I’ve done the MBA thing, I’ve worked in the strategy team of a large software company and I’ve done my share of theorizing and plotting and moving the pieces around the big war chart. So I’m aware of strategery and moats and network effects.

That sort of analysis is interesting and worthwhile, but sometimes when people get into a world of two-by-twos and Porter’s 5 forces and blue ocean red ocean, they lose sight of the real world. The world where real people with real problems walk into real stores and buy real things. In the real world today, Apple is killing it. Look at any metric comparing Apple to other handset manufacturers. ANY METRIC. It will tell the same story. Their handsets are in higher demand than any other manufacturer, so they can charge more than anyone else. And their cost basis is lower because they are selling more identical units with shared components than any other vendor. As a result they are the fastest growing major handset vendor and in a few short years they have gone from not being at the table to eating half of the profits in the whole phone market.

Of course, the converse is also true. If you only look at what consumers are doing with their hard earned dollars today, then you’ll miss the macro changes in the market that are leading indicators of what might happen tomorrow. In the case of phones, the macro issue getting the most attention is the platform war. We have learned from the PC industry that platform network effects are extremely important. While it is dumb to assume that exactly the same dynamics will apply to phones, it would be insane to ignore the possibility that they will will manifest themselves, albeit in a different way.

There are many ways to argue against the platform thesis. First of all, the players are different. Apple 2011 and Google 2011 are not Microsoft 1995 and Apple 1995. Second, the product is different. Mobile has a different set of user experience and technology requirements. Third, the context is different. The biggest factor here might be that during the PC/Mac platform war the web was nascent. Finally, this is a movie we’ve all seen before. Surely handset vendors will see that an Android future leads to the inevitable commoditization of their part of the value chain?

But even with all the rational arguments against it, one has to acknowledge that there are parallels and given that network effects are so extremely powerful, they are parallels worth thinking about. If Android phones and apps get good enough — not necessarily better than iPhones and iOS apps, just good enough — and the real Android application footprint¹ passes a certain tipping point in the market, it might be all over for a decade or more. This, I think, is what Fred Wilson and Bill Gurley are seeing… the horizontal tipping point.

My implicit assumption is that there will be a tipping point. Right now there are really two industry architectures co-existing in the smartphone market, which is inherently unstable. I think it is likely that at some point the market will move to a more stable equilibrium where either the horizontal or vertical architecture is clearly dominant. If this is true, then the interesting questions are around the race to the tipping point. What are the conditions that support each tipping point? How close are we to either one?

The Horizontal Industry Tipping Point

I think most people would agree that the horizontal tipping point is all about apps. Android needs to enter the virtuous cycle where developers go there first because it represents a bigger opportunity, and consumers go there first expecting to find more of the apps they want.

Of course, the phones are also important, and real competitors to the iPhone² would definitely help to kick start the virtuous cycle. By “real competitor” I mean one with an identifiable line of products that have coherent messaging and are selling in volumes that are at least in the same order of magnitude as the iPhone, and whose profits allow sufficient reinvestment to make the product line a sustainable investment. Developers would be excited by them and you would see people using them in the subway.

This doesn’t exist for Android today. Verizon is cobbling together a product line by putting a single brand, Droid, on handsets from different manufacturers. HTC is making a valiant effort to create a branded user experience with HTC Sense. Motorola may follow Xoom with more products and create a credible product line. But it doesn’t exist yet. Today, we make comparisons between one handset manufacturer, Apple, with everyone who makes Android phones (40-100 different devices). That is telling.

While great iPhone-killing Android phones would help to push the industry past the horizontal tipping point, the real pre-requisite is apps. There need to be killer app experiences that are uniquely available on Android. I say “App experiences” and not simply “Apps”, because even if the killer apps were just significantly better on Android this might be enough.

So the crucial question becomes, how much bigger does the (real) Android application footprint need to be before most developers pick Android first, and regard iOS to be optional?

Of course it is hard to be specific, but given the factors in favor of Apple, the answer is somewhere in the region of “a LOT bigger”. With a manicured product line and just a few distinct models, Apple will always be a much more uniform platform footprint. It also has a significant lead today — a much more vibrant app economy and a larger selection of apps. So with an equally sized app footprint, Android isn’t close to big enough to tip the developers in their direction. At double the size? Maybe.

The important points are that (1) in order to win a platform war, Android has to turn out to be the best place to target and find apps. To date, this has not been its strength. And (2) app platform needs be a factor that can generate significant demand side economies of scale. The latter was true for PCs, but we can’t assume that it will be true for mobile.

