The New Apple: Embracing Personalized Technology with a Luxury Twist
While it may seem like we have everything figured out about mobile with the iPhone form factor now cemented in our daily lives, in reality, we are in the early stages of the current mobile renaissance. Consumers are still trying to figure out what sizes of glass should be carried in our pockets or worn on our bodies. Despite all of these changes, there is one theme that has remained unwavering: technology is becoming more personalized. With Apple Watch, Apple is placing a big bet that a device for the wrist is the next progression of personalized technology, which inherently adds an element of luxury and fashion to the mix. Yesterday's Apple Watch keynote wasn't perfect, but management took the opportunity to tweak its marketing message a bit with the goal of positioning the Apple Watch as the newest, most personal device in the iOS product portfolio. The Apple Watch has the potential to be positioned as the primary interface for mobile computing.
Unchartered Territory
If there was one moment of the Apple's "Spring forward" keynote that should stand out it occurred at the 52-minute mark. Up to that point, the presentation was classic Apple. After a little bit of Apple TV news, Jeff Williams introduced a new health research platform that came across as something only Apple would be able to do, and Phil Schiller was up on stage, gleefully explaining why the new MacBook was the best Mac ever imagined. For the first 52 minutes of the event, Apple was at its best, and it showed. When the discussion turned to Apple Watch, Tim Cook and Kevin Lynch spent the next 42 minutes talking about all of the things Apple Watch can do, but the presentation lacked the same level of cohesiveness that was found in the beginning slides. Cook awkwardly worked through the Christy Turlington Burns storyline, which gave off a bad late-night TV talk show vibe. One could sense that the Apple Watch and all of the inherent fashion and luxury surrounding the product is new territory for Apple, and it may very well be more of a "learn as you go" mantra when it comes time to explain the device to the world.
Less Details, More Insight
A prime example of Apple still playing around with how Apple Watch should be marketed was how Apple chose to bypass any mention of the Digital Crown. Back in September, Tim Cook literally introduced the Apple Watch to the world as a device dependent on a breakthough user interface based around the Digital Crown. The Apple Watch borrowed much heritage from a classic watch crown but altered its functionality to essentially be the "pinch and zoom" of the Apple Watch. Jony Ive was quoted in the press about all of the painstaking effort put into coming up with the Digital Crown. Yesterday, the only reference to the Digital Crown was said in passing by Kevin Lynch who mentioned "crown" a few random times during his demo. Such a change in marketing didn't quite stop there as Apple seemingly avoided discussing much of the mechanism dealing with Apple Watch buttons, menus, and swipes. There was also little to no discussion around the device specifications, similar to what Phil Schiller had just finished doing with the MacBook. The Watch is different, and Apple treated it accordingly.
Not coincidentally, reviewers' initial thoughts about the device after 15 minutes of demo time seem to center around the watch feeling a bit complicated to use. There may be a learning curve involved with Apple Watch, and management decided to spend less time talking about those details and more time talking up apps and things that would increase someone's interest in the device. The strategy would seemingly involve Apple Retail to help get people comfortable with the new user interface. Apple did announce there will be an opportunity to preview Apple Watch at Apple Retail stores, which will likely involve a quick overview of the device. We have experienced very few breakthrough user interfaces since the mouse, so maybe our sense of perspective and expectations for ease of use is a bit skewed by the sheer intuitiveness of multi-touch?
Bringing iOS to the Wrist
Some criticism that was thrown towards Apple after the first Apple Watch event in September was that there wasn't a clear reason given for why someone should buy an Apple Watch. Even after yesterday's keynote, there likely were many disappointed pundits awaiting Apple's clear bullet by bullet list for why the Apple Watch is worthy of someone's wrist. In reality, however, Apple explained in not so clear language why Apple Watch makes sense: it brings technology much closer to the user. Similar to the way the iPhone and iPad seemed magical next to laptops and desktops, having a device that is on the wrist, a location with superior line of sight and proximity to the face, may bring new ways of using technology.
Apple could have explained the device a bit better in context of the full product lineup, as shown below. If one was to go back to Apple's previous keynotes, Tim Cook eloquently explained the following slide that was in yesterday's presentation.
Exhibit 1: Apple's Current Primary Product Lineup
Instead of relying on antiquated consumer/professional product matrixes, Apple's product strategy can be described by a personalization analysis, included in Exhibit 2. It is clear where the Watch fits into the mix.
Exhibit 2: Apple Personalization Product Analysis
In terms of selling the Apple Watch to consumers, Apple, as expected, relied on a soft sell approach by merely listing various apps that I would suspect were heavily favored and used by Apple employees that got to test the device over the past few months. While some may have poked fun at the thought of using Instagram on a watch, one would hope Apple obtained valuable input from employees indicating photos on a wrist had some intriguing value to them.
The overarching theme of Kevin Lynch's Apple Watch demo was about iPhone substitution. While many of the Watch app demos fell a bit flat due to the personalized nature of both the app and the device, a close listen to Kevin Lynch's dialogue would be very revealing. If audience members closed their eyes, it would have sounded like Lynch was talking about a new iPhone. Not only did he discuss things that were known to be watch-focus activities, like notifications and messaging, but nearly every app discussed was a popular app on iPhone. Lynch made his ultimate rationale for owning an Apple Watch clear when he said he would want to leave the phone by the door and just use the watch around the house. I suspect there are very few people who really think of Apple Watch as this versatile.
Personalization Allows Luxury
As personalization permeates through mobile technology, one of the more interesting consequences is how luxury is inherently intertwined in the discussion. Since Apple Watch is a device meant to be worn, Apple was correct in assuming people would want the device to represent their personalities and styles. Apple is selling Apple Watch to everyone from high school students to senior executives with a keen fashion sense (although some still seem opposed to Apple's fashion sense). As the level of exclusivity increases, an item is able to display more characteristics of luxury, as shown in Exhibit 3. Moving along the independent axis, supply begins to decline, an often necessary ingredient in luxury markets. Compare a flagship iPhone model that ships hundreds of millions of units per year to a personalized Apple Watch Edition with limited supply. The iPhone will simply not contain the same potential as the Apple Watch to be regarded as a luxury item. Critics would point out that there is plenty of emotion that enters the equation when analyzing and referring to something as luxury. Nevertheless, the general idea behind Exhibit 3 still stands.
Exhibit 3: Exclusivity vs. Luxury
The interesting aspect of Apple embracing luxury is that Apple inherently has the ability to add even more personalization in the form of software, but it may be best to assume the luxury markets treat that with some level of doubt. While the first version of Apple Watch may not push the boundaries of what is possible with customized technology, future reiterations, including various other devices, would certainly beg the question of what the limit is to Apple's luxury motives. Exhibit 4 shows the various Watch collections graphed according to price. It is easy to see that at least on paper, Apple is relying on scarcity ("exclusivity" sounds better for marketing) in order to drive prices higher.
Exhibit 4: Apple Watch Prices by Collection
Threading the Luxury Needle
One of Apple's primary goals yesterday was to transition to a premium mass-market luxury brand. Even though Apple has mastered the art of selling mass-market goods at premium prices, catering to a luxury clientele comes with new risks, including alienating core users who may be turned off by management's focus on the high-end at the detriment of the "low-end." Apple handled the transition well by offering clear distinctions between the three tiers (aluminum for Sport, stainless-steel for Watch, and 18K gold for Edition). Tim Cook's presentation of the Edition pricing (no stated pricing on a slide and no video depicting the gold) suggested there will be a very clear difference, or segmentation, between how the Edition is sold compared to the other two tiers. There will likely be very few instances of $349 Apple Watch Sports being sold next to $17,000 Apple Watch Editions.
Pricing Looks Right; Sales Potential Remains Elevated
Apple is selling the Sport and Watch collections for a reasonably fair price with premium mass-market in mind. The Edition pricing reflects not only the 18k gold but also artificial scarcity with limited production. The initial target market for Apple Watch is approximately 400 million iPhone users. If one were to simply look at iPhone 6 and 6 Plus users as a closer barometer of likely Apple Watch purchasers, the market is now greater than 100 million users. It is important to remember that many consumers do not buy the first version of a product for a multitude of reasons. Therefore, most people will not buy Apple Watch in 2015, or even 2016. With that in mind, I still feel confident in my estimate of 17 million units sold in 2015 with another 35 million units sold in 2016. If looking at sales in terms of months of market, for the first 12 months on the market, Apple will likely sell around 25 million Apple Watches. Beyond 24 months, sales may be a bit more difficult to forecast as it is unclear what the Watch upgrade cycle looks like. Apple has indicated the battery can be swapped out, and some of Jony's recent comments would suggest there may be a scenario where the watch face doesn't change much from year to year.
Expanding the Personal Experience
The primary takeaway from Apple's keynote yesterday was that the iOS product family is expanding as a watch takes up the spot of the most personal device Apple has ever made. The watch holds the potential of becoming the primary input for mobile computing, serving as the assistant that people thought Siri on iPhone was going to become. Meanwhile, the iPhone's relevancy doesn't necessary decline in an Apple Watch-focused world. Instead, the iPhone continues to gain power and capabilities from both the iPad and Mac. The Apple Watch has the potential to overpower iPad in terms of popularity and usage. The device's upgradability is the primary unknown as to whether unit sales will indeed surpass the iPad. However, odds look to be in the watch's favor.
Apple's main selling strategy is to get consumers into an Apple retail store and in front of a watch. It is somewhat similar to the way the iPad took off once people played with one. The obvious difference is that it is much harder to "play" with an Apple Watch in an Apple retail store, and it will likely require an appointment.
Apple is coming up with various devices that each serve a different function, letting the user interact with technology in a few unique ways. Going forward, I suspect the iPhone and Apple Watch will garner the most attention while the Mac is positioned as a product for higher power computing needs. By entering into wearables, Apple is getting its first taste of personalized technology built around accessories (bands) and luxury. The key question going forward is what will Apple learn from this process (both in terms of manufacturing and sales) that can be applied to future Apple Watch editions as well as other wearables? For Apple, the Watch is one way to play a much more significant role in an iPhone user's life.
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Apple Won't Look the Same after Monday's Apple Watch Keynote
The Apple Watch represents the biggest product bet Apple has placed since the iPhone in 2007. Apple will never be the same kind of company once Apple Watch pricing is revealed on Monday. Management's primary focus during Monday's "Spring forward" Apple Watch event will be showing how a premium mass-market technology brand can embrace luxury without alienating a portion of its customer base. On one hand, Apple Watch is a device that seemingly no one asked for, but on the other hand, it is a device that holds enough potential to reshape the mobile landscape by altering the way consumers use iPhones.
Goals for Monday's Keynote
Reposition Apple as a premium mass-market luxury brand. Apple is currently a premium mass-market brand, selling gadgets to addressable markets that number in the hundreds of millions. With Apple Watch, Apple is entering new territory, embracing luxury and the required scarcity of supply that comes with a luxury label. Such scarcity at the high-end is obtained by controlling the demand side of the equation through high prices. Apple Watch Edition collection prices will likely shock those observers who aren't aware of Apple's motivation to become more like a luxury brand. At the same time, Apple is holding on to its premium mass-market heritage by selling Apple Watch Sport at a $349 starting price.
As confirmed in The New Yorker Jony Ive profile, Apple's decision to embrace luxury is deliberate and likely taken in recognition that to be successful in the wearable space, a new strategy would be required. Consumers need to feel connected to a wearable accessory as the device becomes an extension of their personality. Apple's new premium mass-market luxury brand will also help drive subsequent demand for new product categories that position fashion and emotion as key buying determinants, with materials utilized as differentiation between luxury items and premium mass-market goods.
Apple will need to frame this branding message a bit before revealing Apple Watch pricing in order to clearly demonstrate that Apple Watch is targeting everyone from high school students to senior executives with three distinct watch collections, and not just luxury items with low-end counterparts.
Explain Apple Watch. Apple will likely demonstrate through app demos and talking points why the Apple Watch exists: to shift some utility from the iPhone to the wrist. Management can also discuss stand-alone features such as health tracking. There is some risk involved here. Talk up the device functionally too much, and the iPhone upgrade cycle may be put at risk as consumers hold on to iPhones for longer and instead buy new Apple Watches. Talk down the device, and consumers will choose to bypass it altogether. The ability to market Apple Watch in context of the entire Apple ecosystem is a powerful variable that literally no other company can copy, and I would expect Apple to reiterate that. In many ways, some of Apple Watch's features may need to be demonstrated not so much to sell Apple Watch, but to sell the Apple Watch plus iPhone combination.
