The iPhone Was Different
Apple is currently an iPhone company with ancillary iPad, Mac, and software businesses. Few would have expected the iPhone to not only represent 60% of Apple's overall revenue within a few years after launch, but also transform the mobile industry in the process. Steve Jobs' initial goal was for the iPhone to sell 10 million units (capture 1% of the phone market) in 2008. Six years later, Apple sold 169 million iPhones in 2014 (8% share of a much bigger phone market). With the Apple Watch launch a few months away, one question swirling around is how similar will the wearable device be compared to iPhone in terms of importance and popularity. While Apple may find success in positioning Apple Watch as a way to redefine certain aspects of mobile computing, the iPhone will always be known as the first mobile device that truly changed the world. A quick trip to the mall makes it very clear that the iPhone was different.
Over the weekend I ventured out to do some light shopping. Since it was still early in the morning, I decided to go past my usual turning point in the mall and walk the length of the complex. It was the first time I was seeing the other side of this particular mall in years. While there is always some level of attrition with mall retailers, I was quite surprised to see a series of storefronts that had bucked the trend. Instead of closing or reducing square footage, these stores had a larger footprint, merging a few storefronts, leading to a formidable presence in the mall's upper level. These stores started out as smaller kiosks near the food court, and now they were among the bigger stores in the mall. The growing footprint of these mobile carrier retail stores symbolize how the iPhone was different than other Apple products, riding the much bigger wave known as mobile.
Only 10 years ago, the mobile carriers were selling a few dozen "feature" phones, packed with the latest keyboard innovations. After a few minutes of figuring out how many night and weekend minutes would be acceptable, the new cellphone owner would run to find an area in the mall with good reception (that last part is still true today). With much higher foot traffic on any given day (U.S. smartphone penetration moved from 10% in 2009 to 70% in 2014), mobile carrier stores now serve as places to not only buy a more narrow range of gadgets, but also attend to monthly bills, and receive tech support (including cable and home internet for some). Since I buy my phones online, walking past the much-larger AT&T and Verizon stores in the mall reminded me how mobile computing has matured since the iPhone was introduced. While the iPhone is a great device enjoyed by millions, the mobile rocket it strapped itself to certainly helped drive cumulative sales of more than 550 million iPhones.
Instead of transcending the mobile carriers, new Apple products in the near-term will likely be positioned to supplement the iPhone, improving on the device's initial breakthroughs in mobile. The iPhone was truly different; it only took a short walk in the mall, and a quick glance at the mobile carrier stores, to serve as a reminder.
Apple SVP Operations Jeff Williams on BBC's Anti-Apple Documentary
One of my stories in today's AAPL Orchard email was the BBC going undercover into Pegatron, one of Apple's iPhone assemblers. This morning after publication, Apple's head of operations, Jeff Williams, wrote a memo to Apple's UK team addressing BBC's "Apple's Broken Promises" documentary. BBC sent three reporters undercover to work in a Pegatron iPhone factory. I was able to watch the documentary last night. I would recommend watching the video as I thought the first 30 minutes were relatively fair from a journalistic standpoint, including observations and recordings from inside Pegatron. I thought the documentary started to lose credibility in the second half when the discussion turned to the very bottom of Apple's supply chain, focused on tin mining. I wasn't alone as Apple's Williams dedicated a good portion of his memo to that part of the documentary.
Apple SVP Operations Jeff Williams:
“Panorama showed some of the shocking conditions around tin mining in Indonesia. Apple has publicly stated that tin from Indonesia ends up in our products, and some of that tin likely comes from illegal mines. Here are the facts:
Tens of thousands of artisanal miners are selling tin through many middlemen to the smelters who supply to component suppliers who sell to the world. The government is not addressing the issue, and there is widespread corruption in the undeveloped supply chain. Our team visited the same parts of Indonesia visited by the BBC, and of course we are appalled by what’s going on there.
Apple has two choices: We could make sure all of our suppliers buy tin from smelters outside of Indonesia, which would probably be the easiest thing for us to do and would certainly shield us from criticism. But it would be the lazy and cowardly path, because it would do nothing to improve the situation for Indonesian workers or the environment since Apple consumes a tiny fraction of the tin mined there. We chose the second path, which is to stay engaged and try to drive a collective solution.
We spearheaded the creation of an Indonesian Tin Working Group with other technology companies. Apple is pushing to find and implement a system that holds smelters accountable so we can influence artisanal mining in Indonesia. It could be an approach such as “bagging and tagging” legally mined material, which has been successful over time in the Democratic Republic of the Congo. We are looking to drive similar results in Indonesia, which is the right thing to do.”
I thought the entire memo, but in particular that particular section, was well-written. It was tough watching children work in tin mines, but I knew that the BBC positioning these awful situations as being somehow approved by Apple was unfair and not trying to actually help these people. Williams did a good job at clearly explaining what Apple has been doing to address the situation, instead of simply telling its suppliers not to buy tin from those mines. The weird part about the BBC documentary was that the undercover reporters did notice a few protocols not being met inside Pegatron, which I assumed have already been addressed, but BBC went further and started to frame Apple as simply not caring about what was going on in its supply chain, or insinuating the more disingenuous claim that Apple approved of shortcuts or cheats meant to meet certain safety benchmarks or ratios. I thought the BBC reporter had an interesting story idea and took some risk to get the unique footage, but I suspect the conclusions were stretched too far in order to find a juicy story.
Apple Will Save $3 Billion in 2015 by Selling the 16GB iPhone 6/6 Plus
Apple's decision to keep the entry-level storage tier at 16GB for the iPhone 6 and 6 Plus, despite doubling the other capacities to 64GB and 128GB, continues to raise eyebrows. Daring Fireball's John Gruber called it "the single-most disappointing aspect of the new phones." By not doubling the entry-level storage tier to 32GB, I estimate Apple will save $3 billion of profit in 2015. I suspect Apple's bigger concern was the long-term balance between customer's storages needs and maintaining the iPhone's aspirational brand.
Apple's near-term motive behind keeping the 16GB capacity option is pretty clear: get people to buy the 64GB option. From Apple's point of view, consumers would benefit as Apple didn't raise the price of the middle-tier or upper-tier iPhone storage options, despite doubling storage to 64GB and 128GB, respectively. I suspect the issue is a bit more complicated and involves setting precedence for future iPhone revisions, as shown in Exhibit 1. The problem with having three storage tiers in an environment where the lowest storage capacity will soon be able to outstrip customer needs is that Apple risks permanently moving users from higher-priced to lower-priced models, where the cumulative change starts impacting iPhone average selling prices (ASPs) by hundreds of dollars, representing a significant portion of the company's net income.
Exhibit 1: iPhone Storage Scenarios
With Option A, if Apple kept a 16GB storage tier for an additional year (as they are doing now) and got people to upgrade to 64GB (represented by the red arrow), in subsequent years, consumers will likely develop a dependency on that storage level and remain in that middle tier, even after Apple increases the lower tier to 32GB in the future. With Option B, by upgrading all three storage capacities at the same time in Year 2, some consumers will downgrade to the lower storage capacity (represented by the red arrows) as their storage needs would be met with a less expensive model. With both Options A and B, the most popular iPhone model by Year 3 would be the same: 64GB, only with Option A, consumers are paying an additional $100.
Calculating the financial impact from keeping the 16GB model includes a few steps and calculations, highlighted in Exhibits 2 and 3. I have combined the financial impact from the iPhone 6 and 6 Plus in order to not miss the main point of this exercise; finding the difference in iPhone margin, both with and without the 16GB storage capacity tier.
Exhibit 2: Estimated iPhone 6/6 Plus Sales Mix and Margin Data Given Two Case Scenarios
By doubling the middle tier storage capacity to 64GB, while maintaining the price, and keeping the 16GB storage capacity at the bottom tier, I estimate that approximately 30% of previous 16GB iPhone owners will upgrade to 64GB to take advantage of the better deal, resulting in the 64GB being the best selling storage option (48% of sales mix), just slightly outpacing the 16GB version (43%). With the iPhone 5s/5c, I estimate the 16GB tier accounted for 60% of sales. If Apple upgraded the 16GB option to 32GB without changing the price, then it would have continued to be the most popular tier, even enticing some who had previously paid extra for 32GB to downgrade and buy the lower tier.
