An Apple R&D Bonanza
After a brief lull, Apple's R&D expenditures are once again exploding higher. Apple's 2Q18 financial guidance implies the company will soon report the largest year-over-year increase in quarterly R&D expense in its history. Management is on track to spend $14 billion on R&D in FY2018, nearly double the amount spent on R&D just four years ago. The dramatic rise in Apple R&D expenditures raises questions regarding the company's product pipeline and whether management's overall approach to R&D is changing.
The Numbers
Apple's pace of R&D expenditures is nothing like the company has ever seen. The $14 billion of R&D expense that Apple will spend in FY2018 will be more than the amount Apple spent on R&D from 1998 to 2011. The CAGR for Apple's R&D expenditures has been a remarkable 32% since 1998. As seen in Exhibit 1, the ramp in Apple R&D expense spanning more than two decades has been breathtaking.
Exhibit 1: Apple R&D Expense (Annual)
Another way to demonstrate the dramatic rise in Apple R&D is to look at the year-over-year increase in expenditures on a quarterly basis. As seen in Exhibit 2, beginning in FY2Q17, Apple R&D expense growth has been on an uptrend. The expected $725 million increase year-over-year in Apple R&D expenditures in FY2Q18 will be nearly 25% higher than the previous R&D expense growth record. This $725 million figure is obtained by using Apple's guidance for operating expenses and backing into estimates for SG&A and R&D expenses. The recent ramp in R&D expenditures suggests Apple is definitely up to something.
Exhibit 2: Year-Over-Year Increase in Apple R&D Expense (Quarterly)
R&D Growth Drivers
It's easy to assume that the increase in Apple R&D expenditures over the years simply reflects Apple's expanding product line. However, there is more behind Apple's R&D expenditures. Three items are responsible for the growth in Apple R&D expenditures:
Existing products. Apple is doing more these days given a broader product portfolio.
In-house tech development. Apple has positioned controlling the core technologies powering its devices as a main goal.
New products. Apple is developing products for which it has no guarantee of future commercial viability.
Once a project's commercial viability has been established, it becomes that much more difficult for Apple to classify subsequent manufacturing or evolutionary product updates as R&D. This means that cash spent on developing new versions of existing products may not necessarily qualify as R&D. Instead, such expenses may have to be marked as a capital expenditure and amortized or depreciated over the life of the asset.
Another item that isn't contributing to Apple R&D expense is Apple Park construction. Real estate construction costs related to general corporate usage, or even design labs where some R&D may take place, cannot be categorized as R&D expense. Instead, for real estate to be classified as R&D, there has to be uncertainty regarding future commercial viability. As an example, the numerous buildings Apple bought, or began leasing, in the mid-2010s specifically for Project Titan likely boosted R&D at the time. (A map of Project Titan buildings is available to Above Avalon subscribers.)
New Products
Whereas Project Titan was a leading R&D driver a few years ago, there are likely two new items now driving the recent surge in R&D expenditures:
Smart glasses. We know Apple is working on smart glasses given the company's M&A track record (Vrvana, SensoMotoric Instruments, patents, and subtle clues found in Apple management commentary. The team dedicated to the effort is likely massive.
Content distribution efforts. Apple appears to have settled on a broader strategy for content, and it involves doubling down as a content distributor. Apple is investing big when it comes to delivering music, video, apps, news, and written content to more than 850 million users (of which 500 million visit the App Store on a weekly basis). Apple's effort to launch a video streaming service from scratch is likely being classified as R&D. For example, Apple has no guarantee that money spent on script development will lead to a commercially viable video streaming product. We also know Apple is reportedly spending $1 billion on original video content.
Apple is also continuing to work on doubling down on hardware to control the brains powering its products. As long as the byproduct of such efforts leads to products that are significantly different from existing products, Apple is likely able to qualify such efforts as R&D. Ongoing costs associated with Project Titan are also likely substantial, especially relative to smaller product-specific projects found throughout Apple.
Changes
Although Apple remains an incredibly focused company when it comes to products, the amount of money spent on R&D would seem to suggest that management may be relaxing its focus mantra a bit when it comes to researching new ideas. As seen in Exhibit 3, Apple R&D expenditures as a percent of revenue now stand at a 14-year high. This tells us that Apple is spending more on R&D for every dollar of sales earned despite the dramatic rise in sales over the years. For some companies this may not mean much, but for Apple it can't be ignored.
Exhibit 3: Apple R&D Expense as a Percent of Revenue
There are a few possible explanations for the growth in Apple R&D expenditures in recent years:
Greater ambition. Apple finds itself in a position of being able to do a whole lot more. It is estimated that Apple spent $150 million to build the first iPhone in the mid-2000s. At the time, it was a significant amount of cash for Apple. Nearly ten years later, Apple finds itself spending that much money developing one show for its upcoming video streaming service. To a certain degree, Apple management may feel it has an obligation of having to do more given its size. As Tim Cook recently put it, "We can do more things than we used to do because we’re a bit bigger."
Competition. One factor driving Apple's ambition to do more is competition. It is no longer enough just to control hardware and software. Apple now finds itself needing to control the technologies powering its devices. Bringing development of fundamental technologies in-house doesn't come cheap. Apple has opened a series of R&D centers around the world (China, Japan, India, Indonesia, New Zealand, Canada, France, Italy, Israel, Sweden, and the U.K.), many of which are tasked with developing hardware. Some of these R&D outposts are a result of Apple acquiring teams of talent.
More experimentation. Apple is likely experimenting much more when it comes to new ideas and processes. While there is no evidence of Apple allowing more of these ideas to actually proceed to market, it sure looks like Apple management wants to be in a position where it can afford to say "no" to more ideas than in the past.
The third point involving additional experimentation ends up being the most interesting. For a company that positions its ability to focus on a few things at any one time as a core competency, increased experimentation seems to be at odds with this value.
Apple R&D Theory
My theory on the dramatic rise in Apple R&D expenditures is that management is becoming more ambitious. Apple's future is found in new industries. Just as Apple moved from desktops/laptops to personal music players, smartphones, and watches, the company will need to enter new industries to remain relevant. This is not a company that is holding onto the iPhone as tight as possible for fear of change. Apple management is investigating new ideas and processes in order to support future moves into new industries.
This explains Apple's ongoing interest in transportation and Project Titan, an area that Apple has pretty much no expertise in. We have Apple building an entertainment arm from scratch despite having no experience developing scripted content. In each case, Apple has had to rely on outside hires and significant cash outlays to build core competencies.
It's not that Apple has thrown its focus mantra out the window. Apple remains very selective in terms of both its M&A activity and deciding which products make it to market. Instead of funding significant R&D endeavors with no intention of them one day leading to a product, Apple's R&D remains focused on ideas that at least have the potential to see the light of day. The years of development behind making Face ID a reality would be a recent example.
Much of this focus mantra is driven by the fact that Jony Ive and his Industrial Design group oversee Apple's product vision and the user experience found with Apple products. With only 20 or so members, Jony and team can only do so much at any given moment. In a way, Apple's organizational and leadership structure serve as safeguards preventing Apple from spreading itself too thin and doing too much. Instead of trying to expand the design team in order to work on more products, Apple's strategy appears to be to do the opposite and place bigger bets on a few products.
These bigger bets come in the form of owning the core technologies powering Apple devices. Apple wants to reduce dependency on others. We are quickly moving to the point at which every Apple product will be powered by core technologies developed in-house. Such a reality would have been a pipe dream just a few years ago. Apple believes this strategy will give them an advantage in the marketplace. It's a new twist to the Alan Kay line about "people who are really serious about software should make their own hardware." We are moving to the point at which companies serious about software should design their own silicon. Having $285 billion of cash on the balance sheet gives Apple the freedom to pursue this ambitious goal. It is this motivation to control more of the user experience while pursuing new industries to enter that is driving the remarkable increase in Apple R&D expenditures.
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Apple's Strategy for Controlling Sound
September 2016 marked the start of Apple's latest battle in what has been a multi-decade war. This newest battle was going to look and sound different. Apple had unveiled new iPhones lacking dedicated headphone jacks. The controversial move was criticized by many as a sign of Apple going too far in flexing its power and killing off legacy technologies for the sake of change. However, Apple's move wasn't about headphone jacks or even iPhones. Apple had made a big bet regarding the future of "sound on the go," and headphone wires were the enemy. We now see Apple unveiling its revised strategy for controlling sound in the home. The best way to analyze products like AirPods and HomePod is to look at them as the latest weapons in Apple's battle for controlling sound in our lives.
The Strategy
Apple's motivation in controlling sound is based on delivering impactful and memorable user experiences. Accordingly, music has played a fundamental role in Apple's sound strategy for the past two decades. Listening to a particular song can mentally remove someone from his or her surroundings. Music is one of the few things capable of fostering such strong emotional connections and experiences. It's a safe bet to assume music will be around for a very long time while music consumption will remain a key task handled by our computing devices.
There are two parts to Apple's strategy for controlling sound:
- Sound on the Go
- Sound in the Home
Sound on the Go
Apple is no stranger to selling devices designed to deliver sound. However, the iPod marked the beginning of Apple's quest to control sound on the go. Positioned as a "breakthrough digital device," the iPod changed the way we consumed music on the go, offering a much better experience than existing mobile listening options at the time. In what is now difficult to comprehend, the iPod effectively put an end to not being able to have your entire music library in your pocket.
The first iPod commercial highlighted the device's mobility as the user danced around his house while listening to music via iPod and white earbuds. The kicker was found at the end as he stepped outside the four confined walls of his home and into the outside world without missing a beat. The iPod was about consuming sound not just around the home, but more importantly, outside the home.
Over the subsequent years, Apple went on to unveil a number of different iPods, some of which turned out to be more popular than others. However, Apple was just getting started when it came to controlling sound on the go. Sensing that the iPod's long-term threat was found with people listening to music on smartphones, Apple began work on a much more ambitious product: iPhone.
As seen in Exhibit 1, the iPhone changed the course of Apple's sound on the go strategy. While the iPod was thought to be Apple's first mass-market product, the iPhone went on to redefine what it meant to be truly mass market. When Apple unveiled iPhone, the company was selling 50M iPods per year. Apple is currently selling 215M iPhones per year. Even though iPhone was much more than a dedicated music player, Apple never let go of its deep interest in music.
Exhibit 1: Apple "Sound on the Go" Devices Unit Sales (iPod and iPhone)
AirPods mark the latest step in Apple's sound on the go strategy. The device is born out of the belief that there isn't a place for wires in a wearables world. AirPods were initially criticized for their unusual looks, but those concerns have quickly disappeared. Whereas wireless AirPods may have looked odd to some, having wires hanging out of people's ears will eventually look out of place.
Based on sales, AirPods have been a resounding success. According to my estimate, Apple sold approximately 11M pairs of AirPods in 2017. This positions the device as the third best-selling Apple product out of the gate, behind iPad and Apple Watch.
Exhibit 2: AirPods Unit Sales
AirPods sales momentum is poised to continue over the next few years. As Apple Watch achieves greater independency from iPhone, AirPods will play a crucial role in delivering sound to tens of millions of Apple Watch users. Apple will reportedly unveil updated AirPods later this year. The runway for AirPods is long with a list of potential features that could include everything from health tracking to noise cancelling and augmented hearing. The big question found with future AirPods is, which features will get the green light? Apple is also rumored to unveil new noise-cancelling, over-ear headphones in a move suggestive of Apple expanding its line of wireless headphones.