Soft sell the Apple Watch. Apple has consistently used timekeeping, communication, and health & fitness as Apple Watch marketing tent-poles. If one is expecting Apple to drastically change from this strategy when it positions Apple Watch to the public on Monday, there may be some disappointment. Apple spent only 12 minutes demoing Apple Watch last September. On Monday, there will undoubtedly be much more time to demo various apps, including possible in-house apps or features that Apple kept under wraps.
Contrary to consensus opinion, Apple will rely on soft sell messaging where the overall message is that Apple Watch is a personalized device capable of doing various tasks. Relying on a strategy similar to the way iPhone and iPad were sold may fall flat for a luxury item. Instead, Apple needs to rely on the device itself, including its look and design, to spark interest. The hardest part will be getting consumers interested in the device. Once that relationship is established, Apple can rely on its retail infrastructure to turn interest into a sale, and then that's where Apple's marketing message comes into play.
Questions
What will be the price range for the Watch collection? Edition collection pricing will be established with scarcity in mind. Watch collection pricing will determine how big of a seller the mid-tier option will be when compared to the Sport collection. If Watch collection is priced near $500, it may be tough to forecast which will sell more: Watch or Sport. However, if Watch collection is priced above $1000, the Sport collection will be the primary beneficiary from a unit sales perspective.
Will there be new watch bands? While most of the attention has been given to the various watch faces, the bands may be the bigger story of the day. Details ranging from price to availability will help determine how versatile Apple Watch can be and how much fashion enters the buying decision. Is there a possibility Apple will unveil new ultra-luxury bands priced well over $10,000?
What will the Apple Watch rollout look like? Reading in between the lines, it would seem that the Apple Watch rollout will be more measured than previous product launches that we are used to. The going assumption will be that the U.S. will get the device at launch. Tim Cook mentioned Germany will see the device in April, which implies that there will at least be a handful of countries receiving the device within the launch month.
The Apple Watch is a big deal for Apple. Not only does the device represent a new product category, but success will be dependent on behavioral change related to iPhone usage. Wrist real estate is in precious demand, and I continue to see an upcoming battle for ultimate wrist supremacy. Apple's strategy will be to mask additional utility with fashion and design. Luxury presents a number of opportunities, and challenges, for Apple. As recent executive hires have shown, Apple is ready for the challenge. Apple will never look the same after Monday.
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Tackling AAPL's $1 Trillion Question
Apple currently has a $750 billion market capitalization ($612 billion enterprise value). There are two factors that will determine whether Apple will reach a $1 trillion market cap: future financial performance and investor's willingness to pay for that performance.
Future Financial Performance
Apple's cash flow and earnings provide the best view on Apple's ability to sell products. Fortunately for investors, both data points are relatively straightforward with little in the way of required adjustments. Apple has $12 billion of deferred revenue on its balance sheet related to the way software is accounted for, but the overall impact to the bottom line won't change any conclusions found in this post. Carl Icahn raised issues concerning non-cash tax accruals, which have roughly a 10% impact on Apple EPS, but it remains to be seen if such an adjustment is completely warranted. Similar to the deferred revenue, I don't see the adjustment being a factor in the $1 trillion debate.
Apple reported $44.5 billion of net income ($7.42 EPS ) in CY2014. The degree to which Wall Street forecasts future earnings depends on the industry being analyzed. For financial companies, certain financial metrics are typically forecasted three to four years out, while for a company like Apple, estimating beyond two years is a stretch. Investors understand the volatility inherent in consumer technology companies and estimates, especially looking out beyond two years. For CY2015, I am expecting Apple to report $55.8 billion of net income ($9.95 EPS), implying 25% net income growth and 34% EPS growth due to the impact from share buyback. Potential earnings from unannounced Apple products are typically not included in forward estimates. Even though Apple will ship new product categories in the future, most investors are not willing to give credit for that potential EPS boost until more specific information is known.
Investor's Willingness to Pay For Performance
The much harder part in forecasting Apple's future value is related to gauging investor sentiment about Apple's future. Apple's price-to-earnings (P/E) ratio is the primary metric used to value Apple, with price-to-cash flow (P/CF) ratio serving as a secondary measure. Both ratios serve as a representation of how much an investor is willing to pay for a dollar of earnings. As an example, a P/E of 10x would indicate that investors are willing to pay ten times the amount of earnings in order to own a piece of the company and that future earnings stream. The P/E multiple mostly reflects growth expectations. If a company is expected to report strong earnings growth, a higher P/E multiple may be warranted. A P/E of 75x would indicate investors are willing to pay much more for a dollar of earnings because those earnings are expected to experience above average growth. Accordingly, companies with more mature growth have historically had difficulty achieving a P/E above the market average of around 20x.
With AAPL trading around $130/share, Apple has a 17.5x trailing twelve month P/E ratio, which is a bit lower than the overall market. I'm not a fan of trailing P/E ratios because the future is more important than the past. In addition, the current stock price already reflects future growth, so trailing P/E ratios are a lagging indicator (i.e. they don't provide much value). With the stock trading at $130/share, Apple has a 13.1x forward P/E ratio, which is a discount to the average 16x P/E for large cap tech stocks.
Requirements for $1 Trillion
Apple could reach $1 trillion ($171.50/share given current shares outstanding) in two ways:
A) Higher P/E multiple. Apple shares would increase in price if investors are willing to value the company using a higher P/E multiple. Currently Apple has a 12.9x forward multiple. How much higher would the multiple need to increase for Apple to be valued at $1 trillion assuming earnings remain unchanged? Investors would need to pay a 17.2x forward P/E multiple, which is 33% higher than the current 12.9x multiple. Why would an investor be willing to use a 33% higher P/E multiple to value Apple's expected future earnings stream? Two of the more likely reasons include an overall stronger equity market where the overall tide rises as investors rush into equities, and increased confidence in Apple's products and outlook.
B) Stronger earnings growth. If we assume the forward P/E multiple remains unchanged at 12.9x, then Apple would need to grow earnings by another 32% to reach $1 trillion. Assuming Apple grows earnings by approximately 15% annually over the next 2-3 years, Apple would be valued at $1 trillion sometime in 2017. I have doubts it will ultimately play out this way though as I have difficulty seeing the P/E multiple remaining unchanged for the next three years. Investors will likely change their opinion on Apple at some point over the next three years, either becoming more positive or negative.
Easiest Path to $1 Trillion
Apple can reach $1 trillion if investors become 33% more optimistic (using P/E multiple as a proxy) about Apple's future or if Apple is able to grow earnings by 32%. I think Apple's best chance of reaching $1 trillion will be a mixture of the two: higher-than-expected earnings growth and a higher P/E multiple as investors show renewed confidence in Apple as an ecosystem with annuity-like features (a stream of device and services revenue).
With shares trading at $128, investors are relying on certain expectations for Apple, including iPhone and Apple Watch sales, to value the company. Since the iPhone accounts for over 70% of Apple's operating income, any significant change in sales expectations going forward will play a large role in the way investors value Apple. Last week, I detailed an achievable strategy for Apple to grow annual iPhone unit sales by 50% within three years. Is this type of growth reflected in the stock price at current valuations? The question will depend on how many investors believe the strategy is achievable. I suspect there is a bit of skepticism surrounding the thesis.
As for Apple Watch, I published Apple Watch sales estimates of 20-30 million units for the first 12 months on the market, rising to 40-60 million units in the second year on the market. Consensus currently stands around those numbers, with 15-20 million Apple Watch units expected to sell from April to December. In theory, Apple's current $128/share price and analyst estimates already reflect these Apple Watch projections. Therefore, actual watch sales would need to come in stronger than these estimates for positive EPS revisions. In a scenario where EPS estimates are rising due to stronger iPhone or Apple Watch sales, investors may also be willing to pay more for those higher earnings, resulting in a rising P/E multiple.
Given the current share price, Apple is 33% away from a $1 trillion market cap. While that may seem close, it represents nearly $250 billion of additional market capitalization, hardly an easy feat. Apple's best shot of reaching the arbitrary value milestone is reporting stronger than expected iPhone sales over the next 2-3 years and having a successful Apple Watch launch. Since it is impossible to know why every investor buys or sells AAPL shares, no one knows if Apple will reach a $1 trillion market cap. As long as the economy and equity market don't experience any huge shocks or surprises, Apple's existing product categories have enough potential to propel the stock to $1 trillion train.
How about $2 trillion? That is a much more complicated story that deserves its own post.
Wildcard: Apple's stock buyback program represents a very significant unknown in this discussion. Apple has the potential of buying back close to 20% of itself within three years. How will that impact the odds of AAPL reaching $1 trillion? In order to gain a bit of perspective in terms of size, Apple's buyback over the next two years has the potential of boosting EPS by 10-15%. Most analysts should have this type of buyback already included in their estimates and therefore already priced in the stock. The impact that the actual act of buying back shares has on AAPL is another story. There could be a beneficial impact on AAPL shares if management decided to accelerate share buyback and current shareholders show little motive to sell shares. In such a scenario, there would be upside pressure on the stock as the market price rises to find the point where supply and demand is in equilibrium. Conversely, if management slows buyback, any support that resulted from Apple being an active buyer in the market has been removed which may result in stock price weakness. I suspect the stock buyback and Apple's $178 billion of cash are something to keep a very close eye on going forward.
This report was produced by Neil Cybart on March 3, 2015 and is not meant to be used as investment advice.
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Samsung's Smartphone Dilemma
Samsung unveiled the Galaxy S6 and S6 Edge yesterday at Mobile World Congress. Following a 45-minute keynote that lacked much purpose besides highlighting how mistakes made with the Galaxy S5 have now been corrected, I'm left wondering who is Samsung's primary customer: mobile carriers or phone manufacturers? Is Samsung losing all sense of reality by ignoring consumers and instead shipping smartphones in order to drum up marketing for its stronger smartphone components business? I'm no longer confident I know why Samsung is selling smartphones.
Following last year's Mobile World Congress, it was obvious that Samsung was undergoing its second Crisis of Design. As expected, the Galaxy S5's reliance on plastic and gimmicky software contributed to Samsung losing all momentum as a smartphone manufacturer. Increased competition from both the high-end and low-end caught Samsung sleeping. Yesterday, Samsung pressed the reset button on its smartphone strategy as its latest flagship phone was positioned as a fix to last year's mistakes. Whatever option Samsung went with last year, the opposite choice was taken this year. Citing "design of the future," Samsung dropped all of the plastic, opting for metal and glass. Meanwhile, 40% of the phone's features were cut as Samsung used shaky marketing spin to position the reduction as evidence of a new strategy focused on "design with a purpose." Samsung took a few pages from the Apple playbook and removed features such as a removable battery, expansion memory, and water proofing, all of which were reasons that hardcore Samsung fans had stuck with the brand in recent years.
The problem facing Samsung is that nearly every one of the changes made with this current crop of phones was the right move. Better hardware and fewer features have been the trend in the premium phone segment for years and the current winners have been busy building their platforms on the trust such a strategy has formed with consumers. However, Samsung's loyal customer base had remained engaged because Samsung was trying to be different, offering consumers choice and options, while design was considered an after-thought. These consumers place more value in removable batteries and the ability to swap out memory, not the look of the device. By trying to be like another premium smartphone manufacturer, Samsung may have shot itself in the other foot.
Samsung didn't change its entire smartphone strategy. The company reiterated their goal of doing things first so that others will follow, which supposedly leads to more innovation. However, a few minutes later, Samsung announced a mobile payments platform called Samsung Pay using nearly the same presentation and talking points that Apple used five months ago when announcing Apple Pay. Interestingly, the presenter skimmed through this part of the presentation, with very few details as to Samsung Pay's implementation and the fine print. Samsung is apparently licensing the fingerprint reader technology from a third-party, which raises some questions as to the background and long-term sustainability of the feature. I thought this Samsung Pay example summed up the conflict found throughout Samsung's entire presentation.
