Apple Car Development is Advancing - Above Avalon Premium Week in Review
Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on July 21st.
Apple Car Development is Advancing
The Apple Car development project appears to be on track. The WSJ is out with a new report indicating Apple continues to hire auto-related executives and researchers. The latest are Doug Betts, one of the highest auto executives confirmed to now work at Apple, and Paul Furgale, a researcher involved in autonomous vehicles, mapping, and robotics.
Since the Apple Car project remains unconfirmed, the primary evidence we have to judge the project's progression (or lack thereof) is hires and fires that are likely related to Apple's efforts with automobiles.
Here is the WSJ:
"Mr. Betts could be the first major automotive executive to join Apple with experience leveled more at the manufacturing side of the business.
For nearly two decades, he has worked in product quality and manufacturing at an auto company, first as a general manager at Toyota Motor Corp. and later as a vice president at Nissan Motor Co. and Chrysler Group LLC, now FCA US LLC.
In 2009, when Fiat SpA took over Chrysler, CEO Sergio Marchionne tapped Mr. Betts to lead the company's quality turnaround, giving him far-reaching authority over the company's brands and even the final say on key production launches.
Mr. Betts abruptly left Fiat Chrysler last year to pursue other interests. The move came less than a day after the car marker's brands ranked poorly in an influential reliability study."
The WSJ is being pretty kind here in describing Betts' departure. Most industry watchers think Betts was fired this past November due to Fiat, Jeep, Ram, and Dodge taking the bottom four slots on the influential Consumer Reports reliability survey, with the Chrysler brand not far behind.
Obviously, news of Betts being fired due to poor quality performance wouldn't seem to sit right with this latest news from the WSJ that Apple hired him. What is going on?
Industry watchers say Betts was likely used as a scapegoat as the quality problems facing Fiat due to acquiring Chrysler were simply insurmountable and indicative of much bigger company and culture issues, things that one person would not be able to solve on their own. The Daily Kanban, a site dedicated to covering news and analysis from the auto industry, with a focus on Toyota, summed up Chrysler's problems well:
"Chrysler's quality problems seem to be coming from nearly every possible corner. In just a few of the most recent issues to hit the media, FCA [Fiat Chrysler Automobiles] has shown it has problems with everything from a lack of development testing (vibration leading to cracks in Ram Ecodiesel exhaust coupling), to assembly problems (Hellcat fuel leaks). Supplier problems have also featured heavily in FCA's quality snafus, most recently in a recall of Chrysler 200 transmissions due to 'inconsistent assembly procedures at a supplier's plant,' even as [FCA CEO] Marchionne has targeted supplier profits. But perhaps most troubling is the evidence that FCA simply isn't able to catch quality problems before cars go out to customers...
[A] fired executive scapegoat and a snarky [YouTube] ad were deemed a solution to a long-term quality problem. Little wonder Chrysler still finds itself at the bottom of Consumer Reports recommendations."
When you take a step back, Betts' hire at Apple makes much more sense. Betts is a senior level auto executive with stints across a number of companies, including time as head of product quality and supply chain for the Tundra, Sequoia, and Sienna at Toyota in Indiana, where manufacturing techniques are still the envy of the auto industry. This may just be coincidence, but all three of those Toyota vehicles are either SUVs or trucks, and Apple's car project was rumored to include a larger, minivan-type vehicle. Even though he was not able to turn around FCA's fortunes, it is very well possible that Apple sees value in applying his skills and experience to their current project.
One other aspect of Betts that many may not catch is that he has previous experience as Head of Total Customer Satisfaction for Americas at Nissan, which in car lingo means controlling the experience a customer has with a car brand, including everything from how a car is built, to it being bought at a dealer. Betts was overlooking the Nissan experience. Now recall how Apple is all about selling experiences. It sure does seem to fit in my mind.
On his LinkedIn [update: his profile has been deleted], Betts is likely using misdirection, simply saying he is working in Operations at Apple, similar to how former Mercedes R&D head, Johann Jungwirth, lists his job duty at Apple as Director of Mac Systems Engineering.
Betts would seem to be a senior-level hire for the Apple Car group, overseeing an entire team or division within the larger initiative led by Steve Zadesky. It is this type of structure that makes me much more bullish of a full-fledged product under development.
The WSJ has more on Apple apparently hiring Paul Furgale:
"Earlier this year, Apple hired Paul Furgale a well-regarded autonomous vehicle researcher in Switzerland, and has begun recruiting other robotics and machine vision experts to work on a confidential project."
Just to give you a few examples of the type of research Furgale was previously involved in as late as last year, here is a sampling of the publications listing Furgale as a co-author:
- Keyframe-based Visual-Inertial Odometry Using Nonlinear Optimization
- Lighting-Invariant Adaptive Route Following Using Iterative Closest Point Matching
- Infrastructure-Based Calibration of a Multi-Camera Rig
- Self-supervised Calibration for Robotic Systems
Here's more from the WSJ:
"Mr. Furgale had been deputy director of the Autonomous Systems Lab at the Swiss Federal Institute of Technology, or ETH. Mr. Furgale previously had led a European Commission project called V-Charge that sought to develop self-parking vehicle technology...
Mr. Furgale has begun recruiting students and researchers to work with him. Apple has hired a graduate student studying at the University of Michigan and has quietly recruited others."
Two points that I get from this news: 1) Compare Betts to Furgale. While one is a senior-level auto manager, the other is knee-deep in technology and research. Apple is hiring a mix of talent from both the legacy auto industry, as well as academia. 2) I look at the earlier reports back in February saying that Apple wasn't researching autonomous vehicles as a head fake, or misdirection. Evidence suggests they are. Of course, we need to take a few steps to get from Point A to Point B, including semi-autonomous features like better parking and highway travel, but like with any product, I suspect Apple is looking farther in the future, at a world where autonomous vehicles are much more likely to control the road.
Betts and Furgale are both interesting auto-related hires that further strengthen the theory that Apple's ambitions in the automobile industry have no bounds.
Along with the preceding story, the full list of stories sent to Above Avalon members last week included:
- Apple Earnings Summary - Big Picture, Stock Price Reaction, iPhone: Relatively Quiet (Which is Good), Apple Watch: It's Very Early and Things Look Okay, iPad Sales Growth: Fact vs. Theory, Share Buyback: It's Slowing, Additional Earnings Call Notes
- The Day After Apple Earnings on Wall Street
- The Wild Ride on Wall Street
- Judging Apple Watch Success/Failure
- Beme and the iPhone Ecosystem
- Apple Music - A Few Thoughts Three Weeks In
- Washington Looking at Foreign Cash Tax Reform
- Thursday Q&A
Become a member to receive these stories, including my full AAPL 3Q15 earnings recap (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.
Flops, Winners, and Outliers
When is a product a flop? What does a winner look like in consumer technology? How can outliers complicate our thought process? The Apple Watch is getting us to ask all of these questions while failing to provide the instantaneous answers that we crave. Not only has Apple's recent success led market observers to put value in short-term thinking and cynicism, but we have lost all context for how to properly measure product success and failure. It is clear that instead of thinking of flops, winners, and outliers as meaning the same thing across products and companies, context and discernment are needed to properly assess reality.
Flops
Apple has single-handedly morphed the definition of a flop. What once referred to products that were never able to make a lasting impression in consumers' minds (e.g. HP TouchPad, Blackberry Playbook) has now expanded to include product sales that are less than the best selling Apple products of all-time. Some of this aggressiveness to slap the flop label on new products so quickly comes from the proliferation of products not ready for prime time. It remains a mystery why the Amazon Fire Phone ever saw the light of day. Similarly, tech companies positioning their R&D efforts into the public sphere with products like Google Glass have gotten us trained to look for and expect instant flops: products that are never able to find a niche due to a plethora of reasons. Flops aren't just kept for hardware products as a number of Facebook apps, such as Poke and Camera, never were able to find an audience before being thrown aside.
Set in this somewhat confusing environment is Apple, a company that has relied on a strategy of placing very few hardware bets in order to focus attention and resources on a handful of products. In some ways, this rare and unique strategy, which other companies look down upon as being too risky for their own taste, would seem to necessitate a different kind of analysis when it comes to flops. Consensus opinion has landed on the stance that if Apple gave the green light to a new product, that must mean Apple expects it sell in numbers like an iPhone and iPad; anything short of this threshold should earn the flop label.
The primary problem with that thinking, and flops in general, are that they require context, both in terms of setting and timing. There is simply too much diversion in company resources and strategy to use the same flop brush across products, not to mention companies. Even though Apple releases very few products, not everything that comes out Apple HQ is positioned to reach tens of millions of users. Going further, certain models or SKUs may be geared toward a very specific niche that doesn't add up to more than 100,000 customers (think: Mac Pro). This introduces confusion and complexity into what is a flop.
Winners
There is still much disagreement over how to quantify winners in consumer technology. Is market share leader the title one should strive for? In the phone industry, the feature phone master, Symbian, was cast aside in a few short years. Blackberry's early smartphone power was decimated within roughly the same time span. While some may point to profit market share as the more suitable choice for determining success, Apple's monopoly on profits in markets that it plays in doesn't sit well with some people. How about year-over-year growth being used as a litmus test for success? There was a time when Microsoft being able to grow its smartphone market share from one to two percent was classified as a resounding success.
Similar to how flops require context for proper judgement, a product's success is also relative. For a smaller company like GoPro or Fitbit, if the latest camera or fitness wearable registered one million unit sales in a quarter, Wall Street may reward the company with accolades and rating upgrades. For Apple, the same sales rate for a more mature product would be a disappointment, and surely earn a flop badge. There is nothing inherently wrong with this differing rating system and one could argue that is exactly how it should work. The problem with that line of thinking is that success for a company like Apple begins to take on mythical proportions. Everything to come out of the design labs would inevitably be compared to iPhone, a product that Apple is on track to sell 250 million units per year.
How should a winner be defined? Ultimately, the easiest and most universal definition may involve measuring a product's trajectory and looking for signs of momentum.
Outliers
If it wasn't already difficult to figure out how to define a flop or winner, outliers may lead us to continue to struggle trying to find answers to these questions. The iPad is a great example of an outlier, a product that had impeccable market timing and an environment ripe for early sales success. The end result is 280 million units being sold in five years. Today, the product is facing questions as to its long-term trajectories with much of its functionality now being met with other products. When the iPad was launched, the running joke was that it was just a big iPod touch. In retrospect, it was that label that likely indicated why it sold so well, so quickly. It was a product that shared most of the allure of iPhone, only with no contract and a much larger and attractive screen. Once the iPhone screen got larger (and the Mac got thinner and lighter), the iPad was squeezed. The much longer life cycle for the product hasn't helped sales either as consumers hold on to their iPads for much longer than their iPhones.
In our attempt to quantify Apple Watch success, comparisons to the iPad may lead to faulty conclusions, both from a positive and negative angle. It may be too optimistic to assume that a new Apple product can see the same adoption rate as iPad. Just as the iPad is now facing a sales plateau, such a barrier may represent an incorrect conclusion as to how well a new product could do over time.
Another outlier question that undoubtedly needs to be asked involves the iPhone. Is Apple's juggernaut truly a one-of-a-kind product? With such a short upgrade cycle, aided by Apple's relationship with mobile carriers across the world, will it be extremely difficult for another product to meet similar annual sales rates?
What to do?
Taking into account the complications and difficulty in defining flops and winners, set within a sea that contains a few outliers, how should one go about measuring a product's performance?
1) Establish Context. What kind of product is being measured? A $99 fitness wearable that requires no other device to do its job or a $3,500 Mac Pro designed for movie makers? Does the product require a monthly contract or other recurring cost? Will a decaying battery over time require the product to be replaced in a few years, or is the product designed to last many years?
2) Establish Parameters. How should success be defined? Obviously there are major differences when discussing hardware and software initiatives. On one hand, quarterly unit sales may suffice while on the other hand, reaching scale in the form hundreds of millions of users may be the only way to reach success. Even within the same product category, different parameters may exist. For a phone, should we measure success in terms of sales share, profit share, or mind share?
3) Look for Momentum. Rather that merely thinking about a product's long-term potential, it is important to find momentum or signs of life. App developer involvement, early success within a specific demographic, or increased word of mouth may all signal that a product has life and potential to grow over time.
4) Measure Results. It is important to find ways of quantifying parameters and momentum. It is not a coincidence that many technology companies have adopted policies that revolve around providing little to no product sales disclosure. While some of this could be related to competitive reasons, the much more likely reason is to hinder Step #3 from above, making it difficult to know if a product is failing in the marketplace. While Amazon is known for its lack of disclosure, the company has not been shy when disclosing the number of Prime memberships. Along similar lines, Samsung was quick to reveal smartphone sales as the company was consolidating power within the Android OEM space, but when facing struggles at both the low-end and high-end of the smartphone market, the company has now adopted a policy of not disclosing smartphone sales. Even Apple is known to partake in the "tell the world good numbers" party while keeping mediocre results private.
These four steps indicate that measuring flops, winners, and outliers is not easy and likely involves much effort and time: attributes that are seemingly in decreasing supply. The iPhone and iPad may have spoiled us when it comes to thinking about what failure and success mean in consumer technology. In order to get a better grasp of what is happening close to the ground, more effort will be required to bypass the rhetoric and rely on logic and processes to guide the thought process. It won't be easy, but we need to start somewhere.
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AAPL 3Q15 Earnings Preview
Apple is positioned to report another quarterly earnings beat when reporting 3Q results on July 21st. Apple continues to benefit from attractive year-over-year sales comparisons in China. Overall revenue growth is tracking close to 35 percent, with earnings growth exceeding 50 percent. With the iPhone now representing close to 70 percent of Apple's operating income, the product category has become the single-most important factor driving earnings, and that trend will continue in the near-term. With lingering Apple Watch demand questions, many will use earnings as the first opportunity to back into Watch unit sales. Apple guidance should be informative, reflecting not only a new iPhone launch, but also an early read on July sales and any impact from ongoing economic turmoil in China.
Earnings Preview Reading
Over the past three months, the major stories impacting Apple financials have centered around three topics: the iPhone's growing power, Apple's cash, and China Mobile. The following stories serve as good background reading in the lead-up to Apple earnings.
- The iPhone is Taking Over Apple - Apple will be the iPhone company for the foreseeable future. The iPhone's gravitational pull is simply too strong for any new product or service to reach escape velocity and become the next big thing for Apple in the near-term.
- Apple's Cash Dilemma - Apple is unable to keep the pace of share buybacks and dividends in line with its foreign cash generation.
- China Mobile is a Game Changer for Apple - China Mobile has become Apple's most important business partner.
iPhone: No Change in Momentum
Strong iPhone sales trends in China, Europe, and emerging markets will continue to offset lackluster smartphone growth in the U.S. Last quarter, I estimated China Mobile accounted for nearly 40% of Apple's year-over-year iPhone growth, which was certainly boosted by the Chinese New Year in February. China Mobile's importance cannot be stressed enough as the largest mobile carrier in the world will soon account for 20% of all iPhone shipments. Given lower smartphone adoption rate in China compared to U.S. and Europe, I would expect China to continue representing a majority of iPhone growth for the next few quarters.