Sound in the Home
It's easy to look at HomePod as Apple's foray into controlling sound in the home. In reality, the company's sound in the home strategy started with a whimper in 2006 with the iPod Hi-Fi speaker. The speaker was tasked with reinventing the home stereo for the iPod age by being positioned as a companion product to iPod. Apple ended up pulling the plug on the device after just 19 months of sales.
Twelve years later, Apple is giving sound in the home another try with HomePod. There are key differences in strategy this time around. Whereas iPod Hi-Fi was meant to enhance the iPod and iTunes ecosystem, HomePod and its A8 chip are being given a more ambitious goal of reinventing sound in the home by bringing computational audio to the masses. HomePod scans the room it's located in and then tailors sound output to that room. However, Apple isn't using computational audio to underpin its initial HomePod marketing campaign. Instead, Apple is relying on emotion, a page taken directly from the iPod, iPhone, and even AirPods playbooks. The latest HomePod "ad," a 4-minute film directed by Spike Jonze, is striking in theatrics. However, the thing that instantly jumped out to me about the video is how similar it is to the original iPod ad.
In both, we see people enjoying music using Apple devices. While one is listening to an iPod to get him pumped up to leave the house and experience the outside world, the other is listening to HomePod after coming home following a tough day. In both examples, the people lose themselves in the music experience produced by an Apple device.
Apple Music and Beats
Instead of being a revenue or profit driver, Apple Music serves as the glue in Apple's quest to control sound. While Apple's Beats acquisition was driven by music streaming and buying into Jimmy Iovine's overall music vision, Apple probably didn't mind getting a popular headphones brand in Beats. It's not as if Apple was unfamiliar with the power found with headphones (not to mention the branding opportunity).
The fact that Apple kept the Beats brand for headphones speaks to how Beats headphones are likely serving a different target market. In fact, Apple has positioned Beats headphones as a compliment to AirPods. This has likely gone a long way in removing the oxygen from the wireless headphone category market and preventing competitors from establishing any kind of beachhead.
Elephant in the Room
Apple's strategy for controlling sound in the home seems to have met its match in the form of Amazon Echo Dot and Google Home Mini. Whereas iPod, iPhone, AirPods, and Beats are personal devices delivering sound to individual users, cheap stationary smart speakers powered by digital voice assistants are shaping up to be more about communal experiences. In addition, the value found with an Echo or Google Home isn't derived from sound quality but rather from the intelligence of the digital voice assistant that lives in the cloud. This has led the tech community to think Apple misfired by positioning HomePod as a high-quality music speaker.
I see things differently.
The rise of digital voice assistants like Alexa and Google Assistant have seemingly redefined a stationary speaker's purpose so it's now about delivering intelligence rather than sound. The implication here is that the stationary speaker part of the equation is temporary in nature. If the same intelligence can be delivered to the user via another way, say via smart glasses, a smartwatch, or a pair of wireless headphones, low-end stationary speakers lose value. This idea serves as the basis for why I think the current stationary speaker narrative is off the mark. Apple looks at a stationary speaker as a tool capable of delivering intelligent sound. This use case likely won't change any time soon.
With HomePod, Apple isn't selling a high-quality music speaker. Instead, Apple is selling a new kind of music experience - one that isn't able to be produced with mobile devices, low-end speakers used for digital voice assistants, or even high-end speaker systems that may exceed $1,000. This music experience consists of a music streaming service, a digital voice assistant, and a combination of hardware and software that allows HomePod to map its surroundings and adjust sound output accordingly.
iPod did not become popular because it offered vastly superior sound quality on the go. Instead, it became a hit because it offered a better all-around music listening experience versus the competition. In addition, fashion began to matter with iPod and the accompanying white earbuds. We see a similar dynamic take place with AirPods. Millions of people aren't buying AirPods because of their superior sound quality. Instead, AirPods just work and offer a great user experience. Similar to iPod, AirPods are also seeing building momentum in fashion. AirPods are becoming the new cool, fashionable item that people want to be seen wearing on the street.
Juxtaposition
Apple is running away with its controlling sound on the go strategy. The company has no legitimate competition in the wireless headphone market. While this may change, it's not clear where that competition will come from. Meanwhile, Apple's positioning with controlling sound in the home appears to be much more precarious. Many think such a dramatic juxtaposition is due to Alexa and Google Assistant having already established a beachhead in the home. I'm not so sure about that. My suspicion is that HomePod is facing three different issues that make a challenging environment:
- Communal experiences. Voice-controlled smart speakers positioned in a common area aren't personal gadgets like iPhones and AirPods. It's not realistic to assume a family of four will have four different smart speakers catering to each member of the family. Apple's approach to this situation with HomePod appears to be to initially assume the device is for one user and then give that user the option to turn the device into more of a family music speaker that anyone can use to consume music. However, there are questions as to whether that can truly provide a superior music listening experience.
- Not just about music. While music has underpinned Apple's sound on the go strategy, iPhone and AirPods are used for more than music consumption. It's a stretch to say the same thing applies to the first iteration of HomePod with which music consumption is the primary use case. This may change down the road as Apple brings additional features to HomePod, but it's not clear if anything would replace music consumption as the speaker's primary use case.
- Competing against nonconsumption. With HomePod, Apple's most intense competitor ends up being nonconsumption, or the lack of high-quality speakers in the home. Up to now, most people haven't seen the need for or appeal of high-quality sound in the home. The high-end speaker market is niche. Apple is trying to change that and thinks a broader focus on the music listening experience is the answer.
While there are differences between Apple's sound on the go and sound in the home strategies for controlling sound, both share a common trait. Ultimately, each is about delivering experiences. In terms of sound on the go, Apple will likely look to deeply integrate Apple Music into its growing wearables lineup. In addition to delivering music, these wearables products will also serve as a conduit for delivering a digital voice assistant to the user. For sound in the home, Apple believes a use case for a stationary speaker that will likely still be around 5, 10, and even 15 years from now is music consumption. There is a long runway found with HomePod and the ability to reimagine sound to deliver a better music experience.
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The iPhone's Turning Point
Later this year, Apple will unveil a 6.5-inch screen that runs iOS. Five years ago, such a product would have been introduced as the newest member of the iPad family. However, Apple finds itself on the verge of releasing its largest iPhone to date. In fact, the device will likely be one of the largest smartphones in the market. Upon closer examination, such a dramatic change in product strategy was ultimately driven by Apple's realization that iPad mini was the wrong bet. It marked a turning point for iPhone.
An iPad World
The iPad was a rocket ship like nothing Apple had ever seen. It's difficult envisioning a future Apple product that will outsell iPad out of the gate. Three million iPads were sold in the first 80 days. During the first year on the market, 22 million iPads were sold.
As seen in Exhibit 1, iPad sales outpaced iPhone sales by nearly 3x after three years of sales. The iPad made the iPhone look mediocre. Some people even thought the iPad would become a bigger deal than iPhone. One has to wonder if at least a few Apple executives viewed iPad, not iPhone, as the product most capable of changing the world. We were truly living in an iPad world in the early 2010s.
Exhibit 1: iPad and iPhone Sales Out of the Gate
There were a number of factors behind the iPad's astronomical rise overnight. One of the more obvious was Apple's success in making the case that a device like iPad was needed. Apple positioned iPad as a device that sat between an iPhone and Mac. The juxtaposition elevated iPad at the expense of iPhone and Mac. The iPhone was positioned as a small, mobile device that wasn't great for things like web browsing, email, and consuming photos and video. Meanwhile, the Mac was positioned as a heavy beast blown out of the water by iPad for certain tasks.
iPad Mini Rationale
Despite strong iPad sales out of the gate, the early iPad years were also a period of immense anxiety and worry for Apple. Much of this fear was born from Apple's paranoia around competition. A $499 9.7-inch iPad left a price umbrella, so manufacturers can potentially undercut Apple with cheaper and smaller tablets running Android.
In late 2010, Apple was so worried about these 7-inch Android tablets that Steve Jobs made a rare appearance on Apple's earnings conference call to downplay the threat. This is when he gave the now infamous comment about having to sandpaper your fingers to one quarter of their present size in order to use a 7-inch touchscreen. Much of this was posturing as other Apple executives were making the case to Steve that Apple should do a smaller iPad.
Ultimately, it was this fear of cheap Android tablets that pushed Apple to launch iPad mini two years later in 2012. While the product was a rare defensive move from Apple, management also saw something intriguing about the 6-inch to 7-inch screen form factor. Instead of pursuing that interest with a larger iPhone, Apple saw the iPad as the better-suited product. It was increasingly looking like an iPad world after all, and smartphones were all about mobility. This turned out to be a mistake.
Flat-Footed
Just as Apple launched iPad mini, something was brewing over in smartphone land. Samsung was grabbing buzz by shipping smartphones with larger screens. It caught Apple's attention.
In March 2013, on the eve of Samsung's Galaxy S4 unveiling in NYC, Apple SVP Worldwide Marketing Phil Schiller sat down for an exclusive interview with The Wall Street Journal to throw punches at Samsung and downplay the momentum found with larger smartphones. Here's Schiller:
"Given the iPhone 5 is so thin and light, the reason that people are making their devices bigger is to get up to the battery life the iPhone 5 offers."
According to Schiller, large smartphones were being sold simply because manufacturers were able to use the additional size to fit a bigger battery. The devices were not being launched because they provided a better experience, according to Schiller. In reality, Apple was worried. They had just placed a big bet on iPad mini as a way to prevent Android from gaining share in the tablet space. However, the competition wasn't found with smaller Android tablets. Instead, it was found with 5-inch and 6-inch smartphones running Android. Having just launched the 4-inch iPhone 5, Schiller knew that Apple wouldn't have an adequate answer to these larger smartphones for at least another year and a half. Apple was caught flat-footed due to betting on iPad mini.
Turning Point
At some point in 2013, Apple likely made the decision that iPhones had to become larger in a big way. Giving the next major iPhone a small step up in screen size wasn't going to cut it. While Apple was likely pushed in that direction by market forces, the realization that such a move was needed was still a crucial one for management to make. In particular, Apple had to accept the fact that the iPad mini may not have too bright of a future despite just being launched and seeing remarkable strong sales out of the gate. There wasn't going to be a compelling use case for a 7.9-inch iPad in a world with larger smartphones.
What Happened?
My theory as to how all of this came together is that Apple executives were initially mesmerized by iPad's rocket sales out of the gate. It seemed like consumers would own and use both a smartphone and an iPad. Even if iPhone's market share remained on the low side, Apple would be able to sell iPads to feature phone, Blackberry, Windows, and Android users. This outcome would materialize as long as two factors were true:
iOS was the tablet platform of choice for developers. This is why Apple was so concerned about 7-inch Android tablets.
Smartphone screens were small. Larger smartphones would throw a wrench in Apple's strategy as the iPad would lose quite a bit of its value proposition.
Apple had an incentive to keep a sizable screen size differentiation between iPhone and iPad. As a result, Apple downplayed the phablet threat while dragging its feet in terms of shipping larger iPhone screens.