Samsung was more focused on mentioning key words such as design, hardware, camera, and mobile payments, instead of discussing why certain things were being done or removed from the phone. This lack of clarity has been Samsung's problem for years as the company has mostly relied on offering consumers choices that other smartphone makers decided not to pursue. The problem is Apple is now selling larger screen iPhones, and Xiaomi and other local Chinese smartphone vendors are selling decent hardware at lower prices. Samsung's differentiation has disappeared. Samsung may not be at the point of utter desperation, but they certainly came off as remaining quite nervous. Samsung says they want to be first in mobile, but they show great discomfort in leading.
If Samsung is relying on its premium smartphones to market screens, processors, and other components to other smartphone vendors, instead of giving the consumer a good experience, I highly doubt the company will be able to regain the Galaxy sales momentum lost in 2014. Smartphone competition continues to intensify and companies without a mission statement built around the consumer will find dimming prospects. Samsung's refocused attention on its smartphone components business is becoming a major liability and dilemma for the company's ambitions as a smartphone manufacturer.
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Apple's Initial Watch Ad in Vogue is Nearly Perfect
With Apple Watch Keynote 2.0 scheduled for March 9th, the Apple Watch will once again become the talk of the town in tech, fashion, and design circles. In anticipation of an April launch, Apple officially kicked off its Apple Watch marketing campaign with a 12-page spread in the important March issue of Vogue, valued at $2.2 million. I thought the ad was effective in highlighting the Apple Watch as a fashion piece that values design and luxury.
There are only so many brands that can get away with just simply having Watch on a blank page. That one page is estimated to have cost Apple close to $200,000.
Watch Sport
Interestingly, the green fluoroelastomer band made the cut. Apple included a screenshot of the Activity app.
Watch
The milanese loop provides great imagery (this same shot is on Apple's website), while the profile shot is able to show the band's clean and minimal nature. Notice the lack of technology in these shots.
Watch Edition
The rose gray modern buckle could be mistaken as a band from any luxury watch. Meanwhile, a sophisticated and sleek black watch face is used to highlight the Edition collection.
I think this ad is nearly perfect because it effectively gets the message across that this luxury item is much more than just any old watch without actually showing much, if any, of the technology that makes Apple Watch revolutionary. Apple is delicately positioning design and fashion ahead of the device's primary selling point: bringing utility back to the wrist.
Apple is walking a thin line when marketing Apple Watch as the device has to be positioned for everyone, from students to fashion-minded executives. The ad takes many cues from other fashion-oriented ads with minimal text and no prices as the brand is the primary product being sold. I would be very surprised if Jony Ive did not play a major role in creating every page of this ad.
This Apple Watch print ad reminded me of iMac ads from the early 2000s, in which the product also did the talking. In what may be a sign of Apple's increased brand power, and also the difference in target markets (Vogue versus tech publications), notice how much text is included in these iMac ads.
While having a large ad within Vogue is important, in theory anyone with money (and a good ad agency) can get a 12-page spread. The goal is to be on the front cover, which can't be bought in reputable magazines. In one chapter of Adam Lashinsky's "Inside Apple", the story of Steve Jobs lecturing an ad buyer included Steve's often-repeated response: "You worry about the back covers. I'll take care of the front covers." The key test will be if Vogue puts Apple Watch on the front cover. Google Glass got a 12-page editorial spread in 2013 and Apple Watch was featured on the cover of Vogue China, so maybe there is a chance we see Apple Watch on the coveted September issue of Vogue. Regardless, Apple is off to a good start with its Apple Watch marketing campaign.
Apple's Strategy for Growing iPhone Sales by 50% in Three Years
The iPhone is a juggernaut with unit sales up 25% in 2014, representing close to 70% of Apple's operating income. Many market observers are wondering if Apple is approaching a limit to iPhone sales growth. With the iPhone 6 and 6 Plus representing possible inflection points in the phone market, the ingredients are in place for Apple to sell 300 million iPhone units annually within three years, which would represent 50% growth from the 193 million iPhones sold in 2014. By executing on a number of achievable tasks, including taking advantage of weaker smartphone competition, building a wider sales distribution network, broadening the iPhone lineup, and increasing the iPhone's value proposition, Apple would be in a position to increase its phone market share by more than 400 basis points from 11% to 15% within three years.
The iPhone Growth Strategy
I continue to view doubling down on iPhone is in management's best interest as the iPhone 6 and 6 Plus serve as possible inflection points, reinvigorating the iPhone line. Apple can market the larger-screen iPhones to the hundreds of millions of smartphone users who did not buy an iPhone as their first smartphone over the past few years.
There are a number of pieces that need to come together for Apple to sell more than 300 million iPhones annually within three years.
Maintaining the iPhone Upgrade Cycle. With approximately 80-85% of iPhone unit sales coming from previous iPhone owners, it is crucial that Apple maintains a healthy iPhone upgrade cycle. Assuming a 2-3 year life cycle and relying on a few data points from Apple's recent earnings call, I estimate that approximately 185 million iPhone users are likely to buy a new iPhone in 2015, up from 165 million users in 2014 and 130 million users in 2013. Exhibit 1 highlights how crucial iPhone upgrades are to total iPhone sales.
Exhibit 1: iPhone Unit Sales Breakdown (iPhone Upgrade vs. New to iPhone)
The significant increase in iPhone upgrading in 2014 was driven by the iPhone 6 and 6 Plus and that trend will continue in 2015. As the iPhone user base expands, it is not hard to fathom that close to 250 million iPhone users will be upgrading their iPhones on any given year by 2017. Apple would likely position the screen, battery, and camera as some of the more marketable upgrades each year, as well as upgraded components including the fingerprint sensor, speakers, headphone jack (or lack thereof). In addition, Apple will continue to update the iPhone's form factor, including cosmetic chances, as well as altering width and weight.
Appealing to Android Users. Android represented approximately 80% of global smartphone sales in 2014, depicted in Exhibit 2. In order for Apple to achieve 50% iPhone unit sales growth within three years, Apple needs approximately 40-45 million iPhone unit sales annually to come from new users who currently don't own an iPhone. Android would be positioned as the most likely target for these platform switchers given Windows' low market share and Blackberry's lack of sales.
Exhibit 2: Smartphone Shipments and Market Share
Tim Cook mentioned on Apple's most recent earnings call that iPhone 6 and 6 Plus saw a higher Android switcher rate than the previous three iPhone launches. Exhibit 3 highlights this increasing trend of non-iPhone users making up a larger share of total iPhone sales. Given market dynamics, it will be difficult to have non-iPhone users make up more than 20-25% of iPhone sales, unless the iPhone upgrade cycle slows or Apple is more successful in getting new users to the platform.
Exhibit 3: Percent of iPhone Sales to Non-iPhone Users
Considering that Apple sold 20-30 million iPhones to new users annually since 2012, it is achievable to grow this to 40-45 million new users a year (the range required to grow iPhone shipments 50% by 2017). China Mobile alone may represent 15-20 million new iPhone users a year.
With a target of acquiring 40-45 million new iPhone users each year, Apple would be aiming for the top 4% of the Android base, which is a plausible goal. In terms of the most appropriate Android competition, 40-45 million represents less than 15% of Samsung's annual smartphone shipments. The high-end Android phone environment is quite different in 2015 as Samsung has lost momentum and Apple has a more competitive phone in terms of screen size. Samsung still has 20-30% share of the smartphone market in many developed countries, and those users will eventually be ready to upgrade their phone. Samsung has loyalty rates close to 60% in its strongest market (U.S.). Apple has a 90% loyalty rate. While 60% loyalty may seem high, the other way to look at it is 40% of Samsung's base will likely look at what else is in the market when it is time to upgrade phones. This trend may represent Apple's best opportunity to convert Android users to iPhone in developed markets. For the first time, premium Android users will walk into a mobile carrier store and compare similar-sized iPhones and Samsung Galaxy phones.
Appealing to Feature Phone Users. If Apple picked off 40-45 million premium Android users each year, within three to four years, much of the high-end Android market would have switched to iPhone, which may not be the most realistic assumption. In that case, Apple will also likely need to rely on feature phone users looking to buy their first smartphone. With smartphone penetration around 75% in the U.S., according to comScore, and lower penetration rates else where in the world, there is still opportunity for Apple to appeal to customers looking to buy their first smartphone. Gartner estimated there were around 900 million feature phones sold in 2013. While some may think late adopters in developed markets will gravitate towards low-end smartphones, I actually think the opposite may occur as late adopters (especially the top 5-10%) may look at a smartphone as a laptop/desktop replacement and be willing to spend more money on an smartphone.
Exhibit 4 displays overall phone shipments, including the roughly 600-700 million feature phones likely shipped in 2014. Samsung's market share decline (22% from 25%) was likely a result of Apple's stronger iPhone lineup and more competitive offerings from Chinese smartphone vendors.
Exhibit 4: Overall Phone Shipments and Market Share
In China, 20% of iPhone sales last quarter were to first-time smartphone users. Add these first-time smartphone buyers to premium Android switchers, and the goal of getting 40-45 million unit sales annually from the 1.7 billion of non-iPhone phone shipments seems a bit more attainable.
Expand Distribution. Apple now has 72% of the world's mobile phone subscriber base covered with 375 carriers supporting iPhone. In recent years, Apple has benefited greatly by adding carrier distribution partners, such as NTT DOCOMO and China Mobile. Apple is still seeing a positive impact from China Mobile despite it being a full year after launch as Apple continues to work on expanding distribution points in China, both in terms of brick-and-mortar retail as well as online. The easy growth phase may be over in terms of carrier expansion, which is why appealing to Android and feature phone users may represent most of the iPhone's near-term growth potential. Nevertheless, countries such as India and Brazil represent untapped sales potential. While such markets are not as established compared to China, there is room to expand iPhone's reach.
Expand iPhone Product Line and Price Points. While a "cheap" iPhone may not fit in Apple's strategy, I would expect management to continue debating the merits of releasing a new 4-inch screen iPhone that is sold at a slightly lower price than the iPhone 6. A smaller iPhone wouldn't be a top seller when compared to the bigger screens counterparts, but I don't think management will consider that as a factor for whether or not to release a smaller iPhone. The fundamental question comes down to whether the experience produced by using a 4-inch iPhone can be better for some users than using a larger iPhone.
In regards to overall iPhone pricing, I would expect Apple to continue bringing down the entry-level price of older iPhone models. I previously laid out how Apple is able to successfully maintain user experiences by selling older models at a lower price. Such a pricing strategy will help maintain iPhone momentum as Apple focuses on grabbing as much profit share as possible at each price level before moving further down market.
Increase iPhone's Value Proposition. Apple is positioning iPhone into critical aspects of our lives (home, health, car, finance) using HomeKit, HealthKit, CarPlay, and Apple Pay. Such efforts are not only to prevent Android from establishing insurmountable positions in key parts of our daily lives, but also to increase the iPhone's value proposition. The Apple Watch may also come into play as an ancillary device meant to break complex tasks into simpler, more manageable ones, may prove to increase iPhone loyalty and serve as a catalyst for driving news users to iOS.
Financial Impact
Selling approximately 300 million iPhones annually (up from 193 million units sold in 2014) would boost Apple's annual revenue by $60 billion. Assuming Apple is able to maintain iPhone margins, boosting iPhone's share of the phone market from 11% to 15% would equate to an additional $25 billion of operating income, or close to $20 billion on an after-tax basis (roughly $4.00/share). Considering that Apple reported $7.42/share EPS in CY2014, it becomes clear that the iPhone is one of the more important drivers for Apple EPS going forward in the near-term, especially with the Apple Watch accounting for a relatively small share of the revenue pie in the first 1-2 years on the market. Exhibit 5 includes Above Avalon's iPhone units sales and growth estimates.
Exhibit 5: Above Avalon's iPhone Unit Sales and Growth Estimates (Calendar Year)
The Big Picture
In 2014, the iPhone represented approximately 11% of phone market sales. While some question if there is much growth left in iPhone, I think there is an attainable strategy that can lead Apple to grow annual iPhone sales by 50% from 193 million units in 2014 to approximately 300 million units in 2017. In such a scenario, the iPhone would represent 15% of the phone market. For some perspective, even after growing iPhone sales by 50%, five out of six people buying a phone in 2017 would still be choose something other than an iPhone.