Exhibit 1: iPhone Unit Sales Expectation Meter (3Q15)
Mac and iPad: No Longer Earnings Factors, but Still Interesting
Due to the iPhone's elevated share of earnings, the Mac and iPad are no longer relevant from an earnings day perspective. There are still interesting trends at play within each category. The Mac is continuing to take share in a category that is pretty much being decimated with overall PC shipments forecasted to be down 5-10% year-over-year this past quarter. The iPad continues to struggle as the product finds a normalized run rate where the combination of first-time buyers and upgraders results in roughly flat growth. We are not there yet.
Exhibit 2: iPad and Mac Unit Sales Expectation Meters (3Q15)
Apple Watch
Even though Apple is not expected to disclose Apple Watch sales, keen observers with an Apple earnings model will be able to back into a relatively good approximation of Apple Watch sales. I am expecting Apple to have sold 4.25 million Apple Watches from April to June. While there has been much debate as to how the Apple Watch has been selling, more time will be needed to gauge normalized demand; there was evidence of pent-up demand at launch as would be the case with any new Apple product category.
Guidance
Management's guidance will be useful for a few reasons. Since we are quickly approaching the new iPhone launch, guidance will help determine what Apple has seen so far in the month of July in terms of iPhone demand. While there shouldn't be much spillover just yet from the volatile Chinese stock market, any caution built into China sales due to economic concerns may become apparent in guidance. In addition, next quarter will present a more informative view on Apple Watch sales as we move away from launch.
Exhibit 3: Revenue and Margin Guidance Expectation Meters (for 4Q15)
Wall Street Concerns
The biggest headwind facing Apple continues to be fears of slowing iPhone growth in 2016. As has been the case for the past few conference calls, analysts will look for any new commentary on Android switcher rates and iPhone penetration in China and other developing markets. If 2015 was the year of China Mobile and large screen iPhones, company observers are becoming skeptical that the new iPhones will be able to sustain the same type of growth rates next year.
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The iPhone is Taking Over Apple
One theme has become clear in 2015: the iPhone's gravitational pull is simply too strong for any new Apple product or service to reach escape velocity and become the next big thing for Apple in the near-term. From a financial and business perspective, the iPhone is the only product that matters. The iPhone is amassing so much power at Apple, it is difficult to imagine any product being able to dramatically surpass the iPhone in terms of importance over the next five years. Apple will be the iPhone company for the foreseeable future, and that classification introduces opportunities and risks that Apple will need to navigate over the coming years.
Perspective
This past month, the iPhone celebrated its 8th anniversary. It is easy to forget how significant of a factor the iPhone has been to Apple's business since launching in 2007. Taking a look at cumulative data over that time span helps to put the iPhone's one-of-a-kind product status into perspective.
- 726 million iPhones sold
- $443 billion of revenue (50% of total)
- $200 billion of gross profit (60% of total)
- $120 billion of net income (60% of total)
As a sign of continued iPhone momentum, Apple is now selling up to 250 million iPhones a year, or close to a third of total iPhones sold to date.
iPhone's Importance to Apple's Financials
Everyone knows the iPhone is a crucial part of Apple's business, but few realize the extent to which the iPhone is literally taking over Apple's financials. In the first half of FY2015, the iPhone accounted for 69% of Apple's total revenue, up from 57% of revenue during the same time period last year. In terms of gross profit, the trend is even more pronounced, with iPhone accounting for 81% of Apple's gross profit over the past two quarters, up from 68%. Much of this change is related to strong iPhone sales in China following the iPhone 6 and 6 Plus launch in addition to China Mobile beginning to sell the iPhone last year. It has gotten to the point that Apple's quarterly earnings reports should be renamed "iPhone sales updates" because no other part of Apple's business is able to impact the financial statements quite like iPhone.
Exhibits 1 and 2 highlight the iPhone's overall contribution to Apple's revenue and gross profit.
Exhibit 1: iPhone Revenue as Percent of Total Apple Revenue (Fiscal Year)
Exhibit 2: iPhone Gross Profit as Percent of Total Apple Gross Profit (Fiscal Year)
The iPhone's strong margins and short upgrade cycle contribute to the device's significant share of Apple's revenue and earnings as iPhone users are likely to upgrade their high-margin phones every two or three years.
One example of how important the iPhone is to Apple's earnings is a hypothetical scenario in which Apple missed iPhone unit sales quarterly expectations by 10%. Such a scenario wouldn't necessarily be too much of a stretch considering Samsung misjudged demand for the Samsung Galaxy S5 by 40% last year. If Apple missed iPhone sales expectations by 10%, or five million units, EPS would have fallen by 10%. If we then assumed iPad or Mac sales missed expectations by 10%, the resulting EPS impact would be a rounding error.
It is getting to the point that the iPad or Mac are nothing more than asterisks on Apple's quarterly earnings reports which is saying a lot given their influence and sales numbers. Even the pace of Apple's capital return program is starting to be controlled by the iPhone given the product's significant contribution to U.S. cash flow and consequentially available funds to spend on buyback and dividends. Over the course of eight years, the iPhone has earned more than $100 billion of cash for Apple, which has gone a long way in buying back shares and paying dividends.
iPhone's Importance to Apple's Business
From management's point of view, the iPhone's significant power presents both business opportunities and risks. The iPhone's success has given Apple a formidable presence in mobile in terms of market power and positioning. Across the world, the iPhone 6 and 6 Plus have helped Apple grow market share, with a total iPhone user base close to 500 million. This environment remains quite appealing to developers and third-party companies willing to invest in the iOS ecosystem.
Besides funding the capital return program, the cash flow produced from iPhone sales has also been used to help develop new products and initiatives. While iPod sales helped fund iPhone development, iPhone sales will help fund Apple Car development.
Nevertheless, very strong iPhone growth trends do present some risks. From Apple's point of view, it is in their best interest to keep the iPhone user base vibrant and engaged. Such efforts go a long way in preventing fragmentation or stagnation. Accordingly, a situation may arise in which Apple finds itself with such a large iPhone user base that a growing number of users do not upgrade to the latest OS version, weakening the iPhone ecosystem.
In iOS 9, Apple included a series of features to address and turn around slowing iOS adoption rates likely due to users not having enough iPhone storage. As one example, users will receive a pop-up when trying to install iOS 9 on a device with insufficient space and offer to temporarily delete apps in order to make room for the update. The deleted apps would be reinstalled once iOS 9 has been installed. In addition, app thinning, app slicing, on-demand resources, and bitcode are all designed to maintain the vibrant nature of the iPhone user base, especially those who may be using older models.
Another risk created with strong iPhone sales is the difficult part of needing to push the iPhone forward in terms of hardware or software design while facing a growing amount of pushback from users opposed to change. The theory here is that the larger the user base, the more heterogeneous the composition including variation in taste and desires. The end result may be that changes alienate a group of iPhone users. One example of this is Apple changing the iPhone dock connector. A software example is how iOS 7 brought a new look to everyone's iPhone. The fear of embracing change due to potential user pushback or revolt has led to disaster at other technology companies since the lack of change gave competitors room to offer a better product. Evidence would suggest Apple has no intention of following a similar path. Take a look at the newest Macbook for evidence of Apple not being afraid to push design forward even if it meant alienating some users.
One of the biggest risks that Apple faces from a strong iPhone is that the product's importance leads management to ignore other opportunities that may seem too small to matter and are unlikely to reach the iPhone's stature in terms of revenue and profit. In reality, it is those kinds of risks that need to be taken in order to be in a position to eventually ship a product that will one day surpass the iPhone in terms of importance. Once again, Apple seems to be aware of this risk as the Apple Watch certainly contains attributes that may one day lead to people being able to accomplish a good portion of their computing needs with just a device worn on their wrist.
Strengthening iPhone's Value Proposition
The next five years for Apple will likely focus on new products and services positioned to increase the iPhone's value proposition instead of become the next big thing that will eventually surpass the iPhone. On some level, that may sound like Apple is operating in a lower gear than it did in the 2005-2010 period, and in some ways that is true for the simple fact that it is incredibly difficult to ship a product that is more important than the iPhone within a few years of its birth. This dynamic raises some interesting questions including whether this is one reason for Jony Ive's promotion to Chief Design Officer, which frees him from day-to-day managerial duties and instead allows him to look at more strategic tasks in terms of Apple design. These tasks include adapting the company's retail infrastructure to embrace luxury wearables.
It is impossible to say Apple will never ship a product as important and profitable as the iPhone because "never" is quite a long time. Most consumers spend $600-$700 on an iPhone every two or three years which means there is plenty of opportunity to have people spend more money on new Apple products and services. However, over the next five years, the iPhone will remain the most important product that Apple sells, and it would seem that Apple wouldn't have it any other way.
One of Steve Jobs' quotes that has been displayed at Apple HQ sums up Apple's long-term plan with the iPhone really well: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next."
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Trent Reznor Talks Apple Music & Above Avalon Premium Week in Review
Along with periodic Above Avalon posts, I send out a daily update containing stories (10-12 per week) to Above Avalon members via email. The following is a sample story sent to members on July 2nd.
Trent Reznor Talks Apple Music
We are getting a much clearer picture of how Apple Music was created through the creative direction of Trent Reznor.
As a very brief background on Reznor, he, along with Ian Rogers, joined Beats to help launch a music subscription service. The end result was very similar to what we see today with Apple Music.
Reznor has been quite vocal in the past about the music industry and the volatile relationship between artists and music labels when it comes to money. He experienced the music industry from both the perspective of an independent artist and the view of an artist receiving support by a major label, which serves as good background for working on a music subscription service.
Apple has made Reznor available for the Apple Music PR tour and Pitchfork published an interview with him yesterday. I enjoyed the interview for all of the imagery and candor found in his answers.
Here's Reznor on the problem found with most music streaming services:
"I feel like I'm walking into a big box store where all the merchandise is in a cardboard box. I mean, it's there, you can eat all you want. But it's searching for a box in a card catalog versus a place where you walk in and leave kind of blown away by the stuff you didn't realize you wanted when you went in there."
You can start to see that Reznor thinks of music streaming differently than most people. Keep in mind that the product he is describing was what Beats was originally selling. The service never saw widespread adoption before getting bought by Apple. It's easy to see that the message Reznor is describing about how most music streaming sites are awful must have resonated with Apple. Could Apple have built its own music subscription service? Sure, but Beats' music streaming was built on ideals that matched Apple's philosophy. According to Reznor,
"What we tried to do with Apple Music is make the experience around the catalog feel like people that love music have touched it in the various ways it gets presented to you: playlists that noticeably feel better, radio stations that were programmed by people, recommendations that feel less like a computer and more like someone made you a mixtape and you like their taste."
Jimmy Iovine and Eddy Cue described Apple Music as a service a few weeks ago, which now seems much more business-like in retrospect. Meanwhile, I thought Reznor's Apple Music description was the most genuine I have seen published.
You start to understand why Apple is even bothering with music. It's all about selling an experience, something Apple excels at with its current products. That is what Apple means when they say music is in their DNA. There is more here then just Apple thinking they need to do music because they came out with iTunes and the iPod.
Here is Reznor describing what I would say is one of the more controversial parts of Apple Music, Connect:
"[W]e just wanted to make a place where if you're an artist and you want to share something that's more promotional - you're not necessarily looking to get paid on it but you want people to hear it and have as wide a reach as possible - put it up here and it's not locked into anything. You can embed it wherever. It's not meant to just be over here behind this paywall...We wanted to create a place where the people making the art could feel like they could have a center, and ultimately, monetization, and the ability to be provided with some tools that didn't exist as elegantly as they do anywhere else."
I think this is where Reznor's argument, while certainly still making a lot of sense, is being stretched just a bit. The Connect that is being described may be attractive to some artists, but with others there may not be much interest at all. I know in my situation, the 40 artists I am following haven't exactly been active on Connect, but others have said they are seeing plenty of activity. Will we see a split develop among the music community? Will we need to wait until there is a massive audience before we see artists begin to engage more on Connect? Time will tell.
Reznor closes the interview with an interesting take on Apple and risk:
"I'm surrounded by enthusiasm and support and a company that's ready to take risks and allow, what I think, is risky good taste to be a fundamental part of what they're trying to do. It's pretty cool that the biggest company in the world feels that way. It feels good to me right now."
The closer you look at Apple Music, the more you realize Apple is taking a big risk here. While it is a music streaming service just like any other streaming service out there, it is based on ideals that are quite different from others. I think that is why it is so interesting of a product.
Above Avalon members also received the following stories this past week:
Android Switcher Rates Bode Well for iPhone Sales
Q&A Thursday (collection of submitted questions by members)
Apple is Growing Faster than Xiaomi
Reflections on iPhone's 8th Anniversary
Attaching a Price to Apple's Free Music Trial
New iPhones Entering Production
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Beats 1 is the New iPod and Apple's Latest Bet
The iPod was hip and cool. A device that was introduced to the world as being able to hold one thousand songs in your pocket went on to be Apple's trojan horse and take over not only the music industry, but also the entire music culture. The iPod won because it was different and cool, working seamlessly with iTunes in bringing emotion and passion back to music. Fourteen years later, Apple finds itself in a new music predicament. Holding on to the paid music download model a few years too long, Apple is once again trying to recapture music mindshare with Apple Music. Instead of competing on technological terms, Apple is positioning Beats 1 as the new iPod, a tool meant to add emotion and coolness to a sea of commodity music streaming services.
The iPod Was Cool
On October 23, 2001, Apple unveiled a device that went on to position the Mac as the temporary hub of our digital lives and ultimately play a role in shaping modern culture. Wearing a pair of white headphones didn't just mean that you had an iPod in your pocket, but also meant that you were a rebel, someone who thought differently.
Something interesting happened with the iPod. It went from a sign of being different to an outright symbol of being cool. During a time when Macs were destined for art classrooms, and mobile phones left much to be desired in terms of design and functionality, iPods were taking over college campuses and schools like nothing seen before. Music was once again something fun, something that could be listened to mostly anywhere. A fact that now seems like a given was a new experience just 10 years ago.
Beats 1 Is the New iPod
With Apple Music, Apple is once again looking to leave its mark on music culture, which is arguably much more important and valuable than the $15 billion of annual digital and physical music sales. We are no longer in the iTunes era. The iPod we have come to know is now just a footnote in Apple's financial statements. Instead, Beats 1 is being positioned as the new iPod.
Consider how during what was arguably the most important day in Apple's music history, nearly the entire discussion was centered around Beats 1. The 30 million songs now available for streaming are nice, but we are already used to that with other streaming sites. Lots of curated music playlists are helpful, but something seems to be missing. Apple's intention on launch day was clear. The buzz surrounded Beats 1. What was Zane Lowe saying? Who was he playing? What are other people thinking?