The Vertical Industry Tipping Point

PC history has proven that one stable industry architecture (where stability is measured over a decade or more) is a horizontal software platform with multiple hardware vendors. And that might happen with Android. This is where a lot of analysts stop. The success of this model in PCs was so overwhelming that for them it is just a question of when, rather than if, we will reach the horizontal tipping point.

But there are other ways this industry could go.

Apple’s dominance in digital media players is one example, where a single vertical player gets 70-80% of the market and by smart reinvestment of their profits and even smarter exploitation of their supply chain economy of scale advantage (e.g. cornering the market on 1.8″ hard drives, and later flash memory) stays dominant. The only thing that removed iPod from this dominance was a disruption — phones (or more accurately, the iPhone) entering the media player market as a substitute.

Was iPod a consumer electronics dress rehearsal for iPhone? Can Apple reproduce iPod like dominance in the phone market? I argued no for years. Now I see them exercising the same supply chain muscle in the phone market and I’m not as sure of myself. It still seems unlikely given the sheer size and reach of the market, but then again, I would have argued apriori that the current success of the iPhone, documented so well by Horace Dediu, was impossible too.

Still, the more likely outcome in a dominantly vertical industry is several big competitors, each with a different platform. For example, a future where Apple-iOS competes with Nokia-Windows, Samsung-Android and HP-WebOS. In this future there is healthy competition between these major players, but buying a phone is like buying a car. There are well known brands with clear positioning and loyalties, and people with brand affinity know when the new models are coming out.

Where the horizontal industry tipping point was about the network effects associated with apps (aka demand side economies of scale) the vertical industry tipping point is about supply side economies of scale. It is about the effect of relative market share on handset vendor economics.

Here’s how it works. As we get closer to the vertical industry, the increasing share being grabbed by an ever smaller group of manufacturers allows them to exercise economies of scale. Specifically:

1. Marketing economies of scale: Successful handset manufacturers can use a lower overall marketing budget but still spend more on marketing per distinct product line. You see this effect today. Compare Microsoft’s massive, but thinly spread Windows Phone marketing budget and Apple’s laser-focused iPhone marketing budget. Ask 10 people whether they have seen a WP7 ad and then ask them if they have seen an iPhone ad.
2. Manufacturing economies of scale: The more components a handset manufacturer can buy, the better the deal they can drive with the component supplier. This effect is incredibly important, and seldom discussed. Analysts can’t get a hold of it because these deals are closely guarded secrets by suppliers and buyers alike. Some manufacturers will drive enough demand for certain components to take them in-house (e.g. the A5 SoC), further reducing their costs and dependence on suppliers.

The simplest distillation of the success of a strategy is consumer Willingness-to-Pay ($) minus production Cost ($) relative to your competitors. As the industry moves towards the vertical tipping point a few players are increasing the former and decreasing the latter and accelerating away from the rest of the pack. At some point, big companies without these economies of scale just aren’t be able to compete and wither out of the market.

Apple: Speed Limited

Apple is showing signs of marketing and manufacturing economies of scale today. There is something holding them up, but contrary to the popular narrative, it isn’t Android. It is their own ability to scale fast enough to meet market demand.

There is scale in manufacturing, where they have done a remarkable job of going from a company that shipped zero phones to a company that today ships tens of millions of phones and tablets. Still, they are probably scaling production just about as fast as they possibly can. Then there is scale in distribution, which is mostly about getting into the assortment of as many mobile network operators as possible.

In both of these areas their major competitors, Samsung, Motorola, RIM, Nokia, had a massive head start. And none of the phones that compete with iPhone today ship in sufficient volume to even make a supply chain blink or generate sufficient demand to test the reach of a distribution channel. So a flood of products of all shapes and sizes, made more credible by their Android label, is scooping up the smartphone demand that Apple, with its production and distribution limitations, can’t meet.

The crucial question for the vertical industry tipping point is how fast can Apple scale their manufacturing and their distribution. And can they scale fast enough to dominate this massive market? As with the horizontal tipping point, this is impossible to accurately quantify, but I think the fact that Apple is losing ground against Android is a sign that they can’t scale fast enough to achieve an iPod-like dominance of the phone market.

This makes it important to distinguish between two different vertical industry outcomes: iOS dominance and iPhone leadership.

So I think there are three potential outcomes in the mobile handset industry that are worth contemplating:

1. Android dominance implies a future where the industry is horizontal, with an OS vendor creating a dominant application platform with its associated network effects (demand side economies of scale).
2. iOS dominance implies a future where Apple enjoys the demand side economies of scale associated with a dominant application platform, and the supply side economies of scale associated with being the leading handset manufacturer.
3. iPhone leadership implies a future where the dominant player is a vertically integrated handset manufacturer that enjoys supply side economies of scale in manufacturing and marketing.