Obviously, execution remains key, and I continue to think maintaining the iPhone upgrade cycle is Apple's most difficult task. If users stop seeing the need to upgrade their iPhones every 2-3 years, it will be difficult for Apple to achieve 300 million unit sales within three years as there won't be enough new users coming from Android and feature phones to offset the decline. In terms of appealing to Android and feature phone users, the current iPhone lineup has never been stronger. For the first time, Apple will have iPhone models that display very well next to big Android phones in mobile carrier stores. Many consumers go to carrier stores not knowing which phone they will end up purchasing, so having a competitive product with a large screen may be a big factor in explaining how Apple can grow market share. In emerging markets, Apple continues to improve iPhone's distribution infrastructure in order to sell less expensive, older models at additional points of sale. It is in Apple's best interest to double down on the iPhone given current market dynamics and the 2-5 year outlook.
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Apple Is on Track to Buy Back 20% of Itself by 2017 (Video)
An update on Apple's share buyback program. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017.
Don't Focus on Apple Watch Edition Pricing
The ongoing debate over Apple Watch pricing is causing many to miss the big picture: Apple wants the Apple Watch to be for everyone. By selling a device for the wrist, Apple is trying to appeal to a wide range of consumers, from high school students to senior executives. In such a scenario, price is only one piece of the puzzle as Apple positions Apple Watch as both a mass-market good and luxury item.
Tim Cook and Jony Ive have been quite clear from the start: Apple Watch is the most personalized device Apple has ever made. Apple's goal to make wearable products required taking a different page from the old product playbook. Personalization was crucial as different options based on color, material, and style were required. Apple priced the entry-level Apple Watch Sport collection to be a mass-market good, attainable for mostly anyone willing to spend money on an iPhone accessory for the wrist. Prices will likely rise to thousands of dollars for the Edition collection to appeal to the consumer who wants a well-crafted device serving as a luxury status symbol. It really doesn't matter what price the high-end models cost as Apple's strategy will be the same: segmenting the market between mass-market and luxury.
Luxury denotes supply scarcity at higher prices, while mass-market denotes abundant supply at low prices. In an attempt to chase profits and market share, some companies with a traditional luxurious brand are trying to appeal to the mass-market. Such "mass-market luxury" brands can be seen in the automobile industry as Mercedes-Benz, BMW, and Audi continue to move down-market with entry-level vehicle options priced around the ultra-competitive $35,000-$40,000 range. After closer examination, one would see that these prices are artificially low as additional upgrades and options are required to truly get the "experience" of owning one of those high-end brands. By moving down-market, these brands are losing their luxury status and diluting their brands by removing features. Just as mass-market luxury is an oxymoron, many of these brands may be harming their long-term reputations.
Instead of following the automobile playbook when it comes to appealing to both mass market and luxury, Apple is taking a different strategy with Apple Watch. Rather than selling a cheaper Apple Watch model with fewer features, Apple is relying on different materials to establish distinct watch collections. The Apple Watch experience isn't dependent on price. Apple Watch Sport provides the same technological capabilities as Apple Watch Edition; both show notifications, monitor daily activity, and accept incoming tap messages. Instead, the three Apple Watch collections contain different materials, which help give the Edition a more luxurious status with precious metals and greater craftsmanship, compared to the Sport's anodized aluminum and Ion-X glass watch face. By focusing on materials variance instead of feature variance, Apple is hoping to be able to sell a product that appeals to the mass-market and luxury circles at the same time. To complete the sale, Apple will likely need to rethink its retail distribution as well.
There may be Apple retail stores that go days or weeks without selling the most expensive Apple Watch Edition watch face and band combination if it's priced at $20,000. Meanwhile, a customer going into an ultra-luxury jeweler would likely be insulted seeing a $349 Apple Watch Sport being sold next to some of the world's most expensive watches. If Apple is interested in having such a wide variation in price for Apple Watch, a new retail distribution model would likely be utilized. Apple can rely on segmentation for setting up kiosks or a store-within-a-store in high-end shops that sell only Apple Watch Edition or Watch collections. There are reports of Apple building a store-within-a-store in a high-end Paris department store (probably not that high-end as to exclude Sport collection though), but that general idea can be expanded into even more high-end retail locations. Meanwhile, there may not be much reason to stock Apple Watch Edition collection options at big-box retailers like Walmart and Best Buy. By using a more segmented retail distribution, Apple may avoid some of the backlash from appealing to wealthy and less wealthy customers at the same time, which apparently worried executives as reported in The New Yorker profile of Jony Ive.
Another reason I'm not too focused on Apple Watch Edition pricing is that I suspect the device will display inelastic demand once the price exceeds $5,000-$7,500. Said another way, once Apple sells certain models over a certain price, raising the price may not necessarily correspond to a decline in demand, or at least not in a direct relationship. John Gruber at Daring Fireball thinks Apple Watch Edition may come in options approaching $20,000, while others think $10,000 is a given.
There is a much bigger strategy at play here besides just selling expensive wrist gadgets. There is a battle for the wrist. For Apple Watch to be worn on some wrists, the luxury watch that is currently taking up real estate will need to be put back in its watch case. How will Apple be able to accomplish that difficult task? Selling a luxurious device that contains materials denoting high-end and craftsmanship, like precious metals and special watch bands. It's rather interesting that Apple has been able to go so long without customizing the iPhone. There are cottage industries focused on customizing mass-market consumer gadgets like phones into luxury items. With a wearable, this option had to be offered from the start. I'm not too concerned with where Apple Watch Edition pricing will end up because Apple will be utilizing the same strategy regardless of price: positioning Apple Watch as both a mass-market good and luxury item.
Apple Is on Track to Buy Back 20% of Itself by 2017
Apple is sitting on $178 billion of cash. What does Apple plan to do with its excess cash? It looks increasingly likely that Apple has already given us the answer: repurchase shares. Apple will most likely revise its capital return program in April, raising its share buyback authorization and quarterly cash dividend payout. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017.
Apple raised a small amount of debt last quarter, bringing total long-term debt held on the balance sheet to $32 billion at the end of December. Apple has since raised another $8 billion of debt in 2015, bringing the total amount of debt issued to $40 billion. Net cash (gross cash minus debt) stood at $142 billion ($24/share) at the end of December, depicted in Exhibit 1.
Exhibit 1: Apple's Cash, Cash Equivalents and Marketable Securities
From a foreign cash perspective, Apple now has a $158 billion war chest. Due to strong holiday iPhone sales, Apple's U.S. gross cash (cash and debt) increased last quarter to $20 billion, despite continued share repurchases.
Exhibit 2: Apple Gross Cash - U.S. Versus Foreign
As a reminder, Apple can not use its foreign cash to buy back shares or pay dividends without incurring tax penalties. Instead, Apple must rely on U.S. cash. With only $20 billion of U.S. cash remaining, Apple needs to tap the debt markets and rely on U.S. free cash flow (FCF) generation to fund additional share buyback. In Exhibit 3, I estimate Apple's likely U.S. FCF generation over the next three years and possible debt issuance loads ($25 billion a year as yields remain low).
Exhibit 3: Apple's Capital Sources for Capital Return Program
Apple will kick off approximately $45-$50B a year in U.S. excess capital (including debt) over the next few years which can be used to fund the capital return program. Running with $50B a year in share buyback, shown in Exhibit 4, Apple would be in a position to have bought back 18% of its outstanding shares by 2017.
Exhibit 4: Potential Apple Buyback Scenario
Apple began buying back shares in 2013. If Apple continues the current pace of buyback through 2017, the company would have bought back approximately 30% of the company, meaning roughly one out of three AAPL shares that existed in 2012 would have been bought back by the company. Going forward, management will continue to judge the value of share buybacks by comparing P/E and P/CF metrics versus other uses for cash such as special dividends and organic growth opportunities. As seen in Exhibit 5, assuming Apple maintains the pack of buyback around $50 billion a year, Apple will spend $150 billion in buyback over the next three years, versus $68 billion spent on buyback in 2013 and 2014 combined. Apple will likely be able to raise the quarterly cash dividend each year, but the lower share count will result in only a modest increase to divided expense.
Exhibit 5: Expected Apple Capital Return Program Expenditures
The wild card in this discussion remains AAPL stock price. A higher stock price will make share buyback less attractive, resulting in Apple buying back fewer shares. Conversely, a lower stock price would represent an attractive opportunity for Apple to ramp up its share repurchases. Even after three years of aggressive share repurchase activity and paying quarterly cash dividends through 2017, Apple would have more than $225 billion of gross cash remaining on its balance sheet.
This report was produced by Neil Cybart on February 20, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.
Playing Devil's Advocate as Jony Ive and Marc Newson Guide Apple
The big winner from Ian Parker's Jony Ive profile in The New Yorker was Marc Newson. News that Apple hired the industrial designer was unceremoniously announced this past September in a Vanity Fair article. At the time, his position was described as a role where Newson would contribute his advice to Apple from time to time. In reality, Marc Newson may be one of Apple's more significant hires in recent years. In an interview with Charlie Rose back in 2013, Jony explained his relationship with Newson, saying, "We share the same view of the world, and the same taste, and we relate to the same attributes or aspects of an object." Newson then added, "Most importantly we really hate the same things." With Jony and Newson arguably the creative duo guiding Apple forward and sharing much in common with each other, what are the drawbacks and risks in such a dynamic? It is time to play devil's advocate.
Jony and Newson's Vision Becomes Apple's Vision
One risk in having Jony and Newson control Apple's creative direction is that their view of the world becomes Apple's view. The New Yorker's Jony Ive article positioned Newson as Jony's sidekick on the Apple Watch project, with the final product sharing much in common with Newson's prior watch designs. Their attitude and feelings toward what a device worn on the wrist should look like arguably guides everything about Apple Watch all the way down to how a user interacts with notifications and glances. Is having two minds that think similarly about products as strong as having two minds that share the same philosophy but use different paths to get to the same end point?
Lack of Criticism
One secret to Apple's success has been the ability for the industrial design team to discuss and debate ideas in the very early stages of product development. Would a Jony and Newson pairing disrupt this creative stage where ideas no longer get the same amount of criticism? Ian Parker hinted at some of these opposing views when describing Jony's push for Apple to become more of a luxury brand, a topic brought up when contemplating who to hire for it's retail chief. Tim Cook and the rest of the executive board had some concerns with Apple losing touch with the mass market, but in the end, former Burberry CEO Angela Ahrendts was hired as SVP of retail and former Yves Saint Laurent Group CEO Paul Deneve was assigned to special projects. Some will look at this situation and wonder if Jony has the same intuition as Steve Jobs when it comes to being able to consider the details and big picture at the same time. While the comparisons likely hold no relevancy as times have changed, the argument won't go away anytime soon.
Questions Around Product Strategy
A quick search on YouTube would reveal dozens of Newson videos where the industrial designer looks back at his decades of previous contract work designing everything from toilets and guns to airplanes and backpacks. However, Newson's passion is transport and cars, and I don't think it is a coincidence that we now have rumors of Apple showing tangible interest in something related to electric vehicles. Marc Newson designed a concept car for Ford back in 1999, and during a recent recollection of his work, Newson described his goals with the car: "My objective was not to try to produce something that mystifies people, but to try to produce something that is simple for people to understand. You got to be able to get into this car and with one look understand how to operate it. I hate reading instruction manuals. I throw them away immediately. They just bore me." As for all of the cars in the market that are made by many different parts from many different companies, Newson said, "thats one of the reasons why cars to my liking look incredibly incoherent." Those two statements do a great job of describing the biggest criticism of a Jony/Newson duo: Is Apple now going to tackle whatever product Jony and Newson don't like looking at or using, and is that a good strategy? Would Apple's interest in a car be driven by Jony's and Newson's distaste of the current choices in the market?
Biggest Risk Factor: Incorrect Vision
If Apple wants to move into new industries and products, many decisions will depend on how Ive and Newson not only view the product, but how the product is made, and what will be its purpose and function. In such a scenario, the primary risk will be that their vision for a product doesn't resonate with the Apple customer base. This is why I suspect Apple management granted The New Yorker such far-reaching access for its Jony Ive profile. Apple is framing a discussion emphasizing design's importance in Apple product development in order to reduce the chances that a future Apple product doesn't catch on with its core users. Said another way, Apple will depend on words, and product demo videos, to sell new products to early adopters. Since Apple is a company that places very few bets, each bet is extremely large and one misfire would be very costly.
