Tuesday, October 15, 2013

Apple's Design Option to Disrupt the Cell Phone Industry

With iMessage and FaceTime Apple has built an internet-based high quality parallel communications channel that bypasses traditional cell phone services. For any two iOS 7/ OS X Mountain Lion users who are connected to the internet, an integrated parallel channel for video, voice and text messaging is already available. What's more, these conversations already take place with much higher fidelity than current cell phone calls via American carriers that highly compress their phone signal. And the conversation can be carried on across multiple devices--iPhone, iPad, laptop and desktop.

The logical evolution of this is that an Apple device will be able to determine if it is communicating to another Apple device, determine whether or not an internet channel is open between the two, and if so, move the conversation over to the internet channel.

If Apple is successful in creating a smooth running high fidelity WiFi based replacement for the cell phone based carrier, consumer demand for WiFi on a municipal level could drive WiFi adoption to levels that would support an entirely Apple based multichannel communications based ecosystem with message, voice and video integrated into the operating system of each device. Communications between homes outfitted with Apple products can already move over to this channel. We recently attended a kids birthday party via FaceTime. With cupcakes and candles on both sides of the video connection, it was a brilliantly smooth, live and entirely internet-based media experience.

The piece missing in this equation for true mobile disruption is broadly available municipal WiFi. In the years just before the recession there was a move to offer municipal WiFi with serious proposals considered by San Fransisco and attempts by Earthlink to launch a service in Philadelphia. In Philadelphia Earthlink eventually abandoned the project after sustaining low adoption rates and higher than expected costs. Earthlink experienced low adoption rates in part because its service offered little advantages over home based WiFi, so the motivation to switch to a city-wide system was low. In 2007 internet based communications were largely dependent on laptop and computer devices which are less portable and were only recently untethered from the wired network. Smart phones were still relatively new and the integration of services across devices was weak.

In the years since, Apple has built internet based video, voice and text features into OS X and iOS 7, essentially creating a superior quality parallel channel to the cell phone networks right inside of their operating systems. Now it is conceivable that those design features would enable customer demand to drive the viability of wide spread municipal WiFi.

Just how much could this be worth in monetary terms to both a city and its residents? First the current cost structure. Apple currently offers the iPhone 5C for $99 with a two-year contract that ranges from $70 to $530 per month, depending on your data usage. Let's assume a target segment that lives in a major city such as San Fransisco, Chicago or New York City, and uses at least 2 GB of data per month. That person is going to pay $95 per month on AT&T and $100 a month on Verizon. This user is single and doesn't share a plan with anyone. For each user I assume the $99 upfront cost plus $100 per month in use fees. Additionally, they are paying for internet in their home at a rate of about $50 a month. This is an online native with media rich browsing needs--streaming music, television and movies. Bandwidth intensive.

The cell phone alone over two years is going to cost $2499 without taxes. Add internet to that and you have a total bill over two years of $3,699. That's a lot of loot for one person to have phone and internet.

Apple also currently offers a 16GB 5c for $549 with a contract free carrier. That's the unsubsidized cost of the phone (in the two year contract the cost of the phone is recovered in the $1200 per year payment).

Let's imagine for a moment that you live in a large city with publicly available municipal WiFi. With wireless everywhere, you could buy the phones outright, detach from the cellular network and use the local WiFi for long periods of time. In theory your cell phone provider would become a secondary service, only needed for times when you are away from the city. In cities at the scale of San Fransisco and New York City, that could be very little indeed.

Then, under the current cost structure, a phone at full price plus municipal WiFi at $50 per month would cost $1,759 for the two years, a savings of $1,940. Additionally, you could pay $10 a month for a very generic cell phone plan through a company like Consumer Cellular to cover calls needed when WiFi is out of reach (no data transmission). Now, the total cost for the use of the premium consumer smart phone on the market is still at a savings of $1,820 over the current 2-year contract offering from a major carrier, all using existing technologies that just need better implementation and integration.