At first glance, Beats 1 would seem to be a highly unlikely candidate for being the new iPod. How is a radio station with a preprogrammed schedule pushing content to listeners considered hip and cool in 2015?
However, Beats 1 is trying to do much more than be a radio station. Instead of just pushing songs to our iPhones, Beats 1 aims to make us live and breathe music. The modern era of music streaming with millions of songs at our disposal has led us to think of music simply by genre. How else would one sort through millions of songs? As we rely more on the algorithm to control our music listening experience, we are left with a product that is lacking emotion and passion. We remain tied to what we think we know and enjoy. Music discovery is never allowed to materialize. Beats 1 is trying to get us to appreciate and discover music again.
Trent Reznor, one of the masterminds behind Apple Music, explained Apple's motivation to Pitchfork :
"Personally, one of the things that interests me in this space as a fan is that consumption of music is radically different from when I was a kid. You had to make a choice of what you wanted to invest in. There were some good things about that. I listened to some records that I didn’t necessarily like at first, but I listened to them because it was all I had. It shaped the way I think about things. And now that access is ubiquitous and everybody has access, to me, that puts the burden on the service to make music enticing—different portals and entryways and rabbit holes. And what if that experience could be one that turns more people on to great music? I think that’s exciting."
Zane Lowe
Similar to how Apple relied on celebrities to market the iPod, the company is once again adding a new modern twist to the equation with Beats 1, placing Zane Lowe as the face of Apple Music. While he may not be a household name, his ability to discover talent and appreciate the art of music has not been lost. Apple is investing in other personalities along with Lowe, each with a slightly different take and style. But at the end of the day, Beats 1 is Zane Lowe. Notice during the Apple Music launch how Apple executives, many of whom have been quite active on Twitter recently, were quiet. There was not one tweet or message about Apple Music. Instead, it was all Zane Lowe.
Zane Lowe. Photo: The New York Times
Beats Brand Lives On
Even the name of Beats 1 is quite telling. Apple's $3 billion acquisition of Beats last year included branding and people. The Beats brand carries a young, cool and hip connotation while iTunes brings up thoughts of slowness, bloatware, and oldness. I have a difficult time seeing "iTunes 1" having the same kind of impact as Beats 1.
Beats 1 Gives Apple a Fighting Chance
The iPod was a risk. In reality, nearly everything that has turned out successful for Apple was at one time considered to be a big risk. That is not to suggest that everything Apple touches turns into gold, but rather that risk is needed to really change the status quo. Beats 1 is Apple's latest bet. It may not work. People may be turned off by the variety of music and simply not value Zane Lowe's or the other DJ's personality or musical acumen. Radio was mostly declared dead and reimagined as Pandora. Will the world be willing to think again about what radio can be? Trent Reznor summed it up well:
"I’m surrounded by enthusiasm and support and a company that’s ready to take risks and allow, what I think, is risky good taste to be a fundamental part of what they’re trying to do. It’s pretty cool that the biggest company in the world feels that way."
Apple is not starting Beats 1 to appeal to the masses but rather to add something new to the music discussion. After being on the market for years and experiencing refined product and pricing strategy, the iPod changed the game. Beats 1 represents Apple's most likely path toward taking back the music industry. Using a radio station in 2015 to take back music culture - now that is thinking differently.
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The Great Apple Music Pivot
Apple Music is the right product at the wrong price. Music subscriptions based on human curation and discovery are the future, but putting more than 30 million songs behind a paywall won't help facilitate widespread adoption. Apple Music's family plan option will give the service life, but more is needed. The free music subscription model will eventually be too difficult for Apple to ignore. By pivoting to include free music, Apple Music will then be in a much better position to put the business of music on a path to sustainability. The music industry needs its "App Store" moment, and the combination of free music, Apple's premium user base, and Apple Music's Connect would be the closest thing yet to that vision becoming a reality.
Apple Music Ambitions
While the press has run with the Apple Music versus Spotify storyline, in reality, Apple's music ambitions are much more grandiose. Apple is once again trying to build music sustainability by selling an all-encompassing music service. There is precedent for such lofty goals as the iTunes ecosystem presented the music industry with a much needed reprieve from the rise of piracy and genuine questions of music's sustainability. Apple relied on a service that capitalized on ease of use to stoke demand for paid music downloads. Ten years later, while things may have not changed much as labels are still making short-term decisions guided by money, and there are renewed questions around music sustainability, we now live in a world where free music subscriptions are gaining momentum and acceptance.
One reason Apple is fully embracing paid music streaming and avoiding a free music steaming tier is to change the perception surrounding music's inherent value. By having consumers look at music as something worth paying for - a good with inherent value - it will be easier to get people to pay for music through other mediums in the future. A culture based on free may not bode too well when trying to sell new music initiatives and services. Take a look at the App Store for evidence of this trend.
As Spotify has shown, when both a free and paid streaming option are available, a vast majority of users stick with free. With Apple Music, by not offering a free music subscription option, Apple is trying to increase the paid tier's value as that would be the only way to enjoy the full service being sold. There is no question that Apple Music will gain users, and I would go so far to say that it would be shocking if Apple is unable to become the largest paid music streaming service. It helps that Apple's user base is comprised of premium smartphone users that have shown the tendency to spend more on apps and other content. However, I doubt it will be enough to move paid music streaming far beyond the segment of the population that has been paying for music all along.
The Record Labels
In today's disjointed environment where digital music industry revenue is still coming from many directions, record labels continue to spend big money on marketing and promoting their portfolio of music artists in an effort to gain mind share and exposure. The IFPI estimates that over the past five years, labels have spent $20 billion on artists and repertoire (A&R) and marketing. In this environment, free music streaming is an attractive proposition for record labels because their portfolio of artists is able to reach a much wider audience. Simply put, record labels have taken free music streaming hostage. This is one reason why the major labels put their music on YouTube, Spotify's free music tier, and even went so far as to agree to Apple's initial "no pay" stance on Apple Music's three-month free trial. Ultimately, it is this desire for exposure on the part of labels that represents Apple Music's biggest headache as charging for music is made that much more difficult when music is free elsewhere.
Free Music Streaming
Over the past few years, free music streaming has received a bad rap. Free music subscriptions have the potential to be attractive for both music artists and fans because artists gain valuable exposure while fans have access to a vast amount of music. However, there continues to be one major problem with free music subscriptions: ad-supported free music streaming simply does not provide enough revenue for musicians. There are very few alternative monetization techniques available for the average musician unable to tour or grab sponsorships. Meanwhile, paid music subscriptions, which Apple is betting on, remains niche with no evidence of mass market appeal given the presence of free music options elsewhere. It would seem that the music industry is in quite a predicament.
In 2014, subscription streams income accounted for 23% of the music industry's $6.85 billion of digital music revenue. However, in an alarming sign of what is to come without significant industry change, ad-supported free music stream income, despite having 2.5x the number of users, accounted for only a third of the revenue from paid music subscriptions. The math just doesn't add up for free music streaming in its current form, despite its growing popularity. That doesn't mean that free music subscriptions should go away, but rather that more needs to be done to build other ways of valuing music.
Meanwhile, YouTube remains the most popular option to access free music, with more than 1 billion users. According to the IFPI, approximately 27% of internet users listen to music on YouTube without watching the video. Despite having upwards of 10x the number of users compared to music subscription services, YouTube and other video platforms accounted for only $650 million of digital music revenue last year, less than half of the revenue attributed to subscription services.
One positive sign is we are still in the very early stages of the music subscription era. The vast majority of people have not used music streaming. According to the IFPI, there were only 141 million active users for music subscription services at the end of 2014, of which 41 million were paying global subscribers. For perspective, there are approximately 475 million iPhone users out in the wild. Recent user surveys from Ipsos placed paid streaming usage at 16% while free streaming stood at 35% across 13 selected markets. This suggests that there is still time to come up with new and exciting ways of building monetization into free music streaming.
Apple Music Pricing
Apple faces an uphill battle with Apple Music pricing largely as result of the music labels. Initially, it was reported that Apple wanted to price Apple Music at $5 per month to match the amount of money people spent on music in iTunes. The labels said no. Instead, with single memberships at $10 per month, Apple Music is priced in-line with other streaming services, offering full membership for $120 per year.
At first glance, Apple Music would appear to be dead on arrival given that price. However, there are a few other variables at play that will result in Apple Music having some life. While Apple was not able to get labels to agree to lower the price for single memberships, Eddy Cue was able to get the labels to come down in price to $15 per month for the family membership. Given that up to six people can be on the same iCloud account, Apple Music's family pricing will likely be much more popular than single memberships.
In addition, it is important to remember that Spotify has 20 million subscribers paying $10 per month for its music streaming service. Since music streaming is still in the early innings, I suspect Apple will make inroads into this market, and it would be surprising if Apple cannot get more than 20 million people to sign up. The problem is that the upside to this number is limited by not having a free music streaming option.
Apple is aware that entering the music subscription era without a free music tier is like entering a fist fight with both hands tied behind one's back. Accordingly, Apple has made certain aspects of Apple Music accessible to everyone. In terms of marketing, Apple's messaging continues to shift the focus away from music streaming (which is mostly a commodity these days) and instead towards playing up the idea of Apple Music as one service containing various ways of listening to music, curation and discovery led by music tastemakers, and interaction with your favorite artists. Said another way, Apple is trying to build music culture instead of being just a paid music steaming service.
Apple's Long-Term Music Plan
Apple will pivot Apple Music to embrace free music streaming. However, any early success seen with family plans will not be lost. Evidence of a vibrant ecosystem and user base would be very appealing to music labels, which would agree to have their artists and catalogues included in a free music streaming tier on Apple Music.
Music Culture/Discovery. Apple is investing heavily in human discovery and curation by allowing tastemakers like Zane Lowe to represent the face of Apple Music. Beats 1 is positioned as a 24/7 radio station guided by one mission: play great music. The point of such a product is to build excitement, push music discovery, and introduce passion back into music. Having a host of DJs ranging from Drake to Elton John is meant to add personality to what has increasingly been algorithm-driven playlists and radio stations. There are many questions as to how one channel broadcasted across the world is going to work, especially considering all of the different tastes represented by the guest DJs. Nevertheless, much of this focus on music culture will remain a central theme of Apple Music regardless of price and whether Apple has a free music streaming tier.
Connect. In what may the most interesting and intriguing aspect of Apple Music, Connect has the potential to be the very early stage of a fundamentally new kind of service that the music industry has never seen. Connect is a way for artists to connect with fans by sharing content such as pictures, short clips, and exclusive material. While the service has very subtle similarities to Apple's ill-fated Ping product, management has learned its lesson that the world doesn't need another social network.
Connect may be so significant, it can represent the music industry's "App Store" moment. Connect can become the primary medium through which artists can monetize their art beyond music. Typically, the argument has been that artists can monetize free music through merchandising and touring. While for some that may work, the much more sustainable method would simply be to create a medium by which fans can support artists directly through either subscriptions or different access tiers. In the process, the definition of a musician changes. We soon can all become musicians with a route to monetization, even if we aren't professionals. Music is the art of expressing our emotion and views on the world. To think that the only people capable of making money from music are those that go on tour and sell t-shirts is missing the much bigger point.
In a world where all music is free, Connect can be the way that artists sell subscriptions for complete access to the process behind their art. Videos, blogs, and other exclusive content can arguably be much more valuable than the actual music itself. In such a world, discoverability and the ability to reach hundreds of millions of users is critical because to find sustainability, an artist would only need to reach a very small group of loyal fans. Instead of 20% of the population paying $120/year for all the music they want, which primarily would go to the big labels and megastars, in this new world, 100% of the population can listen to all the music they want while supporting artists that they feel a connection to.
The theme behind all of this is decentralizing power from a few labels to everyone:
- Music will be free. As a result, music artists can reach hundreds of millions, if not billions of users.
- Artists have access to information on their fans, making it easy to set up monetization efforts.
- Artists can rely on software to monetize their brand (image and personality) primarily through subscriptions and advertisements, but also through merchandising and sponsorships.
- New talent can transition from discovery to monetization quickly without many barriers.
- The definition of “music artist” becomes boarder to emphasize a wider range of content creators.
The problem with the current music industry structure is that it is difficult, if not impossible, to accomplish many of the preceding bullet points, especially without the support of a label. However, change is in the air. A music artist no longer needs to be sponsored by a Fortune 500 company, sell out the local sports arena, or have 10 million followers on social media to find sustainability. Instead, finding one's true fans and focusing attention on those individuals can lead to sustainability. In such an environment, the most difficult bullet point remains discoverability, which is conveniently one of the underlining themes found within Apple Music.
Measuring Success
Success with Apple Music will change over time. At first, success will be judged by share of the paid music streaming market. The discussion will focus on Apple owning the "premium" music market, or those who are in a position to pay for music. Next, the discussion will focus on ecosystem strength, where the total number of users is paraded around, including those that just listen to Beats 1 and other radio channels. This is where the prospect of free music will be too hard to ignore. Meanwhile, Apple will work on expanding Apple Music's reach into other forms of music content, not to mention mind share. Apple would then introduce a new version of Connect where fans have the opportunity to buy the full experience from individual artists. All the while, the record labels will fight and drag their feet against these changes because they essentially are anti-label, giving most of the power to artists and fans. As Apple begins its new music journey, Apple Music has a future, but a few changes are needed to give the service widespread appeal and the ability to truly add sustainability back to the business of music.
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Taylor Swift is Backing Herself Into a Corner - Above Avalon Premium Week in Review
Along with periodic Above Avalon posts accessible to everyone, I write 10-12 stories a week about Apple sent exclusively to Above Avalon members via a daily email. The following story was sent to members on June 22nd. For more information and to sign-up, visit the membership page.
Taylor Swift is Backing Herself Into a Corner
Taylor Swift was able to capture much of the Sunday news cycle with a well-circulated Tumblr post with a passive aggressive "To Apple, Love Taylor" title. The seven paragraphs that made up the post can be summed up in three sentences:
"I'm sure you are aware that Apple Music will be offering a free 3 month trial to anyone who signs up for the service. I'm not sure you know that Apple Music will not be paying writers, producers, or artists for those three months. I find it to be shocking, disappointing, and completely unlike this historically progressive and generous company."
Eddy Cue responded within 17 hours saying via Twitter that Apple had changed its mind and will pay artists during the free trial period. Apparently, Apple will pay rights holders on per-stream basis, the details of which were not disclosed [Apple will pay 0.2 cents for each song streamed]. It would seem the rate will be less than the regular rate once the trial period ends. Regardless, the change in Apple's stance occurred very quickly. Does this mean everything is okay? Not quite.
Before I go any further, I think it's important to note that Taylor Swift knows exactly what she is doing. Beginning with her WSJ op-ed last year and her recent spat with Spotify where she removed her entire music catalog from the music streaming service, Swift has fully embraced the message that music needs to be valued appropriately. Not only does such positioning likely hold true to her beliefs, but it serves her well from a business sense.