I estimate Apple's cost to upgrade the 16GB tier to 32GB to be approximately $15/device, leading to a little less than a 100 basis point weighted average decline in iPhone margin (to 48% from 49%).
Exhibit 3: Estimated iPhone 6/6 Plus Sales, ASP, Revenue, and Net Income Data in 2015 Given Storage Scenarios from Exhibit 2
All else equal, I estimate that doubling the iPhone's lowest storage capacity tier from 16GB to 32GB would lower Apple's profit by $3 billion. While the storage differences would likely not have an impact on overall iPhone sales, ASP would decline as users opt for the less-expensive model. iPhone revenue would decline by an estimated $5 billion, leading to an after-tax decline of $3 billion in net income.
While some may say this discussion of purposely limiting storage capacities to help maintain profitability is anti-consumer and a money grab, observers need to look at this process as a bit more than just greed. Apple is able to manage iPhone's brand and image by maintaining the device's high price. A case can be made that Apple is looking to get users dependent on higher storage capacities (at some point in the near future, 64GB will likely seem inadequate), by carefully guiding customers into a particular iPhone model each year. I suspect Apple kept the 16GB iPhone 6/6 Plus around in order to make future storage jumps, across all three tiers, a bit more manageable.
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Putting Apple's 20 Million Facebook Video Ad Views into Perspective
Last night I was surfing my Facebook News Feed, and up came Apple's recently released holiday commercial, "The Song." Facebook had it on muted autoplay. A screenshot is included:
The commercial has received 20.7 million total views. Last night around 9:00PM ET the video had around 18M views and was averaging nearly 1.3M views an hour. It would appear that it was showing up on News Feeds up until 11PM ET judging by the frequency and timing of new comments. Along with 20M+ views, the video has 210,000 likes and 8,800 comments, most of them positive (see Exhibit 1), so the engagement was definitely there despite the video being on autoplay.
Exhibit 1: Comments Posted to Apple's Facebook Ad
At 20 million views, I was curious how that compared to Apple's typical advertisement venue; television (the video has 2.4 million views on YouTube where it doesn't seem like it has been part of a YouTube advertisement campaign). While an apples-to-apples comparsion would be tough, I looked at viewership data for Tuesday night's network TV lineup.
Exhibit 2: U.S. Network Television Viewer Data - Top Shows - December 16, 2014
The obvious caveat is that viewer data for the networks includes both live and same day (DVR usage up until 3AM the following morning), while I can only estimate when the Apple ad first appeared on my News Feed. I'm sure there are additional subtleties that matter to marketers, such as 18-49 share, but the takeaway is clear: Facebook video ads matter. With a daily reach roughly on the same scale as prime time network television, not to mention all of the viewer interaction and targeted campaign possibilities, I expect to see future Apple video ads in my Facebook News Feed.
Fitbit's Ongoing Skin Irritation Issues and Lessons from "Antennagate"
Fitbit is once again in the news as early adopters are reporting the Fitbit Charge wearable is causing skin irritation. A similar thing happened earlier this year with the Fitbit Force, which resulted in Fitbit issuing a voluntary recall after consulting with medical experts. Turns out some users experienced an allergic reaction to the adhesive holding the housing and band together. What's going on with the Charge? Fitbit's official response is some of the irritation is a result of the device "staying in contact with the skin for extended periods" and likely due to sweat, water, or soap.
Fitbit's response reminded me a bit of Antennagate and Steve Jobs' initial "just avoid holding it in that way" reaction concerning iPhone 4 reception issues when touching the steel antenna bands. With Apple about to enter the wearable space with Apple Watch, I wonder if we are seeing a future "-gate" in the making where users complain about wrist irritation or discomfort. I thought it was appropriate to look back at Antennagate and compare the lessons learned from that public relations crisis to Fitbit's current issues and the upcoming Apple Watch.
- Not Letting Design Trump Engineering. Antennagate was the result of design trumping engineering as Jony wanted to use a non-coated steel rim for the iPhone 4 despite the obvious drawbacks in terms of signal strength. The end result was problematic signal loss if the gap in the steel rim was covered. Obviously this issue of design being more important than engineering continues to be a risk factor with Apple Watch, especially with its design playing such a crucial role. Having the product be in contact with skin for hours at a time doesn't help matters, although having to take it off to charge each night may actually be Apple's saving grace as people won't wear the watch for days at a time. By having periodic breaks in usage, Apple may not need to worry about users not cleaning or washing the skin underneath the watch band leading to irritation issues, similar to what Fitbit is experiencing.
- Conduct Proper Testing. Apple did not properly test the iPhone 4 due to fear that its redesign would be seen in public. With Apple Watch, executives have been wearing the devices for a few months, which should help catch any obvious long-term use problems. However, it is hard to have a large-scale test program due to fear of an unit getting into the wrong hands.
- Don't Initially Downplay the Problem. Apple initially downplayed any problem with the iPhone 4 with Steve Jobs even going so far as to blame Google, according to Walter Isaacson. While it does seem like Fitbit may be handling the current skin irritation reports better than last time, it is important to not give off-the-cuff remarks about an issue people, no matter how few, are indeed talking about.
- Gather facts. Take the time to gather the needed data, studies, and opinions that will help determine the exact problem and steps needed to address the problem. In a world where an instant response is demanded, taking time to gather the facts is often the hardest step.
- Bring in Public Relations and Advertising Experts. A response to a crisis is just as important as the crisis itself. Tim Cook appears to have mastered the art as seen with Apple's response to the Maps fiasco and, to a lesser extent, Bendgate.
- Appear Firm and Confident in Decision. Steve Jobs did not apologize for Antennagate, but he didn't come off as arrogant during the press conference. Tim Cook did apologize for Apple Maps.
The main lesson learned from Antennagate was to reframe the issue. Apple explained how all phones have antenna issues. Even if the press disagreed with Apple's claim, the discussion has now shifted away from just Apple's antenna issues. For Apple Maps, Apple said they were trying to improve maps for its users by building a new version from the ground up, and with the recent Bendgate, Apple said only nine customers contacted Apple with a bent iPhone, which took a lot of wind out of the conspiracy theorists. Fitbit seems to be pushing the argument that only a few people have complained of an irritation, and all wearable devices show similar reactions if worn for extensive periods of time. If true, I wouldn't be surprised if Apple Watch has few new "-gate" controversies soon after launch, but I expect Apple to be much more prepared this time around.
Apple's iPhone Strategy: Selling Shovels to Miners
When Steve Jobs unveiled the iPhone in 2007, few expected the camera would become one of the device's most popular features, positioning photo as a primary communication medium. While social networks have embraced the growing popularity of taking and sharing photos, and a cottage industry of camera accessories have thrived, Apple is positioned to benefit from the current photo renaissance by selling the software and hardware tools needed to sustain the movement. In essence, Apple is the hardware store selling shovels to gold miners in 1849 dazzled by the prospect of striking it rich. Apple's best strategy continues to be utilizing its hardware and software capabilities to introduce tools that allow users to push the envelope on new forms of communication including photo, video, and eventually haptics.
People use a camera to accomplish different tasks. While some like to capture moments spent with family and friends, others use a camera to take and share class notes, or accomplish daily chores like making a shopping list. Technology writer Om Malik wrote an essay on how the photograph represents a new visual language for the web, making it easier to consume content by removing language barriers and appealing to our senses. We like photos and are able to share and consume images much easier and quicker than text.
Most people now freely send and receive photos using messaging apps, like WhatsApp and iMessage, and social networks to communicate with others. Instagram's 300 million users sending 70 million photos and videos a day serves as the poster child of this movement. Meanwhile, Snapchat is quickly gaining popularity and relevancy in how media and content are distributed through photos and videos, while Pinterest adds a bit of an enterprise angle to the mix.
Apple is positioned quite well in terms of benefitting from this photo renaissance. In many ways, Apple helped kickstart the movement as the iPhone was the first mass-market phone to include adequate cameras capable of taking pictures worthy of sharing, while larger mobile data plans and faster data speeds made photo sharing possible. Even though the first front-facing phone camera was unveiled years before the iPhone was introduced, when two cameras were included in the iPhone 4, millions of people began to take photos of themselves without turning the phone around. A few years later the selfie was born, which I suspect will go down as a movement within the much bigger photograph renaissance. Selfie sticks are becoming popular across the world, and new ways of taking selfies are being introduced, such as the Donut Selfie, which I classified as "selfie innovation." GoPro represents yet another offshoot from the trend of technology changing the way we communicate and record the world.
