Say you are a car company, and have $1B to invest. You can either invest in your current best-selling model in order to improve it, or you can invest in R&D for a cheaper, more economical car that you think would do well in developing nations. Absent other information, TiD would urge you to invest in the cheaper, low margin car, since it may become a disruptive technology in the future. So you go ahead and invest the $1B in this low margin car, and it becomes an international hit! Drivers in India, China, and Brazil are buying them in droves, and your production lines are busy churning out more and more vehicles. You smile at your production volumes, but then you look at your income. Turns out, the margins on these little guys are so low that you’re actually barely making any money on all of those sales! You tell yourself, don’t worry big guy, since you still have your high margin car available for sale, and you’ll make the profits that way. You open your trusty spreadsheet to check the latest sales figures, and lo and behold - the sales dropped! Immediately, you call the director in charge of the high margin car and ask him what went wrong. “We didn’t invest much in improving this model since we spent everything on the low margin car. Meanwhile, our competitors vastly improved the engines, their navigation system, and MPG of their cars, which stole away from our sales”. But you read The Innovator’s Dilemma, you say to yourself. How could everything have gone so wrong?

Now imagine that instead, you invested the high margin vehicle, which was already beloved by your customers. With the extra $1B in R&D, you were able to improve on the features you already offered, thus overpowering the new features your competitors offered. 

For a business book, it is astounding that TiD fails to mention the opportunity cost of investing in a potentially disruptive technology. The costs of investing in disruption do not guarantee results. For large corporations with piles of cash, the opportunity costs of investing extra sums in finding a disruptive technology may be worth it. But large companies with limited cash may find themselves in an odd predicament, and disruption may be the last thing they need.

Sample Size

Christensen gives us examples disruptive technologies in action through the following industries: disk drives, excavators, and steel. 

Acquiring large amounts of sample sizes for a business book of this nature is unfeasible for one person, especially in 1997, when TiD was published. You would have to get access to data from thousands of companies, explore each industry they are in, and find the products and companies being disrupted or disruptive. Instead, TiD gives us examples from a sample size of three, “proving” that disruptive technologies come in two varieties and are indeed what make or break companies. I’m sure you can see the ludicrousness in the preceding sentence yourself. A sample size of three is not enough to base a whole book on. TiD also implies that every industry gets disrupted in the same way, since it doesn’t say otherwise. Does the luxury clothing industry get disrupted by cheap knockoffs? What about expensive Swiss watches that are undercut by low cost Chinese fakes?

As an example, evidence of disruption is found only in five industries (1, 2, 10, 22, and 25), three of which were sampled by The Innovator's Dilemma. No evidence of disruption is found in the other industries.

Known-Unknowns and Known-Knowns

TiD is backed by a lot primary evidence. Christensen was able to speak to managers and CEOs to ask them what went wrong, and more importantly, what they did to fix it. Often times, the fix came in the form of a new, but internal venture, backed by the full faith and credit of the company CEO. This, in turn, allowed the company to create disruptive products, since the internal ventures were unshackled from the unyielding forces of resource allocation. 

I will turn to former U.S. Secretary of Defense, Donald Rumsfeld for my next comment. 

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

We attribute our performance to our behavior - that is, we take credit for what we can measure and see. If a new CEO joins a company, and the sales figures go up, we ascribe the results to the new CEO. That is, after all, the only thing that changed from before to now. Unfortunately, this isn’t entirely true, and we attribute the increase in sales to the CEO because that is the only known we can identify. Many changes may have taken place, but none of these changes are visible or measurable by us. Continuing with our car analogy, perhaps the demand for low cost vehicles increased, which itself is the result of shifted consumer tastes. Consumer tastes were themselves influenced by something else. Perhaps the negative impact large vehicles have had on the environment led consumers to feel bad about their oversized vehicles, opting them over time to prefer smaller and cheaper alternatives. Is it possible to link the increase in sales to the change in consumer taste for smaller vehicles? Sure is possible, but it is much harder and considerably less obvious. Instead, you might attribute the increase in sales to the new CEO, who is a very obvious change. 