Taylor Swift is arguably the biggest music act going today. She is one of the few that can sell out venues each night for months across the world. She has spent years developing her fan base and connects with them extremely well. Simply put, she can afford to take these kind of hard stances and use her music as a bargaining chip.
You will quickly discover that you can't go far talking about music without discussing record labels and the complicated structure where everything is done in such a way as to position the dollar as the ultimate goal. In many ways, Taylor Swift transcends all of this talk because of the power she holds. This means that any discussion involving Taylor Swift is often much more ideological than practical as we can ignore the record label.
At the end of the day, this Taylor Swift vs. Apple battle wasn't even about Apple. It's about valuing music. Swift previously battled Spotify. Yesterday, she called out Apple. Tomorrow, she will call out someone else. Apple is simply a symbol of what Swift is fighting for: raising awareness that the music industry is selling an art form that should be valued accordingly.
Swift's primary argument against Apple's 3 month tier was that such a feature does not value music appropriately. If you are a music artist and you release a new album from July to September, you would have received $0 from Apple Music and the 10s of millions of people trying the service out. While simplistic in thought, basically the entire music industry would have received $0 from Apple for those three months. When you say it like that, it is hard not to agree with Swift's argument, and I suspect that is why Apple changed its tune, deciding to pay artists during the trial period. Swift wasn't the only one to raise this issue in recent days, so it is possible that Apple was at least thinking about this topic for a few days and Swift was the final straw.
Even though Swift won this latest battle (Apple probably will face no long-term negative implications from this though), I still think Swift's long-term positioning in terms of valuing music is problematic. Swift is combining short-term goals with long-term ambitions. She is upset with any service or feature that doesn't value music correctly. She raises very valid (and convincing) arguments. However, when looking at the long-term, Swift is likely backing herself into a corner.
One theme that has developed in the music industry over the past decades, especially the last 10-15 years, is that technology is a formidable force. The music industry has not been able to figure out how to find sustainability with music streaming. There is pain in the streets. Taylor Swift, and a handful of other actors, are using what essentially boils down to aggressive negotiation tactics to force change (i.e. getting people to pay for music). In the near-term, Swift's exposure and power will increase. Her fans will like her even more. And she may very well win many battles (as she did vs. Apple).
However, look at what happened with Swift's battle with Spotify. The music streaming service's momentum in terms of user growth (the most important metric for Spotify) has shown no signs of slowing down after Swift pulled her music collection. In fact, one can argue Spotify gained exposure following Swift's very public battle with its free streaming tier. Here is where I think Swift will find some trouble. She will not be able to control technology. Even though she is the most popular music artist in the world today, that is not enough to shift what will be inevitable in terms of music and technology. She is trying to get everyone to play nicely, but no one person holds enough power to keep everyone in line. A stronger Spotify, including a more popular free streaming option, would seem to go against what Swift is advocating.
Look at how Kid Rock turned out in his opposition to paid downloads on iTunes. Technology, and the world, passed him over. The same will happen with Swift if she doesn't change her tune (which I think she will) over time, concerning how music should ultimately be valued.
Swift wants people to value music appropriately. Apple does too. Swift thinks the best way of doing that is to pay for music. I'm not sure Apple feels the same way long-term. Technology likely has other plans in mind (and I suspect Apple does too) in terms of how one can monetize music to ensure sustainability. Free music streaming isn't going away, regardless of how much Taylor Swift hates it.
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- Apple Stock Buyback Primer (seven chapters)
- Apple's Cash Dilemma (Why Not Just Pay the Tax?)
- One Drawback of Holding $194 Billion of Cash
- The Symbolism Behind the Gold iPhone
- Google's Early Approach to Take On Apple Watch
- Calculating Apple Watch Band Profit
- Just Doing What's Right (Tim Cook and Eddy Cue edition)
- Improving iOS 9 Adoption is High Priority at Apple
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Wall Street Starting to Doubt Apple Watch - Above Avalon Premium Week in Review
Along with periodic Above Avalon posts accessible to everyone, I write 10-12 articles a week about Apple sent exclusively to Above Avalon members via a daily email. The following article was sent to members on June 17th. Please visit the membership page for more information and to sign-up.
Wall Street Starting to Doubt Apple Watch
One by one, sell-side analysts are starting to turn cold on Apple Watch, a product released seven weeks ago. Yesterday, Pacific Crest analyst Andy Hargreaves published a note saying his confidence in Apple Watch is declining as interest appears to be higher in the iPod than Apple Watch, judging by Google Trends, and something needs to be done or else Apple will struggle meeting Watch expectations. Here's Hargreaves:
"Initial Apple Watch demand has been very strong and our most recent checks suggest Apple remains well positioned to produce enough units to meet or exceed our FQ3 unit estimate of 5.5 million and our F2015 unit estimate of 11 million. However, reviews of the device have been mixed, the fashion angle appears to be leaning a bit too much toward "calculator watch," and general consumer interest as measured by search volume is below the iPod (with an "o")...All of this suggests a dramatic increase in functionality is likely needed to grow unit sales and meet current expectations for F2016 unit volumes. Given Apple's developer community, this is clearly possible. However, our confidence is declining, which suggests risk to our F2016 unit estimate of 24 million is increasing."
I will comment on his Watch sales estimates shortly, but it's important to note what he is arguing: once early adopters buy the Watch, evidence in the form of Google Trends would suggest sales will slow. The focus isn't so much on Apple Watch sales for the current quarter or even next (those will probably be fine), but the follow-through as we move away from launch. Basically, the question being raised is will normal people buy the Watch?
Hargreaves is not the first analyst to raise Watch concerns. On Apple's last earnings quarter, Toni Sacconaghi of Sanford Bernstein took issue with Tim Cook's attitude and tone when discussing Apple Watch. Here's Sacconaghi:
"I just wanted to revisit the watch. Tim, I think you've said, when you were talking about your new products, you said we're 'very happy with the reception' and in response to a previous answer, you said, 'relative to demand, it's hard to gauge with no product in the stores.' I would say relative to other product launches, where your commentary around demand was characterized by superlative after superlative, that assessment feels very modest."
Tim responded, "I'm thrilled with it, Tony, so I don't want you to read anything I'm saying any way other than that. So I'm not sure how to say that any clearer than that." Sacconaghi recently visited with Tim Cook and Luca Maestri and once again he made note of their demeanor, saying their tone was "confident, though not ebullient."
All of this doubt should be expected as Apple chose not to disclose Apple Watch sales. That decision was likely not taken too lightly at Apple HQ. If management announced opening weekend sales, a can of worms would be opened where people would expect such disclosure at every turn and any slight deviation would be marked as a negative. Take a look at iPad to see what being aware that unit sales are declining year-over-year can do to a product's perception.
However, by not releasing sales numbers, doubt and worry are allowed to build as there is no concrete evidence to refute an analyst's analysis. Instead, some are left resorting to analyzing management's tone when talking about the Watch.
I suspect one of the driving reasons that led management to keep Apple Watch sales under wraps is that given the current environment, Apple doesn't need to release Watch sales numbers. With the iPhone selling so well and representing a large portion of operating income, I can see Apple looking at that and saying that there wouldn't be much benefit from releasing Watch sales numbers. When you are selling 50 million iPhones a quarter, announcing four million Apple Watch sales may be lost on many market observers. In addition, the less Watch disclosure, the harder it would be for competitors to respond.
The very little amount of data that we do have on Watch sales (primarily from Slice Intelligence, but also Apple revenue guidance for the current quarter) would suggest that Apple Watch sales look solid (4M so far), although the adoption rate may be a bit weaker than that of the initial iPad in 2010. Said another way, the Watch may indeed take a bit longer to catch on with people compared to how the world seemed to accept the iPad over night. Did Apple expect this and feel it was prudent to not release sales early on? It's possible. In a way, Apple would be somewhat hedging its bet just a bit.
Let's not forget, Apple has been big about disclosing sales numbers if they are strong. That's why I think this decision may be related to iPhone strength. Apple would have decided they weren't going to break out Watch sales numbers months ago. I suspect this is not a decision based on opening weekend sales strength or weakness.
Ultimately, Wall Street is all about expectations. Back in November 2014, my very first Watch sales estimate was for 20-30 million units to be sold in the first 12 months on the market. In March 2015, I fine-tuned my estimate to 28 million units in the first 12 months on the market. These numbers are important because they help frame how I look at the Watch and what would be "disappointing" results or "strong" numbers. Every analyst is different, and that is important to take into account when they issue research notes discussing the Watch. Looking back at Hargreaves' note, his 12-month Watch sales estimate looks to be pretty similar to mine across the board, so he's not overly optimistic or pessimistic.
If analysts' main concern is around Apple Watch sales in 2016, I have a feeling we may need to get used to this Apple Watch doubt. We are in the very early innings of this game, and there is no evidence yet to suggest the Watch has struck out.
In addition to the preceding article, Above Avalon members also received the following articles this past week:
- The Genius Move Behind the Phil Schiller Interview
- How to Discover Apple Watch Sales
- Apple is Playing Offense, not Defense
- New Productivity Features Hint at iPad's Future
- Fitbit Prices IPO Above Expectations
- Cablevision CEO Sees Cable Bundle Dying
- Apple's New Search APIs
- Apple Retail Store Renovations
- Apple Hiring News Editors
- Apple Correctly Killed Plans for Beats Wifi Speakers
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Apple's Cash Dilemma
With approximately $200 billion of cash on the balance sheet, Apple's financial strength has never been stronger. However, Apple has a growing dilemma on its hands concerning its cash and capital return program. Apple is unable to keep the pace of share buybacks and dividends in-line with its foreign cash generation. As a result, excess cash that is not needed to run Apple's business continues to build on the balance sheet. While labeling a company with $200 billion of cash as having a cash dilemma seems like hyperbole, Apple's valuation metrics will likely be negatively impacted in the coming years if Apple is unable to return this excess cash to shareholders.
Apple's Total Cash Continues to Increase
Apple currently has $194 billion of cash, cash equivalents, and marketable securities. Not only is this a record in terms of cash held by a single company, but it represents approximately 10% of all cash held on corporate balance sheets. Given Apple's business model, it does not need all of this cash to run its business. With an enterprise value of $583 billion, Apple would theoretically be able to repurchase 30% of itself using the cash on its balance sheet. In reality, things are much more complicated as most of this cash is not able to be used for share buyback because it is held offshore and would be liable for additional tax if returned to the U.S.
Exhibit 1: Apple's Total Cash, Cash Equivalents and Marketable Securities
Most of Apple's Cash is Held Offshore
Apple's foreign cash continues to comprise a growing portion of Apple's overall cash. In the eight years since the iPhone was released, Apple's foreign cash has grown to $171 billion from $7 billion and now accounts for 89% of Apple's total cash, up from 44% in 2007. With approximately 70% of annual revenue coming from outside the U.S., Apple's foreign cash will continue to grow at a much faster pace than its U.S. cash. Apple has been content with keeping foreign cash offshore in order to avoid paying additional tax if it was brought back to the U.S.
Exhibit 2: Apple's Total Cash, Cash Equivalents and Marketable Securities (Foreign vs. U.S.)
Apple has been using some of its foreign cash for organic growth initiatives, including component procurement, international retail and facility expansion, and clean energy initiatives. Even after all of these expenses, cash generation continues to exceed what management needs to run the business.
This past quarter, Apple sold more iPhones in China than in the U.S. for the first time. Rather than this being an isolated event, China will only become a bigger piece of the iPhone sales pie given social-economic trends and an untapped market of more than 600 million phone users. The end result is Apple's foreign cash generation will continue to vastly outpace U.S. cash generation.
Apple's U.S. Cash is Being Depleted
With foreign cash being kept offshore, Apple is forced to use its U.S. cash to fund the capital return program. As a result, Apple has a more "modest" $22 billion of cash available in the U.S., which reflects the impact of more than $40 billion of debt issuance over the past three years. Without issuing debt, Apple would only be able to rely on U.S. free cash flow generation of approximately $20-$25 billion a year to fund buyback and dividends. It is important to remember that Apple needs a certain level of available cash in the U.S. to take care of routine business expenses, not to mention have cash on hand to take advantage of M&A opportunities. It is not prudent to allow this cash total to fall too low, and management has shown the willingness to slow share buybacks instead of depleting U.S. cash reserves.
Exhibit 3: Apple's Cash, Cash Equivalents and Marketable Securities (U.S.)
The Dilemma
Apple's cash dilemma is straight-forward: Apple is generating cash internationally at a much faster rate than it is able to spend on stock repurchases and cash dividends in the U.S. As China continues to make up a larger portion of Apple's product sales, boosting total free cash flow, management is facing some limits as to the amount of available funds used for stock buyback and dividends. The following exhibit shows how the amount of free cash flow (red line) is expected to outpace the amount of cash spent on buyback and dividends (blue line) in the coming years. China is increasingly causing the red line to slope upward as time goes on while the blue line is being pinned as the U.S. is becoming a smaller piece of the overall cash generation pie. In an ideal world, there would no gap between the red and blue lines as most of Apple's free cash flow would be spent on buyback and dividends.
Exhibit 4: Apple's Cash Dilemma
Apple's Options
Management does not have many available options at its disposable for solving its cash dilemma.
- Lobby for U.S. Tax Law Changes/Holiday. The preferred option would be returning cash currently held offshore back to the U.S. in an environment with a lower tax rate (15% or less), or during a special tax holiday similar to 2004. Obviously, Apple would want a rate in the single-digits, but Washington politics may make any change to tax policy a long shot. If the tax rate was lowered, Apple would be able to bring back $140-$150 billion of foreign cash and then buy back up to 20% of itself in relative short-order through a public tender offer. At a forward price/earnings ratio of 12x and a free cash flow yield of 6%, Apple management likely views AAPL's current valuation as attractive for such a tender offer.
- Continue Issuing Debt to Fund Capital Return. Apple is currently using a combination of debt and U.S. free cash flow to fund share buyback and dividends. As Apple's foreign cash grows, Apple can continue to borrow additional debt. However, Apple's cash dilemma will not be solved as foreign cash generation will still likely outpace the rate of capital return even after considering a realistic amount of debt issuance each year. Eventually, Apple would be holding $400-$500 billion of cash, almost all of it offshore, and $150 billion of debt, all of which would have been spent on the capital return program. Apple would then need to manage its debt obligations, only straining its U.S. cash needs even more. Management may begin to cool to the idea of issuing significant amounts of debt if interest rates rise or if Apple's business slows, further making this option somewhat unsustainable in the long run.
- Do Nothing. Management could also slow debt issuance and simply spend less on share buyback. This option would be taken with balance sheet preservation in mind. If Apple slowed all buyback activity, both U.S. and foreign cash would increase and Apple would likely reach $400 billion of total cash in relative short-order. The risk to this option is Wall Street's reaction to Apple sitting on too much excess capital, a scenario that had begun to play out in 2011-2012, and some can argue, is still playing out today.