I like using the current photo renaissance as a easy to understand case study on how Apple should approach M&A. While some want Apple to use its cash to buy a few of the larger social networks, the changing dynamics behind what guides a social network's popularity is often ignored. Facebook correctly bought Instagram, despite having the means to build its own photo-focused social network. Meanwhile, Twitter has seen success with short Vine video clips, but in terms of embracing photos, the solution has not been as smooth as Instagram. If a different form of communication takes off, all of these social networks will need to adapt once again either by buying smaller start-ups or building a organic solution. For Apple, a company with a maniacal goal on staying focused and placing very few big bets, this scenario doesn't seem to fit with the company's mission statement. Instead, a more appropriate strategy for Apple is to sell the tools needed to support and encourage new communication standards and mediums, such as embracing touch and haptics in Apple Watch. As another example, by selling both the hardware camera components, as well as the software, Apple is able to stand out from the crowd in terms of its mobile camera solutions, which helps iPhone and iPad unit sales.
Like a gold rush, while few will strike it rich with photos, like Snapchat and Instagram, many will flop or miss out on the significant upside. Meanwhile, the shop selling the tools (software and hardware camera solutions) will make out like a bandit.
Video - December 15, 2014
I'm trying something new here. I made a short video about my Thoughts on Apple's $155 Billion of Cash article from last week.
The Scott Forstall Mystery
Mystery continues to surround Scott Forstall's removal from Apple in October 2012. Forstall has not given any public comments on the circumstances leading up to his dismissal as SVP of iOS Software, an unusual twist in an industry where executive turnover is common, and talent is scarce. As Apple struggles a bit with recent software launches and mishaps, many are asking if Apple would have been better off with Scott Forstall still leading iOS software. I suspect Apple is giving Forstall quite a bit of financial incentive to remain quiet on what transpired leading to his termination in an effort to not overshadow the Apple Watch launch, a project Forstall likely worked on in the early development stages.
Even though the media may have looked at Scott Forstall's removal as a near-term story in 2012, I have continued to be interested in the long-term implications, not only resulting from the event, but what can be learned from those currently leading Apple, including CEO Tim Cook, SVP of Design Jony Ive, and SVP of Marketing Phil Schiller, and how they determined Forstall had to be relieved of his duties. To properly understand how a company operates, one needs to look at how the company is managed.
The official explanation from Apple for Scott Forstall's removal was to increase collaboration, which implies Forstall was impeding such collaboration. Beyond that, we have been told very little information about the events leading up the management shakeup, besides "sources" telling various journalists there were personality tensions. Fortune reporter Adam Lashinsky positioned the Apple Maps debacle, and Forstall's refusal to apologize for it's problematic launch, as the final nail in the coffin. Not having the other side of the story makes this situation that more interesting.
There were a few noteworthy developments that I think deserve to be mentioned when getting the full perspective on Scott Forstall. In May 2012, quite a few eyebrows were raised when Forstall sold 95% of his AAPL stock holdings. Insider stock trades have notoriously been scrutinized to get clues as to how management views the future. While it would seem obvious that selling stock is a negative, other factors such as asset diversification, restricted stock units, and tax issues come into play. One year earlier, Forstall (along with the entire executive team) was granted restricted stock units worth at the time $60 million, with a vesting schedule through 2016. Selling shares in May of 2012 with the full understanding that his direct ownership would once again increase as options vested would likely limit the amount of negative connotations from Forstall's selling. However, weeks later, the world was shown iOS 6 and reaction was muted compared to previous iOS unveilings. Apple Maps was labeled as a focal point, while Forstall's design ideas were everywhere. Three months later, Apple Maps turned into Apple's biggest nightmare since Antennagate and Forstall's stock sale seemed a bit more appropriate. Did Forstall sense trouble on the horizon?
I suspect that Forstall was finding himself falling out of favor with the direction Jony and the rest of the executive team were heading. Apple was moving beyond phones and tablets into wearables, and software's role was changing.
Tim Cook and Jony have gone on record to say that the Apple Watch was under development for three years, which would date the project back to 2011. I would go further and say that Apple knew it was moving fast into wearables from the success of the iPod nano watch faces. Scott Forstall would have then been involved in the initial development stages of a wearable. While it's unclear when features like the Digital Crown (which plays a major role in the watch's user interface) were developed, I think disagreement around the project played some role in Forstall's ousting, thereby suggesting it was in Apple's best interest to keep Forstall from going public with details of the project not specifically included in his non-disclosure agreement. I think Apple and Forstall negotiated a severance package that contains most, if not all, of his restricted stock units granted to him in 2011 on the condition that he remain out of the public eye. Beyond the Apple Watch, I actually don't think Forstall's knowledge on Apple's future plans is too valuable, especially considering he is already two years removed from Apple. The most valuable piece of information isn't what Apple is working on, but what they aren't working on, and even then I have doubts Forstall would be privy to everything occurring in Jony's labs.
Some observers say Apple must miss not having Scott Forstall. I look at the statement as unfalsifiable since it is impossible to know all of the corresponding events that would have taken place if Scott Forstall were still as Apple. I would point out that considering some of Apple's biggest product mishaps occurred under Forstall's leadership, I tend to think Forstall's value-add to Apple has been overestimated. In addition, Craig Federighi has been doing a relatively good job leading software engineering as seen with the upbeat developer reaction following WWDC 2014.
Apple's success is due to its management team being more valuable as a collective group than each individual separately. Scott Forstall's sheer talent and vision led him to hold one of the more powerful positions within Apple, largely at the blessing of Steve Jobs, however I suspect Apple's changing priorities with wearables contributed to his dismissal. If there is one lesson to learn from the Forstall mystery these past two years, it is that executive collaboration has contributed to the Apple of yesterday (new touch interface and app revolution) being very different from the Apple of today (new ecosystem services and personalized wearable hardware).
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Jony Ive Is the Most Powerful Person at Apple
Yesterday I put forth my theory on the issue underlying this ongoing App Store scuffle with developers: a bigger battle between Apple hardware and software. While Apple is quite confident, and some would even say defiant, with its hardware and design, software seems to be treated with some level of hesitation and debate as Apple continues to think about how iOS should be used, especially after a plethora of new APIs are released to developers. Regardless of the near-term solution to the App Store issues, be it management changes, organizational structure tweaks, or nothing at all, I suspect Apple SVP of Design Jonathan Ive's influence will play a role in the discussion. I deliberately hinted in yesterday's article that in my view, Jony is currently the most powerful person at Apple. I knew such a statement needed an article unto itself because of its controversial underpinnings. We are currently seeing Jony's Apple uncurl its wings, and while there are clearly risks involved with Jony holding so much power, in some ways, Jony is filling some of Steve Job's old role as master collaborator and thinker.
The world generally knows very little about Jony Ive. While there have been some books written about the man, such as Leander Kahney's Jony Ive: The Genius Behind Apple's Greatest Products, I've always been able to fall back on Walter Issacson's biography, Steve Jobs, to get a bit more direct interpretation from Steve Jobs himself on certain topics.
Here's Steve Jobs on Jony:
“The difference that Jony has made, not only at Apple but in the world, is huge. He is a wickedly intelligent person in all ways. He understands business concepts, marketing concepts. He picks stuff up just like that, click. He understands what we do at our core better than anyone. If I had a spiritual partner at Apple, it’s Jony. Jony and I think up most of the products together and then pull others in and say, ‘Hey, what do you think about this?’ He gets the big picture as well as the most infinitesimal details about each product. And he understands that Apple is a product company. He’s not just a designer. That’s why he works directly fort me. He has more operational power than anyone else at Apple except me. There’s no one who can tell him what to do, or to butt out. That’s the way I set it up.”