The App Platform Isn’t What it Used to Be

The striking thing about the three scenarios above is that the first two, the most popular two, are based on the fundamental assumption that app platform network effects will be a significant factor in determining the outcome. But will they?

One big wildcard is the extent to which cross-platform web-based experiences reduce the ability of a native app platform to create meaningful network effects. This is the huge difference between the PC world of the late ’80s and the phone world of 2011. Native apps may continue to be significant, but the existence of the web makes them less significant than apps were back in the day.

This isn’t an argument that all apps will be web apps. Regardless of whether the client is a native app or web based, these days a lot of the important computing is on a server somewhere, and not on the local client. The “app” is most often little more than a presentation layer. Native client-side apps are better because they react faster, handle offline situations better and have more tailored user experiences than their web based counterparts. Most of them are in a sense just custom browsers for a specific web service.

The other difference between the ’80s and today is the massive advances that have happened in development technologies. Single developers are churning out sophisticated apps and doing so for multiple platforms. Even if native apps reign supreme, it really isn’t clear that developers will face agonizing decisions about whether to do iOS or Android. They’ll just do both!

What this means is that the first two of my three scenarios are probably built on something that won’t exist: A platform with sufficiently strong demand side economies of scale that this determines the market outcome.

The New Platform Network Effects

Ironically, Apple is to blame for this recent obsession with app platform network effects. Just a few years ago the vast majority of people were so past native apps and everyone was looking for the new dominant platform in the cloud, but the success of their iOS AppStore has sucked our thinking all the way back to 1995 (incidentally, a place much more comfortable for many analysts than 2011).

And it is still possible that an Internet based service plays the role in mobile that native apps did for PCs in the 90’s. In some respects, iTunes is doing this today. The service is unique to iOS based handheld devices, and if a social service like Ping actually worked, it could generate a powerful network effect.

But that’s overlooking the biggest single network effect since the PC app: Search. In the search space, Google is killing it. Their search product is an oil gusher of advertising revenue, where Microsoft, with a very similar product, is hemorrhaging money. Why? Demand side economies of scale. More people use Google search, so Google can deliver more relevant search results, so more people use Google search.

If Google could take this network effect and apply it to Android, that would change the game. Many things conspire to make this improbable though. For one, regulatory agencies saw Windows happen, and they aren’t keen on that kind of de-facto monopoly repeating itself. But even putting regulation aside, it would be a huge gamble for Google to forego the traffic from a marget segment as large as the one iOS represents today.

Could Google achieve a network effect through another bundle of services that work best on Android? Possibly, but they haven’t shown this sort of success with obvious network effect candidates, like the social graph. They are still first and foremost (and only?) a search and advertising company.

And while the social graphs of Facebook and Twitter have powerful network effects, they are not currently tied to any one device OS platform.

The Outcome: A Very Ordinary Industry Architecture

So far it looks unlikely that the next generation of computing devices will have an industry governed by demand side economies of scale. Supply side economies of scale, on the other hand, are very much alive and well. Component costs, and even access to component supply, will continue to be a crucial differentiating factor for manufacturers. With more noise bombarding consumers every day, marketing economies of scale will also continue to be important.

It follows that the two outcomes that define the popular Android versus iOS narrative are much less likely than a concentrated and effectively vertical industry with several strong competitors. Even if some of these competitors share an OS, this OS will not be dominant in the sense that Windows is dominant in the PC industry today. App platform network effects will influence the industry, making for fewer competitors than in a market like TVs or toasters. But they won’t define it.

The extent of Apple leadership will not be determined by the success of Android. Rather, it will be limited by Apple’s own ability to scale manufacturing and distribution. These limitations might allow other manufacturers (and potentially close partnerships like Microsoft-Nokia) to regain share and grow faster than Apple for a period of time. No doubt myopic analysts will again take this as a sign that Apple is “dead in the water”, but in the end it is highly likely that the industry will stabilize with the company in a convincing leadership position.

But only until that equilibrium is disrupted.

—

1. Given Android’s fragmentation it is important to make a distinction between the real app platform footprint and just the number of Android phones. Analysts jump to lazy conclusions using the number of Android phones shipped as a proxy for the application footprint, but it isn’t reasonable to do this (yet).
2. In this piece I’m using “iPhone” as shorthand for the family of handheld devices that Apple bases on iOS, to distinguish it from iOS the application platform.