Responses to Criticism
There are a few logical responses to criticism originating from a Jony and Newson pairing. Much of the worry or concern originates from the idea that Apple's close-knit industrial design group would no longer function as a team capable of pushing back at Jony and Newson. One can argue that was indeed one ulterior motive for having The New Yorker article published; to stress how design at Apple is actually much more than one or two people. Apple did the once unthinkable and allowed members of Jony's industrial design team talk to the press. A few years ago, Apple was nervous to let their names even leak to the press. Such a change in strategy is noteworthy and deliberate. It would seem that Apple understands what the criticism would be of a Jony/Newson pairing and is trying to address the issue: Design is built throughout the organization and is not dependent on one person.
Since Newson shares many of the same philosophies as Jony and the industrial design team, which was personally built by Jony over the years, there is a good likelihood that the current design talent in place (responsible for the Mac, iPod, iPhone, iPad, and now Apple Watch) will continue to function without skipping a beat. It would be more concerning if Newson held fundamentally different views on industrial design, like how a product should be made, in which case the built-in criticism from the design team may not be as effective.
There is also little evidence to suggest that Tim Cook and the rest of the executive team will just roll over to Jony's demands and decisions. The team still includes executives that have battle wounds from countering, pushing back, and winning arguments against Steve Jobs for years. At the end of the day, Apple is being run by a group of senior executives who have shown the ability to put the product front and center.
Jony Ive and Marc Newson both have track records that speak for themselves in terms of taking complicated things and making them simple and more functional. The key question going forward will be if they are successful in letting their intuition guide them in an environment where design collaboration and teamwork are rewarded. As long as the product remains Apple's primary focus, a Jony and Newson duo has the potential of working out well.
Apple Wants to Design a Car as Ambition Knows No Bounds
What is an automobile? Why do automobiles look the way they do? How does one use an automobile?
Anyone who has owned or driven an automobile would have answers to these questions, formed over the span of their driving careers. Ask the same questions to someone who has never driven an automobile and the answers may be enlightening. Driving an automobile is not natural. We need to teach ourselves the art of navigating a heavy machine, composed of thousand of little parts, through the world. Is the driving learning experience focused on suppressing intuition in order to adapt to a machine that hasn't changed much in decades? Is it possible to make an automobile more intuitive that someone with no driving experience can hop in and get to where they want to go in a much more enjoyable way than what exists today?
Apple SVP of design Jony Ive and Apple industrial designer Marc Newson with U2's Bono. Photograph courtesy (RED).
By entering the automobile industry, Apple would be rethinking what an automobile should and shouldn't be in today's society, moving past the ideas that we have been relying on for decades, which now represent barriers to making the automobile more natural and easy to use. Apple doesn't appear to be following any rules as it takes its product-focus mantra into industries ready to be disrupted by a new experience created from combining software innovation with revolutionary hardware capabilities and design. Apple wants to rethink the automobile.
What We Know
At this early stage we have a few ideas as to what Apple is currently doing with automobiles.
Apple set up a team with senior managers in a secret location away from HQ. This is an indication that the project, codenamed "Titan" is past the "kicking the tires" phase. Instead, this would appear to be a legitimate focus for Apple with the intention of this effort leading to products. I was hesitant to jump on board the initial "Apple is doing a car" rumors because there was no evidence that Apple had a team in place with managerial structure (implying timelines and agendas). Everything changed this past Friday with reports from the Financial Times and The Wall Street Journal (later confirmed by Bloomberg and Reuters). Steve Zadesky, a former Ford engineer who contributed to iPod and iPhone development, has been assigned project lead and reportedly has been given permission to create a 1,000-person team with personnel from different Apple groups. This move is very significant, indicative that this is likely much bigger than simply an advanced CarPlay product or merely battery research.
Apple has talked to European automobile contract manufacturers. Apple executives reportedly met with Magna Steyr, a contract manufacturer for high-end cars, suggesting Apple may be interested in continuing its successful model of focusing on design and contracting manufacturing to another company. The primary value in the automobile industry doesn't come from the capital intensive stage of assembly, as any car marker, including Tesla, will reluctantly point out. Apple's $178 billion will certainly come in handy in terms of helping partner companies reach scale quickly. By having someone else make the actual car, what at first seems like an impossible task is now that much more realistic.
Apple has been hiring automotive talent. Recent hires include individuals with overall automobile R&D backgrounds (Johann Jungwirth from Mercedes Benz - who was interestingly given a bogus Mac engineering title) automobile safety backgrounds (Robert Gough from Autoliv), as well as battery technology (Haran Arasaratnam from Ford). Higher-level hires indicate Apple's motivation and desire for a product that goes beyond merely software, with other hires involved in electric engines and automobile interiors. If these hires are taken at face value, then an Apple-designed car is indeed on the table.
The focus appears to be electric. While the four major news sources (FT, WSJ, Bloomberg, Reuters) all report Apple is considering an electric vehicle, a few say Apple isn't thinking autonomous automobiles, while others say they are. At this early stage, I wouldn't include or exclude anything in terms of autonomous vehicles. We are already seeing vehicles that can park themselves and essentially drive themselves down the highway. Instead, it is safe to assume that Apple is looking at everything, including robotics, metals, and materials research.
Why Automobiles?
The idea of Apple wanting to play in the space is not surprising as automobiles are turning into moving pieces of software. Today's cars feel like "smart" phones in the pre-iPhone era: dashboards that are increasingly more confusing, ineffective communication systems that reduce driver and passenger safety, and cameras and sensors that aren't being utilized. Basically, smart cars are quite dumb. And we haven't even discussed the vehicle's outward appearance, where design is often a byproduct of a manufacturing process that rewards investment efficiency, something Apple doesn't believe in.
The 2015 Porsche Macan interior leaves much to be desired in terms of bringing the dashboard into the mobile era. Photo courtesy (Porsche).
It is rather remarkable how the automobile dashboard has had such a difficult time transitioning from a world where software played a very minor role in automobiles to one where software found in our phones, tablets, and soon watches, is easier to use and more utilitarian than software found in an automobile. As any driver can attest to, slapping a few touch screens on the dashboard doesn't work and is the car's equivalent of the pre-iPhone smartphone; clunky, ineffective, and needing to be rethought.
Apple would enter the automobile industry because they think they have a compelling product that capitalizes on taking software, hardware, and services to create a new experience. It is critical to not set limits on what that product may or may not be, as the actual automobile is dependent on advances in manufacturing, energy, retail, and even financing, all of which are open to change. The fact that the automobile genre will likely be around for a very long time only reinforces the idea of Apple wanting to become a long-term player in the space and see where software and hardware takes them. There is only so much that can be done by just shipping software to other automakers. Discounting future Apple products merely because they aren't like Apple's existing product line is not only short-sighted, but also lacking in intellectual honesty.
Apple's Car Project Compared to the "Apple Way"
From the few details we know about the project, there are some very apparent similarities between this car project and the "Apple way", or the process Apple has followed in the past to turn raw ideas into finished products.
The Apple pirate flag that flew outside the Bandley 3 building in 1983 and 1984 where the Mac team was located. The flag became a sign of rebellion, independence and original spirit.
As of late last week, I was not convinced Apple was going to do a full-fledged car because there was little evidence of a complete team in place with senior managers and high-level outside hires. Up to then we had only reports of sporadic hires and vague plans. We now know Apple has formed such an autonomous group of employees, some of which were poached from other Apple divisions, and set up in an separate location away from HQ, similar in nature to a start-up. This type of information supports the idea that Apple is not just working on minor products or random software initiatives. I now believe Apple is indeed interested in an Apple-designed car.
At Apple, ideas are grown from years of debate and collaboration. It is hard to write what Apple may or may not do in the automobile industry because Apple doesn't even know the answers yet. We are still looking at a 3-5 year horizon for this project. Ideas need to be discussed, tested, and at times thrown away in order to truly come up with a product worthy of receiving one of Apple's rare "yes" approvals. Having a team separated from everyone else and including various backgrounds and prior experiences makes this process that much more achievable. There is no cross effort to design a car in order to sell more of product A or B or to help boost sales in region A or B. This group's one and only task in to make a great product, with some of Apple's current products serving as merely ingredients, not beneficiaries.
Difficulties
Apple has traditionally entered industries that have been marked off as unattractive and difficult for new entrants. In this regard the automotive industry is a prime target for Apple.
Manufacturing. The capital intensive nature of the business leads to unproductively-long development cycles, while in the U.S., distribution has been hampered by outdated franchise laws designed in an era to prevent automakers from gaining too much power. However, Tesla's early success in electric vehicles stands out as evidence that we are indeed in a new era where technology is reducing barriers to entry for the automobile industry. It is no longer impossible for a start-up to design, manufacture, and sell an automobile.
Recently, however, even Tesla is coming to terms with reality that an immense level of capital is needed to build tens of thousands of electric vehicles. The old way of building cars is still rearing its ugly face. Apple could approach this situation by relying on a third-party to build the vehicle. Apple has the most sophisticated supply chain and manufacturing partners on earth, so adding a car to the mix is not an impossible feat. There are assemblers in Europe that manufacture cars for other companies, similar to Foxconn producing the iPhone. Even Foxconn is planning on making electric vehicles. In addition, senior Apple management, including CFO Luca Maestri, has extensive experience in automobile manufacturing. Simply put, Apple is already ahead of most other technology companies when it comes to knowing how to build cars.
Personalization. Automobiles are personal objects that are shaped by the cultures they provide transportation to, which makes uniformity in terms of design and distribution difficult. While America is rekindling its love for SUVs, other parts of the world crave smaller, more practical people movers. Finding the right balance, if that is even Apple's goal, would be a challenge.
Safety. Automobiles are powerful machines that involve moving people at high speeds which contain an element of bodily injury that previous Apple products have never before included.
Additional Headaches. Retail, shipping, and maintenance are other aspects of the automobile industry that often lead to headaches. To make a car, Apple would need to address all of these issues.
The primary question to ask in terms of these difficulties is if there is anything large enough to represent a valid reason for Apple not to go forward with its automobile ambitions. At the end of the day, most of these difficulties fall by the wayside.
Let's Speculate
Apple industrial designer Marc Newson and SVP of design Jony Ive would likely play a vital role in the design (both hardware and software) of an Apple Car. Photo courtesy (Vanity Fair).
If there is a place for speculation, Apple is focused on rethinking everything about an automobile, from doors, seats, steering wheel, dashboard, brakes, manufacturing, retail and financing. Recent hires beyond just CarPlay expertise support this theory, as well as Apple's design focus, outlined by The New Yorker profile of Jony Ive. While most ideas may die on the drawing board, others may run into problems in manufacturing. The point is the simple question of what is an automobile needs to be asked when thinking of Apple's plans for entering the automobile industry. Why are certain things being done today? Why is this particular feature, knob, or dial present in all cars? Why are cars not able to do this or that? These type of questions are likely being asked right now within Apple's car team, at some undisclosed location away from Apple HQ.
A new experience probably isn't possible in the automobile industry unless the topics of materials, manufacturing, and energy are addressed. More innovation would likely need to be done in parts of the product that a consumer will never see compared to the actual passenger compartments, matching much of Apple's history with previous products. Taking software and using it in terms of a car's safety, energy, and entertainment aspects may end up producing a much better experience for the driver and passengers.
Apple's entry into the phone market didn't include grandiose ideas such as a phone that defied gravity or was able to read minds, instead it was a phone that utilized a new user interface. People often underestimate how a few rather simple ideas, done correctly, can actually come together in such a way as to produce a completely innovative experience. I would think the same will apply to Apple and the automobile. A new user interface that allows the driver to interact with a completely re-thought automobile is Apple's likely focus. Of course, design will exist at nearly every corner and will be the glue that helps turn ideas into reality.
While there continues to be an ongoing debate whether autonomous vehicles will be a reality or not within the next 10-15 years, the much bigger focus should be that the automobile represents a device (albeit a big device) in our lives that in one way or another will be involved in society for a very long time. The auto industry is in a natural position for technology to play a much bigger role in going forward. Why let automakers with little to no technological experience continue to make suboptimal products?
Apple Ambition
The primary takeaway from all of this car news is that Apple has no intention in playing it safe or resting on its laurels. Even though Apple's current product lineup has plenty of room to grow, Apple isn't looking to coast on iPhone fumes, but rather tackle the next big issue. Much of the developed world has gotten use to what travel means in terms of automobiles. Apple is interested in rethinking travel. It is important to not simply hitch on to the idea of Apple selling a car, but also rethinking certain aspects of the automobile, including software, battery technology and robotics.