How is Holding too Much Cash a Dilemma?
Apple's market valuation is obtained in the marketplace at a price where AAPL buyers and sellers are willing to trade shares to each other. If there is greater demand for shares at a certain price, the price will rise until demand and supply are in equilibrium. Investors buying Apple shares are interested in owning a piece of the company's assets used to generate cash in the future. Since a company's value is obtained by discounting future cash flows and excess cash is not involved in future cash generation, the market is forced to include the cash in its Apple valuation. The end result is there is a high likelihood of either Apple's cash being valued incorrectly, or much more likely, Apple's underlying business being valued at a discount. This is the fundamental logic behind those that have been pushing Apple to use its excess cash to buy back more stock.
Unless foreign cash is brought back to the U.S. in order to boost the magnitude of share buyback, Apple's excess cash will continue to grow, and the valuation metric that the market is giving Apple will continue to be suppressed. This is one likely reason why Apple is trading at a 12x forward P/E multiple. Apple CFO Luca Maestri has quite the dilemma on his hands.
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Apple Is Playing Offense at WWDC
Apple is on the offensive. This is not a company content with standing by and letting Google, Facebook, Spotify and a handful of other third-parties take over critical elements of the user experience of approximately 500 million iPhone users. Instead of just swinging a sword and trying to compete with everyone indiscriminately, Apple is carefully positioning its resources and the overall iOS platform to stress value propositions at which Apple has historically excelled. These include personalization, emotion, and privacy. WWDC highlights how battles are being chosen meticulously as Apple's mission is clear: reducing its dependency on others. With the News app, Apple is trying to change users' habits in terms of how they get content. Apple Music is a test in how successful Apple will be once again in not just getting customers to pay for something that is free elsewhere, but rethinking the music industry. Siri and Spotlight are being positioned as Apple's method for rethinking search. Instead of sitting back and letting third-parties have all the fun, Apple wants more.
The Chess Game Heading into WWDC
Apple had the wind at its back headed into this year's WWDC. The iPhone 6 and 6 Plus have resonated with consumers across the world, especially in China, leading to more than 40% unit growth year-to-date in 2015. One metric that Tim Cook has reiterated on recent earnings conference calls is the Android switcher rate, or the percent of iPhone sales that can be attributed to former Android users. Recent Kantar data and Above Avalon estimates would suggest that approximately 20-25% of iPhone sales in 2015 have come from customers new to iOS, which totals to nearly 25-30 million users entering the iOS ecosystem for the first time.
The iOS platform has hit critical mass; it is large enough to sustain app innovation and developer interest. Nearly every major third-party consumer-facing technology company, including Google, Apple's primary competitor, have all but guaranteed support for the iOS platform, a noteworthy reversal from years of doubt and cynicism from those who warned Apple's smartphone 10% market share may eventually be outmatched by Android's massive reach. The problem with that logic turned out to be that Apple actually has 70%+ market share in the premium smartphone market which includes those who are very likely to use apps and services.
On top of that, Google and Facebook have business models that depend on obtaining data at scale, and Apple's highly engaged users are a prime target. It would be difficult, if not impossible, for Google and Facebook to ignore 500 million iPhone users.
Given the current environment, one would assume Apple is feeling pretty good. Executives could push out an iOS refinement update, watch iPhone sales roll in, and coast along until WWDC 2016. In reality, Apple is more nervous now than ever before.
This nervousness is not born from weakness, but rather strength. Apple is nervous about the unknown, the low probability event, the Black Swan that we can't even imagine. It is with this nervousness that Apple positioned certain new OS X and iOS 9 features as preemptive moves on the hypothetical chess board.
Apple wants to be in a position where it can counter the scenario of Google, Facebook, or another powerful third-party taking over such a large amount of the user experience that Apple's relationship with the user is harmed. People are spending an increasing amount of time on social networks while music streaming is taking over. Even though both of these activities are not directly hurting Apple's financials, it's clear management wants to be better positioned to respond to each trend.
While there are very few, if any, credible competitors that can truly ship software, services, and hardware at scale, it would be theoretically possible for a company to take user engagement on iOS and try to leverage it into a new direction using their own differentiated hardware. If Apple can position itself more strategically as a counter to third-party offerings, reducing its dependency on others, Apple could be in a better position to maintain the user experience and battle third-party apps and services in the future.
Fighting for Your Attention
Although Apple may be seeing success in terms of smartphone sales, a fierce battle has been occurring for our attention once we turn on our gadgets. Press and hold the iPhone home button and the battleground emerges: our home screen. Software and services companies are each angling for our attention. Tech pundits often say Facebook's greatest threat is Google. Instead, Facebook's greatest threat is our short attention span. Services that largely do similar things are increasingly fighting for mind share in the areas of messaging, email, photo storage, and entertainment. When considering that a service can benefit from a network effect, the battle is only intensified as the apps and services with the most users achieve the best quality, thereby making it that much easier to attract new users.
Whereas hardware manufacturers measure success by the 10s of millions of users, for software, success is now measured in 100s of millions. As more people spend more time on smartphones, the battle for our attention is only intensifying. It is for this reason that iOS is such an attractive proposition for companies craving reach and scale amongst premium users.
In the early days of the iPhone, it was common to see a smartphone with lots of apps, each possessing a specific duty or job role. I created separate folders for social apps and news. Today, I still open my social app folder every day, but now my news folder has become irrelevant as I get most of my news from Twitter. This type of fierce competition for my attention is still playing out in area of social platforms and media brands, but it's clear that given the finite amount of attention, there will be winners and losers.
With a suite of over 20 apps, Apple has relied on its vertical integration of shipping hardware, apps and services. In 2012, Apple jumped into maps. In 2014 Apple launched its health, fitness, and payments initiatives. And at this week's WWDC, Apple launched new News and Music apps, with rumors of a video service arriving sometime later this year or 2016. All of these services share one purpose: controlling our time and experience. They are meant to represent tasks or things that we do each day and to which Apple can add differentiation. One should not expect Apple to try to be the answer to everything, such as entering social media or other services that are inherently less fundamental to Apple's product line-up.
News
Apple's News app isn't so much a competitive jab at Facebook, but instead a hook for grabbing people's attention. Apple's description of the new app is quite clear: "News conveniently collects all the stories you want to read, from top news sources, based on topics you're most interested in - so you no longer need to move from app to app to stay informed." With News, Apple is trying to keep our attention just a little bit longer. Take a look at Facebook's Instant Articles and Snapchat's Discover to see what the war over attention is leading to. Technology companies are trying to shift commoditized news into a differentiated service meant to keep you within their properties.
This type of attention-holding strategy isn't new. In brick-and-mortar retail, Walmart includes various stores within its stores, such as vision centers, fast food restaurants, and medical clinics in an effort to get you inside a Walmart. Similarly, Facebook wants people to spend more time within its apps by offering additional services, like news.
I don't view Apple as necessarily trying to rethink news or put other companies out of business. Instead, it is looked at as a tool to enrich the iOS platform while maintaining a closer relationship with the user.
The risk in the strategy is that many users still have to go to Facebook, regardless of reading news. Going back to the Walmart analogy, it would be the equivalent of having to go to Walmart regardless of which medical clinic you visited. Chances are good you will end at the clinic inside Walmart rather than going across town to the stand-alone clinic. At the end of the day, the easiest path usually wins. It is for this reason that I think caution needs to be held before assuming News will be a runaway hit. Instead, I look at it as Apple moving a piece on the chess board, trying to gain a better competitive position in the future.
Apple Music
Apple's ambitions in music are underestimated. As Eddy Cue and Jimmy Iovine have made it very clear, Apple Music is not about music streaming, but rather a new music ecosystem meant to offer listeners across the world (100+ countries at launch) a place to not only access music, but become part of something bigger, interacting with musicians and receiving recommendations. Eddy Cue and Jimmy Iovine don't say it, but Apple Music is inherently built to keep your attention rather than just engage you in the physical act of listening to music. Technically speaking, Apple is now getting into content creation with its 24/7 radio station, Beats 1, as Zane Lowe will have a music show that contains interviews and other content.
Connect, which will serve as a venue for musicians to connect with their fans, while distinct enough from the Ping disaster, contains just enough social media to make people begin wondering if there may be a bit more that meets the eye, where Connect can become a musician's first stop for sharing content. It is important to point out that despite Apple introducing new features that undoubtedly chase people's attention, the company is not being hostile to third-parties. Connect allows sharing through Facebook and Twitter.
Apple Music is competing with the free streaming services of the world, including YouTube. While Apple may have indeed gotten people to pay for music once around (iTunes), it will be challenging for Apple to completely rethink the music industry without a free, ad-supported streaming option. Nevertheless, Apple is going to give it a try, positioning service and a new culture-defining internet radio option, as reasons customers will be willing to give Apple Music their attention and pay for something that can be gotten for free in the next app over.
Siri and Spotlight
We saw hints of Apple's ambitions in search last year, but this year's WWDC all but confirmed that Apple is quickly looking to distance itself from Google search.
Apple's intentions on reducing its dependence on third-parties is not just limited to apps and software. All of Apple's new announcements related to an improved Siri and Spotlight, not to mention a new search API, are meant to have us move past Google dependence. In the process, Apple is able to build on its relationship with the user and not necessarily collect troves of data. Apple feels very confident that it doesn't need all of your data to produce "magic" as Phil Schiller described it. In reality, what Apple is suggesting is that it can produce an enjoyable environment that doesn't let technology overwhelm the user, yet still position the iPhone as a personal assistant. Apple calls it "intelligence," which is appropriately quite different from the connotations surrounding Google's "machine-learning" initiatives.
Pushing Forward with iPad and Apple Watch Software
Apple’s mission hasn’t changed from its founding in the 1970s. As Jony Ive put it at the Condé Nast International Luxury Conference this past April, Apple has always been about making technology more personal. The primary way Apple will be able to continue going down that path is if they control our time and attention by selling gadgets filled with apps and services that we increasingly use to navigate the world.
Nowhere is this strategy more apparent than Apple’s current product line-up, pieces of glass ranging from the Apple Watch to the iMac. At every stage in between, each product possesses a different function or role. This is the primary reason why Tim Cook hasn’t sounded the alarm about the iPad despite the product losing all of its sales momentum. For Apple, the iPad still has a role in the world. It’s just that a greater number of people are able to get their jobs done using iPhones and Macs. At WWDC, Apple all but assured us that a larger 12.9-inch iPad Plus will be released in the future with Split View, Slide Over, and picture-in-picture video. An iPad Plus isn't meant to turn around the iPad line, but instead serve a particular set of needs that can be answered with a multi-touch Force Touch-enabled large display. Some of Apple's products are simply more popular than others, based on screen size and mobility. Success isn't determined by the number of unit sales, but instead how effective a product is in addressing a particular set of problems.
From Apple’s perspective, positioning the iPhone as a computer in our pocket is central to controlling our time because of how we are able to bring the iPhone mostly everywhere we go. Taking things further, in a quest to control even more of our time, what better way than to sell a computer that is literally on us? The Apple Watch is Apple's first personalized piece of technology that can be worn. The outlook for native apps able to tap into much of the advanced components found in the Watch only validates Tim Cook's claim that the wrist is indeed a very interesting place. The day is still early with wearables, but Apple isn't waiting to push the envelope on what can be done on the wrist.
WWDC 2016 and Beyond
When considering Apple’s future, take a look at your daily calendar and at the activities that take up significant portions of your day. Anything from sleeping, watching TV, and commuting to and from work likely represent areas of interest for Apple. Of course, management is quite selective and as Tim Cook mentioned last year, executives actually spend most of their day debating what not to do. Apple is built on a model of placing very few big bets that can change the world, not lots of little bets very likely to fail but not likely to have much long-lasting impact. Apple's offensive strategy was on display at this year's WWDC including additional Siri capability, new and updated apps meant to hold user's attention, and a new Music platform positioned to regain music mindshare. Such tactical maneuvering is indicative that Apple is not pausing despite its improved market positioning when compared to Android. Apple is playing offense.
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Apple's Metaio Acquisition Could Be a Game Changer (Above Avalon Premium Sample)
Along with weekly Above Avalon posts accessible to everyone, I write 2-3 stories about Apple each day covering a range of topics delivered exclusively via email ($10/month or $100/year). The following story was included in the email sent on June 1, 2015. To sign up, visit the membership page.
While most think Apple is asleep at the wheel, busy spending all of its cash on share buybacks, evidence continues to add up that Apple is planning for the future. News broke late last week that Apple bought Metaio. Even though Apple confirmed the deal by providing the typical PR response about buying small companies from time to time, signs point to this Metaio acquisition being a bit different. There is evidence to suggest this is a big deal in terms of implications on future products and services.
Metaio is a leader in augmented reality (AR) and co-founders Thomas Alt and Peter Meier are considered some of the industry's pioneers. Even though Metaio is called a "start-up," the company has been around for over a decade and actually had its founding as a research initiative from VW back in 2000. In one keynote, Alt introduced Metaio with "we've been around forever." Metaio even organized the biggest AR conference each year. Simply put, I have a hard time seeing Metaio selling to Apple without something significant coming from this. That theory is also supported by Apple's track record with M&A where they typically buy companies and technology with a clear goal in mind, often to plug a hole in product strategy.
Last year, Thomas Alt gave a talk that touched on a few reasons why I suspect he may have went on to sell to Apple. 1) monetization remains hard in the field 2) it is becoming increasingly more difficult with the resources Metaio had to track unknown, or outdoor environments, and not just a closed, indoor environment. Said another way, Metaio may have run its course as an independent company and needed a bigger partner to reach its future goals, including the much bigger mission of getting the AR industry off the ground.
The impressive thing about Metaio is the entire vertical chain of products that they offer from Metaio SDK/Creator/Cloud and Junaio (an AR browser across platforms). The company has 140,000+ developers (many of which aren't happy with this sudden news of an acquisition), 1000+ B2B customers including eight automakers, 130 employees, and a patent and IP portfolio.
What can AR be used for? Metaio had previously marketed itself to industrial clients for the following use cases: digital manuals, training education, monitoring, accessories and spare parts (think cars), customer service, inspection, and remote maintenance.
AR has a very basic premise: interact with the world. The problem I have had with many AR use cases (and increasingly much of the hardware developed for AR) is that it is very obtrusive and distorts reality to such a degree that I think side effects are created. If there is a way to position AR as a way of actually improving reality and not just adding more noise, I can see Apple moving forward with such initiatives.
It is very easy to see that Metaio has been heavily involved in the auto market and the concept of the augmented city. There are many interesting possibilities around this use case, building off of AR's primary value of helping to navigate the world. Add this acquisition to Apple's Primesense acquisition (which one of Metaio's co-founders had previously classified as interesting), and I think the concepts of both indoor (and outdoor) mapping where depth and mobility are present start to head in the direction Apple may be headed.