Similarly, TiD substitutes unknowns with knowns in order to explain many of the strategies used by companies and their CEOs. A CEO may say the increase in sales would not have been possible if not for the newly funded internal venture, but how can he be so sure? Many of Christensen’s interviews were conducted before the advent of powerful computers that process terabytes of data, which makes the results even more dubious. Could it be that disruption is simply a known-unknown, rather than a known-known as TiD establishes it to be?

We know about the known-knowns. We know about the known-unknowns, but we cannot explain them. We don't know about unknown-unknowns, and therefore cannot explain them. TiD confuses the purple triangles with the green circles. 

User Experience, Prestige, and Other Intangibles

You will have to use your prior knowledge of sustaining and disruptive technologies for this next passage, so if the definitions escape you, read them once more at the start of this post. If you remember them, let us continue. iPhone - is it a sustaining or disruptive technology? For starters, it came bundled with a web browser, a phone, and camera, none of which were wholly new technologies. The PocketPC, which came known to be as Windows Mobile, also offered all of those features. Thus, the value proposition of the PocketPC was the same, on paper, as that of the iPhone. The PocketPC flopped, while the iPhone prospered. Would that mean we could call the PocketPC a sustaining technology, and the iPhone a disruptive one? What makes the iPhone any more disruptive than the PocketPC? Playing devils advocate with myself, I would say the user experience of the iPhone was monumentally better, making it much more convenient to use. But as far as the value proposition - it was almost the same as that of the PocketPC. 

When I was a young, puerile kid, my grandfather gave me a Casio calculator watch. I though it was the epitome of cool, and I wore it everywhere. My grandfather gave it to me because it looked futuristic, but also because he knew I would never wear a mechanical at that young age. My Casio checked off all the typical characteristics of a disruptive technology: it was in most cases cheaper than a mechanical watch, it was simpler to read time with, it weighed less, and it even provided me with the unprecedented value of having a portable calculator with me everywhere I went! Many years later, however, the mechanical watch industry is alive and well. 

The above are only two examples that illustrate the shortcomings of TiD. The first example with the PocketPC and the iPhone attempts to show that despite the fact that both products are on paper disruptive technologies, that alone did not make them successful products. Much more is needed than just a new value proposition or a cheaper price. As Apple has shown through the years, a great user experience goes a long way. My Casio calculator watch also fit the bill to be labeled a disruptive technology, even though in retrospect we know there was nothing disruptive about it. Watches are often luxury goods that carry an element of prestige and social class with them. It may very well be that smartwatches will in the future provide so much value as to overpower that element of prestige, but the point remains - disruptive products may be disruptive in ways TiD did not foresee.

Performance Oversupply

Performance Oversupply (PO) is exactly what it sounds like: it is when a product gets packed with so many features and performance enhancements that it becomes more powerful than is required by the consumer. Thus, the consumer experiences diminishing returns from the performance of the product, since he can’t make use of it. A great example of PO are the latest computers that are being released. The average consumer doesn’t need all of the power that is packed into the machine, since all they will be doing is watching YouTube videos, browsing the web, and using some sort of word processor. In effect, the computer is more powerful than the power an average consumer needs from the computer. If we made a hypothetical power scale, the computer would be an 8, while the needs of the consumer would be a 5. The difference (8 - 5 = 3) is the Performance Oversupply.

Performance supply is an 8. Performance demand is a 5. Performance Oversupply = 8 - 5 = 3.

TiD contends that when a PO occurs, the technology is ripe for disruption. Going by the preceding case, you could argue the iPad/Chromebooks/Ultrabooks are the form of disruption Christensen was talking about, since they’re less powerful, cheaper versions of the PCs they replaced. These less powerful, “disruptive” technologies provide exactly, if not slightly less power, than the consumer desires. On our hypothetical power scale, they would score around a 4.8. 