Jony has long held a considerable amount of power at Apple. While the last major executive reshuffle in 2012 led to Jony gaining more responsibility by assigning him to lead Human Interface across the company, I don't necessarily look at the change as altering Jony's ultimate power trajectory. If Jony is the most powerful person at Apple, where does Tim Cook fit into the picture? On an organizational chart, Tim Cook may indeed be at the top (I have some doubts that is the case, but for simplicity's sake, I will take what is written on Apple's leadership page as correct), it is far from given that a company's CEO is the de facto most powerful employee at that company. A CEO works for a public company's board of directors, which has the power to fire that CEO (one reason why proper corporate governance calls for the CEO to not also hold the board chairman seat). While CEOs may think they have the ability to fire or hire anyone at will without any checks or balances, they are mistaken. Of course, in practice, this type of situation doesn't come up too often, but maybe that's more of a statement on mediocrity in corporate America and board rooms. Fortunately for Apple, there isn't much evidence to suggest "power" is an issue between Jony and Tim Cook. Both men are well aware of their involvement in the Apple machine and what would happen if that machine stops working, as seen with the 2012 reorganization.
Understanding the power Jony possesses at Apple goes a long way in analyzing how Apple operates and thinks about products and new industries, which relates back to the ongoing issues with Apple software user interface and App Store review. As discussed in my article yesterday, Apple's software quality seems to be having a tough time matching hardware quality. As someone with a similar opinion but a slightly different take told me on Twitter, software development needs to slow down to catch a breath. The much bigger picture is that software plays a vital role in how a user feels and thinks about a product. With Jony overseeing Human Interface, there may be a gap developing so that a somewhat final software product doesn't quite mesh with Jony's vision and intended interface guidelines. While I wouldn't go so far as to say that is the sole reason driving the App Store's ongoing issues (which involve communication issues), I think the much larger theme is that Jony will play an increasing role in where Apple software (including the App Store) is heading.
How does Jony operate, and is he able to the fill the void left by Steve? I suspect Jony has mastered the art of collaboration and inspiration, which helps mitigate much of the internal risk that destroys other companies. His small industrial design team is firing on all cylinders. Obviously, Steve is irreplaceable and Jony must now rely on his intuition and gut (with input from others) regarding Apple's direction, but the important take away is I do think Jony plays a significant role in setting that direction. What then drives Jony?
As transcribed by Dezeen, here is Jony talking at Design Museum in London last month:
“I really, truly believe that people can sense care. In the same way that they can sense carelessness. I think this is about respect that we have for each other. If you expect me to buy something where all I can sense is carelessness, actually I think that is personally offensive. It’s offensive culturally, because it shows a disregard for our fellow human. I’m not saying that we get it right all the time, but at least our intent is to really, really care. Good design for me starts with that determination and motivation and I don’t think there’s anything, ever, that’s good that’s come from carelessness. The sad thing is that so much of what we’re surrounded by in the physical world that is a product of manufacture, so much of it testifies to carelessness. The one good thing about that is if you do care it is really conspicuous.”
I thought this paragraph did a wonderful job at explaining Apple's mission in the world: making great products filled with passion. While industry consensus is set on hardware being commoditized and software taking over the world, there are important points missing. First, as software expands, new industries, with a lot of problematic product, need to be rethought. Next, a "product" doesn't have to be tangible. Finally, passion and emotion come from an experience (both tangible and intangible). Jony Ive has actually been the most powerful person at Apple for years. The only difference now is that the outside world is starting to see it is Jony who is truly conducting the delicate process of transforming ideas into products.
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Month One
Above Avalon has been in existence for one month. I would like to share some data from the first 31 days. Unique visitors is the primary metric I've been tracking, and numbers are exceeding my expectations.
Posts: 36
Unique Visitors: 16,169 (750/day normal run rate)
RSS subscribers: 896
Podcast RSS subscribers: 2,201
The amount I have learned over the past four weeks has been incredible. I'm quite happy with how my daily Apple email is going; it now has 760 subscribers. Thank you to those who have emailed or messaged me to say how they look forward to reading the email each day. I've been fortunate enough to get some great feedback and suggestions, and I always welcome additional comments.
I have much bigger plans for Above Avalon and the daily email, so stay tuned. In the meantime, if you have a coworker, friend, relative, or neighbor that may be interested in Above Avalon or my daily Apple email, I would greatly appreciate it if you spread the word. A few retweets or links go a long way as well.
Thank you to those of you that are enjoying the site each day. Your early support is greatly appreciated.
-Neil
If the Apple App Store Is a Battlefield, Jony Ive Is the Commander
The latest quarrel between Apple and developers seems to go a bit deeper than the cat-and-mouse game that has been played for the past five years. Without going into much detail (largely because I think that misses the big picture and there is debate over how justifiable some of these App Store review decisions are), the crux of the latest situation is that Apple released new APIs in iOS 8 and there now seems to be confusion and disagreement within Apple as to how these new features should be embraced.
There is a growing murmur that the latest battle is a sign of internal conflict at Apple with software engineering pinned against those in charge of App Store review. Many are pointing at comments written by Greg Gardner, creator of Launch, whose app was rejected from the App Store. He says Apple wanted to use his app as an example for rethinking how developers look at app guidelines.
“During this same conversion, I also asked specifically why Launcher was removed from the App Store after 9 days when other similar apps are still available weeks later. The answer to this question was the most interesting and informative response I had ever heard from them. They basically said that Launcher was a trailblazer in uncharted territories and that they felt that they needed to make an example of it in order to get the word out to developers that its functionality is not acceptable without them having to publish new specific guidelines. And they said that the fact that they aren’t seeing hundreds of similar apps submitted every day is proof to them that taking down Launcher was successful in this regard.
This was a pretty big revelation to me. After Launcher was rejected and the press picked up on it and started writing articles which painted Apple in a bad light, I was afraid that Apple might be mad at me. But it turns out that was actually the outcome they were looking for all along. They acted swiftly and made me the sacrificial lamb. And after that, removing other apps with similar functionality became a low priority for them.”
Instead of the App Store representing a battle between Apple and developers, I look at the skirmish as indicative of a much bigger war going on within Apple between software and hardware. The same battle ultimately costs Scott Forstall his job (internal power struggles don't help matters), transferring more responsibility to Jony Ive. I would argue that Jony Ive did not necessarily get more power from the transition as he already held more power than anyone else at Apple, as previously detailed in Steve Jobs' comments to Walter Isaacson. My theory is that Jony holds more power than Tim Cook, which makes him part of this App Store debate.
Apple's hardware and design teams are firing on all cylinders. Apple's global supply chain is unparalleled in scope and efficiency, component supplier relationships appear to have hit a stronger and more cordial tone, and nearly the entire product lineup has been updated or revised within a short timespan, with iPhone, Mac, and iPad seeing annual refreshes. In addition, Apple is now ushering a new era of personalized hardware devices. Meanwhile, Apple's software products have seen more mixed results with a buggy iOS 8 release, lingering questions surrounding Apple's ability to handle annual iOS refreshes, and software limitations starting to hold back several product's potential.
The debate is whether software is getting intentionally left behind, or if the lack of motivation and resources represents another power struggle within Apple where hardware and design are given priority, at the detriment of software. In both scenarios, I think Jony will play a vital role in the discussion (even if he is to blame), since I suspect the Apple we are seeing today is quickly transforming into Jony's vision of the Apple of tomorrow, a company focused on using design to create tangible products that possess passion. The challenge for Jony, and Apple, is figuring out a way to incorporate software and developers into this vision. One of the biggest risks Apple is facing by not being clear with the App Store, and developers, is that innovative apps aren't being made as developers decide not to spend precious resources testing App Store guidelines. Regardless of the outcome, including if a new VP-level executive is tasked with running the App Store and interacting with developers, or if there is a change in the SVP ranks, I expect Jony Ive will continue to play an important role in guiding Apple.
Developers have played a big role in getting Apple to where it is today, and will ultimately play just as big of a role in determining Apple's future success.
Thoughts on Apple's $155 Billion of Cash
Apple is relying on robust free cash flow and debt issuance to support its aggressive $130 billion capital management program. Even though Apple has $155 billion of cash, cash equivalents, and marketable securities at quarter end, the company's overall financial flexibility is limited somewhat by having approximately 90% of total cash held by foreign subsidiaries, while component purchase commitments and other obligations total $26 billion. With approximately $50 billion of expected free cash flow, I suspect Apple will issue more debt and commercial paper to increase its capital management program in 2015, while maintaining enough flexibility to invest in organic growth opportunities, including M&A. I don't view going private as a realistic option for Apple at this time given low feasibility and practicality.
Historical Analysis
Excluding the $29 billion of debt and $6 billion of commercial paper from Apple's gross cash, Apple's net cash, cash equivalents, and marketable securities stood at $120 billion at quarter end. Exhibit 1 highlights how Apple's net cash has remained relatively unchanged since the capital management program was initiated in 2012, a testament of the company's robust free cash flow.