Metaio's developer tools and prior discussion around AR's biggest road block being the lack of relevant content would suggest that Apple may look to bring developers into the fold which would not only give AR a big shot in the arm, but support Metaio's vision of getting AR off the ground.
One theme that is apparent these past few months: there are a growing number of signs that Apple is building and planning for future (unannounced) initiatives. This acquisition firmly places Apple in the augmented reality game, and I suspect the end goal is much bigger than just gaming and other gimmicky demos.
In addition to the preceding post, Above Avalon members received the following articles this past week (100 percent related to Apple). To read these stories and to receive future stories via email, sign-up at the membership page.
- Tim Cook's Stance on Privacy Isn't Actually About Your Data
- The Chess Game Heading into WWDC
- Odds of Apple Replacing Google as Default Search in Safari Going Up
- Apple Music is Sounding More Interesting
- A Closer Look at Apple's Services Business Segment
- New iPhone Ads
- iPhone Sales Share - April Update
- Jay Blahnik Touting Apple's Health Strategy
- Next Phase of Apple Watch Retail
- Google I/O
- IBM Loves MacBooks
The Apple vs. Google Battle Has Changed
The biggest takeaway from Google I/O 2015 was how different Apple and Google are approaching mobile, each guided by their own mission statement and strategy. After years of fierce competition for smartphone market share, the battle between the two companies has changed. Google's ambitions include connecting the next billion users and obtaining scale across its suite of services which requires supporting an iPhone user base quickly moving towards 500 million users. Apple's ambitions are aimed at making technology more personal and lessening its dependency on Google, its primary competitor. The next battle in mobile has begun and it may be just as fierce as the initial rounds. The battle is moving beyond the smartphone and is now based on which platform is more successful in occupying a user's time with the best experience.
Since the iPhone launch in 2007, the Apple vs. Google battle has not remained constant, instead going through distinct stages, beginning with an arms-race for market share, followed by an Android OEM consolidation phase led by Samsung, and now the large screen iPhone renaissance ushering in the current phase where the battle is moving beyond the smartphone.
Battling over Daily Activations (2009-2011)
The early days of the smartphone war were all about market share. The daily beat of the tech press was focused on which mobile operating system was doing better in terms of sales. Google, and Andy Rubin especially, prided themselves on periodically announcing Android daily activations. One of the rare times Steve Jobs was on an Apple earnings conference call with analysts occurred in 4Q10 to put some cold water on Android activations news. The mission was clear: promote iOS as a platform worth developing apps for. Here was Jobs:
"Last week, Eric Schmidt reiterated that they are activating 200,000 Android devices per day. And have around 90,000 apps in their App Store. For comparison, Apple has activated around 275,000 iOS devices per day on average for the past 30 days with a peak of almost 300,000 iOS devices per day on a few of those days. And Apple has 300,000 apps on its App Store.
Unfortunately, there is no solid data on how many Android phones are shipped each quarter. We hope that manufacturers will soon start reporting the number of Android handsets they ship each quarter. But today that just isn't the case."
The battle was not only fought in the marketplace and press, but also in the court room as Apple began setting up its patent litigation offense against various hardware companies using Android to compete with Apple. Apple's goal with litigation wasn't about the money, but rather pride and to slow competitors down in the marketplace. Market share was everything in the early days of the smartphone race.
Samsung's Reign (2012-2013)
The 2012-2013 time frame was interesting for Apple as Samsung was able to make very strong inroads within the Android ecosystem, capitalizing on the lack of a large-screen iPhone in the high-end of the market and lack of proper competition in the low-end. While there was never much in the way of widespread defections of iOS users fleeing to Samsung, the ability for one hardware manufacturer with such immense distribution network to grab so much power within the Android ecosystem was alarming to Apple. The battle was aired on TV in the form of a very successful line of Samsung commercials mocking Apple customers, not to mention continued battles in the courtroom.
As evidence of how seriously Apple took the Samsung threat, in 2012, Phil Schiller tried to preempt Samsung's big Galaxy S4 keynote in NYC by talking with the WSJ the day prior in order to discredit Android and provide some counter balance to the overwhelmingly positive press coverage given to Samsung. Schiller went on to say:
"Android is often given as a free replacement for a feature phone and the experience isn't as good as an iPhone...When you take an Android device out of the box, you have to sign up to nine accounts with different vendors to get the experience iOS comes with."
It is important to note how Apple positioned Samsung as merely the preferred hardware competitor at the moment. Google, not Samsung, was the ultimate long-term threat as Apple saw that Samsung was gaining market share purely on the back of Android. Without Android, Samsung phones would not be viable competition for the iPhone.
The New Battle
Apple now finds itself with an iPhone user base approaching 500 million users, and strong market positions in key geographic territories including the U.S. (40% sales share), U.K (40% share), and China (25% share). Any concerns related to iOS being crowded out by Android OEMs in a repeat of the Windows era have likely been put to bed. Apple's iOS platform now has critical mass, or the ability to entice developers and third-parties, including Google, Facebook, and Twitter, to support iOS users.
One of the clearest themes from Google I/O 2015 was that Google needs iOS and its 475 million highly-engaged iPhone users for Google's business model to succeed. Looking ahead a few years and assuming continued 10-20% iPhone unit sales growth, it will be nearly impossible for a third-party with a business model dependent on achieving scale to ignore what has the potential to be a 600-700 million user ecosystem (if not larger).
While one can make an argument that Google made a strategic misstep by limiting Google Maps on iOS a few years ago, which ended up pushing Apple into developing its own maps initiative, hindsight is 20/20. Google may have thought it was worth taking the bet at that time as iOS was a very different, and weaker, platform in 2012 than today.
The Apple vs. Google battle has now moved beyond the smartphone. Walk into a carrier store and given the choice between an iPhone or Android-powered smartphone (the two most likely options), Google's services will be found on each. In addition, the prices between an iPhone and high-end Android-powered phone will be roughly the same. While Google may be excelling at machine learning-based cloud initiatives, it is not being positioned as a factor for buying an Android phone instead of an iPhone. Given the limited distribution behind Nexus devices, it is difficult to have much confidence in that line of Android hardware representing a viable alternative for most consumers.
Instead, the smartphone buying decision is likely related more to the other pieces of glass either being worn (smartwatches), in one's purse or backpack (tablets), or at home and on the work desk (desktops/laptops). Extend the exercise further to incorporate third-party devices in the home and driveway, and the entire iOS or Android ecosystem is becoming the much bigger deciding factor for what will be your next smartphone.
Apple's Strategy
Apple wants to be at the intersection of technology and liberal arts. Producing personalized technology experiences will require Apple to maintain control over the variables that come together to create experiences for the user. A key component will be owning critical technologies and services that may otherwise rely or require scale in future initiatives. A prime example would be avoiding the debacle over maps where functionality was limited by a third-party. In the future, mapping will likely be a required core competency for personal transport ambitions. If iOS represents a minority share of the automobile market, such a market position may pose a competitive risk in terms of relying on third-partners for map data.
The same thinking applies to Apple controlling the experience for providing content like movies and music to consumers. Notice how Apple doesn't need to own or produce the content in order to accomplish its goal. Instead, being the broker between the content owner and the consumer provides Apple room to add something new to the experience. Apple could then extend this experience to Android to further entice people to make the switch to iOS (as is planned with Apple Music).
Another way Apple can maintain its consumer experience is to embrace the emotion and feeling found with luxury. As seen with the Apple Watch, relying on materials and looks as the primary differentiation between a $400 and $17,000 device produces certain emotions that would be hard to match on Android or a competing platform where the virtues of luxury don't exist.
Google's Strategy
Google's ambition for its cloud-based services is increasingly competing more with Facebook than Apple as Google's business model is based on solving technological problems by accessing the world's data. Google wants all smartphone users to use its products, regardless if on Android or iOS. Similarly, Facebook is after the same data. Just like how Facebook unbundled its core app into a suite of apps, Google seems to be following a similar path, transforming into a suite of services and apps. Google wants to be at the intersection of technology and computer science. Judging by its engineering talent, I don't think anyone doubts Google will continue to push the envelope with such initiatives.
Going Forward
Google I/O made it clear that Google needs Apple and iOS. To ignore such a vibrant base of highly-engaged users, especially when other companies like Facebook enjoy a prominent place in the platform, would be highly destructive to Google's ambitions. On the other hand, Apple also needs Google as its services remain very popular among iOS users. However, judging from Apple's prior actions and mission statement to personalize technology, I would expect Apple will continue to try to minimize its dependence on Google as such a situation represents a long-term threat to Apple's mission.
Similar to how the Nexus experience provides the closest thing to pure Android, I suspect Apple wants to continue down the path of being in a position to ship an iPhone and suite of apps and services that make it possible to live within the Apple ecosystem without much interference from Google. While most consumers will end up settling somewhere in the middle, using both Apple and Google products and services, it is this quest to control the entire user experience that ultimately validates the competition between Apple and Google as genuine.
The probability of a world where Android excels as a direct result of iOS faltering is becoming more remote as time goes on. Instead, Google is becoming more reliant on a healthy iOS platform, which improves the chances of iOS continuing to grow and gain additional power. Meanwhile, the Android platform continues to become splintered and less effective at Google's mission of positioning services in such a way as to reach scale.
The primary question is now focused on how successful Apple will be in loosening its dependency on Google services. There are signs that we may see a more aggressive stance from Apple towards replacing many Google services with homegrown alternatives. This motivation will likely come to represent the driving factor for the continued battle between the two companies. While we may see skirmishes from time to time over individual features and services, the much bigger battle is clear: Apple and Google are built on a fundamentally different view of the world and each will now fight to occupy a user's time with the best experience. The battle has moved beyond the smartphone.
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Apple Watch is Making Luxury Watchmakers Uncomfortable - Above Avalon Premium Weekly Recap
The following post is the sample story used to demonstrate the type of stories sent daily to Above Avalon Premium Members. The following story was sent on May 25th, 2015.
Apple Watch is Making Luxury Watchmakers Uncomfortable
The luxury watch industry still can't understand why someone would buy an Apple Watch.
Here's Alexander Schmiedt, managing director for watches at Montblanc, speaking with Bloomberg: "Our products should have very long life cycles. In modern technologies the life cycle is exactly the opposite. It may be the hottest thing today, and in one year it's already outdated, and in two years you're made fun of for still using it."
Montblanc will be selling a $390 "e-Strap," a stainless steel display designed to be attached to the watch band and worn on the underside of the wrist. Functionality is pretty limited compared to something like Apple Watch.
And here's Johann Rupert, owner of Montblanc: "I love Apple, but just when I've gone and set everything up for an iPhone 5, the iPhone 6 is coming out and the cords change. That is not to say the Apple Watch is not a great product. I predict it will do very well, but I don't think that customers are going to be ecstatic to throw away watches in one to two years when the technology is obsolete."
I thought those two quotes summed up the luxury watch industry's reaction to Apple Watch pretty well. Jean-Claude Biver of TAG Heuer has said something similar, unsure how to compete with something that isn't timeless. It's not that technology is foreign to luxury watchmakers, but I suspect software and the fast-pace of change found in technology are creating headaches. An iPhone 5 doesn't become obsolete in two years on its own, but rather a legitimately better device in the market helps to make it obsolete. The same dynamic is not found in the watch market.
Such uneasiness towards Apple Watch originates from the changing value proposition found in the luxury watch industry. With Apple Watch, consumers can begin valuing utility on the wrist. A luxury watch's timelessness was something that you were required to value if you wanted high-end jewelry for the wrist.
I suspect we are entering an era where people are still going to want the jewelry aspect found in their old watch, including the craftsmanship, but no longer place the same kind of value on a device's timelessness. For an industry built on timelessness, you can start to see how the Apple Watch spells trouble.
The other common reaction that I'm seeing related to Apple Watch is that the product increases awareness for other timepieces and wearables, almost like the Apple Watch is a gateway drug for "real" watches. I'm not so sure about that. After using Apple Watch, I don't have a greater appreciation for wearables or traditional luxury watches. If anything, the feeling is less. I just don't look at the Apple Watch as a watch.
If I craved something that looked more refined or polished, I could just upgrade from the Sport to Watch collection or change watch bands, and that type of reasoning is why I think Apple will actually keep the innovation and updates pretty vibrant for the higher-end Watch models. The Watch and Edition collections will likely account for 80% of Apple Watch profits despite only accounting for 20% of sales.
Consensus already assumes the low-end luxury Watch market (watches selling in the $200-$1000) is in trouble, but very few people will go on record and discuss how the overall watch market, including watches sold at higher prices, is in trouble because of devices that add utility to the wrist. The problem may not necessarily be that their current customers will run out and buy an Apple Watch, but that young professionals end up valuing utility over the traits the luxury watch market have traditionally marketed.
If new money stops flowing to the luxury watch market, the environment will become very difficult.
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The Jony Ive Promotion
Apple announced on Monday that Jony Ive will be promoted to Chief Design Officer, relinquishing his day-to-day managerial duties to Richard Howarth and Alan Dye. Reaction to the news has been mixed, with some thinking this announcement is the beginning of the end for Jony at Apple. I disagree. I look at this news as paving a sustainable path for Jony Ive to continue guiding Apple. In the process, we also now know the future leaders of Apple's design efforts. When we understand how Apple turns ideas into products, it becomes clear that Jony's new role is the closest thing yet to the unofficial role Steve Jobs held at Apple. We are in the midst of Jony Ive's Apple.
A Well-Planned and Intelligent Promotion
When Scott Forstall was removed from his position as VP of iOS software at the end of 2012, Tim Cook positioned the move as an effort to increase collaboration. In reality, much of the resulting executive shuffling was done with the near-term in mind. Apple was kicking off the Apple Watch project, and iOS needed a rethinking. Along with maintaining his leadership over the Industrial Design team, Jony was given leadership over Human Interface, which is not a trivial amount of additional responsibility and more importantly, time. While everything over the next two years appeared to go relatively smoothly (Apple software critics would disagree with that assertion), the managerial duties were likely taking their toll on Jony.
In the well-read The New Yorker Jony Ive profile published in February, Ian Parker made it seem like Jony was absolutely exhausted from the Apple Watch development. I just don't think Jony's job responsibilities and workload were sustainable. Here's Parker:
"[Jony] was a few days from starting a three-week vacation, the longest of his career. The past year had been 'the most difficult' he'd experienced since joining Apple, he said later that day, explaining that the weariness I'd sometimes seen wasn't typical. Since our previous meeting, he'd had pneumonia. 'I just brunt myself into not being very well,' he said. He had discouraged the thought that Newson's appointment portended his own eventual departure, although when I spoke to [Laurene] Powell Jobs she wondered if 'there might be a way where there's a slightly different structure that's a little more sustainable and sustaining.'"
