As Companies Focus on Services, Will Hardware Become Irrelevant?

In recent weeks, Amazon.com, Microsoft and Apple have all held splashy events to tout their newest tablets -- the Kindle Fire HD, the Surface and the iPad Mini. But even as Amazon CEO Jeff Bezos talked up the specs of the new Kindle Fire, he noted that the market is becoming less about the gadgets themselves, and more about how companies can make money off additional services and purchases that appeal to device users.

Technology companies now see the buying of a tablet as merely the beginning of a long relationship with a consumer -- a relationship that will extend across multiple platforms and content types, with users periodically paying subscription fees or purchasing individual applications, music, movies and television shows. And if the firm is assured of a future payoff, it can offset the losses from charging less for the device.

But making such a transition is easier said than done, according to Wharton legal studies and business ethics professor Andrea Matwyshyn. "At present, this model is limited to only a few players," she says. "The services model definitely works for Amazon, given its content library with books and its expansion into [streaming] movies and TV. [But it] is more challenging for those companies without content licensing."

On the other hand, Matwyshyn notes that companies focused solely on hardware, such as Dell, Hewlett-Packard and Lenovo, face the prospect of falling profit margins as more diversified firms find new ways to monetize hardware devices. Apple, she adds, may be the only company that can command a premium for hardware due to its software integration, app selection and large installed base of 100 million iPads. (That number is only expected to grow following the October 23 unveiling of the 7.9-inch iPad Mini, which starts at $329. The 8.9-inch Kindle Fire HD starts at $299.)

But Amazon and other competitors are faced with the challenge of finding ways to subsidize their business models. For Amazon, the path forward is fairly clear-cut: Use the Kindle Fire to sell more goods. According to Bezos, Kindle users tend to buy more content and goods from the e-commerce company than those who don't have one.

"We want to have the best tablet at any price," said Bezos at Amazon's September 6 press conference in Santa Monica, Calif. "Invention doesn't stop with the hardware.... We want to make money when people use our devices, not when they buy our devices. If someone buys our devices and puts them in the drawer and never uses them, we don't deserve to make money."

Bezos called for the end of the gadget ethos, which revolves around hardware as the driving force for a consumer purchase. He added that consumers should get off the hardware upgrade treadmill that much of the technology industry relies on. Amazon's approach is to break even, or take a slight loss, on its hardware, be choosy with device features to keep costs low and make money on usage. Hardware is important because it has to be competitive, Bezos noted, but specifications should not be the reason people buy a device.

Kindle customers are invited to subscribe to Amazon's Prime shipping service for $79.99 a year, giving them free access to a large online video streaming library and to complementary two-day shipping for physical goods purchased on the site. Essentially, Amazon has turned the Kindle into a kiosk for its larger e-commerce business. According to research firm UBM Techinsights, Amazon's cost for materials at best equals the price of its tablet, creating a nonexistent-to-negative profit margin for the Kindle itself.

Wharton marketing professor Eric Bradlow is the co-author of a case study examining Amazon's Kindle Fire model. "One reason for Amazon [selling its own devices] is that if some other manufacturer controls the device, then it can conceptually control access," Bradlow says. "By having an Amazon device in people's hands, you are the first point of contact. The relationship starts with Amazon." Other firms, including Microsoft and Google, are exploring their own strategies for how to monetize device use beyond the initial purchase.

It's unclear how traditional hardware vendors will be able to navigate this new world order. According to research firm IDC, PC sales fell 8.6% in the third quarter of this year, at least partially due to the popularity of tablet devices. "Companies like HP and Dell are going to be in a tight spot. Their profit margins are already being squeezed," Knowledge@Wharton technology and media editor Kendall Whitehouse points out. "The market is increasingly challenging for companies that are just hardware players."

The Lure of Services and Subscriptions

While consumer loyalty once resided solely with a particular piece of hardware, users today are much more likely to commit themselves to particular services or platforms. "These companies are trying to differentiate themselves and get people to their platforms at a lower cost," says Wharton management professor David Hsu. "The question these companies are trying to answer is: What's the value of getting someone on your platform?"