Based on Jony Ive's recollection of events, Apple tested larger iPhone prototypes with screens ranging from 4 inches to 6 inches as early as 2011. Apple designers thought a 5.7-inch screen felt good for iPhone, but the size was later deemed too large. It would end up taking another three years for Apple to launch iPhone 6 and 6 Plus with 4.7-inch and 5.5-inch screens, respectively.
Annual iPad sales peaked at 74M units at the end of 2013. According to my estimates, strong iPad mini sales played a big role in establishing that sales peak. In fact, iPad mini sales likely exceeded 35M units on an annual basis at their high point. However, the realization that the most formidable competition was found with larger smartphones rather than smaller tablets pushed Apple. The company was no longer hesitant to run with larger iPhones even if it meant weaker iPad fundamentals weren't too far behind.
As seen in Exhibit 2, which breaks out 7.9-inch iPad sales, iPad mini sales were decimated following Apple's move into larger iPhones.
Exhibit 2: iPad Unit Sales (TTM)
We now see Apple becoming extremely aggressive with larger iPhones. A 6.5-inch screen iPhone will launch less than a year after a 5.8-inch screen. A 6.5-inch iPhone would have been unfathomable during the early iPad years. Such a device would have decimated Apple's iPad strategy. Today, Apple is comfortable ceding a much larger portion of the market to iPhone at the expense of iPad. This has led to a much stronger iPhone franchise.
Earlier this week, Samsung unveiled its latest flagship smartphones, the Galaxy S9 and S9+. Unlike five years ago, when Schiller nervously tried to upstage Samsung's keynote, it is doubtful Apple even blinked an eye this time around. Apple removed Samsung's key advantage when it began to ship larger iPhones in 2014. The iPhone versus Samsung dynamic has never been the same since.
Lessons
There are a few lessons to be taken from this situation.
Cannibalization is OK. Cannibalizing a product is OK as long as you are the one doing the cannibalizing. For Apple, the thought of severely damaging iPad mini, which looks to be the best-selling iPad size out of the gate, wasn't easy. It would be the equivalent of Apple deciding to give AirPods health and fitness monitoring even if it meant Apple Watch would be permanently impacted as a result. However, Apple found itself with a much stronger iPhone business as a result of cannibalizing a portion of the iPad line. A 6.5-inch iPhone will likely sell for $1,199 while the original 7.9-inch iPad mini retailed for just $329.
Admit Mistakes and Embrace Change. There is this attitude that Apple doesn't make mistakes and instead the company needs to possess the right strategy out of the gate to be a winner. Reality is quite different. Apple is willing to admit to mistakes and then make needed changes to get back on course. Apple's decision to set aside iPad cannibalization fears and launch larger smartphones fundamentally changed both the iPhone and iPad businesses.
Get Rid of Dogma. Throwing away the dogma that smartphones derived value from small screens was crucial in uncapping iPhone's potential. In what may be hard to believe, we are likely still underestimating the trend found with larger smartphones. Apple has seen growing momentum with its 5.5-inch iPhone Plus models over the years. In fact, the iPhone 8 Plus is the best-selling 5.5-inch iPhone relative to its 4.7-inch sibling. Meanwhile, Apple will sell tens of millions of the 5.8-inch iPhone X in 2018. A 6.5-inch iPhone may outsell an iPad mini despite selling for 4x more.
Ultimately, the iPad mini's demise at the hand of larger iPhones led Apple to view the iPhone and iPad as siblings on the same computing spectrum. In such a vision, smartphones are allowed to possess increasingly large screens (6+ inches) while iPad screens trend larger (10.5-inch and 12.9-inch) in an attempt to stand out from increasingly larger smartphones.
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The Goldilocks Era for iPhone Has Begun
Not too hot. Not too cold. The iPhone is entering a new era that can best be characterized as status quo. The days of huge growth are over, and fundamentals aren't likely to improve significantly from current levels. However, underlying dynamics found with the iPhone business will likely prevent sales and revenue from dropping precipitously in the near term. We are in the iPhone's Goldilocks era.
iPhone Growth Era Over
iPhone sales have plateaued at a 215M units per year pace. As seen in Exhibit 1, Apple reached this sales plateau in mid-2016. The unit sales growth era that had defined iPhone for years is over.
Exhibit 1: iPhone Unit Sales (Trailing Twelve Months)
One issue found with Exhibit 1 is that reported iPhone sales include channel inventory adjustments. This opens the door to Apple management having a greater level of discretion over reported sales, especially in an environment of slowing demand. In an effort to get the most accurate view of iPhone demand, channel inventory adjustments have to be excluded to reveal sales on a sell-through basis (i.e. customer demand).
As seen in Exhibit 2, strong iPhone 6 and 6 Plus sales in late 2014 and early 2015 marked a high point for iPhone unit sales growth on a sell-through basis. After a difficult 2016, growth in sell-through demand has been anemic for the past five quarters. Management's 2Q18 guidance points to only a slight improvement in iPhone sell-through demand. Analysts calling for the "OLED iPhone" to kick off an iPhone megaupgrade cycle in 2018 - something I've been skeptical about from the beginning given the number of growth headwinds found in the iPhone business - have given up on the thesis.
Exhibit 2: iPhone Unit Sales Growth (Sell-Through Basis)
Red Flags
The lack of iPhone unit sales growth is not surprising. In May 2016, I published "iPhone Warning Signs" and the conclusion that "the iPhone growth story is breaking apart and management does not seem to be in control of the situation." Over the past two years, this is exactly what has happened as the four iPhone growth warnings signs highlighted in my article have fully materialized.
- Mobile carrier expansion is complete. Apple no longer has a sales tailwind from bringing iPhone to new carriers around the world.
- India isn't the next China. Any expectation of India becoming an iPhone sales growth engine in the near term is misplaced.
- Smartphone saturation. The era of iPhone sales growth coming from people buying their first smartphone has come to an end.
- Running out of Android switchers. There are only so many premium Android users in a position to switch to iPhone.
Two additional red flags have now appeared:
- Slowing iPhone upgrade rate. iPhone users are holding on to their devices for longer before upgrading. This trend has been unfolding for years, but the impact on iPhone sales is only now being felt.
- Overserving users. One reason iPhone users are holding on to their devices for longer is that their needs are being met with older models and less capable features. While new iPhones are still intriguing and enticing to a majority of iPhone users, a growing percentage of the iPhone installed base is content with their current device.
Instead of there being one particular reason or cause for the lack of iPhone unit sales growth, the six preceding factors have come together to create a much less friendly growth environment.
The Sky Isn't Falling
Given the presence of so many iPhone sales growth headwinds, it is logical to assume that iPhone sales will decline, potentially substantially, from current levels. In such a hypothetical situation, iPhone sales could even track similar to iPad sales which are now trending at 40% below peak levels. However, such a scenario isn't likely in the near term given the unique fundamentals underlying the iPhone business. A closer look at the dynamic between the two main iPhone sales drivers show a more resilient iPhone business.
There are two iPhone sales drivers:
- New iPhone users (a.k.a. switchers). This group includes consumers buying their first iPhone from Apple or a third-party retailer. Once someone buys an iPhone from Apple or a third-party retailer, that person becomes part of the iPhone installed base.
- Existing iPhone users (a.k.a. upgraders). This group includes current iPhone owners who purchase another iPhone from Apple or a third-party retailer.
Over the past six years, Apple has seen very strong iPhone sales to new users. This has helped Apple grow the iPhone installed base from 100M people in 2011 to more than 700M in 2018. These new users have come from various sources over the years. In the beginning, feature phone users drove iPhone installed base growth. Eventually, Blackberry users became a growth driver. Today, former Android users and people using preowned or hand-me-down iPhones are driving Apple's iPhone installed base growth.
As seen in Exhibit 3, I estimate Apple grew the iPhone installed base by more than 100 million people in 2017. While adding 100 million customers to the iPhone installed base is no small feat, my estimate reflects Apple's first year-over-year decline in the number of new users entering the installed base. The iPhone sales growth headwinds mentioned above are starting to take their toll. It is logical to assume iPhone sales to new users will continue to decline as time goes on.
Exhibit 3: iPhone Unit Sales to New Users
One of the largest benefits found with years of strong growth in the iPhone installed base is that Apple now has hundreds of million of users in a position to upgrade to a new iPhone. Exhibit 4 highlights annual iPhone sales to upgraders. According to my estimate, Apple sold a record number of iPhones to existing users in 2017. This may seem counterintuitive given the slowing iPhone upgrade rate. However, following years of dramatic growth in the iPhone installed base, there are simply more iPhone users in a position to upgrade. The increase in the installed base has more than offset the sales headwind caused by a slowing iPhone upgrade rate. It is logical to assume iPhone sales to upgraders will remain robust as time goes on.
Exhibit 4: iPhone Unit Sales to Upgraders
Combining iPhone sales to new users with sales to upgraders provides a clearer view of the dynamic underlying the iPhone business. The number of iPhones sold to existing users is increasing at approximately the same rate as the number of iPhones sold to new users is declining. This dynamic resulted in Apple reporting roughly flat iPhone sales for the past two years. In essence, the iPhone business is operating at sales equilibrium. It took iPad years to find its sales equilibrium after putting in a sales peak in 2013. Products like iPod and Blackberry never found a sales equilibrium as outside forces reduced their long-term value in the marketplace.
Exhibit 5 highlights the iPhone sales equilibrium dynamic. The blue portion of the bars (iPhone sales to existing users upgrading) made up a larger portion of overall iPhone sales in 2017 while the grey portion (iPhone sales to new users) shrunk.
Exhibit 5: iPhone Unit Sales Mix (New Users vs. Upgraders)
Defining the Goldilocks Era
The iPhone business has entered a new era in which status quo is the new normal. Along with unit sales growth, this dynamic will encompass other iPhone fundamentals such as average selling price (ASP), revenue, and margin trends.
Unit Sales. There is no clear path for Apple to grow iPhone sales substantially from current levels. While Apple may still report quarterly iPhone unit sales growth from time to time, especially if year-over-year compares are favorable, the growth would not represent some kind of step increase in sales.
As long as Apple is bringing in new users, a scenario that is likely to continue for at least the next few years, the iPhone installed base will continue to expand. This expansion will help offset some of the pressure from a slowing upgrade rate. A good rule of thumb is that annual iPhone sales will remain around 215M units, give or take 10 percent, for the next two to three years.
Once new user trends slow to the point of Apple barely bringing in any new users, all bets are off in terms of annual iPhone sales. From a unit sales perspective, the lack of new users will likely mark the top for iPhone sales given an upgrade cycle that continues to elongate. Apple likely has a few years before reaching this point.
ASP. Similar to iPhone sales growth, iPhone ASP will likely follow this Goldilocks path of not being too hot or cold, but rather following a status quo. As seen in Exhibit 6, after years of remarkable consistency, iPhone ASP hit $796 in 1Q18. Not only was this a record high for iPhone ASP, but the $178 sequential jump in ASP was also a record. The strong results were driven by a perfect storm of the higher-priced iPhone 8 and 8 Plus as well having the iPhone X launch take place in 1Q18.
Management commentary points to iPhone ASP falling in 2Q18. ASP will then decline further as we move away from the iPhone 8, 8 Plus, and X launches.