Exhibit 1: Apple's Net Cash, Cash Equivalents, and Marketable Securities Position
Apple's domestic cash continues to decline, and now stands at $18 billion, due to the ongoing capital management program. With international sales accounting for 60% of total sales, Apple's foreign cash levels have ballooned to $137 billion, as depicted in Exhibit 2.
Exhibit 2: Apple Cash - U.S. Versus Foreign
At the same time, Apple's contractual obligations have been steadily increasing and now stand at $24 billion. Purchase commitments and other obligations include components, product tooling and manufacturing process equipment, and commitments related to advertising, R&D, Internet and telecommunications services and other obligations.
Apple launched a $10 billion share buyback program in 2012, with subsequent annual revisions to $60 billion in 2013, and $90 billion in 2014. Apple currently has $22 billion of share buyback authorization remaining. Exhibit 3 highlights Apple's share repurchase and dividend activity since 2012.
Exhibit 3: Apple Capital Management Activity
Forward Analysis: Apple's 2015 Capital Management Program
I expect the board to revise Apple's capital management program in 2015 to match the company's free cash flow, which would support an additional $40 billion of capital repatriation. I expect the share repurchase authorization to be increased by $30 billion to $120 billion, while the quarterly cash dividend is increased to $0.50/share, from $0.47/share. In order to fund the share repurchases and dividend using U.S. cash, I expect Apple to raise additional debt. In terms of total cash, Apple may reach $170 billion of gross cash, cash equivalents, and marketable securities by year-end 2015, of which approximately $50 billion would be from debt and commercial paper issuances.
In terms of Apple going private, the amount of debt that would need to be raised to make a leveraged buyout or leveraged recapitalization possible would likely be insurmountable at this time, even after considering Apple's $170 billion of expected cash by year-end 2015. In addition, with no significant Apple insider share ownership, it is unclear where the motive for going private would originate from as management has shown no prior desire for such a move, and shareholders would need to weigh the pros and cons of going private versus alternatives, including splitting the company up or spinning segments off. From a purely business standpoint, while there are benefits from going private, such as being able to manage the business easier with a long-term viewpoint, there is little evidence to suggest Apple has not been able to do that as a public company. Being public also helps in terms of accessing capital markets and paying employee compensation using stock. Similar to Dell, if Apple found itself in a situation where underperforming business segments were masking better-performing pieces, going private may make more sense, although the sheer volume of funds required would be daunting.
This report should be used to understand my views on Apple's capital management program, especially when I discuss the topic in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. This report was produced by Neil Cybart on December 9, 2014.
Apple's New iPad Ad Looked Familiar
Apple's new iPad Air 2 commercial, Change, was released yesterday.
The ad was very similar to the iPhone 5s Dreams ad released four months ago.
In each ad, Apple is stressing the user's ability to transform software and hardware into a personalized device capable of navigating the world. While a very select group of people will be installing iPads into motorcycle gas tanks, or using iPhones to check a horse's vital signs, the message isn't to make the viewer feel connected to the depicted scenes, but rather to plant the seed that these devices have the potential to be used in ways that computers have never been able to be used for before.
The interesting part about comparing the two ads is how the new iPhones are able to handle nearly all of the activities depicted in the iPad commercial. In addition, the scenes from the iPhone ad come off as more genuine because everyone will have their iPhone with them, while the iPad as a mobile device is a harder sell (Apple had roughly 60% of the activities shown in the iPad ad depict a mobile use case, which I describe as being used outside a room with four walls). Apple's latest iPad ad is just another piece of evidence that the grey area between a phone and a tablet is disappearing. One big question heading into 2015 will be if a larger iPad Pro will change this dynamic, giving the tablet more differentiated use cases versus the iPhone.
Apple's Accelerating iPhone Business; Establishing 2015 Estimates
I expect Apple's iPhone business to report accelerating growth in 2015 due to a combination of strong iOS user loyalty trends, carrier and geographic expansion, and share gains in developed markets. Following my 1Q15 iPhone sales estimate note published two weeks ago, I am establishing my quarterly iPhone unit sales estimates for the rest of 2015. Based on the initial success of iPhone 6 and 6 Plus, I expect Apple to report 25% unit growth for full-year 2015, up from 13% growth in 2014. Exhibit 1 highlights my quarterly iPhone estimates for 2015, while Exhibit 2 puts my 211 million iPhone unit estimate for 2015 in perspective with previous years.
Exhibit 1: Above Avalon iPhone Estimates
Exhibit 2: Annual iPhone Sales (fiscal year)
Topics to consider:
User Loyalty and Vibrant Upgrade Cycle. Apple has loyal iPhone users that upgrade on a regular basis, and the iPhone 6 launch looks to have successfully continued that trend. CIRP estimated that approximately 80% of U.S. consumers that bought the new iPhone 6 and 6 Plus in the first 30 days after launch were current iPhone users, up from 74% for the iPhone 5s launch in 2013. Kantar Worldpanel estimated that 86% of British iPhone buyers upgraded from an older iPhone for the three months ending October 2014. User loyalty is only one piece of the puzzle, as Apple needs a vibrant upgrade cycle to build and retain that loyalty. Apple has remained on a two year upgrade cycle built around a new form factor, with the off, or "S", years focused on refinements and component upgrades.
Additional Carriers. It may be easy to underestimate the impact from new carriers on iPhone's growth, but Apple has had a few recent high-profile additions. Apple launched the iPhone on NTT DOCOMO in 2013, and China Mobile in 2014. I estimate Apple is selling around 5-7 million iPhones a quarter through China Mobile, which would represent approximately 30% of my 2015 iPhone unit growth estimate. My declining quarterly iPhone unit growth estimates through 2015 partially reflects normalizing growth rates related to China Mobile.
In many other countries, including the U.S., Apple has been steadily working on bringing the iPhone to additional carriers, albeit much smaller than NTT DOCOMO and China Mobile. While individually each carrier may not contribute much to the bottom line, collectively they do represent a noticeable addition to iPhone's distribution channel.
Emerging Market Expansion/Further Penetration in Developed Markets. Apple expects the new iPhones to reach 119 countries by year-end, the fastest roll-out for iPhone. Apple is still in the early stages of tapping iPhone retail distribution in China, India, and Brazil. A report published last week discussed Apple's plans to expand its retail capabilities in India by opening 500 retail stores using a franchise model. In many developed countries, iPhone 6 and 6 Plus sales share is tracking ahead of iPhone 5s sales trends in 2013, suggesting Apple is capturing share from competing platforms.
Apple has a few levers to pull to maintain iPhone growth:
Upgrade Cycle. Apple has been successful in releasing iPhone features that do not over serve the market. It is in Apple's best interest to keep the iPhone upgrade cycle as short as possible by pushing the envelope with features that matter to iPhone users: screen, camera, sensors like Touch ID, and design. I would not be surprised if Apple continues to use the "S" cycle to come out with different iPhone colors, similar to the iPhone 5s.
Geographic Expansion. Apple will continue to focus on bringing the iPhone to new markets beyond just continued development in China and India. I also expect Apple to continue lowering iPhone's entry-level price, which will help drive sales in countries that do not rely on carrier-financed "subsidies" or installment plans.
Ecosystem Services. With Apple Pay, Apple is beginning to flex the iOS ecosystem by providing consumers additional value, while looking to find new lock-in mechanisms as media and content no longer increase ecosystem switching costs. Apple Pay's eventual expansion into new markets may also have a larger impact on sales in countries that were once considered outside Apple's core iPhone sales focus.
This report should be used to understand my views on Apple's 2015 iPhone sales, especially when I discuss the topic in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. Downside risks to my estimates include: iPhone supply issues and weaker-than-expected customer demand. Upside risks to my estimates include: stronger-than-expected customer demand, especially in China. This report was produced by Neil Cybart on December 8, 2014.
I publish a daily email about Apple called AAPL Orchard. Click here to subscribe.
Apple and Amazon View Failure Very Differently
Amazon CEO Jeff Bezos was the keynote speaker at the Business Insider Ignition conference a few days ago. A few of his comments about failure jumped out to me.
“It’s incredibly hard to get people to take bold bets. You need to encourage that and if you are going to take bold bets, there are going to be experiments, and if there are experiments, you don’t know ahead of time whether they are going to work. Experiments are by their very nature prone to failure, but big successes, a few big successes compensate for dozens and dozens of things that didn’t work.”