According to Whitehouse, the ultimate goal for many technology companies is to build a subscription base for some aspect of their offerings. "The subscription model is very appealing," he notes. "Whether it's software, media or services, there's a big push toward subscription fees," which provide a steady source of revenue.

Microsoft CEO Steve Ballmer cited the recently released Windows 8 as an example of the company's efforts to integrate its slate of music, video games and applications services. The company also plans to sell subscriptions to its Office desktop productivity suite and SkyDrive storage service. Analysts are split on the potential success of Windows 8, largely because consumers have to get used to the interface's new design at a time when a bevy of devices from other firms are hitting the market.

In Microsoft's case, the push toward increasing services and subscription-based offerings may not do much to increase revenue significantly, says Wharton legal studies and business ethics professor Kevin Werbach. "Microsoft's problem is the law of large numbers," he notes. "It has been so successful and so entrenched for so long that it needs to find 11-figure opportunities to move the needle in a positive way. There aren't many of those. Software alone isn't likely to provide one."

On the other hand, Werbach adds that Microsoft has the advantage of controlling a software platform -- Windows -- that it can integrate into in-house devices like the company's Surface tablet device or the Xbox video game system. Microsoft's size also allows it to absorb losses incurred while it waits for various products to catch on and find a market. For example, Werbach notes that while the Xbox is now profitable, it lost money for years after its launch.

Google is another company that needs to find big opportunities to move the revenue needle, experts suggest. The search giant can sell advertising through its 7-inch Nexus tablet and has also launched the Google Play store to sell e-books, music and applications. But it still lacks the depth that Apple and Amazon can offer through their competing services. "The thing that's consistent across all of these business models is customer tethering -- having an ongoing connection with the consumer," Whitehouse points out. "Amazon wants to sell more books and music. Google cares about gathering data on your online search and browsing habits. Microsoft wants to sell you updates to new versions of their software. Each of these provides the opportunity for a continuing revenue stream for these companies."

Indeed, Google CEO Larry Page was confident that his company could become a device player and use that market to sell more ads and more content. "Mobile search queries and mobile commerce are growing dramatically across the world. I switch between my Nexus phone, my Nexus 7 tablet and my Chromebook, and it causes disruption. It also creates amazing opportunity," Page noted during Google's earnings conference call on October 18.

The Hardware Scramble

Moves by longtime partners like Microsoft, and new entrants such as Amazon and Google, to manufacture devices in-house present a significant challenge for traditional hardware vendors. According to Wharton operations and information management professor Kartik Hosanagar, the choice for hardware firms is to either "become strong back-end suppliers of hardware to services firms ... or to focus exclusively on enterprise markets."

But Hsu suggests that hardware will become an increasingly smaller portion of the technology value chain. "If you think about the lifetime value of a consumer, hardware is an increasingly smaller part," says Hsu. "HP and Dell realize that there's commodification."

The enterprise, or business, market might be a natural fit for hardware companies because it's an area where none of the current players has a significant presence. "Services mean something different in the enterprise context -- more consulting than apps or content," Werbach points out. "Having a foot in hardware as part of an integrated package is valuable; that is one reason Oracle bought Sun Microsystems. But none of the major enterprise IT players is focusing on hardware as the key differentiator or revenue generator anymore."

To stay in the consumer business, hardware vendors will have to build content libraries or partner with firms that have them, Matwyshyn notes. For instance, a company like Time Warner could partner with a hardware manufacturer to bring both devices and an integrated platform to consumers. Sony, for example, could become a key player because it manufactures hardware and controls a significant amount of content through its media arm, she adds. "Hardware companies could form strategic deals with [content] companies focused on subscription models. These models won't work well without hardware."

Hsu, however, predicts that such deals aren't likely to come anytime soon. Culturally, both hardware makers and content companies are predisposed to protect existing revenue streams, he notes. Content companies wouldn't want to upset cable providers, and PC makers will initially focus on breaking into new hardware categories, such as tablets and smartphones. Ultimately, however, partnerships could be forced by market conditions.

"These companies will have to look at innovative partnerships," says Hsu. "Service and content companies and hardware vendors could partner for mutual gain."

Knowledge@Wharton