Apple can only push so far with iPhone pricing in the near term before demand trails off due to accessibility concerns. While many thought that threshold was $999 for an iPhone, in reality it's probably closer to $1,500. In addition, Apple will likely continue to get aggressive at the low end of the iPhone pricing spectrum. Accordingly, a reversion to the ASP mean of $650 is likely. The addition of a higher-priced iPhone X with a larger screen should keep iPhone ASP from falling too far below $650 in the near term.
Exhibit 6: iPhone Average Selling Price
Revenue. Apple saw robust iPhone revenue growth in 1Q18 due to the dramatic jump in iPhone ASP. Going forward, an ASP reverting back to the mean, combined with modest iPhone unit sales growth, will make it difficult for Apple to maintain robust iPhone revenue growth.
Margins. Apple doesn't disclose iPhone margins. However, given the company's stable overall gross margin, there is no reason to believe iPhone margins have deteriorated significantly in recent years. While Services revenue growth has certainly contributed to Apple's stable overall gross margin, much of that positive impact has likely been offset by weaker wearable and iPad margins.
One reason iPhone margins won't likely change much in the near term is Apple's broader iPhone strategy of using higher-priced, high-margin SKUs to offset margin pressure from lower-priced SKUs.
Implications
There are two major implications from the iPhone business entering a Goldilocks era:
- Time. A relatively stable iPhone business buys Apple management much needed time to come up with the next big thing(s). It's been a little more than three years since Apple unveiled Apple Watch, the company's most recent major new product category. New products like Apple Pencil, AirPods, and HomePod are accessories meant to work with Apple's major product categories. It's not realistic to expect Apple to launch new major product categories every three or four years. Instead, pressure for Apple to unveil a new product category will likely begin to grow in 2019 or 2020, five to six years after the Apple Watch was unveiled.
- Money. The iPhone is kicking off approximately $60 billion of gross profit per year. Assuming iPhone fundamentals remain relatively unchanged from current levels, Apple stands to earn close to $200 billion of gross profit from iPhone over the next three years. This is enough cash to support Apple's organic growth, R&D, M&A, and still leave funds to handle the capital return program.
Risks and Wildcards
In the mid-2000s, there was a school of thought that viewed the U.S as having a Goldilocks economy. Instead of strong growth, which would lead to inflation, or weak growth, which would lead to a recession, the economy was following a path somewhere in the middle. As it turned out, an asset bubble was forming in housing during this period. The bubble burst in 2007. A massive recession ensued, made much worse by toxic financial instruments based on an inflated asset.
Is there a variable that may do the same to the iPhone business? What may be developing or building in the background that has the potential to appear suddenly and quickly unravel the iPhone business overnight?
A few of the more popular items positioned as iPhone risks include:
- Voice. The expansion of rudimentary digital voice assistants into new platforms where data is increasingly transferred via voice and value moves away from apps and touch screens.
- Post Device Era. All-powerful cloud services eventually reduce the value found with hardware.
- China. The iPhone business can experience a sizable contraction overnight due to new policies enacted in China targeting Apple.
- Lack of Innovation. Mediocre features that are on par with competitors can lead to longer upgrade cycles, lower margins, and fewer sales.
- New Product(s). A new kind of product reduces the value found with iPhone.
Out of those five items, China regulatory issues represent the only item capable of impacting a decent portion of iPhone sales overnight. China is responsible for approximately 30% of iPhone sales. The other risks don't pose as much of a near-term concern for the iPhone business.
The largest wildcard that will jeopardize the iPhone business over the long run is a new kind of screen that is able to grab our time and attention away from iPhone. (I don't think voice by itself will be the answer.) This screen won't replace the iPhone, just as the iPhone didn't replace a laptop or desktop. Instead, this screen will initially appeal to those who felt overserved by iPhone. Eventually, this screen will begin to handle an increasing number of new tasks and workflows, some of which were never given to iPhone. Apple Watch and a pair of augmented reality (AR) glasses are best positioned to be those screens.
The initial versions of AR glasses for the mass market will probably be more like head-up displays positioned as smartphone accessories. This leads me to think that it will be difficult for new products to unravel the iPhone business overnight. The iPhone is simply too multi-functional and multi-purpose. The artificial sense of safety found with such a statement does not escape me. The moment when it seems like there is nothing that can impact a business or product is usually the time when safety needs to be thrown out the window.
Big Picture
The iPhone's Goldilocks era is all about stable fundamentals for the next two to three years. During this period, Apple will continue to experiment with higher-priced and more capable SKUs at the high end while making iPhone more accessible with lower pricing at the low-end.
As for what comes after the Goldilocks era, a good argument can be made that iPhone's future is one of a powerful AR navigator. In this environment, Apple Watch and Apple Glasses handle much of the low-hanging fruit in terms of mobile tasks and workflows while iPhone is a more powerful computer targeting increasingly niche applications. This would lead to less robust iPhone unit sales but improved ASP and margin trends.
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Apple 1Q18 Earnings Expectations
If Apple's 4Q17 amounted to a throwaway quarter, 1Q18 earnings will prove to be much more important for Apple. For the first time in six years, Apple's FY1Q results will reflect a full flagship iPhone launch. Typically, iPhone launches have been split between Apple's FY4Q and FY1Q. On top of it all, this wasn't just any iPhone launch as it was Apple's first flagship iPhone to begin at $1,000. The iPhone X will have a major impact on Apple's 1Q18 results.
The following table contains my Apple 1Q18 estimates. The ingredients are in place for Apple to beat consensus and its own revenue guidance.
My full perspective and commentary behind these estimates are available to Above Avalon subscribers. (Become a subscriber to access my 6,000-word Apple 1Q18 earnings preview available here. To sign up, visit the subscription page.)
Items Worth Watching
There are five variables worth watching when Apple releases earnings on Thursday.
- iPhone ASP. iPhone unit sales won't tell the full story as to how the iPhone business performed during 1Q18. Instead, iPhone average selling price (ASP) will provide useful clues for determining how iPhone X sold. I expect Apple to report the largest quarterly sequential jump in iPhone ASP on record because of strong iPhone X sales. The dramatic jump in iPhone ASP is the primary reason why my revenue estimate is 10% above the top of Apple's 1Q18 guidance range.
- iPad ASP. While Apple is expected to report continued iPad unit sales growth, iPad ASP will provide clues as to whether the low-end 9.7-inch iPad, the iPad Pro, or a combination of the two sold well.
- Other Products. The "Other Products" line item will include Apple Watch and AirPods revenue. Both products likely saw very strong sales momentum during the holiday season as Apple wearables are quickly connecting with the mass market.
- China. The underlying fundamentals found with Apple's China business have been trending stronger than consensus assumes. There is a possibility that China was the primary driver for iPhone X sales, which will have a major impact on Apple's overall results. In addition, there have been signs of broad Apple ecosystem strength in China as seen with non-iPhone sales.
- 2Q18 Guidance. There's never an Apple quarter in which management's revenue guidance isn't an item worth watching. Apple's 2Q18 revenue guidance will give us a look at how the company is thinking about the broader iPhone upgrade cycle as we move away last year's iPhone launches.
1Q18 Expectation Meters
Each quarter, I publish expectation meters ahead of Apple's earnings release. Given the significant amount of modeling work that goes into each of my Apple financial estimates, these expectation meters turn single-point estimates into ranges in order to more accurately judge Apple's quarterly performance.
In each expectation meter, the grey shaded area is my expectation range. In most cases, a result that falls within this range signifies that the product or variable being measured is performing as expected. A result that lands in the green shaded area denotes strong performance and likely leads me to raise my assumptions and estimates going forward. Vice-versa, a result that lands in the red shaded area has the opposite effect and leads me to reduce my assumptions.
I am publishing four expectations meters for Apple's 1Q18: iPhone unit sales, iPhone ASP, iPad unit sales, and 2Q18 guidance.
My iPhone unit sales expectation range stretches from 80M to 84M iPhones. An iPhone unit sales result within this range would be labeled as "expected." A result that exceeds 84M iPhones would be viewed as strong, while a sub-80M iPhone result would lead me to reassess my sales expectations going forward.
For the first time, an iPhone ASP expectation meter is being shared. This reflects the importance found with the variable for Apple's 1Q18 earnings. An iPhone ASP below $750 would come in well below my expectations and point to sales momentum being found with lower-cost iPhone options.
The iPad is the second-best selling Apple product category. Accordingly, the product remains a good reflection of how the broader Apple ecosystem is trending, especially in terms of emerging markets, enterprise, and education.
Based on consensus, sell-side analysts expect Apple to earn $68B of revenue in 2Q18. Expectations have been declining in recent weeks as a growing number of analysts think strong 1Q18 iPhone results may have been a result of demand being pulled ahead from 2Q18.
Revenue guidance in the $65B to $70B vicinity would likely be viewed positively while revenue closer to $60B would be viewed more negatively. It is worth pointing out that Apple reported $54B of revenue in 2Q17.
Above Avalon subscribers have access to my full 1Q18 earnings preview (four parts):
- Setting the Stage
- iPhone Sales Estimate
- iPad, Apple Watch, Mac, Services Estimates
- Revenue, EPS, 2Q18 Guidance, Big Picture
Subscribers will also receive my exclusive earnings reaction emails containing all of my thoughts and observations on Apple's 1Q18 earnings report and conference call. To read my Apple earnings preview and receive my earnings reaction notes, sign up at the subscription page.
Apple Watch Is a Bridge to the Future
Something has changed inside Apple Retail stores. On a recent trip to my local Apple Store on a Sunday afternoon, it was actually difficult to get up close to the Apple Watch tables. People were looking at and buying various Apple Watch models and bands. It brought back memories of the early hoopla found when trying out iPad for the first time. Just two years ago, the lack of crowds around the Apple Watch tables led people to wonder if the Apple Watch was a misfire. Something is changing when it comes to the way people are thinking about Apple Watch.
Sales Momentum
My recent Apple Store observation is not an isolated incident. More people are buying Apple Watches these days. During the three quarters leading up Apple's FY1Q18, Apple Watch unit sales have been up at least 50 percent year-over-year. From a unit sales perspective, this works out to Apple Watch sales trending at a little less than 20M units on an annual basis. In what will come as a surprise to most people, Apple Watch likely outsold Amazon Echo during the holidays despite Apple Watch selling for nearly 10x more money.
Based on unit sales, the Apple Watch business is currently about the size of the Mac business. When considering that the Apple Watch is less than three years old, for the product to be nearly outselling Mac on an annual basis is quite the achievement. As seen in the chart below, assuming Apple is able to maintain Apple Watch sales momentum, the sales gap between Apple Watch and iPad will continue to narrow.
There is currently no legitimate wrist wearables market. Instead, there is only an Apple Watch market. Android Wear continues to be a nonfactor. Samsung and Fossil haven't been able to put all of the pieces together. Garmin has been able to carve a nice niche for itself in the endurance sports space, but there is no obvious path for the company to take to broaden its appeal. Meanwhile, the former leader of wrist wearables, Fitbit, is quickly fading away.
A Bridge
Why is Apple Watch sales momentum growing? My theory is that consumers are starting to see a place for Apple Watch in their lives. While Apple's revised Apple Watch marketing campaign around health and fitness has led to a clearer sales pitch, I think the health and fitness messaging ends up being Apple's way to get its wrist in the door. People aren't buying and using Apple Watch just for its health and fitness monitoring features. There is something more at play here.