This all makes perfect sense - but there is another side to every coin. What if the needs of the consumer increase to match the PO? I find it best to explain through example, so let’s turn to one. YouTube is becoming television for the masses. More and more people are watching YouTube (or some other type of online video) every year, and as a result of technological improvements, the quality of these videos improve tremendously. YouTube now supports 4K UltraHD video, which requires much more processing power to consume. Not only is the world watching more videos, but a greater number of people are now editing and uploading their own videos. These content consumers and content creators are bridging the gap between the power demands of the consumer and the PO. Instead of a ranking of 5 for consumer needs, these consumers now rank a 7. Thus, the PO is reduced to (8 - 7 = 1). This suggests there might be room for Performance Oversupply, and disruption in this market may not happen after all.

Performance supply is an 8. Performance demand is a 7. Performance Oversupply = 8 - 7 = 1. The point of this illustration is to show that performance demand can increase, which in turn decreases Performance Oversupply.

For this example, the performance of the PC is kept stable at 8, since the rate of progress on processor technology has been slowing considerably in recent years, while consumer demands have been growing.

The Randomness Factor

This next commentary is similar to the Known-Unknowns and Known-Knowns point we touched on earlier, but it ventures a bit further, into new territory. The question I ask is as follows: does the whole of a disruptive technology come from what a company does in terms of productive effort (R&D, employees, management, etc…), or can a certain percentage of the technology be attributed to luck or randomness? In fact, TiD does make one brief reference to the element of luck in the success of a company, but it then proceeds to dismiss it almost entirely. Here’s what Christensen writes on the subject of luck:

“One might be to conclude that firms such as Digital, IBM, Apple, Sears, Xerox, and Bucyrus Erie must never had even well managed. Maybe they were successful because of good luck and fortuitous timing, rather than good management. Maybe they finally fell on hard times because their good fortune ran out. Maybe. An alternative explanation, however, is that these failed firms were as well-run as one could expect a firm managed by mortals to be - but that there is something about the way decisions get made in successful organizations that sows the seeds of eventual failure….The research reported in this book supports this latter view.”

Christensen is essentially saying that luck is not as important a factor as the processes for decision making. And he’s right in the grand sense - a company cannot attribute its success only to the element of luck, because it would have to consistently produce “lucky” products, which by definition, does not happen often. But in regards to disruptive technologies, which is precisely what the book is centered upon, luck is a crucial element. To better illustrate this point, let’s use a quote from Ed Catmull’s (the President of Pixar) book, Creativity, Inc.:

“When companies are successful, it is natural to assume that this is a result of leaders making shrewd decisions. Those leaders go forward believing that they have figured out the key to building a thriving company. In fact, randomness and luck played a key role in that success.”

So who are we to believe; the intelligent Harvard professor with years of experience, or the creative genius who helped spawn many of the worlds greatest animated films? I, for one, believe both are right…partially. Most people read TiD and treat it as the bible. I recommend reading it with a grain of salt. The processes of a company do indeed make-it-or-break-it, but luck is undeniably a critical factor too. The iPhone was a great product, but it also had fortuitous timing (luck), which is what made it so disruptive. 

Luck and randomness is what happens in the dashed circle. Everything else in the larger circle is attributed to the productive efforts of the company. The size of the luck and randomness circle is arbitrary and used only to illustrate the idea. 

No Book is Perfect

The Innovator’s Dilemma would have been a fantastic blog post, but as a book, it is extremely light on ideas and data points. As I have attempted to show through the above examples, there are a lot of points that TiD fails to explain. Basic economic concepts such as opportunity cost are left untouched by Christensen. Moreover, the sample size for the book is highly questionable. It often substitutes unknowns with knowns, and randomness with good decisions by managers. Intangibles are also oddly missing from TiD. Finally, while Christensen clearly shows how Performance Oversupply is a sign for an upcoming disruption, he keeps the power needs of consumers a static variable, which is demonstrably not a realistic assumption.

A disruptive product has become a business buzzword for good product which steals sales from the status-quo product. It is a word that explains the effect a product has had on the market, but not how that effect took place. It is an umbrella term for everything and nothing, all at once. While The Innovator’s Dilemma raises many excellent ideas, no book is without its faults and deserves to be read without skepticism. I will end this essay with a quote from Samuel Lee, an Assistant Professor of Finance at NYU. 

There are two ways to validate an economic or financial theory: wait 100 years and collect new data, or look at a fresh new data set, such as another time period or different markets. It can take decades before someone’s held accountable for a bunk theory.