Apple's focus on other industries, including the home and health, also need to be rethought. While Apple management has said that they spend most of their time deciding which products to focus on, observers can no longer just consider small pocketable devices, but instead entire industries with a range of product sizes and usages.
The automobile's future is one filled with technology and Apple wants to be part of the game. Using a structure and mission statement created over the past 15 years, Apple is focused on creating a product worthy of an Apple logo. Only then will the real adventure begin as the automobile is still in the beginning stages of its long journey.
Apple's ambition knows no bounds.
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Three Month Update
Above Avalon has been in existence for three months. I provided an update as to how things were going after the first month, so I figured an update after the first quarter would be appropriate. The primary metric I've been tracking continues to be unique visitors, and I'm quite happy with where things are heading.
Posts: 68
Unique Visitors:
- Month 1: 16,528
- Month 2: 25,464
- Month 3: 25,324 (1,000/day normal run rate)
While there were 4-5 days that saw an unusually high amount of referral traffic from other sites, 65% of traffic is either direct or from Twitter. There have been a few other sources that have been helpful in spreading the word about the site on nearly a daily basis. Thank you.
Subscribers:
- Above Avalon Twitter: 1,110
- RSS: 2,253
- Podcast RSS: 3,686
I started to add video into the mix and am pleased with the results. I expect to publish more videos in the future. The AAPL Orchard daily email now has 1,400 subscribers and continues to exceed my expectations.
Top Ten Most Popular Above Avalon Posts:
- Selling Apple Watch
- Apple's $3 Billion Bet on Reinventing the Music Industry
- Apple Will Save $3 Billion in 2015 by Selling 16GB iPhone 6 and 6 Plus
- Apple's Plan for iPad in an iPhone World
- Jeff Williams: Apple CEO Material
- Jony Ive is the Most Powerful Person at Apple
- Apple Watch Isn't a Luxury Watch
- The Scott Forstall Mystery
- Apple Watch: A Superb Economic Moat Years in the Making
- Larger iPhones May Be a Game Changer
If you are reading this, chances are good that you contributed quite a bit to these results, so thank you. As I said during my first month update, a few retweets and link sharing make a difference. I continue to get email and messages from people who only discovered the site from hearing about it from a friend. My goal with Above Avalon is not only to understand how Apple looks at the world, but also to think differently about the world beyond Apple. My long-term goal is to have many of you join me in this journey, and so far things have exceeded my expectations. Thank you for your early support!
Neil
The Trick of Downplaying Hardware
"I don't really think that Apple was ever a hardware company, even at the beginning of time." -Tim Cook, February 2015
Tim Cook presented at the Goldman Sachs Technology and Internet Conference earlier this week to a crowd of Wall Street investors that have historically had trouble appropriately valuing hardware companies. Cook's comments on hardware/software piqued my interest. Cook reiterated that Apple has never been a hardware company but is instead all about the software. There is much more to the story with many implications on how the world sees Apple and where Apple's future lies. By putting the focus on software, Apple is purposely downplaying hardware.
Software plays a vital role in Apple's business, and there is little evidence to suggest otherwise. However, some of Tim Cook's comments would lead people to scratch their heads. For example, on one hand, Cook reiterates that it's all about the software, citing examples such as iTunes, iOS, OS X, and now services like Apple Pay. On the other hand, Cook is quick to say it's all about the experience of integrating hardware, software, and services, such as the iPod + iTunes juggernaut, iPhone, iPad, and soon Apple Watch. The two arguments don't quite mesh seamlessly as the latter requires well-designed hardware to produce the critical experience that Apple is focused on selling.
Apple is purposely downplaying hardware, which by incident is validation that hardware is a crucial piece to Apple's success. I've long felt that Jony Ive's design acumen and his creations ranging from iMac to iPod, iPhone, iPad, and now Apple Watch are responsible for where Apple is today. Why downplay hardware? They want to direct attention elsewhere.
Apple excels at producing hardware, and one can argue we are getting to the stage where Apple's supply chain is reaching such a point that competitors are simply unable to compete as Apple secures all available components and resources. By stressing software, Apple would be shifting the focus away from its hardware strength.
Another issue that I'm sure Apple is well aware of is that Wall Street and Silicon Valley simply don't understand hardware. There is a widely held view that all hardware becomes commoditized and as a result, companies with above average hardware margins and focus will see pain. GoPro, a 13-year old company now with a $6 billion market cap flew under the radar for years because of its reliance on hardware. Meanwhile, software enterprise start-ups are the envy of all. This is not to suggest that software is overrated, but that not all hardware is created equally, and it's when a single company begins to control the entire experience around that hardware that magic happens.
This dilemma leads to discussion of Apple's foray into different parts of our life including our home, health, car, and wallet, with platforms built on iOS. The situation magnificently encapsulates Apple's trick of downplaying hardware. While the focus is on software taking over our world, in reality, what is happening is the iPhone's value proposition is increasing. Software is increasing hardware's value. Of course, few will notice this and as a result hardware will continue to be underestimated, but Apple won't mind. It's not easy to downplay one's strengths, but Apple has excelled at it for years.
The Evolving Notification
Notifications play a crucial role in how we interact with technology. Just as gadgets evolve, notifications haven't remained static. As we enter the wearables era, the notification is about to undergo one of its more significant advancements in history. The Apple Watch will improve on the pager from the 1990s and position silent haptic feedback as a notification. The ability to send and receive messages via "taps" on the wrist will turn the modern notification into a communication medium. While the smartphone may have taken the notification and run a little too far with it in the wrong direction, the Apple Watch will likely put the notification on a new, more sustainable path.
Even though we now associate notifications with pop-ups on our phones and tablets, the idea of a notification has been part of our lives for a very long time. A notification is simply something that gives us information to compute. A few everyday examples have included:
1885: A steam train whistle (and smoke) alerting people of an approaching train.
1935: A raised mailbox flag indicating to the mail carrier that a letter needs to be picked up.
1975: An air siren to warn of a nearby tornado.
1995: A vibration and chime on a pager alerting the user to an incoming call.
2005: A chime alerting the user that a new AOL IM has been received on the desktop computer.
2010: A blinking light on a Blackberry indicating new email.
2015: A popup on a smartphone indicating Sam Smith won a Grammy.
2016: A double tap on the wrist from Apple Watch informing us that our significant other is leaving the store.
Taking a look at some of these notifications through the years, some of which are still common today, the smartphone's impact on notification evolution stands out. The smartphone era expanded the notification to include various types of data, including: breaking news, app updates and song recommendations. The ability to push text notifications have produced negative side effects as companies have flocked to notifications to get attention. Not only are we inundated with pop-ups, unless we manage our phone settings carefully, but even the idea of a proper notification has lost its meaning. The notification went from a useful source of information to mostly a marketing plow generating interest in apps.
Apple Watch has the potential to put the notification back on track. With the expectation that the device will be worn on the wrist for most of the day, an Apple Watch will not only add personalization and customization to notifications, but it will transform the way we think of notifications in mobile. Apple Watch will turn notifications into a new form of communication.
Notifications on Apple Watch will likely continue a few broader notification trends that have been evolving over time:
- Personalization. Wearable devices promote personalization in a much more effective way than smartphones. I would expect more notification filtering, reducing the number of notifications pushed to a wearable compared to a phone. It will be very hard for a news app to be able to push breaking news to Apple Watch in the same way popups are sent to a smart phone. Whereas we may not mind getting notified on our phone whenever someone messaged us on Twitter, we may want to only be notified when certain people contact us if notifications are pushed to Apple Watch.
- Customization. Having the ability to determine what kind of notification is desired (Short Look or Long Look) dependent on location or social setting (wrist raise or not) will become the norm.
I would expect the definition of a notification to once again include haptic feedback (vibration) with Apple Watch. In such an example, a simple tap on the watch face would produce a silent vibration on the recipient's wrist (assuming they are wearing Apple Watch). That tap, or a series of long and short taps, can both serve as a notification and message. In this context, the pager of the 1990s stood out. While a pager could have been worn on the waist to alert the user via vibration, the notification contained only so much information that would signal the importance of the message. The ability to communicate was still mostly one-sided. With Apple Watch, the notification can become a two-way communication medium, serving both as an indicator of an incoming message as well as the message itself. While much of this sounds similar to Morse code, one key difference is that Apple Watch users will be able to personalize the messaging, coming up with their own patterns and codes to communicate with a select group of family and friends.
Given my expectations on where notifications are headed, I have some doubts over wearable devices, such as smart rings and bracelets, that position notifications as simply an alert. If these devices are unable to provide ways to interact and respond directly to the notification, I have trouble seeing where value is created. Since most wearables require a phone, the primary reason someone would buy and wear a wearable is to remove the need to check their phone, not to serve as a reminder to check their phone.
Notifications play a vital role in our daily lives. While the smartphone may have taken the notification and run a little too far with it in the wrong direction, the Apple Watch will likely position the notification as a tool to utilize technology in a more personalized way.
I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.
Apple is Getting Paid to Raise Debt
Apple just raised $1.35 billion of Swiss-franc denominated debt in two tranches (0.28% and 0.74% implied yields), according to the WSJ. Apple is raising debt to fund its capital return program. In what can only be described as being at the right place at the right time, Apple is essentially getting paid to raise debt.
Apple may enter currency swaps to effectively convert Swiss Franc-denominated notes to U.S. dollar-denominated debt, which would increase the effective "cost" of the debt. Even taking this cost into consideration, Apple is in a position to earn a small profit by issuing debt. By raising debt, Apple is able to use borrowed cash to buy back AAPL shares, thereby saving on dividend expense. All else equal, and assuming an estimated $13 million after tax currency swap cost, Apple would make a profit of $1 million by raising $1 billion of debt at a 0.28% interest rate, as depicted in the table below.
Exhibit 1: How Apple Can Make a Profit by Raising Debt
Apple will have raised close to $40 billion after including today's debt issuance. It is important to recognize that the total amount of debt is spread out over various maturities ranging from 2 years to 30 years, depicted in Exhibit 2.
Exhibit 2: Apple's Long-Term Debt
By holding debt with a wide range of maturities, Apple isn't on the hook to repay the $40 billion at once. Instead, Apple will be able to use U.S. operating cash flow (or foreign cash in the event of U.S. corporate tax reform) to repay the debt as it comes due.
What is management's long-term strategy by raising debt?
- Use debt to fund share buyback for what management considers to be undervalued AAPL shares.
- Once AAPL shares are appropriately priced, slow the pace of buyback.
- With slower buyback, U.S. operating cash flow can be used to repay debt as it comes due.
- Repeat cycle with AAPL share valuation being the primary determining factor.
Management is utilizing proper capital allocation practices to not only take advantage of what they consider to be undervalued AAPL shares, but deal with excess cash weighing on Apple's cost of capital. Since $158 billion of foreign cash can not be used for share buyback or dividends, management is raising inexpensive debt as a substitute. Market observers look at this as a sign that management is confident in Apple's future and that the company won't likely require $100+ billion of cash for organic growth opportunities.
There will be a day when raising debt isn't in Apple's (and shareholders') best interest, but that day isn't today.
This report was produced by Neil Cybart on February 10, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.
Thoughts on Apple's Employee Retention "Problem"
Bloomberg published a story late last week on how Tesla has been hiring Apple talent over the past few years and now has more than 150 former Apple employees on payroll. Anyone who has been tracking Tesla would be familiar with this issue considering that several current (and former) Tesla executives were former Apple employees. I think this issue says more about Tesla than it does Apple. Tesla CEO Elon Musk is a charismatic leader with a clear vision on rethinking the automobile and energy industries. Who wouldn't want to be part of that type of project?
The primary issue with roping Apple into this discussion and analyzing the company with a negative tone is that by doing so, one is comparing Apple's strategy and product roadmap to Tesla. The assumption is if 150 employees were willing to leave Apple to work at Tesla, then that must mean Apple was unable to retain talent with exciting ideas and projects. I disagree.
As we have seen over the years at Apple, there should be no expectation that talent responsible for bringing a collection of raw ideas into a finished product, such as the iPod or iPhone, will stay around until the next big thing is developed. Many people on these teams held positions and responsibilities focused on specific tasks. Instead of being shifted into another role these employees may join other companies that have their own "iPhone-like" project under development. When I hear that an Apple employee left for another company, I often look at it as a positive for the company they are joining, not necessarily a negative for Apple.