Close to 20 million people bought an Apple Watch in 2017 because the device has become a bridge between the present and future. By including a screen, Apple Watch retains the familiarity found with smartphones, tablets, and laptops/desktops. At the same time, Apple Watch is giving wearers a glimpse of the future by introducing new ideas around how artificial intelligence, voice, digital assistants, and smart sensors can come together to produce a new kind of experience.
A Revolution
We are witnessing nothing short of a revolution with Apple Watch. The device holds the potential to become more disruptive to the current computing paradigm than even Apple may want to acknowledge. This potential is becoming easier to see as time goes on.
Apple Watch is designed to initially pick the low hanging fruit from the iPhone and iPad trees in terms of handling relatively simple use cases like receiving notifications, checking the time and weather, and tracking our daily activity. The device handles these tasks by approaching touch screens in a unique way. Apple Watch is designed for glances instead of prolonged viewing or watching.
For companies with business models based on grabbing as much of our attention as possible, Apple Watch does not represent a preferred revolution. This is likely one reason why Android Wear has failed to amount to much for Google. There just isn't much incentive for Google to put Android on the wrist. Apple Watch will also likely end up being quite disruptive to Apple's existing ecosystem. Apple management doesn't mind this future. Instead, they are embracing the unknown.
The same can't be said for a segment of the iOS developer community that ranges from indies to multinational companies. This group is becoming nervous about Apple Watch because it's not clear how the device will support the existing app ecosystem. In fact, this explains why a small portion of the Apple community has been so dismissive of Apple Watch from the start. News of major companies backing away from Apple Watch support has led this community to think that Apple Watch is in trouble. In reality, this is backwards. The current app ecosystem, not Apple Watch, is in trouble.
While Apple sees what the Apple Watch can become, management likely isn't sure of the exact path that will be taken to get there. For example, the honeycomb pattern of apps on Apple Watch is likely based too much on the present state of technology. Meanwhile, Apple's ongoing quest to figure out what to do with the Apple Watch side button is another sign of the company trying to capture the genie in the bottle in terms of how we will use apps on the wrist.
The reality is that Apple Watch likely won't support the same kind of ecosystem that we are accustomed to with iPhone and iPad. Apple Watch ends up being designed more for what may come after the App Store. Instead of relying on a collection of apps on my wrist, most of my interactions with services and features on Apple Watch end up being through the Siri watch face and various cards featuring glanceable amounts of information and data chosen for me by a digital assistant. These cards are personalized for me based on the time of day and my schedule. The implications of this computing experience are immense. We move away from pulling data from various apps and getting pushed mostly useless notifications to being pushed a curated feed of data that is always changing and tailored to the day at hand. Every app developer will be impacted by this dynamic.
Betting Big
Given how Apple Watch is playing such a crucial role in Apple's product vision, one assumes the product is gaining importance and priority within Apple. A closer look at Apple's product strategy confirms Apple Watch's growing influence within the company.
The Apple Watch-centric feel to Apple's recent product strategy is becoming hard to miss. While AirPods are a pair of wireless headphones that work with a plethora of devices, including iPhone, Apple is positioning them as an Apple Watch accessory more than anything else. The subtle references to AirPods in the following ad make it difficult to know if it's an Apple Watch or AirPods ad. (It's actually an Apple Watch & Apple Music ad, and it's pretty great.) The ad is meant to highlight the ability to listen to music on the go with Apple Watch and AirPods.
New accessories for Apple Watch won't stop with AirPods. Apple's upcoming stationary speaker, HomePod, will likely turn into a useful Apple Watch accessory as Watch wearers get additional music controls on their wrist. In one of the animated videos on Apple's HomePod website, the only Apple product shown in the room other than HomePod is Apple Watch. There is no iPhone, iPad, or Mac in sight. For some companies, this can be brushed off as a simple oversight, but not for Apple. It's intentional.
Vision
When it comes to thinking of a product or feature that may one day serve as a legitimate iPhone alternative, there is a small but passionate group who thinks a paradigm around voice is the answer. In this voice world, screens and keyboards still exist, but their value will have been greatly diminished. Everything from hardware to the app ecosystem is expected to be disrupted in this voice-centric world. Meanwhile, there is another group who doesn't think it's a good bet to assume screens will lose value in our lives. While voice may be a useful input mechanism, screens and user manipulation on screens will remain a valuable way to consume data for the foreseeable future.
Apple has a vision for how we will use the combination of voice and screens in the future. Unlike Amazon and Google, who are desperately trying to position voice as a way to leapfrog over the current smartphone/tablet and app paradigm, Apple is approaching things from a different angle. Instead of betting on a voice interface that may push some information to a stationary screen, Apple is betting on mobile screens that are home to a digital assistant. Apple is placing a bet that consumers will want the familiarity of a touch screen to transition to a future of greater AI and digital assistants. In addition, Apple thinks user manipulation via screen (fingers, hands, and eyes) will remain a crucial part of the computing experience for the foreseeable future.
Priorities
Here are Apple's priorities for Apple Watch in order for the device to become a more desirable bridge between the present and future:
Independency from iPhone. Apple Watch's largest new features since launch have been related to achieving greater independency (GPS in 2016 and cellular connectivity in 2017). The writing has been on the wall since 2014. Apple Watch will eventually become completely independent of iPhone. We will likely be surprised at how quickly this independency will be achieved.
Powerful screen. The most useful and powerful screen in our lives will be the one that is on us. For most people, that screen is currently our smartphone. In the future, Apple Watch and a pair of AR glasses will have a good chance of holding that distinction.
Powerful camera. The most useful and powerful camera in our lives will be the one that is on us. For most people, that camera is currently found in our smartphone. In a world where we may begin to leave iPhone behind, there is logic found in giving Apple Watch a selfie camera with Face ID.
Superb health monitoring. It's difficult to think of another device that will be on our body as much as a wristwatch. According to Apple, the Activity app is the most used Apple Watch app. This doesn't come as a surprise given the wide range of notifications and reminders delivered to Apple Watch wearers throughout the day.
Home to our digital assistant. Creating a device that can both listen to our voice and provide visual context is a powerful way to quietly place a digital assistant in our lives. The Siri watch face on Apple Watch is the embodiment of this intelligent assistant. Apple believes an intelligent assistant that is always on you, and comes with a screen, is more powerful than one that is just confined to four walls. Amazon's urgency to bring its voice assistant, Alexa, to wearables adds validity to Apple's stance.
The Big Question
One question facing Apple is how the company plans on taking the app ecosystem that turned iPhone and iPad into juggernauts and use it to push Apple Watch and future wearables (i.e. Apple Glasses). Apple's product strategy has been receiving criticism given Amazon's push to get Alexa into as many third-party products as possible. Even if Amazon's advantage is in perception only, which I think there is truth to, such perceived notions can prove to be a danger to Apple.
It appears that Apple's strategy of building a new wearables ecosystem consists of two overarching themes. The first is establishing a platform of first-party hardware, software, and services. For example, AirPods and Apple Music will end up being great marketing tools for Apple Watch (and vice versa). The same will likely be said about HomePod.
Apple also has invested significantly in getting the health, fitness, and medical industries to embrace Apple Watch. Items like GymKit allow Apple Watch wearers to pair their device with fitness equipment. Third-party products like AliveCor's KardiaBand, which takes a clinical grade EKG, are literally being built for Apple Watch. Meanwhile, the list of medical and heath devices that work with Apple Watch is growing while ResearchKit and CareKit gain influence in the health and medical industries. This is where Apple's sheer dominance in wrist wearables helps the company appeal to third parties looking to offer health and medical services.
Later this year, there will be more than 40 million people wearing an Apple Watch on a daily basis. As competition for our attention moves away from smartphones and tablets, it will soon become evident that Apple holds immense power in being the largest wearables software provider in the world. This power will manifest itself in Apple's digital assistant occupying a growing role in hundreds of millions of users' lives. Apple Watch is becoming Apple's bridge to this new world.
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Apple Questions for 2018
The beginning of January is a great time to embrace the unknown found with the new year. Instead of trying to manufacture clarity with a long list of predictions for the new year, there is much more value in embracing the unknown and asking questions. This is my fourth installment of Apple questions. Previous years' questions can be found below:
Here are my Apple questions for 2018:
iPhone
New iPhones. How many new iPhones will Apple launch in 2018? In 2017, Apple unveiled three new iPhone models simultaneously for the first time with iPhone 8, 8 Plus, and X. This dynamic makes 2018 the most interesting year yet when it comes to contemplating the company's plans for new iPhone models.
Larger iPhones. Will Apple introduce a larger iPhone? One of the more pronounced multi-year trends with iPhone has been a move to larger form factors. A strong case can be made for Apple to introduce a larger version of the iPhone X. By removing the home button and front-facing bezel, an iPhone with a 6.5-inch screen and Face ID would end up being close in size to the iPhone Plus.
Face ID 2.0. Will Apple unveil a second version of Face ID with additional features and capabilities? Examples include working at closer proximity to one's face or when flat on a table.
iPhone SE. Will Apple update the iPhone SE? A 4-inch smartphone screen is looking increasingly out of place in today's smartphone landscape, not to mention Apple's product line. However, the iPhone SE represents Apple's entry-level option into the iPhone ecosystem. In addition, iPhone SE is Apple's ticket for building a supply chain and assembly network in India.
Pricing. How will Apple expand the iPhone's pricing spectrum in 2018? Apple has been aggressive at cutting entry-level iPhone pricing while introducing higher-priced SKUs at the other end of the spectrum.
Naming. What is Apple's plan for iPhone nomenclature going forward? While iPhone X certainly stands out in the naming department, the name adds a new twist when it comes to marketing new iPhones.
Upgrade Cycle. Will the iPhone upgrade cycle continue to extend? The average iPhone user is holding on to their iPhone for a longer amount of time before upgrading. A continuation of this trend will have a significant impact on the iPhone business.
Overserving Users. Will we see additional evidence of Apple overserving customers with iPhone? If a portion of the iPhone user base feels like their needs are being met with older iPhones and less advanced features, Apple will face a new challenge with iPhone.
India. How will Apple alter its iPhone strategy in India in order to improve accessibility?
New User Growth. How will Apple respond to slowing new iPhone user growth? The company appears to be running out of pockets of premium smartphone users around the world. In order to expand the iPhone installed base, Apple will either have to appeal to increasingly loyal premium Android users or begin to move down the pricing pyramid to appeal to Android users in lower price tiers.
iPad
New iPads. Will Apple unveil news iPads? Apple does not necessarily follow an annual schedule for iPad updates as it does with iPhone.
Face ID. Will iPad receive Face ID in 2018? Face ID is the future, and it's inevitable that the technology will make its way over to iPad. However, there are many questions surrounding the timing of such a move and the actual implementation.
iPad mini. What is Apple's plan for the 7.9-inch iPad mini? The form factor is becoming increasingly awkward in a product line containing larger iPads and iPhones. By removing iPad mini 2 from the lineup last year, the iPad mini form factor lost its place as the lowest-priced, entry-level option for the iPad ecosystem.