Since 100 years have not passed, I took the second approach.

Apple Watch: The Good, the Bad, and the Ugly

Apple has become one of the largest companies in the world, which means every move the company makes gets thoroughly analyzed. Since I began following Apple in 2007, I recall analysts predicting that the iPhone, the iPad, and every update to those products will be a failure. In order to call a product a failure, one must compare it to a similar product. Analysts called the iPad a failure because they expected it to sell as well as the iPhone, which would never be the case. I am sure that while designing the iPad, Apple knew this too. iPhone sales are so great because they are practically a necessity, they're subsidized by carriers in the U.S., and provide unbelievable value for the price.

The iPad never had a chance to enter a market as large as the iPhone. In the past few quarters, iPad unit sales have been slowing. They have slowed so much, in fact, that Apple sold more iPads in every quarter of 2013 than 2014. My explanation the declination of the iPad is that it was never backed by the full faith and credit of Apple. The iPhone was always their number-one product, and everyone the iPad got just piggybacked off the iPhone. A smaller market for tablets, and a lack of effort from Apple is what significantly slowed iPad growth.

This post, however, is not about the iPhone nor the iPad. It's about Apple's new product - the Apple Watch. I began with a brief background of the iPhone and the iPad just to explain the basic reasons for why the iPhone is so popular, and why the iPad is not.

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There is no shortage of Apple Watch predictions on the web. I do not aim to regurgitate any of them. I will simply list some thoughts, and you can do the thinking on your own.

• There are many people still working for Apple that have been there since the original iPhone. Many of them stayed on the same product. That is, they've been working on some element of the iPhone (hardware, camera, Safari, Mail, etc) for the last few years. Sometimes they join a different team, such as switching from working on the Mail app to the Core OS, but they're still working on the same product, the iPhone. Sometimes they get transferred to work on the iPad, but this is just a side project for them. Unlike the iPad, which was a half-hearted effort, many original iPhone engineers and designers are now working full-time on the Apple Watch. That does not mean it will be a successful product, but it does mean it's getting Apple's effort.
• Related to Apple's effort in the watch are the people hired to work on it. There are many. I will name some of the more well-known hires. Kevin Lynch (previously CTO at Adobe), Angela Ahrendts (she's in charge of Apple retail, but her fashion background undeniably helps), Marc Newson (albeit working part-time), Patrick Pruniaux (previously VP of Sales at Tag Heuer), Jay Blahnik (fitness consultant), Michael O-Reilly (previously VP at Masimo), and many others involved with medical sensors. I don't recall as many experienced hires coming aboard to work on the iPad.
• There are one of three paths the Apple Watch can follow. First, it can flop, and Apple will abandon efforts. For the watch to flop, there it must either be a bad product, the competition must be better, or there is simply no market demand for it. Historically speaking, Apple is not known to design bad products. One can argue that Apple has lost its way and will design a bad product, but not much evidence supports this theory. As I've written previously, designing a smartwatch is extremely difficult and expensive, and not many companies can undertake such a herculean effort. The major players in the smartwatch space so far are Fitbit, Jawbone, Pebble, Motorola, Samsung, Garmin, Microsoft, and a handful of others. I don't see any of the smaller players competing effectively against Apple, but a better smartwatch from Samsung or Microsoft is something Apple should be thinking about. The smaller players can, however, compete on price by offering cheaper options. This can be a disruptive technology in the future, but not in the short term. Finally, there may simply be no demand for smartwatches. I do not have billions of dollars to spend on consultants and market research, so I do not know how the market will react to a smartwatch. But I do know that Apple has billions of dollars to spend on consultants and market research, and I can only assume they did some sort of research before beginning work on such a large project. Market research can be wrong, and Apple may have found a market where none actually exists (or is too small to matter), but I wouldn't bet on it.
• It can be a semi-successful product like the iPad. Being the risk-avoidant person that I am, if I had to take a bet to predict the outcome of the Apple Watch, this is the option I would choose. But I'm not a gambling man, so I wouldn't even be playing this game. In the business, this option is what we call a hedge, since it covers the bases if the Apple Watch is a flop or a success. Billion dollar companies are not usually huge risk-takers, and Apple is the epitome of a company that avoids or reduces risks. For the Apple Watch to be a semi-successful product, multiple things can happen, either concurrently or alone. The Apple Watch may not be a bad product, but it may not be amazing either. It may end up being just a decent smartwatch. Technology and smartwatch aficionados may be the only ones to purchase it, which will stimulate reasonable sales volume. Not enough to call it a success, but enough to cover the expenses of designing, manufacturing, and distributing the product. Additionally, the market for smartwatches may actually be smaller than predicted. This would obviously decrease the potential of the watch significantly. Again, there are nuances to this point as well. The market can be tiny, and Apple will experience losses. The market can be medium-sized, and Apple will breakeven. Or the smartwatch market can be slightly smaller than predicted, leading to satisfactory but not ideal sales. Of course, nobody knows for sure. At the moment, the smartwatch market is tiny, but that's because the value proposition for current smartwatches is equally small. Nobody expected the smartphone market to be as large as it is today, and the same can be true for the smartwatch market.
• It can be extremely successful like the iPhone. This is, of course, the ideal scenario for Apple. It implies that the Apple Watch is a great product and there is a large market for smartwatches. Once again, there is nuance to the point. A great product doesn't imply a perfect product, rather, it's one that meets consumer needs and slightly surpasses them. I will again make reference to the iPhone because it is most relevant to this discussion. The original iPhone was by no means a perfect phone; it had terrible battery life (compared to flip-phones), everything was slow as if covered in molasses, and it didn't even have an App Store. But it allowed consumers so many things that they couldn't have done previously. After a few updates and revisions, the iPhone became a hit and remains one to this day. In short, the iPhone started by meeting and slightly exceeding expectations, through updates it became even better, and now it is Apple's most successful product (perhaps even the most successful product of all time). The iPad did not follow this trajectory. It did not meet expectations when it came out. Nor did the updates bring it in-line with consumer expectations. Hence, it was a good product in a medium-sized market, and sales reflected that reality. I do not know how the Apple Watch will turn out: will it be a bad, good, or great product? I can also assuredly say that no analyst worth his salt knows which of the echelons the watch will become. Apple might think it knows, but even for them it is impossible to know for sure.