Companies that don’t embrace failure, they eventually get in the desperate position where the only thing they can do is make a Hail Mary bet at the very end of their corporate existence…I don’t believe in bet the company bets. That’s when you are desperate.”
Last month, Apple SVP Design Jony Ive gave a talk at Design Museum and the topic of failure was discussed.
“I would say the priority is that we learn how to care and we learn how to fail and that we’re prepared to screw up the work that we’ve done and throw it away even if we don’t know what we’re going to do instead. When I’ve explained to people before and said ‘well we screwed this up, we parked this,’ normally I can say ‘and look what we went on to do’.
If it’s not very good we should just stop it, even if we’ve spent a lot of money trying to develop it. It’s scary, and we’ve been there on many occasions where you’ve spent this much money and I’m talking too loud to try and convince myself that it’s OK and it’s not. It’s one of the fantastic things that I feel so fortunate to work with a group of people who are very comfortable with that ‘yeah it’s not good enough we should stop doing this’ and we don’t talk about all the money we’ve just spent. Well, they might do behind my back.”
Both men accept failure and I suspect nearly every human needs to accept failure in some capacity. What is interesting is where Bezos and Jony are willing to accept those failures. For Jony and Apple, the goal is to fail behind closed doors. For Amazon, failure out in the public marketplace is thought to have little consequence and is even encouraged. For Apple, failure is actually minimized by taking bigger risks. Amazon does the exact opposite, by not taking big risks, failure is more acceptable and manageable.
I'm intrigued by Amazon's hardware strategy. While the Kindle found its niche, subsequent versions that were more akin to iPad never saw the same level of success, while every other Amazon consumer tech hardware product hasn't lived up to the hype (Amazon has never released sales numbers, but share/sales data and surveys all point to the same conclusions). For Amazon, public failure with the Fire Phone is acceptable, and even applauded, as the thought process is that things can be learned about a failure, and then future versions may have a better chance of success. Do consumer habits support such a stance? Will consumers forget about past product shortcomings, and give subsequent reiterations a fair chance? I'm not so sure.
Over the past 10 years, Apple has had very few hardware failures, with the iPod Hi-Fi speaker system standing out as maybe the biggest flop. While Apple has its fair share of hardware blemishes or minor flaws that are rectified in subsequent versions, the public has come to expect Apple's best when it comes to hardware, as most of the company's failures have been kept hidden in Jony's labs, with the public seeing only the big hardware bets. Brand equity is built in consumers' minds, while public perception and anticipation remain elevated. I suspect consumer tech hardware failures take a much bigger long-term toll on a company than Jeff Bezos would like the world to believe.
Apple's Share Repurchases Have Benefited Shareholders: Follow-Up
Since my Apple's Share Repurchases Have Benefited Shareholders by $80 Billion article was mentioned on Business Insider Deputy Editor Jay Yarow's latest podcast with Eric Jackson and Ben Thompson, titled Tim Cook's $100 Billion Mistake (44:19 mark), I thought it was appropriate to publish my response. The part of the podcast specifically related to my article had to deal with whether Apple's buyback was a waste of time and resources, akin to IBM financial engineering, and if Tim Cook is just merely trying to please shareholders.
My response: Apple's stock buyback is meant to benefit shareholders. Who else would the stock buyback be meant for? Apple is owned by its shareholders and with that ownership comes privileges such as voting in directors that are tasked with overseeing Tim Cook to make sure shareholders' interests are being considered. The stock buyback is a transfer of wealth meant to benefit shareholders (who aren't selling shares to Apple), especially when the stock being bought is considered undervalued by traditional financial valuation metrics, such as forward price/earnings and price/cash flow ratios.
It is a fact that the buyback has raised EPS per share and that each remaining share now has a higher ownership percentage (albeit very tiny) of Apple's earnings. Apple has bought back 10% of its shares, which means that for Apple to trade at the same market cap today than it did two years ago, would require 10% fewer shares needing to be bought. In terms of dividends, the remaining shareholders may now be in a better position to benefit if Apple raises its dividend purely because of fewer shares outstanding. Arguing that Tim Cook is "wasting" money by simply giving excess cash back to shareholders fails to grasp the actual debate of whether share buyback benefited shareholders. I laid out my argument for how shareholders have benefited by $80 billion, but the podcast didn't address that, instead just saying that buybacks don't benefit stocks and shareholders (with no evidence to support that claim) and that Tim Cook was trying to please shareholders, instead of taking the excess cash and buying companies, that by no means are guaranteed to fit seamlessly and effortlessly into Apple's unique structure.
CEOs and CFOs are tasked with keeping shareholders' best interests in mind. For many public companies, CEOs spend a few weeks on the road each year meeting with investors and representing the company to Wall Street. CFOs are often tasked with talking to clients throughout the year, which may end up taking up significant portions of their schedules. This is part of proper corporate governance and should be applauded, not ridiculed, or positioned as a bad decision. Management teams ultimately work for shareholders, through the board of directors, so taking a dinner with a group of investors does not mean Tim Cook is engrossed in Wall Street to the point of not having time to manage Apple.
The bigger issue with the Apple share repurchase debate comes down to unfalsifiable statements, or claims that can not be proven false, such as:
"Apple stock would be worth just as much as it is now if the buyback was not done."
One can not prove this statement false because it never happened. We don't know what Apple would look like if it hadn't bought back stock. I find the current debate to be quite funny as it essentially boils down to arguing whether Apple should alter it's strategy to spend excess cash, the same strategy responsible for giving them $150 billion of cash. Apple buys companies. Apple buys back its stock. Apple pays dividends. Despite doing all three of these things simultaneously, Apple still has $150 billion of cash that can be used to buy other companies, invest in itself, and return excess cash to shareholders. Classifying buyback as a waste with no proven benefit to shareholders, without any analysis or data to back up such a claim, takes things a bit too far.
Apple Watch's Secret Weapon
Apple Watch creates an interesting dilemma as personalized luxury, built around technology, is positioned against timelessness. There is increasing evidence that Apple Watch's personalized luxury will trump the device's lack of timelessness, which will not only impact Apple's financials, but cause a major upheaval in the traditional luxury watch market.
Starting in early 2015, Apple will sell three distinct watch collections, each positioned for a different type of buyer. Apple Watch Sport will be positioned for those with a more active lifestyle, or just looking for a less-subtle fashion accessory, while Apple Watch will be for the all-purpose, practical buyer. At the top of the price range, Apple Watch Edition will rely on refined elegance to sell to the few that truly value personalized luxury. Both the Apple Watch Sport and Apple Watch will be priced at levels that leaves timelessness out of the purchase decision, largely as a result of the device's perceived utility and value. The Apple Watch Edition raises some interesting questions though in terms of luxury, technology, and timelessness.
The luxury watch market prides itself on combining craftsmanship and timelessness to create emotion, which is then passed down from generation to generation. With a smartwatch, and its reliance on parts that will not be able to stand up against the test of time, how can luxury be a selling point? Several luxury watchmakers have given hints that they think a smartwatch's lack of timelessness guarantees traditional luxury watches will not be threatened by this new crop of wrist gadgets. I'm not so sure that logic will stand the test of time.
With Apple Watch Edition, Apple is appealing to a small group of buyers that want luxury combined with personalization (think different bands and faces), something traditional luxury watches are unable to provide. Will there be buyers that prefer luxury over technology's inherit lack of timelessness? Looking at the cottage industry that has developed around adding personal luxury to iPhones, the answer is a resounding yes. Luxury is a feeling one receives from wearing or using a product, regardless of it's utility or lifespan. Dezeen highlighted Feld & Volk, which describes itself as "an association, consisting of artists and engineers, who create unique devices developed on the basis of iPhone and iPad." Feld & Volk disassembled the iPhone 6 to see which parts could be swapped out with more expensive counterparts. The end result is a collection of truly unique iPhones, one of which is called 'Wood', a $4,799 iPhone 6 that includes a back panel made of Karelian birch, 24K gold plated buttons, and an illuminated Apple logo made of sapphire glass. Meanwhile, another company called Brikk sells a 24K gold iPhone 6 Plus for $5,995. Vertu sells a range of Android-powered phones, with some models costing up to $20,000. While the market for these phones is quite small (Vertu has sold over 300,000 phones to date), the same can be said about Apple Watch Edition if the device is priced around the $5,000 to $8,000 range. I estimated Apple could sell a few hundred thousand watches a year from the Apple Watch Edition collection assuming a $7,500 average price, with China being the major target market.