The Apple employee retention debate boils down to two questions:
Does Apple have an employee retention problem? I spent the past few days rethinking the question and concluded it may just be too loaded to answer completely. Apple's structure necessitates the need to continuously hire outside talent since Apple's mission is focused on coming up with new products. It is not reasonable to think that Apple's current employee base and skill set can fully realize Apple's mission without looking outside for help. Accordingly, the much more important question may be does Apple have an employee acquisition problem?
Apple is a somewhat routine acquirer, often hiring teams of people, or at the minimum acquiring technology, and Apple is constantly searching for new people to fill talent holes. Some of Apple's recent high-profile hires include:
- Luca Maestri (CFO)
- Angela Ahrendts (SVP Retail)
- Kevin Lynch (VP Technology)
- Dr. Michael O'Reilly (VP Medical Technology)
- Paul Deneve (VP Special Projects)
- Ravi Narasimhan (R&D)
- Dr. Roy Raymann (R&D)
- Marc Newson (Industrial Design)
As seen with some of Apple's very high profile executive hires, does Apple have an employee acquisition problem? Will most of these employees stay for the rest of their careers? Is that now a retention problem for Apple? I'm sure if Apple management had its way, some of the former Apple employees currently working at Tesla would still be at Apple. The Bloomberg piece mentioned that Apple had increased financial incentives to entice Tesla employees to join Apple. I wouldn't want to be so naive as to assume Apple management is able to retain everyone they want, but I just don't see employee retention as one of Apple's pressing issues given the company's product-centric model focused on new products in new disciplines.
Is employee retention a risk factor for Apple? Yes. Employee retention is a risk factor for any company. The mistake that I see many people make is equating "risk" with "problem." Just because something is a risk factor, there is no claim being made that it is currently a problem. In addition, employee acquisition is just as big of a risk factor for Apple, if not bigger, than employee retention.
The primary pushback I have received on this subject is that Apple's success is not dependent on high level executive hires but software engineers, and recent "issues" with Apple software and services is a sign that Apple is indeed having issues retaining this talent. It is no secret that Apple is lacking in resources, with engineering talent being one example, but there is simply not enough evidence to suggest that employee retention is the culprit of recent software "issues." Rather, Apple's focus on acquiring the next marginal customer and the corresponding pressure to ship new and exciting software features at a increasingly fast pace has produced tradeoffs with software quality taking the brunt of the fallout. I'm not convinced that having more chefs in the kitchen would necessary change the outcome.
Ultimately, a properly functioning Apple organizational structure and business model will appeal to the best and the brightest. Judging from some of Apple's recent hires, this is still the case. Once Apple ships a product and resources shift to the next big thing, a certain level of turnover should be expected within Apple ranks as materials and resources are reallocated. Finding the people needed to turn ideas into reality is Apple's biggest risk factor. Apple is expanding into new areas in which company resources had historically been underemphasized such as health, wearables, and content discovery and curation. Apple has made progress in terms of employee acquisition and retention in these areas. Given Tesla's success at appealing to those Apple employees with a desire to work on automobiles and energy projects, this issue will become much more interesting when it's time for Apple to see if there is anything they can add to the transportation and energy industries. When that time comes, the quality and excitement of the potential plans and projects will dictate how successful Apple will be with employee retention and acquisition.
Apple's New Music Strategy
Music is an awkward subject for Apple. Music streaming represents one of the rare instances of Apple losing control of one of its product's life cycle (iTunes and the move from paid downloads to streaming). In some ways, this should not be considered too big of a deal since the music business is a fraction of its former self as the product has seemingly been commoditized. In reality, it is more complicated, as Apple's future product aspirations remain aligned with content, just not in a way that most people think. Music streaming and piracy will force Apple to reluctantly pivot its music strategy. While one can harp on the fact that Apple is incredibly late to the game, there are signs that Apple has already settled on a new music strategy: curation and discoverability.
Music was the lifeline that Apple was desperately searching for in the early 2000s. Positioning a breakthrough user interface as the primary selling point, iPod and iTunes revolutionized what it meant to buy and consume music. Today, music is different. I asked a simple question on Twitter earlier this week: Where do you get your music? The answer wasn't simple: iTunes, iTunes Radio, Beats, Spotify, Bandcamp, Google Play, Amazon, Pandora, CDs, Kickstarter/PledgeMusic, Deezer, Emusic, Spinrilla, YouTube, Bleep, Boomkat, Soundcloud, Rdio, eBay, blogs, Sirius XM.
At first glance, such a situation would seem pretty bleak for Apple as music consumption is no longer tied to using iTunes. In reality, there is still a way for Apple to regain a standing with music and it involves taking a page from the iPod/iTunes playbook: software. Differentiation in music still exists through curation and discoverability, although it remains obscure and clunky. Faint elements of social can be found throughout the entire process. Ask someone why they choose Soundcloud over Spotify or iTunes and you will get an answer. While it is debatable whether that answer is easy to replicate, the point is there is an answer. People still consider there to be some level of uniqueness in terms of how they discover music. Apple's goal is to position Beats as the answer to music's software problem. Mark Gurman over at 9to5Mac reported earlier this week that Apple's plans for Beats includes an interface redesign that sits on top of Beats existing technologies and content, while reintroducing some social elements into the service.
Apple can use software to develop a music platform where curation and discoverability guide the experience; something that was always an afterthought in iTunes. Apple's entry into paid streaming may be the start of a long journey leading to artist sustainability beyond music sales, which I discussed a few months ago in my longer-term view of the music industry. While a few companies have determined that the value is in producing and owning content (music, video), Apple's success with selling devices used to consume content changes the equation. Apple is able to create more value as a gatekeeper between an overwhelming amount of content and the end user. The company owning or distributing (cable/internet providers) the product is unable to fully embrace curation due to the inherent conflict with its business model. Add in the requirement of still needing hardware to enjoy content, and a long-term content/hardware strategy is born.
There are still some questions that need to be answered. If I'm positioning the software behind the content as the value proposition, how does Apple benefit if the end product is available on competing platforms? One way would be to embrace the idea that a service available to 100s of millions of additional users on Android can be used as a way to not only guarantee proper levels of music industry support, but also market a vibrant iOS ecosystem. I have a choice: use Beats music streaming on my Android phone, or enjoy Beats music streaming in my iOS ecosystem (iPhone, Apple Watch, Mac, Apple TV). Having iTunes on Windows helped sell iPods, with a delayed benefit to Mac sales. What if a Beats app on Android helps sell the music service itself (since critical mass is important for discoverability), with iOS devices receiving the delayed benefit?
Apple isn't taking an easy path when it comes to rethinking music as some of their actions have been somewhat forced upon them by outside factors. Nevertheless, Apple remains in an interesting position to utilize their software and hardware solutions in order to remove friction from the equation. Curation and discoverability represent Apple's best shot in music.
Apple Watch: A Superb Economic Moat Years in the Making
One of the more intriguing subjects that continues to puzzle me is Apple Watch competition. I struggle coming up with companies, or even industries, that are in a position to ship a credible threat to Apple Watch. While several companies have indicated interest in entering the space, I have doubt these players know where that space is even located. Apple has been building one of the company's largest economic moats in years with Apple Watch, a device with competitive advantages created from wrapping hardware, software, apps, and services into experiences. Apple claims the Apple Watch is only the beginning, while competitors aren't even sure what is about to begin.
Repeat of the iPad?
When Apple introduced the iPad in 2010, it took the competition a number of years to even figure out what made the iPad so "magical"; the experience from using a device where software and hardware combine to make the hardware melt away. I suspect a similar situation may occur with Apple Watch, only this time the economic moat surrounding the device may be a lot wider and deeper than it ever was with iPad.
Apple Watch Competition Sources
Luxury Watch Industry. Since Apple Watch will be worn on the wrist and Apple has stressed the device's luxury and fashion tendencies, it is natural to look towards the luxury watch industry for some kind of response to Apple Watch. Soon after the device was unveiled, the attitude towards Apple Watch was one of laughter and mockery. In recent weeks, several watch manufacturers have announced plans to ship their own smartwatch, competing against a device they had brushed off only a few months prior. The primary issue with expecting much of a competitive threat from a company like Swatch or TAG Heuer is that the value proposition of a luxury watch is different than that of Apple Watch. Luxury watches rely on craftsmanship and timelessness because their utility proposition was replaced years ago by phones. With the Apple Watch returning utility to the wrist, craftsmanship shifts to include hardware and software, while timeliness melts away. When a company's primary selling point is shipping a watch that can last forever, it will be hard to compete with a luxury device that positions time-keeping as merely a feature and is intended to be replaced every few years. Ultra-luxury watch manufacturers? I doubt they will even attempt to compete with a $349 gadget for the wrist that can be worn while working out. A $10,000 Marc Newson Apple Watch collection may be another story.
Technology Industry. If utility is returning to the wrist, technology companies would surely be in a position to come up with hardware devices controlled by software. We already see various smartwatch options being shipped today, although none have the right ingredients to truly stand out. Adding the requirement of having to wear the device adds a layer of complexity that I doubt most in Silicon Valley grasp. Fashion and design will matter more than a wearable's technological capabilities. Having a device on one's body extends that user's personality and emotion to something that will be on public display. The negative public reaction thrown at Google Glass serves as a prime example of technology lacking industrial design elements. Even then, designing a good product isn't enough. Fitbit and Jawbone bought in top designers to create their wearables, yet the devices haven't found success beyond niche markets as many question their utility and performance.
Fashion Industry. With a clear understanding of how fashion develops and morphs over time, those involved in the process of turning fabric and material into expression would be in a position to capitalize on the ability to appeal to a user's comfort level with wearables. However, the addition of technology into the discussion means that outside resources will need to be brought in to compete against Apple Watch.
Fitness Industry. The fitness industry had been one of the leading purveyors of the wearable industry. Nike exited the space in 2014, most likely in recognition of moving beyond a core competency and spending resources on not only the wrong bets, but at the wrong casino. The primary problem facing fitness companies and wearables is that fitness is niche. Appealing to fitness tracking limits the use case even further. The triathlon industry is well served by wearable gadgets from Timex and Garmin (among others), but with an addressable market numbering less than a few million, the numbers just aren't there for broader applications. Instead of pushing the idea of fitness, Apple will focus on health, a much boarder application that, in theory, applies to everyone. The biggest roadblock with health monitoring is that the concept indirectly advocates for behavioral change, including diets, routines, habits and schedules.
Entertainment Industry. Since today's culture seems to elevate celebrities and stardom, I wouldn't be surprised if there are a few attempts in Hollywood to monetize millions of Instagram followers into merchandising opportunities dealing with wearable devices that have to do more with what it says about the user than actual utility. Of course, lack of longevity would be a risk, but at that point, I doubt it would be a concern for those shipping such a product.
Other. There is always a possibility that single use-case devices could gain a solid footing, such as is the case with Disney's MagicBand, or a health-focused wrist band subsidized by insurance companies, threatening multifunctional devices like Apple Watch. Such specialized devices will not focus on the technology, design, or even utility, but rather some kind of limited, but intriguing experience. I would classify this type of idea as the true wildcard.
Partnerships and Acquisitions
The most likely source of Apple Watch competition will initially come from partnerships between the luxury watch industry and technology companies. TAG Heuer has already hinted at combining forces with a Silicon Valley firm, and it is not too much of a stretch to think of a scenario where technology companies partner with fashion houses in order to understand how to sell a wearable. Partnerships haven't exactly had the best outcomes in the past and I wouldn't expect anything to change in wearables. Partnerships are formed with the stated goal of joining forces, bringing together resources from two (or more) organizations. However, in that process of combining ideas, differing business models and organizational structures add complexity and friction that turn two companies working together to make an amazing product into two companies becoming desperate, cutting corners and making mistakes in order to stay relevant.
M&A within the current smartwatch industry is also possible as a near-term solution to appease shareholders and board of directors. Considering the deep pockets of large cap tech relative to many possible target valuations, these acquisitions would be sold as low risk/high reward, similar to how every other tech acquisition is marketed.