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I started this piece with a brief history of the iPhone and the iPad, and heavily relied on their trajectories to predict the possible paths the Apple Watch can take. What I explicitly did not do is tell you how many units the watch will sell, what the average selling price would be, and how much revenue the product will contribute. I left this out because I do not know, and my best guess is as good as any analysts out there. Surely you can measure the size of the smartwatch market as it is now, and you can even add the traditional watch market to this pool. Perhaps you also take into account the fitness wearable one. You then multiply this aggregate market pool by a percentage share that Apple will take from it, and now you have Apple's share of smartwatch revenues and volumes. If you are especially ambitious, you added a growth rate to the market, since presumably it will expand in the future. Will that be an accurate figure of Apple's market share?

I would be lying if I said I did not already attempt to do this. My spreadsheets are filled with Apple Watch estimates (guesstimates). It is impossible to run a successful business without them, and I am not saying it is foolish to calculate projections, but this is not a concern you should be worried about. This is a problem for Apple and its consultants. For you, dear consumer, care only about the finished product.

Twitter: Introspective

Preface: This is the first of a new series of articles I will be writing, which are called Introspectives. For these types of articles, I will be doing some number-crunching and analysis, so that they are more in-depth and introspective (thus the name). They will include graphs/charts, followed by my thoughts on what the data shows. My hope with these introspectives is threefold. First, and with selfish intentions, I want to get better at data visualization and manipulation, and the best way for me to learn is through working with real data. Second, my hope is to share my opinions on what the data exposes, which the mainstream tech media did not pick up on. Finally, my goal for these introspectives is to create a narrative based on facts. In short, I want them to be strong enough to stand on their own. 

The first introspective will be on Twitter, partly because it's the social network I use most, and partly because it's not doing so well. For me, it's exponentially more interesting to dig into unsuccessful companies than successful ones. 