Why would someone pay $7,500 for a watch that will not stand the test of time? The value of personalized luxury outweighs the device's short utility period. Looking at the Apple Watch Edition, I don't see the point in having the electronics be interchangeable or upgradable. An individual buying such a watch doesn't care about the device's lack of timelessness and that should keep traditional watch makers awake at night. Apple's embrace of personalized luxury has the potential to shake-up a number of industries, including the traditional luxury watch market.
iPad's Biggest Problem in Education is iPad
Apple has a storied history in the education market with a long-standing goal of transforming the way students use technology to learn. In recent months, the rise of Chromebooks and the "Cloud" and a few well-publicized iPad initiative failures have raised questions if Apple is approaching the education market with the correct strategy or if competitors' offerings are squeezing out Apple products from the classroom. I don't look at Chromebooks as competing with iPad in education and I'm rather baffled at why the education market is being labeled as a zero-sum game for computing devices. Instead, I view the iPad's biggest roadblock in education is the iPad. With a rather limited range of functionality in a strict learning environment, instead of appealing to the education mass market, iPad may be better suited serving niche learning environments where a higher-priced, specialized learning tool is desired.
Education and Technology
Unlike the consumer market, education and technology are guided by different principals including elected boards, budgets, studies, and mandates. When discussing technology adoption in education I think it is important to recognize this different structure compared to the consumer market. Even within education, there are different environments for how technology is adopted as private, parochial, and charter schools determine technology prerequisites differently than public schools. While the economy may have improved, many municipalities continue to run with very tight budgets, and education is often the largest expense line item for most cities. With such a backdrop, school districts are looking to make each technology dollar go as far as possible. Price matters in education and that dynamic can not be stressed enough. Two weeks ago, the NYC Department of Education approved Chromebooks due to two reasons: familiarity and low-price.
Chromebook Advantages
Along with price, school districts are buying Chromebooks for various reasons, including the fact that the computer serves student's needs really well. With many teachers and administrators relying on Google Apps for daily tasks such as attendance, grading, and scheduling, not to much more student-facing apps like YouTube, a Chromebook is an obvious way of utilizing Google's services and cloud infrastructure. Concerning affordability, deployability, and supportability, Chromebooks check off many prerequisites that schools are looking for to expand technology in the classroom.
iPad Disadvantages
While people love iPads, teachers and administrators have run into issues with iPads in the classroom, including logistical bottlenecks and usability. When compared to how schools use Chromebooks (sharing is a key tenet), iPads' single-user framework embraces the idea of the iPad remaining with the same student in school and at home. While this program has been adopted in smaller schools where families buy the iPad themselves, for larger school systems, this computing method is impractical, and may represent one of the biggest roadblocks for widespread iPad usage in education. Looking at iPad in the upper grades, lack of usability begins to stand out with no dedicated keyboard and lackluster curriculum offerings.
The Cloud
The argument is pretty straightforward: With everything moving to the cloud, hardware will turn into a commodity. In some ways it's simply taking a page from Christensen's 'Innovator's Dilemma'. What's missing? Brand and design. However, in education, school boards aren't looking at brand and design when considering what can be purchased to fit within a certain budget. Instead, design is largely pushed to very specific needs, such as gadgets for science labs or music halls. I suspect there will still be strong demand for differentiated, personalized hardware going forward, and the specialized education market is no different.
L.A. School District iPad Program Embodies iPad's Issues in Education
In 2013, the Los Angeles Unified School District launched a $1.3 billion technology initiative that included purchasing 605,000 iPads. Then-Superintendent John Deasy applauded the program and said the launch went smoothly. Fast forward to yesterday, and the FBI seized 20 boxes of documents related to the way the iPad bidding process was handled with accusations that Deasy rushed the iPad initiative through because he wanted to partner with Apple. As of today, the district has purchased "only" 91,000 iPads with plans on buying an additional 14,875 units, but along with laptops and 4,000 Chromebooks. What went wrong? Were Chromebooks to blame for iPad's misfortune? Not quite.
Rushed Rollout and Improper Training. Teachers complained of a rushed iPad rollout, where iPads were delivered, but the underlining curriculum was either not available or not even in existence.
iPad Misusage. Students deleted security filters exposing them to the full internet. Anecdotal evidence points to widespread misusage, including students stealing or hiding iPads in school with no proper protocol for tracking where each iPad was at all times.
In both of those cases, the iPad and any underlying infrastructure, or lack thereof, was to blame for iPad's failure. While price did play a role as well, there is little evidence of Chromebooks and laptops replacing the need for iPads altogether, but rather the iPad was simply never up to the broader initiative.
Apple's iPad Strategy in Education
Apple's biggest problem in education is iPad, not the Chromebook. In many cases, where Chromebooks are being bought in bulk, the iPad was never positioned as a viable competitor or option to begin with. A few things Apple may do to address this current dilemma include:
Embrace Niche. Not trying to be everything to everyone. Instead of shipping a product geared towards widespread education adoption, Apple would focus on what makes the iPad stand out: the seamless intersection of hardware and software. The iPad may be more appropriate for lower grades where touch has a bigger impact on learning and there seems to be a more vibrant curriculum available, while the iPad can be used for more specific uses in the higher grades such as in the sciences and arts.
Infrastructure. I think one of iPad's issues in education is the lack of support for teachers and administrators in terms of apps and device management. Whereas Chromebooks give students the bare necessities (which is all that is desired); iPad educational software, especially with higher grades in mind, has been disappointing and unable to tap iPad's potential. Apple's grand vision for interactive textbooks has flatlined due to much larger complexities beyond just iPad and Apple.
Apple's goal in education has always been to foster new ways of learning. Over the years, as technology costs have come down and schools embraced the cloud, cheaper opportunities have ushered in more widespread technology usage in schools. Meanwhile, Apple continues to sell millions of higher-priced iPads into education annually, despite school boards trying to meet budgets, and various mandates adding layers of bureaucracy to purchasing decisions. In this context, iPad's ultimate goal in education is to provide specialized hardware and software for fostering new ways of learning, and I suspect there is a healthy market for such a product.
Apple Flash Crash Brings the Worst out of Stock News Websites
Apple stock experienced a flash crash yesterday morning, dropping 3% in one minute on extremely heavy volume. With Apple trading near all-time highs, market pundits have become increasingly eager to point out why Apple's stock dropped. CNBC ran an article yesterday titled, "Here's why Apple shares took a dive: Pros". With such a headline, I knew what I was getting myself into and I wasn't disappointed as the article contained six reasons, impressively none of which were related to each other, that explained why Apple's stock had crashed.
Reason 1: Morgan Stanley Downgrade
Daryanani got on the phone with his trading desk to find out what they were seeing. It's a common occurrence on Wall Street for sell-side analysts to periodically check-in with their trading desk to see if there is anything unusual with the incoming buy and sell orders. In reality, the traders are just reading blogs and AOL IM themselves looking for reasons a stock is up or down since they don't know either.
Reason 2: Program Selling
After getting off the phone with his traders, maybe Daryanani got some incoming calls from clients that actually knew what was going on. CNBC gives the reason one sentence.
Reason 3: Technical Analysis
People sold Apple because it crossed a random moving average.
Reason 4: Profit-Taking
Apple is down 3% in one minute and Basenese concludes that it resulted from long-term investors deciding now is the time to sell. It is just a coincidence that everyone decided to sell at exactly the same second...literally.
Reason 5: Stock Upgrade
Basenese also thinks a stock upgrade may have caused Apple's stock to crash. I assume a stock downgrade would cause Apple's stock to pop?
Reason 6: Weak Black Friday Sales
I assume this reason came in from traders with little to no knowledge about Apple or that Black Friday sales metrics were largely irrelevant because of retailers holding sales during the week leading up to Black Friday.
The CNBC article has 143 comments so I assume it accomplished its goal of attracting page views. Meanwhile, Reuters published an article yesterday about Apple's flash crash, listing one primary explantation: algorithmic and high-frequency trading.