Pricing. How aggressive will Apple become with entry-level 9.7-inch iPad pricing? The company slashed 9.7-inch iPad pricing to $329 ($299 for education institutions) last year. There is likely room for Apple to become even more aggressive with 9.7-inch iPad pricing.
Education. Will Apple unveil new iPad features specifically targeting education? Management is well aware of iPad's weakened position in the classroom due to school districts and administrators tailoring curricula to cheap Chromebooks.
Apple Watch
New Apple Watches. Will there be a new Apple Watch unveiled in 2018? While Apple seems to be following an annual cadence for Apple Watch updates, running too fast with assumptions can be dangerous when contemplating such a young product category.
New Form Factor. Will Apple alter the Apple Watch form factor? With only minor cosmetic changes year-to-year, Apple has maintained the original Apple Watch form factor unveiled in 2014.
Upgrade Cycle. Will Apple begin to reveal assumptions regarding an Apple Watch upgrade cycle? A revised Apple Watch form factor would speak volumes as to how Apple is thinking about a potential Apple Watch upgrade cycle.
New Features. Which features will anchor a new Apple Watch? Similar to iPhone, Apple likely wants to have two or three marquee features to anchor a marketing campaign around a new device. The easy answer has been "better and improved health sensors." However, the past two years have shown that Apple has been focused on the device gaining independency with key Watch features. In 2016, the key feature was GPS. Last year, it was cellular connectivity.
New Watch Bands. How many new Apple Watch band collections will Apple unveil in 2018?
watchOS 5. Which new features will anchor watchOS 5? Apple's strategy to choose quality over quantity with watchOS 4 worked out well for the company and Watch owners.
New Partnerships. Will Apple introduce new Apple Watch partnerships? Instead of expanding the number of partnerships, Apple has been focused on strengthening its existing ones with Hermès and Nike. However, 2018 may be different, especially if Apple sees the need to remove oxygen from the fashion or endurance smartwatch niche in which Fossil and Garmin are playing, respectively.
Pricing. How aggressive will Apple become with entry-level Apple Watch pricing?
Sales Disclosure. Will Apple begin to disclose Apple Watch unit sales? A strong case can be made for Apple to take advantage of strong Apple Watch sales momentum and disclose unit sales. Apple Watch revenue can continue to be lumped in with the Other Products line item.
Mac
New MacBook Pro. Will Apple unveil a new MacBook Pro in 2018? As with iPad, Apple doesn't necessarily follow an annual cadence when it comes to Mac updates. However, Apple management has indicated it is aware of some user complaints with MacBook Pro. Historically, Apple has been quick at addressing issues and problems, assuming Apple views MacBook Pro complaints as legitimate problems.
MacBook Air. Will Apple continue to sell MacBook Air? The model increasingly appears to be merely a placeholder in order for Apple to sell a Mac portable for less than $1,000.
Mac Pro. Will Apple unveil the new Mac Pro and standalone display in 2018? We know a new Mac Pro is coming, but the big question is when.
Mac mini. What are Apple's plans for Mac mini? Despite Tim Cook strongly signaling a new Mac mini is in the works, there continues to be a debate as to whether the Mac mini even has a future at Apple.
AirPods
New AirPods. Will Apple unveil new AirPods in 2018? We know a new AirPods case designed to work with Apple's new AirPower wireless charging pad is in the pipeline. There are plenty of new features, including various health-related items, that can be added to AirPods. The question is if any of those features will get the green light to market, especially when Apple is looking to position Apple Watch as the health monitoring device.
Additional Colors. Will Apple sell AirPods in a color other than white? While there is likely consumer interest in various AirPod colors, it's not a given that AirPods will follow Apple Watch bands and come in a range of color options.
Additional Sizes. What is Apple's stance on offering various AirPod sizes?
HomePod
Launch. When will Apple launch HomePod? Given the company's statement on HomePod launching in "early 2018," a CY1Q18 launch would make sense.
Features. Will Apple unveil new HomePod features that weren't announced on stage during WWDC? There is still a decent amount of unknown found with HomePod, especially when it comes to how the device is designed to be used with Siri and other Apple products/services.
Pricing. Will Apple launch HomePod at $349? It would be unprecedented for Apple to change the price of an unreleased product between unveil and launch.
Apple TV
Pricing. Will Apple update Apple TV pricing? Apple increased Apple TV pricing with Apple TV 4K. The move highlighted a company with a very different view of the video streaming box market.
iOS
iOS 12. What will be the major themes for iOS 12? A release focused more on quality over quantity in terms of new features wouldn't necessarily be met with much disagreement in some parts of the Apple community.
Features. Which features will get Apple's attention? Candidates high on the list include the camera, photos, ARKit, and HomeKit.
Siri
I am giving Siri its own category to reflect its growing importance.
Vision. How is Apple going to push Siri forward in 2018? The question is left broad on purpose. There is evidence of the digital voice assistant receiving far too much criticism given what amounts to genuine improvement and advancement in recent years. In addition, there is a growing debate as to how Apple looks at Siri's role in our lives.
Content
Apple Music. What are Apple's plans for Apple Music in 2018? With approximately 35M paying Apple Music subscribers, Apple is about one-third of the way to reaching its unofficial goal of having 100M paying Apple Music subscribers. When taking into account family accounts, there are now between 40M and 45M people using Apple Music.
Apple Video. When will Apple launch its video streaming service? The company continues to build out its Apple Studios division as a billion dollar content budget is put to work to assemble a bundle of original content programming.
Content Bundle. Will Apple combine Apple Music with Apple Video to form an Apple Entertainment bundle? Such a product would certainly give both Apple Music and Apple Video differentiation in what is becoming a crowded market.
Podcasts. Will Apple look to leverage its long-standing power as a podcast distributor into something else?
Services
Apple Maps. What are Apple's plans for improving Apple Maps in non-U.S. geographies?
Apple Pay. Does Apple have a strategy for increasing Apple Pay adoption among U.S. retailers?
M&A
Acquisition Targets. Which companies will Apple buy in 2018? This question is left open-ended on purpose. One would expect AR companies to remain high on the M&A target list.
Investments. Will Apple take a deeper step into venture capital and tech fund investing? The company has said such investments will aid in the discovery of new technology in an increasingly competitive landscape.
Project Titan
Objectives. What are Apple's plans and objectives for Project Titan in 2018?
Washington and Wall Street
U.S. Manufacturing. How will Apple respond to increased pressure from Washington to bring manufacturing jobs back to the U.S.? The company's primary response has been to ratchet up the PR around job creation. Will Apple expand its manufacturing fund for U.S. manufacturers? The company has been gifting sizable amounts of capital to U.S. suppliers in exchange for improved supply of critical components needed for Apple products.
Cash Strategy. When will Apple bring back its foreign cash? Once the cash is in U.S. subsidiaries, how will Apple remove excess cash from the balance sheet?
Buyback. How much will Apple spend on share buyback in 2018?
Dividends. What will be Apple's new quarterly cash dividend? The announcement will be made in the spring.
Management
Turnover. Will there be any high-level turnover at Apple in 2018? There is no obvious candidate in the SVP ranks that is either at risk of being removed or close to retirement. The most recent departure was that of former general counsel Bruce Sewell, who retired at the end of last year.
New Faces. Will Tim Cook expand Apple's executive team? The last addition to the SVP ranks was Johny Srouji, who was promoted at the end of 2015 to SVP Hardware Technologies.
Tim Cook's Inner Circle. How will responsibility be split among Tim Cook's inner circle? Jeff Williams, Eddy Cue, and Phil Schiller are each overlooking key aspects of Apple's business. Williams oversees Apple Watch and health. Cue is becoming Apple's content czar, and Schiller was given leadership over the App Store across all platforms.
Power. Which executive will gain power and influence within Apple in 2018?
Apple Industrial Design
Jony Ive. Will we get any surprises from Jony? With Apple Park mostly completed and the new design language for Apple Retail finished, Jony appears to be dedicating time and attention to new product initiatives.
Turnover. Will there be additional turnover in the Apple Industrial Design group? Apple lost an industrial designer in both 2016 and 2017.
New Hires. Will Apple add to its Industrial Design group? While Jony may want to make the team even smaller, there is space for one or two new industrial designers. An additional benefit of a few new hires would be adding fresh ideas into the team dynamic underpinning Apple Industrial Design.
New Workspace. How will Apple's industrial designers adapt to Apple Park? For the first time, Apple will have one large design studio housing hundreds of designers instead of a web of disconnected spaces. This process will inevitably lead to changes in team dynamics.
Wildcards
Product Events. How many product events will Apple hold in 2018? Apple held only two events in 2017 (WWDC in June and the iPhone X / Apple Watch event in September at Steve Jobs Theater). One theory as to why Apple experienced a number of hardware and software delays in 2017 was that the company had to prematurely announce products since there were only two events to unveil them (June and September).
Health and Medical. Does Apple plan to announce new health and medical initiatives?
Public Image. Will Apple alter its public image in 2018? Changes can include a renewed focus on a particular area of the business.
New Product Categories. Will Apple unveil a completely new product category this year? In recent years, Apple has unveiled a number of new accessories. In 2015, Apple unveiled Apple Pencil. In 2016, Apple unveiled AirPods. Last year, Apple unveiled HomePod.
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Grading Apple's 2017
Apple had an eventful 2017. Over the span of just a few months, the company updated nearly its entire product line. In addition, we saw Apple unveil a number of noteworthy strategy changes and even a pivot across its major product categories. The year concluded with a handful of high-profile problems including a serious macOS security flaw, delayed software and hardware releases, and the company getting caught in a crisis of its own making involving throttling older iPhones.
Grading Methodology
It's easy to point out the inevitable long list of problems and mishaps Apple experiences in any given year and then conclude that the company went off the rails. By such measure, 2017 was a pretty bad year for Apple. On the other hand, there is little value found in just focusing on items that are traditionally viewed as positives, but are in reality bare minimums for Apple to maintain status quo, such as updating existing products or generating significant amounts of cash.
There are two ways to judge Apple's performance in 2017:
- Financial perspective. Base the company's degree of success or failure on financial metrics including margins, ASPs, unit sales, and revenue.
- Product perspective. Analyze the positives and negatives found with Apple's product strategy.
A hybrid approach is used for my grading process. A successful product strategy will eventually manifest itself in positive financial trends. However, financials are sometimes unable to tell the full story. By using both financial and product perspectives to grade Apple in 2017, the two schools of thought end up complimenting each other, leading to an in-depth review that fully captures Apple's performance.
Report Card
My report card for Apple's 2017 is broken into eight categories.
iPad. After a multi-year stretch of steep unit sales declines, questionable marketing, and an increasingly complicated product line, Apple turned things around with iPad in 2017. Management unveiled a number of significant strategy changes to iPad. These came together nicely to give the product category its best year since 2013, despite unit sales remaining approximately 40% below peak levels.
Signs of light at the end of the iPad tunnel began to appear in 2016 as sales of larger iPads continued to outperform sales of the smaller 7.9-inch form factor. It became clear that the iPad mini was not only contributing to iPad's ongoing unit sales decline, but was also holding the iPad back.
In February 2017, Apple unveiled its first multi-ad campaign for iPad Pro. The ads were noteworthy for what they told us about how Apple management viewed iPad. Traditionally, Apple's argument had been that the iPad is actually a computer due to having features X, Y, and Z. Apple was now saying the iPad Pro isn't a computer. Instead, iPad is better than a computer due to having features X, Y, and Z.