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Income Statement Exploration

If you peaked into my spreadsheet, you would find a lot of work done on Twitter's balance sheet. While it's true that the balance sheet is fundamental to a company's analysis, it doesn't tell us much about the future potential, since balance sheets are snapshots in time. On the contrary, income statements represent data over a period of time (3, 6, 9, or 12 months), and provide us with more interesting information. Let's start with the basics: Revenues and Cost of Revenues. 

Revenue vs. Cost of Revenue

- This is a fairly simple chart, showing us the revenues and the expenses required to create those revenues. It's a healthy sign when a company has higher revenues than cost of revenues (from hereon abbreviated CoR), which is indeed the case for Twitter. 

- Notice how revenues and CoR began to divulge heavily starting with Q3' 13, which is when Twitter's revenue hit a growth spurt. Since social media is a young business, is it difficult to benchmark if Twitter's CoR is within industry standards, considering the industry is so young. You could compare Twitter to Facebook, or LinkedIn, but any differences wouldn't be an immediate cause for concern. 

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Income Statement Breakdown

This next chart includes revenues and CoR, but it also incorporates other elements of the income statement, notably Research and Development, Sales and Marketing, and General and Administrative expenses. 

- This chart is what Twitter should be concerned about. Total costs and expenses, which includes all of the above items, exceeds revenues by a significant amount. 

- R&D is almost half as large as revenues. Twitter started spending a huge amount on R&D in Q1' 14, probably to search for products and services that could be incorporated into Twitter. We've seen Twitter Music (which failed), the ability to tweet multiple photos, and detailed tweet activity, among many other small additions to the service this year. All of these features are great, but they don't fundamentally add new use-cases to Twitter the service. This leads me to think that the immense amounts that Twitter spends on R&D could be toned down, which to their credit, they seem to have done in Q3' 14. We will see what happens to R&D spending in Q4' 14, but my advice is to slow it down, since results are unsatisfactory. 

- The next highest expense on Twitter's income statement is Sales and Marketing, which is almost as high as R&D in Q3' 14 ($164 vs. $183 million). Here, I am not so confident that Twitter should reduce spending. It seems like S&M and revenues go hand-in-hand, since the company must advertise the service to advertisers (ironic, but that's how the online advertising business works). 

- General and Administrative expenses make up the lowest costs, but they too have been steadily increasing. Again, it's hard to say if this item is too high or too low, but it's worth noting that executive salaries are placed in here. Given Twitter's gross management turnover, I would expect G&A expenses to increase in future periods. 

 - As I'm sure you noticed, expenses ballooned in Q4' 13. Without getting too technical, the explanation for this is Twitter's stock-based compensation expense, which accounted for $406 million in restricted stock units (RSU's). They expensed these in Q4' 13 in no doubt to gain some favorable tax treatment in future years, where losses could be used to offset any profits. 

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Revenue and Net Loss

As a summary of the income statement breakdown, I've included a revenue and net loss chart that encompasses everything we've talked about previously. Some observations follow.

- Since Q3' 13, it looks like Twitter has been attempting to contain its net loss to half of its revenues. Management can spin it any way they like, but these consecutive net losses are worrying and don't seem to be stopping in the future. Twitter is either too costly to run, or it can't find enough revenue streams to offset the high costs. Or perhaps both. 

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Balance Sheets, Income Statements, and Narratives

As an accounting major, I can tell you it's very easy to get lost in the numbers, and forget about the big picture. While the details certainly matter (MACRS or straight-line depreciation), they don't tell us the true condition of a company. Think about the time you got a nice big juicy pimple on your forehead, which is extremely noticeable to everybody. Does this mean you have a life threatening disease? Of course not. But it may be a sign that you should cut back on that General Tso's Chicken you've been ordering every Wednesday night. At the very least, you know to skip the fortune cookie. 

Similarly, the expenses we looked into previously (CoR, R&D, S&M, G&A) are extremely obvious to everybody, and lend themselves to be preoccupied with. However, they don't tell us the true condition of the company - they only explain half the story. The other half of the story, which in the pimple example would be the functioning of your immune system, is the company narrative.  