Reason 1: Algorithmic Trading
Similar to the 2010 Flash Crash, yesterday's flash crash impacted over 300 stocks, not just Apple. The U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading (CFTC) looked into the 2010 Flash Crash and concluded that one trader initiated a sell program to sell S&P 500 futures contracts. High-frequency trading firms saw the order and started selling the contracts they had just bought from this one trader. A resulting liquidity vacuum (lack of buyers) formed and then spread into the equity markets. I suspect something along those lines impacted the stock market yesterday morning. Of course, this theory doesn't lead to the most exciting headlines and stories, so when the next flash crash occurs (and it will), I'm confident we will see new articles from the "pros" giving us six explantations for why Apple crashed.
Apple's Share Repurchases Have Benefited Shareholders by $80 Billion
With Apple having completed 75% of it's current share repurchase program, and a recent increase in chatter concerning whether share repurchases are the best use of Apple's cash, it is a good time to review Apple's share buyback program and assess its logic and success. It is important to first understand what a stock repurchase program is and how companies use buyback as a signaling mechanism when framing Apple's decision to initiate the largest capital management program in history. I estimate Apple's ongoing share repurchase program has added $80 billion of price to Apple's stock, benefitting current shareholders as the gap between Apple's stock price and value has narrowed. Despite committing to $90 billion of share repurchases and having $22 billion of buyback authorization remaining, Apple has kept all of its options open for creating additional shareholder value through funding sensible M&A and capital expenditures.
What are Share Repurchases?
A share repurchase program, often called share buyback, is the process of a company buying back its own shares either through the public market or private transactions. Share repurchases, along with cash dividends, are two of the primary ways companies can return excess cash to shareholders. The mechanism of share repurchases are not controversial; as shares are repurchased, a company's outstanding share count declines, thereby boosting each remaining share's ownership percentage. Consequently, each remaining shareholder that did not sell shares to the company would then have a higher share of earnings and cash flow. Exhibit 1 demonstrates this process as a hypothetical 10% share buyback lowers shares outstanding, while having no impact on earnings, leading to higher EPS and a higher overall ownership share for the top shareholder assuming no shares were sold. I assume it was an all-cash share buyback in a low-yielding environment with no loss of investment income.
Exhibit 1: Hypothetical Share Repurchase Program's Impact on Top Shareholder Ownership and EPS
The principal-agent dynamic underlying publicly-traded companies drives capital management decisions. Executives (agents) are hired with the goal of utilizing a company's assets in order to earn a return on shareholders' (principals) investment. The board of directors are elected by shareholders to monitor that management is considering shareholders' best interests. Management teams determine if share repurchases or dividends are appropriate when a company is sitting on excess capital, which may negatively impact financial metrics such as return on assets and equity, while the board of directors officially authorizes capital management actions.
This principal-agent relationship doesn't always work in shareholders' best interest as conflicts and differing incentives complicate matters, as seen with the recent string of corporate boardroom raiding by hedge funds. It's in this setting that Tim Cook is tasked with balancing Apple's long-term well-being with Apple shareholders' best interests in terms of excess cash on the balance sheet.
Share repurchases also have a "signaling effect", impacting how investors view a company's future. By initiating a share repurchase program, it is believed that management views its shares as undervalued and its future is bright enough to part with excess cash. Share repurchases have increased in popularity in recent years as capital gains are often taxed at lower rates than dividends, there is less risk of management teams wasting excess cash on M&A (which there are numerous examples of in the technology sector), and there are fewer side-effects from slowing or stopping buyback programs compared to dividends.
Apple's Share Repurchase Program
Apple has the largest share repurchase program in history, which stands as a testament to the company's successful products. Exhibit 2 highlights the pace at which Apple has repurchased shares. Since 2012, Apple has spent $68 billion on buyback repurchasing approximately 10% of common shares outstanding, with approximately $22 billion remaining in the current authorization.
Exhibit 2: Apple Share Repurchases - Open Market and Accelerated Share Repurchase (ASR)
Logic for Apple Share Repurchase; How Shareholders Have Benefited by $80 Billion
Using today's stock price, Apple's $68 billion of shares repurchased over the past two and a half years would be worth approximately $108 billion, or nearly 40% higher. In reality, this return is hypothetical since Apple does not benefit from previously repurchased stock rising in value, but it does help break apart the thesis that Apple has squandered money on buyback. If one was to look at the impact that Apple's buyback has had on the company's reported financials, EPS has risen approximately $0.50/share, all else equal, as depicted in Exhibit 3. Similar to Exhibit 1, I assume cash was invested in low-yielding short-term investments that did not produce significant income.
Exhibit 3: Share Repurchase Impact on Apple's Net Income, Shares Outstanding, and EPS
Taking this additional $0.48 of EPS resulting from fewer shares outstanding and multiplying it by Apple's current 15x forward P/E multiple would result in approximately $7/share of additional stock price. However, one also needs to take into account any change in P/E multiple as a result of the buyback. Obviously, this part of the exercise is up for debate given different variables impacting valuation multiples, including higher EPS revisions resulting from iPhone strength. Apple's forward P/E multiple has expanded from 13x to 15x since the stock buyback program was put into place. Giving equal weight to buyback and iPhone strength as causing the P/E multiple to rise, another $5-$7/share of stock price can be attributed to buyback (2 (P/E multiple expansion) x $5.97 (Apple's 2014 EPS without EPS accretion resulting from buyback) x 0.5 (to reflect iPhone strength's impact on higher P/E multiple)). Said another way, the market has assigned approximately $13/share of additional price ($80 billion) to Apple's stock due to share repurchases.
Stock buyback shouldn't have much, if any, impact on Apple's value, aside from lowering the cost of capital if there have been corresponding debt issuances. However, the gap between Apple's stock price and value is closing because of the ongoing share buyback program.The marketplace went from not appropriately valuing Apple's cash to now willing to pay more for Apple's cash and additional capital management actions that may lie in the future.
While Apple's shareholders have benefited by buyback, has Apple, the company, benefited? To answer this question, one has to consider other options Apple could have taken with the $68 billion funneled into buyback.
A) Large M&A. Management could spend excess cash on a few large acquisitions. As I explained in my article "Large M&A is Not in Apple's DNA: Case Study of Why Apple Won't Buy Tesla", Apple's product success is built on collaboration and design and reinforced by Apple's organizational structure, leaving no room for large M&A. Instead, Apple continues to be an active acquirer, having bought approximately 35 smaller companies since the beginning of 2013, most of which were never made public. Apple looks at acquisitions as a way to fill talent and resource holes that could only be addressed in a timely manner by acquisition (such as Authentic and fingerprint sensor technology).
B) Dividends. Apple could issue a special one-time dividend or increase its quarterly cash dividend. Obvious drawbacks to issuing dividends include shareholder tax implications and negative signaling that management doesn't view it's stock as undervalued and worthy of share repurchases.
Instead, Tim Cook and the board are using Apple's $150 billion of cash to fund dividends and buyback, while keeping enough ammunition to create shareholder value through organic and M&A possibilities, including significant capital expenditures, which topped $11 billion in 2014 and is expected to reach $13 billion in 2015.
Stock Buyback's Long-term Implications on Apple
As I wrote in my article, "AAPL and $700 Billion", short-term stock price swings don't give much indication as to how Apple, the company, is faring due to many moving variables involved in how a stock's price is determined. While the market was concerned about Apple's iPhone business and declining margins in late 2012 and 2013, Apple was busy developing the Apple Watch. Apple's stock underperformance had little to no impact on Apple's R&D and future plans. While I will admit that a company's stock serves as an incentive mechanism for employee morale, I believe any short-term reactions tend to correct themselves overtime, limiting the long-term impact on employee morale.
Apple's stock buyback program highlights that Tim Cook and the Apple board are fostering a shareholder-friendly environment, which stands in contrast to a few tech behemoths with anti-shareholder voting structures. Despite the $68 billion spent on share repurchases since 2012, Apple still has more than $150 billion of cash, thanks in part to $29 billion of debt issuances. Ultimately, Apple's long-term buyback plans will depend on how the product pipeline materializes. It wouldn't be a stretch to assume Apple will utilize share buyback during periods of stock price underperformance and low valuation, while buyback is limited during periods of stock price greed and optimism. Given the current environment and product portfolio, as well Apple's stock valuation, Tim Cook and the board are doing the right thing buying back shares.
This report was produced by Neil Cybart on December 1, 2014.
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