In March 2017, Apple announced a number of iPad strategy changes. Apple took the iPad Air 2 and gave it a new processor, screen, name, and $70 price cut. The changes, which added much-needed simplicity to the iPad line, amounted to Apple doubling down on larger iPad form factors. In addition, Apple was convinced that a lower-cost 9.7-inch iPad would entice existing iPad owners still on their first iPad to upgrade.
Apple continued to run with iPad at WWDC, dedicating 21% of the keynote to iPad. Management announced an all-new 10.5-inch iPad Pro, which replaces the 9.7-inch model. The 10.5-inch screen iPad, with a 20% larger screen than the 9.7-inch model, supports full-size on-screen and smart keyboards. Apple announced significant software features for iPad via iOS 11, including a dock, drag and drop, a redesigned keyboard, and a files app.
The result of Apple's numerous iPad changes throughout 2017 were iPad sales surprising to the upside. As seen in Exhibit 1, on a trailing twelve months basis, iPad unit sales have grown for the past three quarters. The holiday quarter (1Q18) will likely represent the fourth consecutive quarter of iPad unit sales growth.
Exhibit 1: iPad Unit Sales - Trailing Twelve Months
iPad milestones in 2017:
- Unveil a revised iPad marketing strategy.
- Become ultra-aggressive with 9.7-inch iPad pricing.
- Introduce an all-new 10.5-inch screen form factor.
- Push significant iPad software improvements in iOS 11.
iPad issues in 2017:
- There are still genuine questions as to just how fast Apple is pushing iPad in order for the device to serve as a viable Mac alternative for content creators.
- iPad still faces an uphill battle in education settings.
Grade: A
Apple demonstrated the willingness to take some big risks with iPad in 2017. Pricing and marketing changes may end up being a much larger deal for iPad sales in 2018 than software enhancements found in iOS 11.
Apple Watch. Apple Watch had a banner year in 2017. Apple sold approximately 18M Apple Watches during the year, up a whopping 70% from 2016. As shown in Exhibit 2, Apple Watch sales have become so strong that there is now more upside found with management disclosing unit sales rather than keeping them hidden and just providing sales clues.
Exhibit 2: Apple Watch Unit Sales - Trailing Twelve Months
In March 2017, Apple unveiled its spring 2017 Apple Watch band collection. This was the first time that Apple unveiled a significant update to Apple Watch bands outside of a keynote.
At WWDC, Apple's watchOS 4 portion of the keynote was among the company's strongest segments. Along with some user interface tweaks, new watch faces, such as the Siri face, turned the Apple Watch into a completely new kind of device. Apple is relying on machine learning to provide Apple Watch wearers personalized information based on their daily routine.
However, the Apple Watch highlight in 2017 occurred in September at Apple's inaugural event at Steve Jobs Theater. In fact, Apple Watch was the strongest segment of Apple's presentation. Apple has found a use case specifically designed for the Watch - health tracking - and has been successful in wrapping both product and ad marketing around this new use case. Health-tracking capabilities such as the new heart-tracking capabilities are intriguing. Such moves help shine light on Apple's goal with Apple Watch: make the device an indispensable product for the mass market by positioning it as a lifesaver, literally.
Apple Watch Series 3 ended up being a pleasant surprise given how Apple was able to add LTE connectivity without making Apple Watch that much thicker. Items such as building the antenna directly into the screen reveal how Apple is head and shoulders above the competition in the wrist wearables space.
Apple Watch milestones in 2017:
- Launch a cellular Apple Watch with very few hiccups.
- Position quality over quantity in terms of new features found with watchOS 4.
- Introduce compelling new Apple Watch band options throughout the year.
Apple Watch issues in 2017:
- Apple has plenty of work ahead of itself to improve Apple Watch adoption, which still stands at less than 5% of the iPhone user base.
- There are questions as to just how widespread third-party developers outside of the health/fitness segment can take advantage of Apple Watch in a sustainable way.
Grade: A+
While there are obvious items to improve with Apple Watch, there is no legitimate reason to deny Apple Watch the A+ that it deserved in 2017. It was an all-around great year for Apple Watch.
iPhone. There are two ways to look at the iPhone business in 2017. The first is through a product lens. The second is using a business lens. From a product perspective, the iPhone business is thriving. Based on my time with iPhone 8 and iPhone X, the devices are successes as each represents an improvement from its predecessor. The iPhone 8 provides a better user experience than the iPhone 7, and the iPhone X provides a better experience than iPhone 8. In addition, Apple continues to hit the nail in the head in terms of iPhone marketing and focusing on camera enhancements.
With iPhone X, Apple launched one of its more significant technological accomplishments in years. Removing the home button and the very popular Touch ID could have derailed the entire iPhone business if done poorly or incorrectly. Instead, Apple nailed it. iPhone X is a big win for various teams at Apple including designers, engineers, and product marketers.
From a business perspective, the iPhone story is more complicated. A growing number of concerns have appeared. In early 2016, it was clear that the iPhone's growth story was winding down. As seen in Exhibit 3, over the subsequent six quarters since 3Q16, much of my iPhone growth concerns have materialized. While it is still possible for Apple to report stretches of iPhone unit sales growth, the days of 40% to 50% growth are over. Given a number of factors, Apple is now much more dependent on iPhone upgraders to maintain unit sales. This adds more risk to the overall iPhone story, especially given how the iPhone upgrade cycle is extending.
Exhibit 3: iPhone Unit Sales - Trailing Twelve Months
At the same time, there is early evidence of a portion of the iPhone user base becoming satisfied from a feature perspective with older iPhones, similar to what took place with the iPad business years ago. On the flip side, features like the iPhone Upgrade Program and the fact that Apple is still pushing noteworthy updates on an annual basis will likely help to offset some of the headwind found with a portion of the base being content with less. In addition, Apple continues to do very well when it comes to maintaining iPhone margins and ASPs, a byproduct of Apple expanding the iPhone pricing spectrum.
It was hard to ignore what seemed like an outsized number of iOS bugs in 2017. Some were more of a nuisance variety. Others were more embarrassing and even worrying for Apple. In addition, after a very promising start, tepid ARKit developer adoption took some of the wind out of the AR sails, although we are still in the very early stages.
Apple then suffered an iPhone crisis this past December when it was revealed that the company was slowing down CPU performance for older iPhones in order to avoid iPhones from shutting down due to degrading batteries. The crisis was of Apple's own doing given the company's complete lack of transparency surrounding its actions. iPhone throttling is a big problem for Apple, indicative of longer-term issues involving iPhone users holding on to their iPhones for longer.
iPhone milestones in 2017:
- Launch iPhone 8, 8 Plus, and X.
- Successfully position Face ID as an alternative to Touch ID on iPhone X.
iPhone issues in 2017:
- Structural growth issues.
- iPhone upgrade cycle is getting longer.
- No clear strategy for boosting iPhone sales in India. (Apple has no intention of dropping iPhone pricing to levels needed for significant sales.)
- iPhone throttling crisis.
Grade: B+
The iPhone throttling crisis and various iOS 11 bugs do not wipe out the legitimate successes Apple saw with iPhone X in 2017.
Mac. The Mac business entered 2017 on crutches. Apple had just released the highly controversial MacBook Pro a few months earlier. Questions were building regarding Apple's commitment to the pro Mac user.
In early 2017, Apple shocked many by convening five outside journalists for an on-the-record 90-minute briefing to talk about the Mac. Apple had changed course and was now working on a new modular Mac Pro and standalone display. The decision to reveal its hand well before a finished product was ready certainly seemed to be born out of desperation as Apple tried to limit possible defections within the highly influential content creation niche. Fortunately for Apple, much of the migration chatter is likely just that, talk. Regardless, Apple now seems fully committed to catering to the niche, which should alleviate some of the concerns held by users in that community.
While Apple continued to demonstrate a vision for the Mac's future, the product category is increasingly representing Apple's weak point. In fact, it became clear in 2017 that the Mac is Apple's Achilles' heel. At its core, there are genuine questions to ask regarding whether Apple should be dedicating more resources to come up with improved alternatives to the Mac or betting on increasingly niche Mac models targeting less than 0.1% of the Apple user base.
Mac milestones in 2017:
- Launch iMac Pro.
Mac issues in 2017:
- Questions surround Apple's Mac portable strategy and the broader direction for Mac in a mobile world.
Grade: C+
It's easy for some to look at the new MacBook Pro and instantly give the Mac an "F" in 2017. Such an action would ignore the tangible positives found with Mac in terms of iMac Pro and the decision to dedicate resources to pro Mac users.
Accessories. The primary product categories within Apple's accessories bucket include AirPods, Beats headphones, and Apple TV. Despite ongoing AirPods supply issues during the first half of 2017, the product had a stellar year from a sales perspective with Apple shipping as many as 12M units. With Apple TV, Apple continues to make progress on a number of fronts. Management has decided to take a very different approach to the video streaming box market than the competition has as seen with higher Apple TV pricing at a time when the trend is a race to the bottom.
Accessories milestones in 2017:
- Ramp AirPods supply throughout the year.
- Launch Apple TV 4K with the revised Siri remote.
Accessories issues in 2017:
- HomePod launch was delayed to early 2018.
- Questions surround Apple's willingness to cede market share in the TV streaming box space to competition.
Grade: A-
AirPods' A+ offsets lower grades for Apple TV and the delayed HomePod.
Services. Apple's Services category is officially comprised of iCloud, AppleCare, Apple Pay, Apple Music, and Apple's various app and content stores. For this exercise, Apple Maps and Siri are also included here. Apple isn't a services company. Accordingly, it's difficult to point to any particular Apple service as being head and shoulders over the competition in 2017. Instead, Apple's focus continues to be found with making sure that its various services offer an all-around good customer experience. This goal often involves deep services and hardware integration. Apple Pay on Apple Watch is a prime example. Controlling Apple Music playback via Apple Watch is another example.
As seen with ongoing issues with Apple Maps and Siri, Apple has plenty of services work ahead of itself. However, there are signs of progress. Apple Maps in the U.S. is legitimately good. Meanwhile, Siri on Apple Watch has never been better.
Services milestones in 2017:
- Continued momentum found with the App Store and Apple positioning itself as an attractive platform for third-party paid subscriptions.
Services issues in 2017:
- Apple Services quality is highly dependent on geography with notable issues in key Apple markets including China and India.
Grade: B-
It's easy to look at something like Apple Maps in India and instantly slap an "F" on Apple Services. However, this ignores the tangible progress made in 2017 with various Apple Services.
Financial Strategy. There weren't too many negatives found with Apple's financial strategy in 2017. Apple continues to generate more cash than it needs to fund the business. Management spent an amount equal to 90% of its free cash flow generation, which is cash left over after funding the business, on share buyback and quarterly cash dividends during FY2017. Even after taking into consideration capital management activity, Apple's net cash remained around $150B. Apple spent approximately $700 million on announced M&A during the year, more than half of which is attributed to the recently announced Shazam acquisition.