Apple Watch Competitive Advantages
The Apple Watch embodies Apple's philosophy of combining multiple disciplines (technology, health, arts, payments) into one experience. Competitive advantages include:
1) Engaged iPhone User Base. Apple Watch is dependent on iPhone for a few reasons, including being able to send computing requirements to a much bigger battery. Having an engaged base of more than 400 million users (most using the latest software) is an advantage Apple holds that currently no other company can match.
2) Technology. By relying on customized components, such as the Apple S1 chip, Apple will force competitors to cut corners with less attractive alternatives where the end goal is to have as few compromises as possible.
3) Efficient Supply Chain. Apple has built a supply chain that is capable of producing nearly 100 million iOS devices in a quarter. The ability to efficiently scale production of not only Apple Watch 1.0, but updates and new versions in subsequent years, is an asset that can not emphasized. Apple's ability to control various component supply, such as sapphire watch faces, could also pose a problem to competing products.
4) Vibrant Developer Ecosystem. As seen with iPhone and iPad success, developer support is crucial for ushering in personal technology with Apple Watch. While the current level of developer functionality found in WatchKit may be underwhelming to some, developer interest in the device exists with many wanting to try the device before thinking of ways to expand iOS apps to Apple Watch.
5) Apple Retail Stores. Apple's 447 retail stores provide a great opportunity for consumers to try Apple Watch in a setting managed by Apple. While 447 points of sale will pale in comparsion to the eventual network of retailers that will sell Apple Watch, the Apple retail stores serve as a starting point to get millions of Apple Watches out in the wild. The best form of marketing will be word-of-mouth and simply noticing the device being used by early adopters.
Missing Pieces
One theme when discussing possible Apple Watch competitors is that there are very few entities that hold all of the pieces needed to ship a viable product. For companies focused on luxury design, the technology aspect of the device makes it difficult to do much besides partnering with others. Technology companies likely lack the design talent to turn components into something consumers will want to be seen wearing. Apple Watch's dependency on a phone can also not be understated as any competing device won't have the same vibrant ecosystem to build on, which I suspect is an issue many in the watch industry don't quite fully comprehend.
Years in the Making
Apple has spent the past four years creating a device that deserves to take up the few square inches of wrist real estate where proper line of sight and touch accessibility can help usher in a new era of personal technology. I suspect it will take a few years for other companies to even think of the Apple Watch in this way, let alone be in a position to ship a competing product. Companies will monitor how the Apple Watch sells out of the gate to see if the device is worth responding to, only delaying attempts at competing. The Apple Watch relies not only on the latest and greatest smartphones, but design and fashion concepts that are expensive to copy and master. Being able to put all of these pieces together into a marketable product makes it clear that Apple has built quite an economic moat with Apple Watch, and the iOS ecosystem stands to be the primary beneficiary.
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Logic Behind Apple Raising Debt Despite Holding $178 Billion of Cash
Apple raised another $6.5 billion of debt this week, bringing total debt raised to $39 billion. Why is Apple issuing debt despite holding $178 billion of cash? With approximately 89% ($158 billion) of Apple's cash held by foreign subsidiaries, management is relying on free cash flow and debt to fund share repurchases and quarterly cash dividends. Given the low interest rate environment, management is improving Apple's overall cost of capital by borrowing money for less than 1.5% (after-tax cost) in order to repurchase AAPL shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% free cash flow yield.
Current Capital Return Program
Last April, management increased the share buyback program to $90 billion from $60 billion. Along with the quarterly cash dividend, the total capital return program totaled $130 billion. Apple currently has $17 billion of share buyback authorization remaining and will undoubtedly increase the program in April, as well as raise the quarterly dividend.
Available Cash for Capital Return Program
Apple had $20 billion of cash available for capital management activities and U.S. investment needs at the end of 1Q15. After Monday's debt issuance, Apple now has more than $27 billion of cash in the U.S. If management were to use the $158 billion of cash located offshore for share buyback or dividends, Apple would be liable to pay 35% U.S. income tax on the repatriated funds. Considering that Apple is able to issue debt at a 2-3% yield with a tax break related to interest expense, it is easy to see that paying 35% tax on offshore cash is not in Apple's best interests. While there are financial techniques that allow Apple to "use" funds located in offshore subsidiaries for U.S. business purposes, the intricacies of such arrangements are for another post.
Due to Apple's global operations, approximately 40% of total free cash flow is available for capital management and routine cash needs in the U.S. If Apple were to pin its share buyback to just U.S. free cash flow, Apple's overall cash total would grow to hundreds of billions of dollars and investors may start to discount the cash (one of the primary reasons for the buyback). Instead, Apple has set a buyback pace that exceeds annual U.S. free cash flow, requiring management to raise debt (both short-term and long-term, as well as commercial paper, which is very short-term debt) to supplement free cash flow.
Apple's 1Q15 Cash Flow
A look at Apple's 1Q15 10-Q helps frame the math behind Apple issuing debt to fund share repurchases. For the three months ending December 27, 2014, Apple reported operating cash flow of $34 billion, which reflects net income and then all of the other non-cash line items that flowed through the income statement, but had no impact on cash. In terms of capital expenditures, Apple spent $3 billion on property, plant and equipment. This can be a range of items and for this exercise it really isn't that important. Subtracting the $3.2 billion from $33.7 billion, would give free cash flow (FCF) of $31 billion. A few weeks ago, I recorded a brief tutorial on free cash flow, which is a better representation of a company's underlying financial health than earnings. Keep in mind, this $30.5 billion of FCF is for the entire company. A few other calculations would suggest that approximately 40% of FCF, or $12 billion, is available in the U.S.
Moving down the cash flow statement to cash flow from financing, Apple spent $3 billion on dividends and $5 billion on share buyback in 1Q15. Proceeds from debt (the Euro denominated debt) totaled a little more than $3 billion, while Apple repaid $2 billion of commercial paper, leaving $1 billion of net debt issued. Subtracting the issued debt from dividends and share buyback cash flows leads to cash flow from financing of $7 billion, which means Apple used $7 billion of cash to cover share buybacks and dividends last quarter. Since U.S. FCF was $12 billion, Apple had enough to not only cover its capital return program, but also add to cash levels.
While Apple had enough FCF to satsify its capital management initiatives last quarter, Apple's holiday quarter is historically the largest quarter from a revenue and profit viewpoint with declining cash flow levels for the rest of the fiscal year. In addition, Apple's capital management pace is much more robust than $5 to 7 billion a quarter. Apple's accelerated share repurchase program meant that Apple prepaid $9 billion in 4Q14 for shares repurchased in 1Q15. Going forward, Apple is more likely to be on a $10-$12 billion quarterly pace for share buyback and dividends, which would require additional debt issuance.
Math Behind Issuing Debt to Fund Share Buyback
Running with a hypothetical example using the $6.5 billion of debt issued this week, as seen in Exhibit 1, Apple could take the additional capital, buy back 54 million shares, save on dividend expense, and essentially end up paying a net of $46 million per annum to borrow $6.5 billion.
Exhibit 1: Hypothetical Apple Scenario for Issuing Debt to Fund Share Buyback
Apple's $39 billion of long-term debt has a 2.0% average effective interest rate. Taking into account that interest payments are tax deductible, Apple is effectively paying 1.3% per annum to borrow cash. With shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% FCF yield, taking excess capital to buy back stock is a cost effective way of improving Apple's cost of capital. I wouldn't expect any significant change to this strategy in the near-term as long as interest rates stay low and Apple's business prospects look promising.
Apple Doesn't Sell Phones
In the eight years since Apple introduced the iPhone, traditional business and industry analysis has failed miserably at predicting Apple's approach to technology. Ben Thompson, writing at Stratechery, articulated three reasons why tech observers misunderstand Apple. I think the heart of the issue was briefly touched upon by his third point dealing with Apple's stated goal of making great products. Apple has actually been playing a completely different game than everyone else for years. Apple has been successful at building iPhone momentum in the face of what seems to be insurmountable obstacles because Apple doesn't sell phones, but rather experiences. The best selling experience is called iPhone.
Apple is a company built in such a way as to be a product-driven organization. When trying to define Apple's products, a somewhat savvy observer would answer: hardware, software, apps and services. In reality, Apple is selling much more than tangibles. The combination of those elements into one device creates emotion. Apple's primary products are experiences. From videotaping themselves unboxing new Apple products to vividly recalling the day they bought their first iPhone at an Apple store, people crave experiences, and Apple has been focused on selling such a product for years.
An iPhone represents something different to each of the 400 million current users. For some, it is a remarkable symbol of design, while for others it embodies hard work and accomplishment. It may also just be a device used to take pictures and send Snaps on Snapchat. Regardless of what the device represents, the experience of using an iPhone on a daily basis for years creates a bond. It is that bond that Apple is focused on nurturing and maintaining over time. A bond that is so strong that 9 out of 10 iPhone buyers decide to buy another iPhone. A look at other companies selling handsets would show a completely different paradigm. Samsung is so removed from the consumer, management wasn't even aware that people weren't buying the latest flagship Galaxy phone until the mobile carriers complained of unsold inventory.
Once the iPhone is thought of as an experience and not a phone, the mobile industry begins to look very different, and much of the mystery surrounding Apple's decisions fade away.
Competition. Apple's biggest competitor in the phone industry is the previous year's iPhone. The implications of this are significant, helping to frame why Apple never seems to follow industry protocol or respond directly to competitors. As an Apple competitor, this strategy is hard to counter because Apple is always one step ahead, as shown with Samsung's current lack of direction in mobile.
Two other examples of this strategy were Apple's AuthenTec acquisition and the decision to hold off on large screen iPhones. Apple turned fingerprint scanning from a gimmick feature into an enjoyable experience and competitors have so far been unable to find an answer. Meanwhile, Apple SVP of design Jony Ive's decision to hold off on larger screens for the iPhone was Apple's attempt at getting it right, instead of being first. Apple had plenty of experience with larger screens since the iPhone was born from the concept that eventually became the iPad. Jony Ive waited in order to make sure the experience was just right. Judging by Samsung's recent struggles, being the first to market a feature or idea, such as large screens, doesn't guarantee success.
Since the previous iPhone represents the competition to beat, Apple doesn't get distracted by features on competing phones that amount to little more than smoke and mirrors, as seen with most of Samsung's features, and pretty much the entire Amazon Fire Phone feature list.
Addressable Market. Following Apple's record 193 million iPhones sold in 2014, it would be easy to rely on smartphone shipment data to figure out iPhone's remaining addressable market in the premium Android space. In reality, that strategy is prone to error as it fails to describe how Apple views the landscape. Apple wants to sell experiences to as many people as possible. Take a look at Apple's renewed product strategy and it's clear that Apple isn't content on just selling these experiences to a certain segment of the population. Apple comes up with new products with the goal of appealing to all consumers, not specific tiers or layers of a market.
Price. Many consumers face price obstacles when wanting to buy an Apple experience. However, Apple has shown that roadblocks are meant to be overcome. Apple doesn't look at low prices as motivation to come up with an inferior experience, instead Apple positions the ultimate iPhone experience as an aspirational goal, while reducing the cost of older iPhones (which at their time were the best experiences on the market). By reducing older iPhone prices, Apple is able to accomplish the goal of selling a great experience at a lower cost, while keeping a different, newer experience as something to desire. Apple has also shown the ability to address price in different ways other than just selling older experiences at a lower price. Apple's iPad mini continues to sell relatively well, with very strong satisfaction rates, and has proved to be quite an attractive proposition for those who want to experience iOS for much less than the cost of an iPhone.
Apple Retail. In the context of selling experiences, Apple's retail plans take on a much more strategic importance and is the primary reason why I look at the retail stores as a key competitive advantage for Apple. A look at Apple's current retail push into China would suggest that management is focused on selling the iPhone experience, not just a merely a phone. Many people go to flagship Apple stores, which some have described as museums, just to visit and take in the environment, a rather remarkable feat when other retailers struggle to even get attention.
Apple knows what kind of experiences it wants to sell years ahead of time. Features, components, and designs included in Apple's current product lineup are often included as groundwork for what is to come. By recognizing that Apple's primary products are experiences, management's strategy in terms of pricing, marketing, and product direction begin to make more sense. Of course, selling experiences is much harder than selling hardware gadgets or software. Even Apple has failed to deliver a great experience from time to time. The key is to do less and concentrate all available resources on building few, but very meaningful, experiences. As long as Apple doesn't just sell a phone, the iPhone will see continued success.