Evidence would suggest that Jony's promotion was a long-time in the making and not due to some recent event or sudden decision. Not only is the Apple Watch launch now in the rear-view mirror, but both Howarth and Dye had been positioned in the press going as far back as late 2014. This move is made from a position of strength. Ultimately, promoting Jony to Chief Design Officer is a long-term solution to positioning Jony in a spot where he can do what he does best: make complicated technology more personal.
Titles Are Overrated
While the Chief Design Officer title may cause some to scratch their head with bewilderment as to what it means or doesn't mean, it is important to not get too caught up trying to match Apple corporate titles with importance and job duties. I've long felt Jony is the most powerful person at Apple, despite him not having the CEO title next to his name. As SVP of Design, I think Jony's current title went a long way in seemingly minimizing his influence at Apple. Jony was merely one of eight other SVPs, a comparison that likely was far from the truth.
I look at the title of Chief Design Officer as mostly ceremonial, not indicative of any less willingness by Jony to continue working on future Apple products. Tim Cook couldn't be more clear when explaining Jony's new role:
"Design is one of the most important ways we communicate with our customers, and our reputation for world-class design differentiates Apple from every other company in the world. As Chief Design Officer, Jony will remain responsible for all of our design, focusing entirely on current design projects, new ideas and future initiatives. On July 1, he will hand off his day-to-day managerial responsibilities of ID and UI to Richard Howarth, our new vice president of Industrial Design, and Alan Dye, our new vice president of User Interface Design."
Those job duties not only sound awfully similar to the role Jony has been doing for years as SVP of Design, but they sound incredibly ambitious, effectively giving Jony reign across Apple.
I suspect one issue that many pundits are having when analyzing this news is they are getting too caught up with titles, assuming Chief Design Officer is codeword for "Chairman" or something similar which does indeed have a connotation of transitioning more to a part-time or supervisory role. Similar to how Steve Jobs held the CEO title while Tim Cook performed most of the CEO duties, I think Jony Ive got a new fancy title for no other reason than to show recognition and appreciation for his past accomplishments.
New Leaders Add Clarity
While most were preoccupied with Jony's new job role, Tim Cook added a large amount of known to the sensitive subject of succession planning by announcing two new leaders in Apple design (Richard Howarth, VP of Industrial Design, and Alan Dye, VP of User Interface Design). As Jony's public profile increased over the years, the murmur of "Who will replace Jony?" grew louder and louder. While Wall Street has historically had a weak spot when it comes to valuing Apple design and understanding Jony's importance to the company, the greater level of clarity and certainty when dealing with a company's succession planning, the better.
There is not much public information about Howarth and Dye other than they have been at Apple for years (Howarth for 20 years). Both were successful in prior Apple projects, earning their dues and subsequent promotions. Upper mobility is not common at Apple, so I tend to think Tim Cook and Jony Ive must have really been impressed with these two gentlemen.
Apple's industrial design team should be considered more of a family than a collection of co-workers. The 19 industrial designers aren't at Apple for the money or fame. If they were, they would have left years ago. Instead, they believe in and care about solving problems and making great things. They work very well together, judging by the lack of turnover, and they have seen much success turning raw ideas into finished products. Such an environment and background leads me to think these new managerial appointments won't likely usher in a round of corporate politics and changing group dynamics. It certainly is something to watch for, however, with company departures as the clearest evidence of such a situation occurring.
Leading vs. Managing
With Howarth and Dye serving as Jony's two lieutenants in terms of managing day-to-day aspects of Apple design, what would such a dynamic look like and where would Jony fit into the picture? I consider Jony's new role to be much more about leadership while Howarth and Dye handle the more corporate side of things - the actual management of teams. The amount of additional time and attention that Jony can spend on entirely new projects, while leaning on his two right hands to make sure that schedules are being met and projects are receiving all of the resources they need, goes a long way in describing Apple's strategy over the next few years.
I see an environment in which Jony's potential can be unleashed even more now than the world has already seen. Similar to how Steve Jobs was known to head down to Jony's design lab to hang out, I suspect in some ways, Jony wants to do the same - check out of the day-to-day executive grind and lose himself in research and design elements on whatever topic or subject he choses. By being positioned in more of a leadership role than a managerial role, Jony could maybe be more like Jony.
Future Design Projects and Marc Newson
In his Telegraph article, Stephen Fry briefly mentions what Jony Ive will be up to once his promotion takes place: "Jony will travel more, he told me. Among other things, he will bring his energies to bear - as he has already since their inception - on the Apple Stores that are proliferating around the world. The company's retail spaces have been one of their most extraordinary success."
Take a look at Jony's travel itinerary the past few months, and it is no surprise that he will indeed be traveling more. While Fry positions Apple Retail stores as a likely focus for Jony, the truth is he could end up traveling to various countries, meeting and working with different people or simply researching different aspects of the world. While this may represent a change from what some may be used to at Apple, since when was change automatically a bad thing?
Apple's product road map will likely revolve around two major trends: wearables and personal transport initiatives (not to mention iPhones, iPads, Macs). I look at Jony's new role, along with Marc Newson's recent hire as a London-based member of Apple's design team, as the clearest sign yet that these two gentlemen have some big things planned for the future. Here's Marc Newson in a Telegraph article from 2014:
"[T]he world of automobiles I just find completely heinous...I have old cars but I rarely drive them anywhere. I must confess we do have a Peugeot people-carrier thing that I really hate going in. But car design, is driven by marketing, by people that are not designers. And it's just a completely sort of myopic approach...One of biggest sources of inspiration as a designer is basically looking at things and hating them. I have other designer friends who feel the same way, like Jony Ive."
I recently began to lay out the rationale for why Apple will enter the automobile industry and I do think this Jony Ive promotion is a way for projects like an Apple electric car to go forward, not to mention rethinking the Apple Store experience to better match this new product roadmap.
Moving Closer to the "Steve Jobs" Role
Not only will Steve Jobs never be replaced, but Apple should never think that someone needs to fill the role that Steve Jobs held. Steve had specific strengths and weaknesses that make any comparison to someone else illogical. Instead, I think the much more appropriate way of thinking about this subject is to ask who would be the best person to make sure that Apple's culture remains alive and well while ideas are allowed to mature from raw form to finished product, virtues that Steve Jobs oversaw.
In announcing Jony's promotion, Tim Cook talked about how Jony would have less managerial responsibilities. Typically, one would assume a promotion goes the other way around, leading to more oversight over teams. In reality, I suspect Jony's promotion involves overlooking Apple's mission much more closely, with more flexibility than ever before. Jony Ive will still be Jony Ive, but I think this promotion positions him much more closely to the role Steve Jobs had: making sure the product always comes first.
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Analyzing the iPhone User Base - Above Avalon Premium Recap
The following article was sent to Above Avalon members on May 19th, 2015.
Analyzing the iPhone User Base
One data point that I find increasingly important to keep track of is the current iPhone user base. This information isn't just useful when talking about the iPhone upgrade cycle, but it becomes critical when referring to adoption rates for services such as Apple Pay, and soon, Apple Music, and Apple's video streaming service.
Apple is actually somewhat good about disclosing financial information, or at least the right kind of data to reach educated estimates about most pieces of its business. You just need to have all the pieces of the puzzle in hand.
Last month, Tim Cook said on Apple's earnings call that 20% of the "active [iPhone] installed base" had upgraded to the iPhone 6 and 6 Plus. This data point compares to Cook's commentary back in January that approximately 13-14% of the iPhone installed base had upgraded (his exact quote was "mid-teens" or "barely in the teens").
Since we know Apple sold 61 million iPhones last quarter, we make an assumption as to what percent of the total were iPhone 6 and 6 Plus. I have long felt that 80% of total iPhone sales is a fair estimate for the newest iPhone model(s) on the market. Therefore, I estimate approximately 48 million iPhone 6 and 6 Plus units were sold January through March.
Running basic arithmetic with that 48 million number and Tim Cook's comments about the installed base, I get an iPhone installed base of approximately 475 million users. Is this an exact number? No. Is this a good estimate of roughly the number of people with an iPhone (all models)? Yes.
With this estimate in hand, we can start to break out the iPhone base by model. iPhone 6 has been outselling 6 Plus by approximately 2.5x, while both have been outselling the iPhone 5s and 5c by nearly 4-to-1. Taking into account these ratios, I suspect the current iPhone user base breakout looks something like:
iPhone 6: 85 million users
iPhone 6 Plus: 35 million users
Older (5s, 5c, 5, 4s): 355 million users
Total: 475 million users
That 355 million user base of iPhone 5s and older phones represents the key number to look at when determining the prime market for iPhone owners looking to upgrade to a new iPhone this coming fall. But 355 million is still a very big number. Using Fiksu data and adjusting for its U.S. and Eurocentric tendencies, my best estimate of the current iPhone user base is:
iPhone 6: 85 million users
iPhone 6 Plus: 35 million users
iPhone 5s: 125 million users
iPhone 5c: 50 million users
iPhone 5: 80 million users
iPhone 4s: 60 million users
iPhone 4 and earlier: 40 million users
Total: 475 million users
There is a lot that can reached by using that data, but I struggle seeing how someone can look at that breakout and not think similarly to Tim Cook when he says there is still a significant number of iPhone users in the market for an iPhone upgrade. Then take into account Apple's growing presence in China, and you can start to see how Apple can realistically sell more than 250 million iPhones in FY2016 (they are on track to sell 230 million in FY2015).
Bonus: One easy way to come up with a quick geographical mix of iPhone sales? If the number of iPhones sold in Greater China now outpaces the U.S., we know the U.S. has represented a consistent 35-40% of total Apple sales. That would suggest iPhone sales mix is something like: Greater China 37%, U.S. 35%, Other 28%.
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- Apple and Uber Well-Positioned to Lead Automobile Industry
- Apple and Auto Industry M&A
- Icahn Invests in Lyft
- Carl Icahn is Still on Tim Cook's Side
- Spotify Wants Your Time
- Apple Television Plans Put On Ice
- Weak Apple Watch Demand?
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- Verizon/AOL vs. Apple
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- Apple Buys a GPS Company
- Tony Fadell is Concerned about Wearables Battery Life
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Uber, Not Tesla, Will Be Apple's Competition in the Automobile Industry
We are quickly approaching a pivotal moment in Apple's history as technology and mobile are on a collision course with the automobile. While most would conclude Elon Musk's Tesla and a few of the strongest automakers are the leading contenders of this new automobile era, Apple and Uber are the two companies best positioned to rule the new era of the automobile.
The Auto Industry Is Ripe for Change
Timing is everything. A few years too early and even the best product will fail to catch on with the consumer, while a few years too late and the best product will likely have already shipped. We are quickly moving towards a period where the auto industry is positioned for change.
Many are still not convinced Apple will enter the automobile industry because of doubt Apple can come up with a product that leapfrogs the best-ranked vehicle on the road today: Tesla's Model S. The problem with that thinking is that "better," when thinking about the future automobile, won't be defined by performance such as battery range, speed or acceleration. Instead, the primary innovation that will hit the auto industry will be shifting dynamics in which power moves from traditional auto manufacturers and car dealerships to technology companies that empower the consumer. Convenience and personalization will outweigh traditional performance metrics.
To rethink the automobile, one has to attack the current industry structure. Apple has had prior success with rethinking the way industries operate. The iPod, despite a revolutionary input method, did not become a mass-market success until Apple convinced the music industry to move to a $0.99 per song download model for long-term survival. The iPhone's biggest innovation may have been shifting the balance of power in the mobile phone industry from the carriers to Apple, something few analysts and pundits thought was possible. At the end of the day, Apple was able to position its products as the catalysts of change. This same type of "breakthrough" moment will occur in the automobile industry. Owning the manufacturing infrastructure capable of producing millions of cars will shift from a source of power to a liability. Instead, the power in the automobile industry will be found by the company owning the mobile ecosystem that empowers the consumer.
While many think Tesla is pushing the envelope in terms of altering the automobile industry, a closer analysis would reveal that Tesla is actually largely residing within the same structure, facing identical limitations to any other automaker, especially in terms of capital requirements and growth. Instead, companies like Uber are not only positioned to wreak havoc in the auto industry, but they are already causing much change. Uber isn't just a ridesharing app, but an aggregated demand phenomenon. Said another way, Uber is using the smartphone to match demand and supply for automobiles efficiently and cheaply. Uber is not alone as Lyft, its closest competitor, has seen some levels of success as well.
Many assume Uber will be the best taxi service in the world, but there are more important underlying trends taking place in the auto market. The automobile's value proposition is changing and few current automakers will be able to respond and remain relevant. Apple's ability to build experiences around style and a thriving ecosystem and Uber's ability to shift power back to the consumer represent the changes that will shake up the auto market the most since the Model T's introduction in the early 1900s.
Using the Model T to Determine the Future
Henry Ford had a very simple goal with the Model T: set the world free. Up to then, personal transportation was for the rich and privileged, which severely limited society's potential. The Model T was cheap, reliable, and utilitarian. These attributes were seen just by looking at the vehicle and its high-quality parts and high ground clearance to navigate a world with very few paved roads. Ford sold the Model T for the equivalent of what is around $5,000-$10,000 in today's dollars (the average price for a new car today is $33,000), a byproduct of pricing the automobile low to stoke demand, thereby making it cheaper to produce through economies of scale.
1917 Ford Model T Photo courtesy (Boldride).
At the high point in 1923, Ford was selling 2 million Model Ts a year, representing approximately 50% of the vehicles on the road. The automobile was a tool for getting from Point A to Point B. Ford nailed the value proposition, and it seemed that the future was in his hands. However, there was one thing that he did not expect to happen.
Chevrolet introduced something that ultimately marked the end of Ford's dominance: different car styles. The automobile moved beyond just a utilitarian vehicle as people were buying new automobiles according to how they looked. Over the next 80 years this trend has only intensified. We now have an auto industry hungry for sales, segmenting the market according to not just style, but also performance and price. We went from a world where one model accounted for a majority of the cars on the road to one where buyers can spend months finding cars that best suit them.
Changing Value Proposition
The primary reason technology will alter the the automobile industry's power structure is that the automobile's value proposition will shift. We already see signs of this shift taking shape. The New York Times highlighted how teenagers can't wait until they turn 16 so that can have their own Uber. The way we value the automobile is changing. People who have never owned or driven a car may indeed hold the purest form of vehicles: tools to get us from Point A to Point B. Car ownership has likely corrupted those that have a car in the driveway, leading us to ignore the negatives and instead focus on the "positives" such as having a car at our disposal. Uber is beginning to expose those "positives" as thin attempts at finding purpose behind a large monthly expenditure.
There are outliers to this dynamic, such as high-end performance cars, but they aren't for the masses and don't represent the overall trend that is occurring across the world.
We are soon entering a period where a car's primary value will resemble that of the Model T, utility. People are once again starting to look at cars as devices that move them from Point A to Point B. However, technology has made it possible to improve on Ford's concept. The smartphone and software will make it possible to position convenience and personalization as the primary value attributes of personal transport.