Let's ease into the Twitter narrative slowly, starting with revenues, costs, and monthly active users (MAU's). 

Revenues, Total Costs, and Users

- Only one new piece of evidence has been introduced into this chart, and that is MAU's. Revenues and total costs are both dollar-sign items, while MAU's are an intangible, but equally fundamental statistic to the salubriousness of Twitter. What becomes immediately clear from this chart is that user growth is not in as rapid as revenue or expense growth. In fact, user growth is downright sluggish, especially compared to the growth of Facebook and Instagram (found later in this analysis). 

- What Twitter has been able to do was to increase revenues much quicker than users. The goal of this analysis isn't to figure out how they've done it (although that is certainly interesting as well), but instead, the focus is on the future. At a certain point, there is a limit to what Twitter can charge an advertiser to place an ad on the service. That limit is monthly active users. Given the lazy growth of MAU's, revenues growth will eventually plateau to be in line with user growth. This is assuming that Twitter-the-service continues to be the main product for Twitter-the-company. Twitter doesn't have diversified income streams like WhatsApp and Instagram, which Facebook smartly purchased, so revenue growth is bound to hit a roadblock if nothing changes. One can only assume Twitter knows this, and is working on new products and services down the road. 

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Sometimes it helps to visualize the same data in a different light. Below is a chart showing MAU's and revenues, as well as a logarithmic trendline of the MAU's. Note the y-axes, which correspond to different data points. 

MAU's and Revenues

- The MAU trendline tells the whole story. User growth started up rapidly,  growing from Q1' 12 through Q1' 13, and then slowing down thereafter. I wasn't able to find revenues for that period of time, since Twitter was still a private company, but if Q3' 13 is any indication, revenues were measly - there were no public shareholders to please yet. 

- It looks like there is some fanciful accounting going on in Q3' 13. As mentioned earlier, Twitter had a large stock-based compensation expense in Q4' 13, and I'm guessing they accelerated revenue recognition in that same quarter to make the loss look better. As a result, the next quarter (Q1' 14) had very little revenue growth. This is conjecture, of course, but accountants are known to manipulate revenue recognition like so. 

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Normally, I don't like comparing social media companies to each other. Social media is it's own industry, but it's too adolescent to benchmark companies against each other. Facebook serves needs that are different from Instagram, and the latter serves different needs than Twitter. That said, they are all social companies, so some sort of comparison is allowable. Comparing Twitter to Facebook/Instagram serves to further explain its narrative. It's also a great tool for getting a feel for the size of Twitter. With that, let's look at the MAU's of Facebook, Instagram, and Twitter.

MAU's: Twitter + Facebook + Instagram

- Facebook is king. Zuckerberg's company simply engulfs Twitter and Instagram (reminder: it's owned by Facebook), and it's so large that comparing Twitter to Facebook would be futile. It does tell us one thing though - Twitter is not Facebook, and it will not be the next Facebook. 

- The story of this chart is actually lies with Instagram. Just recently, Instagram announced it has 300 million MAU's, which makes it larger than Twitter. To be fair, Instagram is primarily a photo sharing service, while Twitter focuses on 140-character text messages, but you can bet Twitter would love to have Instagram under its portfolio. If you recall, Twitter wanted to purchase Instagram, but likely got outbid by Facebook for it. Regrets, I've had a few. 

- Analysts like to dig extremely deep into the details, but all we need to see about how Twitter is doing is right in this chart. Twitter's MAU growth was not able to match that of Facebook, and eventually, people realized Twitter is not Facebook and will never be as large as Facebook. Stock markets adjusted, and everyone moved on. Now Instagram, another product in Facebook's portfolio, outpaced Twitter's growth. The trajectory of Instagram shows it's going up, while Twitter's is slowing down and might even level-off. This doesn't make Twitter a bad company, it just signals that it will no longer be a growth company, which led investors to invest in Twitter in the first place. 