How viable is this? When Earthlink installed its municipal WiFi in Philadelphia it anticipated 20 to 25 nodes per square mile to supply adequate service to the entire city. In reality they had to install an average of 42 nodes per square mile, approximately double the cost estimated. The 2007 Earthlink bid to provide municipal WiFi to San Fransisco estimated a $6 million to $10 million capital investment plus $1.5 million to $2 million annual maintenance costs. If we double those estimates based on their experience in Philadelphia, we get a $20 million capital outlay plus $4 million a year in operating expenses. If the service charged moderately heavy users $50 a month it would take less than 7,000 of our target users to break-even on the monthly costs. If the same 7,000 users went off of their monthly cell phone plans to use Apple's wireless based video, voice and text features with a low cost ancillary cellphone contract as described above, their combined savings would be $13.5 million in the first two years. Theoretically that's money directly into residents' pockets and into the local economy.

Using the above numbers, with 14,000 users at $50 a month for a total of $8.4 million in revenues and $4 million in operating expenses per year, the city would have a positive cash flow of $4.4 million over 12 months. That would pay off the $20 million investment in less than 5 years while injecting $13.5 million each year in cash into the local economy through cost cutting for residents. And that is with a fairly narrow segment of adopters. Add a graduated pricing structure to that with lower costs for lower income and lower data intensive users plus higher costs for the high end 50 GB+ user and you have a very viable business model. In a city like San Fransisco with hundreds of thousands of potential customers, you can see where this quickly goes.

If multiple cities were to invest in their residents this way, demand for a pay-as-you-use-it wireless service would go up as urbanites migrate away from cell phone companies as a necessary central service for their smart phones. This would reposition cell phone companies as an ancillary service to be activated and paid for only when and where municipal WiFi is unreachable.

FaceTime and iMessage only work from one iOS/OS X device to another. Making WiFi based calls and texts outside of the iOS/OS X ecosystem currently requires Skype or another add-on app or service. We could assume that the integration of those products would improve, although as WiFi expands, Apple's superior design by integrating communication tools directly into its operating system only reinforces the advantages for consumers to purchase Apple products. Additionally, it will be customer adoption and demand that drives the transition. Apple has no investment in municipal WiFi one way or the other. But it is guiding demand for it through design in its operating systems. Keeping the integration focused on communicating between Apple devices reinforces the future advantages of the iOS/OS X platform.

Apple has a history of disrupting through a similar process. In the good old days when a removable disk was required to transfer files between computers, every computer came with a built in removable disk drive. To move away from this, Apple first started building network transfer features into its operating system. As users became used to the idea that one day network transfer would be the solution, Apple simply stopped providing any built in removable storage. This effectively repositioned the disk manufacturers as external to the integrity of the computer itself. The disk drive became an add on that you had to purchase separately and attach externally to your computer. At this point a low-cost USB flash drive is all you need for most external file transfer needs. Everything else is handled via the network. A similar process may be at work here, with cell phone carriers, which are currently essential to a mobile communications device, being eventually repositioned as ancillary or even optional.

To be clear, for this to work municipal WiFi would have to provide sufficient coverage within the city so that a user could move freely without losing their connection to the signal and without interruptions to login or reconnect. It can't be an anemic partial coverage with holes and weak spots. The coverage has to be complete and seamless in order to convert our above target user who wants data rich coverage and ease of mobility within the city limits. If the city designs for that user, so many others would benefit as well.

In typical Apple fashion, minimal discussion has been made around this. The user is left to demonstrate the demand in a pull system where Apple both guides and responds to their needs via design refinement. Adoption will drive the service with minimal additional investment from Apple. If adoption rates are high, it will pull users in through the user experience. This only reinforces Apple's dominance in the smart phone industry in the form of an increased advantage to owning the phones. If adoption rates are lower, there is minimal cost. Build now for the option to disrupt as demand dictates. Here a real options strategy meets product design with extremely low operating leverage and a finance strategy to back it up. Whether you are rooting for or against Apple, that's brilliant strategy.


This is by no means the final word on the viability of the cost estimates provided by Earthlink in their bid to the City of San Fransisco nor does it evaluate how suitable the coverage proposed there would be to our target user. But it does demonstrate that design improvements in the past six years have refined a target segment of early adopters who could pay for such an investment at reasonable adoption rates.

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