Convenience
Uber is currently at the forefront of offering convenient personal transport. Using a smartphone (or Watch) to indicate demand for an automobile and then track the approaching vehicle on a map in real-time goes a long way in turning the vehicle into a commodity. Uber begins to question whether car ownership is the most convenient way of getting from Point A to Point B. The frustration with parking, maintenance, and the actual act of driving has its limitations.
This is bad news for automakers as the idea of ridesharing causes consumers to think beyond factors and attributes that automakers have spent decades building and marketing as reasons to buy their product. This shock to the system has similarities to the cell phone market when the iPhone altered what people expect and want out of a smartphone. One can now make the argument that the same thing is happening in the luxury watch market following the launch of Apple Watch. I'm convinced many other industries will follow a similar path as technology and software upend the status quo.
Personalization
There is one thing that Apple has the potential to excel at with an automobile: using hardware, software and services to personalize the driving experience. The ability to have the driver and passenger compartment adapt to one's lifestyle and personality is something that the world has never seen or even thought about.
Every subsequent technological breakthrough found in an Apple product has included a move towards becoming more personal. That trend will continue with the automobile.
Having a car be able to adapt to whoever is sitting in it, which makes more sense in a world where car ownership is on the decline, will be one of the most revolutionary developments the automobile has ever experienced. We are used to a certain level of customization in automobiles such as different seat positions, but personalization will add much more in the way of software to customization to produce an entirely new experience. A family with four kids and luggage has different needs than a commuter headed to work. Having a car that can adapt to both of these users in terms of seating, amenities, and not to mention technological needs and luxuries will be much more important than having a car that has fast acceleration or longer driving range.
Succeeding in Land of Disdain
If Uber's success and popularity aren't enough evidence that the world is ready for a new way of personal transport, consider the complete destruction of car culture in the U.S., where most of today's car loyalists still look at the 1950s and 1960s as the pinnacle of car fandom. Today people buy vehicles because they need to. There is now a certain level of disdain in the automobile buying market.
I have little confidence that the current fleet of automakers will be able to compete in an industry built on a different value proposition. Companies born in a mobile era such as Uber and Lyft are best positioned because they can extract value from a sea of commodity, where all of the cars are the same in and out. Mobile companies wouldn't be limited by car manufacturing which will represent a ball and chain. This is the primary reason why I fear Tesla, a pioneer in electric vehicles, may remain a pioneer because of its manufacturing facility.
Apple. The company that excels at selling experiences will rely on pages from previous playbooks with the automobile. Design will play a crucial element of any product from Apple with Jony Ive, Marc Newson, and the industrial design team playing a role in every piece that goes into the vehicle. Apple will rely on third-party contract manufacturers to assemble the actual electric vehicle. Mapping and other telemetrics will combine with a revolutionary personalization system to position the car to handle additional autonomous features including accident avoidance. I haven't even mentioned the innovation in terms of materials. In a sea of commodity, Apple knows how to build a pretty cool-looking vessel.
Uber. While a network effect has given Uber an increasingly valuable proposition for drivers (and users), I would expect the company to continue moving towards controlling key technologies that play a role in the Uber experience, such as mapping technology and navigation. The risk for Uber is being locked out of smartphones or operating systems in the future, the same fears held by Amazon and Facebook. This dynamic is made that much more interesting in an era where the entire automobile will controlled by an operating system. Uber's response may include eventually producing the entire automobile, relying on strong cash flow from ride-sharing to contract with a third-party to produce pretty generic commoditized vehicles.
Why Not Tesla?
Tesla's approach is largely confined within a legacy industry which represents its biggest challenge. While Tesla clearly has a lead in terms of software compared to other automakers, there are doubts that the company has enough resources to truly move beyond just performance-based metrics and begin to create an overall personal transportation experience.
Self-Driving Cars and Car Ownership
The automobile's value proposition will change regardless of self-driving cars. While there is strong evidence that truly autonomous cars are still many years off, the much more important aspect is that convenience and personalization (the new value drivers for the automobile industry) can be achieved in stages. A growing number of people already consider Uber as more convenient than owning a car, and this is in a world with no autonomous cars.
If self-driving cars do become a reality, then car ownership trends and the overall auto industry and will undergo such change in short order, it is difficult to truly conceptualize how many existing companies will lose relevancy overnight.
What About CarPlay?
Many people still think Apple's primary ambitions in the automobile industry are related to an expanded CarPlay where our iPhones will sync with a car's dashboard and infotainment system. On the surface, that plan sounds a lot easier than rethinking the entire car. However, there are several issues that are not being addressed. Putting CarPlay in a car not built by Apple is the equivalent of Apple putting iTunes on a Motorola phone in 2004. There are fundamental issues with not controlling the entire experience as the car manufacturer has a different value proposition than Apple.
Car manufacturers have not shown any willingness to lose major aspects of their vehicles dashboards and diagnostics to technology companies. Much of this is moot anyways because the overall auto industry structure is not altered one bit by just controlling the dashboard. To truly change the world, which is the only thing Apple would be focused on doing by entering the automobile, they need to embrace convenience and personalization and alter the way value is extracted from the automobile industry. That is only possible by owning the entire automobile including contracting out manufacturing to a third-party and owning the retail distribution.
The Next 10 Years Will Determine the Next 100 Years
The themes we see playing out over the next 10 years in the automobile industry will serve as the foundation for the next 100 years of personal transport. This likely means that Apple has no choice but to enter the automobile industry. The change that the auto market will undergo will have a number of important implications including the way cities are laid out, how we function as society, and how the car is just the beginning of how technology can impact our lives. Simply put, having technology companies control personal transport will be the start of controlling the home and other large portions of our lives.
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Significant R&D Increase Suggests Apple is Working on Something Big
Apple goes to great lengths to maintain secrecy around future products. As was the case with iPod, iPhone, iPad, and Watch, Apple knows that being able to introduce a product to the world for the first time on stage is one ingredient for success. Consumers love surprises and Apple is a master magician. While much of that secrecy comes in the form of employee non-disclosure agreements, extra security, and new doors around Apple HQ, the amount of money Apple is spending on developing these new products is public, listed as research and development (R&D) in its financial statements. Taking a look at the increased amount of money Apple has been pouring into R&D beginning last summer, it is looking increasingly likely management gave the green light for Apple's next big project. I suspect Apple has begun work on battery, telematics, and autonomous driving initiatives related to personal transport.
Apple has been a very consistent R&D spender, reporting increased R&D expenditures each year since 1998, with sequential quarterly declines in R&D spend in only six out of the past 38 quarters. Apple is now spending close to $2 billion per quarter on R&D, an amount that is downright remarkable when considering Apple's very lean product line-up can still fit on just one of Jony's wooden design studio tables.
Exhibit 1: Apple Annual R&D Expense (1996 - 2016E)
From a modeling perspective, R&D as a percent of sales is the traditional metric used to judge Apple's R&D pace. Exhibit 2 highlights how Apple has allocated additional resources to R&D in recent years as R&D as a percent of total revenue has been increasing. When considering that much of Apple's recent revenue increase has been due to carrier expansion for the iPhone, and not a broad company-wide expansion in product offerings, the recent rise in R&D as a percent of total revenues stands out that much more.
Exhibit 2: Apple Annual R&D Expense as Percent of Revenue (1996 - 2016E)
While pretty straight-forward, R&D as a percent of revenue can be misleading, making it difficult to comprehend how much money is being funneled into R&D. A more relevant and informative way to analyze Apple's R&D spend is to look at the actual dollar increase from year to year. This method is more sensible because Apple has a functional organizational structure with a culture based on placing few, but extremely large, product bets. There is little evidence to suggest that Apple has altered the way it approaches new product development and R&D expenditures. In the past, the bulk of Apple's R&D program has been focused on specific projects and goals. This stands at contrast with a strategy of setting up a number of R&D labs with no clear directive other than to find future products. If Apple is spending R&D, it is a good bet they have a specific goal in mind for those dollars.
As shown in Exhibit 3, starting last summer, Apple's quarterly R&D expense has increased $500 million from the previous year. This pace is up from the $200-$300 million quarterly increase during the Apple Watch development phase. For perspective, it has been estimated that Apple spent just $150 million developing the iPhone, which can actually be seen in Exhibit 3 when looking at R&D increases in 2005 and 2006. Looking at the recent jump in R&D, I suspect we are seeing the early stages of Apple beginning to add talent and processes for future personal transportation initiatives.
Exhibit 3: Apple Year-Over-Year (YOY) Quarterly R&D Expense Increase (3Q05 - 4Q15E)
The primary reason I attribute Apple's increased R&D expense to personal transport initiatives is most of the evolutionary updates to iPhone, iPad, and now Apple Watch would have a difficult time being classified as R&D. Once a project's commercial viability has been established, it becomes that much more difficult to classify manufacturing or evolutionary product updates as R&D expense. In addition, real estate construction costs related to general corporate usage, such as cafeterias, or even design labs where some R&D elements may take place, can not be categorized as R&D. It is even questionable to what degree Apple could have classified Apple Watch manufacturing following the September 2014 introduction keynote as R&D because of questions surrounding commercial viability.
Even though there are a number of accounting guidelines as to what can or can't be classified as R&D, there is often wiggle room as to whether an expense is classified as an operating or R&D expense and run immediately through the income statement, or marked as a capital expenditure and amortized or depreciated over the life of the asset. With that said, the number of explanations for what the recent R&D increase can represent is not long and likely not related to products currently being sold.
In terms of battery technology, Apple may be building up resources and talent in an attempt to push the boundaries as to what can be done with batteries, and not just approach the problem from an improved battery management system, like Tesla. While details on Apple's goals remain few and far between, it is not hard to imagine selling an electric car with a battery that ends range anxiety, or the fear of having insufficient range to reach a destination, is in Apple's best interest. Apple reportedly hired a team of battery experts from A123 Systems last summer to develop "a large-scale battery division", which is likely not just a coincidence with the increased R&D expense at approximately the same time. The other major focal point for R&D may be positioning the automobile for autonomous driving. While a driver may still be required for years, the initial software and technology that can be put into an automobile for accident avoidance is enough to warrant expenditures and research into more autonomous features.
Over the next few years, other than employee hires and fires, the clearest sign of Apple moving forward with a brand new product will likely come down to R&D. I would expect R&D increases to remain lumpy going forward, in conjunction with the progress being made (or lack thereof) with new ideas and processes. As Apple CFO Luca Maestri said on Apple's recent earnings conference call, "[Apple is] developing some core foundational technologies more in house now than we were in the past. And of course we're also spending ahead of some of the products that will generate revenues in the future....Research and development is the core of the company. Innovation is the core of the company." While most people may hear Maestri and think of new smartphone cameras or Force Touch on iPhone, I'm thinking Apple has much bigger and bolder ideas in mind.
Apple's $10 billion annual R&D pace is an indicator that management is looking to move beyond phones, tablets, and watches in a quest to find another industry that Apple can bring coolness to, where the status quo has resulted in our expectations for what is possible to be lowered. An industry where Apple can surprise consumers with something new.
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China Mobile Is a Game Changer for Apple
Apple reported record 2Q15 earnings with revenue up 27% on strong iPhone sales. While the iPhone 6 and 6 Plus continue to sell well across the world, it is clear that China Mobile is driving Apple's recent financial resurgence. Relying on data from Apple's 2Q15 earnings report and 10-Q, I estimate Apple earned $2 billion of operating income from selling 10 million iPhones to China Mobile customers last quarter.
Despite being told for years that China would become a very important country for Apple, there had been little to show for it in Apple's financial statements. China's second and third largest mobile carriers, China Unicom and China Telecom, respectively, were selling iPhone but with sales starting at such a low base, the growth wasn't a factor when compared to Apple's other operating segments. In December 2013, after years of negotiation and business talks, China Mobile and Apple announced an agreement for the world's largest mobile carrier to sell iPhone. It took a number of months for momentum to build, but all signs now point to China Mobile being a very significant partner for Apple.
While it can be difficult to put China Mobile's size in perspective, we are able to get a good approximation of just how significant the largest carrier in the world is by looking at customer data. It is important to segment China Mobile's 815 million customers by 2G, 3G, and 4G subscribers in order to better understand the number of customers that are realistically in a position to buy an iPhone (denoted in blue in Exhibit 1). China Mobile's 378 million 3G and 4G customer base is 50% larger than the combined 254 million subscriber base for AT&T and Verizon.
Exhibit 1: Total Customers for Largest Chinese and U.S. Mobile Carriers
Heading into this week's earnings, I was confident Apple would sell more iPhones than consensus was expecting because Tim Cook had previously disclosed that iPhone supply/demand was not in equilibrium until February. In addition, given how close China Mobile's iPhone launch was in January 2014 to the Chinese New Year that year, this year's Chinese New Year would see a much bigger boost from China Mobile selling iPhone. Cook reiterated this as a key driver to the strong quarter on the earnings call Monday evening.
We are seeing the result of Apple pushing iPhone into previously untapped territories in China thanks to its China Mobile relationship. Apple is confident its products are making headway into China's middle class. Exhibit 2 highlights how the addition of China Mobile now brings the realistic target market for iPhone in China to 654 million customers. If one were to assume the top 10-15% of these customers buy an iPhone, similar to iPhone's share of the global overall smartphone market, Apple would sell 60 to 100 million iPhones in China. Taking into account the average iPhone lifecycle (2-3 years), Apple would eventually be in a position to sell 25 to 40 million iPhones in China each year to this loyal customer base.
Exhibit 2: Apple's Target Market for iPhone in China (3G/4G Customer Mix)
However, recent data from Kantar suggests that iPhone sales share is not 10-15% in China, but closer to 25% and climbing. Accordingly, such data would suggest Apple is selling upwards of 60 to 70 million iPhones in China each year, with China Mobile representing close to 60% of that total. It is possible China Mobile is selling 10 million iPhones a quarter, nearly 15% of Apple's global iPhone sales. Exhibit 3 highlights how China Mobile likely accounted for 40% of Apple's iPhone unit growth this past quarter. Excluding the impact from China Mobile growth, iPhone unit sales would have been up 24% year-over-year, still stronger than the growth experienced in 2014, but a bit less than the reported 40% growth.
Exhibit 3: Where is iPhone Growth Coming From?
Apple likely made close to $2 billion of operating income from China Mobile last quarter. As disclosed in Apple's latest 10-Q, Apple reported a 90% year-over-year increase (up $3 billion to $6.7 billion) in operating income in Greater China. I suspect China Mobile was the primary driver of that growth.
Even though iPhone sales growth remains robust in various countries including Korea, Singapore, Taiwan, Vietnam, Canada, Mexico, Germany, and Turkey, I suspect they pale in importance to the type of unit growth numbers coming from China Mobile in recent quarters. The iPhone's near-term sales trajectory will largely be determined by the iPhone upgrade cycle and Apple's success with selling the iPhone to China Mobile's 378 million 3G and 4G customers. China Mobile has become Apple's most important business partner.
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