- You're probably now thinking Twitter should be worried about Instagram's success. They should be worried insofar as to why Twitter can't match Instagram's growth rate. But I wouldn't worry about Instagram in the competitive sense, since they are two entirely different social networks. I haven't looked into the data, but I would venture to say that many people use both Twitter and Instagram (in addition to Facebook), and use of one service doesn't take away users from the other. I also don't see Instagram adding any functionality similar to Twitter, since the beauty of Instagram is its elementary simplicity. In short, Twitter shouldn't be actively preoccupied about Instagram's success, and instead focus on their own issues (of which there are many). 

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This final chart displays the same data as above, in a slightly different view. Note that there is no Instagram MAU's for Q1' 14 and Q2' 14, because Instagram didn't release this data to the public. 

MAU's: Twitter + Facebook + Instagram #2

- It's easier to see by how much Facebook trumps both Instagram and Twitter in this chart. Facebook is huge.

- Q3' 2014 is when Instagram overtook Twitter. It's worth reiterating that this doesn't mean much in itself, it only tells us how successful Instagram was in growing.

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Coda

As I was writing this introspective, I was faced with a conundrum. On one hand, I wanted to present my findings about Twitter. On the other, I wanted to give my advice on what Twitter should do to grow as a company. Since I have no higher body to report to, I chose to do both. Sprinkled within this analysis are my opinions, which I believe are good strategic decisions for Twitter. That said, the focus of this analysis was not recommendations, of which I have many. If you are interested in my recommendations, or just have a comment to add, feel free to contact me via email, or fittingly, by Twitter.

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Download the PDF of this report: Twitter Introspective

How Apple is Spending its Cash

What happens when you become so rich that you don't know what to do with your money? You got yourself a nice black Benz with a heated steering wheel. You travelled to New Zealand to view the spectacular coral reefs. You even got a house maid. Now what?

I'm drawing an analogy, of course, but the fictional scenario above is a rudimentary representation of where Apple finds itself now. The company has too much cash, which is lying around unproductively. The main job of a corporation is to provide value to its stockholders. This value comes mainly in the form of stock appreciation and dividends, the latter of which Apple has been slowly increasing. As a company's growth slows, it tends to invest less heavily into the business, and instead spews off dividends to investors.

Tech writers almost always recommend Apple spend its mountain of cash in the form of Research & Development and hiring, but this advice is lacking an understanding of what money can buy. Apple has classically spent less on R&D than competitors, but this has never stopped them from releasing the most popular and innovative products. Just like with anything, there is quantity and quality. Spending billions on R&D because you have billions to spend is not a winning strategy - it's unlikely to provide adequate returns in the form of revolutionary products and it won't provide investor's with the value they seek. This is not the pharmaceutical industry and Apple is no longer a growth stock (it is too big).

Many industry mavens also eagerly advise Apple to staff-up, especially now, since the latest iOS and OS X releases have been riddled with bugs. They seem to think that Apple possesses a machine that turns dollars into productive employees. I assure you, this is not the case, because if it were, Apple would be far richer than it is now. While I agree that Apple should hire more qualified employees (particularly in the App Store, Search, Maps, and iCloud teams), what Apple should do is not what Apple could do. Staffing up teams quickly is a recipe for disaster, especially at a company with such a unique culture as Apple. It can take months, if not years, for an employee to be assimilated into the company. Let's also not forget that this employee will also need to be trained by current employees, taking their productive time away from work. Fortunately, Apple seems to be trying to solve this problem. From what I've seen anecdotally on Twitter and the web, many top-notch individuals have been pouched to join Apple in the last few years, and particularly this year. It's worth pointing out though - we don't know how many have left Apple in the same period.

Apple has also significantly accelerated its massive stock buyback program in order to put its cash to productive use. Stock buybacks are a divisive thing; ask 10 investors if it's a good idea and you'll hear 100 opinions. Buybacks are extremely situational, and they might work for some companies while not for others. In the case of Apple, however, I think they are a good idea because those acquired shares can be redistributed to employees, old and new. It's notoriously hard to recruit great engineers in the valley, and no better incentive exists than cash and stock.

It's easy to write advice about what Apple should do with all of its cash, but it would be foolish to think that Apple is unaware about all these possibilities. At the same time, management myopia is defintely something Apple should steer clear of, as it was that thinking that turned BlackBerry into BlackBerry.