Apple's pricing strategy continued to intrigue in 2017. Many of Apple's newest products, such as Apple Watch and AirPods, are underpriced in comparison to the competition. Even iPhone X at $999 ended up being not as outlandishly priced when compared to competing premium flagship offerings from other smartphone manufacturers. As shown in Exhibit 4, average selling price (ASP) trends remained intact despite Apple cutting entry-level pricing for iPhone and iPad. Overall margin trends were benign as higher-priced SKUs containing a higher margin offset lower-margin SKUs at the opposite end of the pricing spectrum. In addition, higher-margin Apple Services revenue is likely offsetting margin pressure in Apple's other product categories.
Grade: A+
Exhibit 4: iPhone and iPad Average Selling Price
Other. There were a number of other highlights during the year that don't neatly fit into one of the preceding categories.
- Apple held a successful WWDC at San Jose.
- Steve Jobs Theater / Apple Park had its grand opening.
- Wall Street embraced a new approach to Apple with the focus increasingly being aimed at the company's balance sheet and excess cash.
- Apple began ramping its original video programming effort.
- Apple continues to place a big bet on hardware (owning the core technologies powering its devices) in order to become a better software provider.
Final Grade
Apple had a good 2017. Taking an equally-weighted average of the grades from the preceding seven categories, Apple earned an A- for its 2017 performance. When giving iPhone, iPad, Apple Watch, and Services additional weight in comparison to the other categories, Apple still earned an A-.
Much attention was given to Apple's various software bugs, delays, and mishaps in 2017. In addition, there was an increasing amount of skepticism facing Apple and its approach to voice-first interfaces, the smart home, and the broader "post device" narrative in 2017. However, upon closer examination, Apple made genuine strides in most of its product categories. With the company's broader bet on hardware, Apple provided a sneak peak at its dramatically different view on hardware's role in our lives going forward. In addition, Apple's growing momentum with wearables bodes well for the company's near-term prospects in many industries and fields that the company is said to be suffering in.
A missing piece to Apple's report card ends up representing a crucial ingredient for future report cards: Apple R&D. A sizable portion of Apple's attention during any given year is given to unannounced products. It is difficult to assess the progress Apple is making with R&D given the company's strict stance on secrecy and keeping ideas hidden until they are ready for prime time. One way to judge Apple's R&D progress is to look at M&A. Along those lines, it looks like Apple Glasses continue to be a high priority based on Apple acquiring SensoMotoric Instruments and Vrvana. In addition, Apple's transportation ambitions remain intact as judged by various clues pointing to the company expanding its autonomous car R&D efforts.
An interesting exercise to conclude Apple's annual review involves thinking of how 2017 will be viewed in a few years. I continue to think that Apple finds itself in the early stages of the wearables era. With Apple Glasses positioned as the most likely new product category (HomePod will be positioned as a music accessory), 2017 will likely be looked back at as just another year in the run-up to Apple having a full-fledged line of wearables products. Meanwhile, transportation initiatives continue to represent a long-term focus for Apple.
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Apple's Growing Bet on Hardware
Apple isn't a hardware company. Nevertheless, hardware's importance to Apple continues to grow. Apple is now overseeing a supply chain and manufacturing apparatus responsible for producing more than 300M gadgets per year. As Silicon Valley increasingly bets on services and intelligent assistants, many are making a critical mistake in downplaying hardware. As Alan Kay, a tech industry pioneer, once said, “People who are really serious about software should make their own hardware." Apple is betting that Kay's advice will remain relevant in the future. Apple is doubling down on hardware in order to become the most powerful software provider in the wearables era.
Hardware Strategy
The vast majority of Apple's products are assembled by contract manufacturers in Asia. This wasn't always the case. In the 1990s, Apple owned its own factories. However, the company was imploding financially from a bloated product line and a costly manufacturing apparatus. Apple's supply chain and network of factories just weren't efficient. In March 1998, Steve Jobs hired Tim Cook as SVP of Operations to save Apple, literally. Cook's initial tasks included quickly drawing down excess Mac inventory in addition to laying the groundwork for Apple's outsourcing strategy.
Cook began to rethink Apple's supply chain, going so far as to get suppliers to move closer to Apple's new assemblers. Apple soon discovered that manufacturers and assemblers in China were capable of meeting the company's high standards like no other. It was around this time that Apple began its long-standing partnership with Foxconn, the company's largest product assembler. Cook also instituted a just-in-time inventory production system which addressed excess inventory issues that nearly crippled Apple.
While much attention has been placed on Apple's contract manufacturers, little is reported on the degree to which Apple works with its suppliers and assemblers. It is not uncommon for Apple designers to spend weeks, or even months, at factories in China. Apple does not design a product in California and just send final manufacturing instructions to its assemblers. The amount of collaboration that occurs between Apple and its various suppliers and manufacturers would surprise most outsiders.
Even though Apple doesn't own factories, the company does own a significant amount of equipment and machines housed in third-party factories. As of the end of September, Apple held $54B of machinery, equipment and internal-use software on its balance sheet. A significant portion of this total is machinery used in the production of Apple's products.
Expanding the Bet on Hardware
Apple's bet on hardware continues to grow. In the past, controlling hardware still amounted to Apple being dependent on others to provide the core technology and components. Apple began to see the value in controlling its own destiny by owning the core technology powering its devices.
In 2010, Apple unveiled the iPad. The device was powered by an A4 processor, the first Apple-designed chip. The A4 was made possible by Apple's P.A. Semi acquisition two years earlier. Jumping ahead seven years, Apple now has a range of processors:
- A Series: iPhone and iPad
- S Series: Apple Watch
- W Series: AirPods, Beats, and Apple Watch
- T Series: Mac
Back in September, Apple introduced the A11 Bionic chip in iPhone 8, 8 Plus, and X. The chip includes the first Apple-designed GPU solution. There is now an increasing amount of evidence that Apple is moving into modem design and power management chips. Apple's end goal is to create a system-on-a-chip (SoC) that includes Apple Ax processors, GPUs, and LTE modem chips.
Apple's current hardware strategy is all about controlling the experience found with its products. In the past, differentiation came from simply doing both hardware and software. Differentiation is now found when there is tighter control over the core components powering products.
Scale
It's easy to think of Apple as just an iPhone maker. More than 210M iPhones are sold per year, and no other Apple product comes close to surpassing iPhone in terms of unit sales. However, iPhone is only one piece of Apple's hardware story.
According to my estimates, Apple sold 322M gadgets in FY2017. This total includes unit sales from every major product category and accessory powered by Apple software (iPhones, iPads, Macs, Apple Watches, AirPods, iPods, Apple Pencils, Beats headphones, and Apple TVs). After a down year in 2016, when Apple shipped 8% fewer devices than in 2015, the company returned to unit sales growth in 2017. In fact, Apple shipped 7% more devices in 2017 than in 2016.
Exhibit 1: Apple Gadget Unit Sales
Apple gadget sales include: iPhones, iPads, Macs, Apple Watches, AirPods, iPods, Beats headphones, Apple Pencils, and Apple TVs.
Additional accessories such as Apple Watch bands, iPhone and iPad cases and covers, and various charging cords and cables push the total number of Apple products sold in FY2017 well past 400M.
Along with demonstrating Apple's success at selling mass-market items, these sales numbers illustrate the ability of Apple's supply chain and manufacturing apparatus to produce hardware at scale. In fact, there aren't too many companies operating at Apple's hardware scale. While Samsung doesn't disclose smartphone sales, industry estimates peg the company at selling approximately 300M smartphones per year, which includes a wide range of models. Every other smartphone manufacturer is selling fewer smartphones than Apple is selling. Meanwhile, the world's largest PC makers and other consumer electronics companies don't have the sales required to come close to matching Apple in terms of hardware sales.
Wearables
Apple's hardware scale is about to undergo significant changes. The upcoming wearables era will prove to be a game changer for hardware sales. As there are a little under a billion users, it is not inconceivable for Apple to eventually ship a billion gadgets per year. While this may seem hard to believe considering Apple sold 322 million gadgets in FY2017, the wearables era will likely be defined in terms of ecosystems consisting of different wearable devices. An Apple product line including Apple Watch, AirPods, Beats, and Apple Glasses, combined with a user base of more than one billion people, will lead to massive demand for hardware.
We are already starting to see the beginning stages of wearables impact Apple's manufacturing apparatus. According to my estimates, Apple sold nearly 30M wearable devices in FY2017, up from 10M devices in FY2016. Nearly one out of ten gadgets Apple sells is a wearable. Looking ahead, it is possible we will see Apple sell 50M wearable devices in FY2018 as Apple Watch and AirPods are seeing remarkable momentum in the marketplace. Both Apple Watch and AirPods are products that contain the potential of one day selling in the hundreds of millions of units per year. Meanwhile, it is inevitable that Apple will one day sell a pair of augmented reality glasses.
Exhibit 2: Apple Gadget Unit Sales by Product
Note: "Other" includes Apple Pencils, Apple TVs, and Beats headphones. Wearables include Apple Watches, AirPods, and select Beats headphones.
Hardware Prowess
In many ways, Apple's product event this past September at Steve Jobs Theater demonstrates the scope of Apple's hardware prowess. Apple unveiled a cellular Apple Watch and iPhone X, two products made possible only after years of intensive collaboration throughout Apple. The amount of collaboration required puts the company's extensive efforts with Apple Park, a campus designed to improve collaboration within Apple, into perspective.
Everything from the iPhone X's OLED display to the neural engine found inside the A11 Bionic chip come together to produce an experience that would be impossible to create by a company focused just on software or hardware. Similarly, the W2 and S2 chips found in Apple Watch Series 3, along with the ability to include cellular without jeopardizing device thickness or even battery life, is remarkable. After placing big bets on hardware for decades, Apple is now in a position where its hardware capabilities are opening doors for Apple software and services.
While Apple's hardware bets are already providing the company a competitive advantage over peers with smartphones, tablets, and wearables, the long-term implications of Apple's hardware strategy are still being underestimated. Apple is well-positioned to build the most formidable supply chain and manufacturing apparatus for wearables. Apple now finds itself making bets in terms of controlling core components in products. The company is also investigating new manufacturing techniques and processes that will give the company an advantage over peers in the wearables space. This may be better measured in decades than in years. Apple has never seen a scenario like this play itself out before. This is unchartered territory.
Google, Microsoft, Amazon, and Facebook have been busy talking about a "post device" era in which the very idea of a device fades away. Instead powerful voice assistants and cloud services powered by artificial intelligence ultimately gain power at the expense of hardware. Apple is betting on a very different future. Apple sees a world in which hardware gains power in our lives. Apple is moving to the point at which it will have near complete control over every major component powering its device. Whether it is seen in new kinds of displays, smarter cameras, or custom silicon, hardware has a role to play in pushing more intelligent software and services. Instead of tomorrow's winners being those companies controlling powerful software and services, the winners will be companies shipping hardware that can melt away allowing the user to interact with software with as few barriers as possible.
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The End to Apple’s Cash Dilemma
With the U.S. Senate passing its tax bill earlier this month, the probability of a U.S. corporate tax overhaul has never been higher. While differences between the House and Senate tax bills still have to be reconciled in conference, the end to Apple's cash dilemma is in sight. Both bills move the U.S. to a territorial-based tax system. In addition, both bills include deemed repatriation at a 14% rate. (The Senate bill calls for a 14.49% tax rate.) The repatriation tax change alone benefits Apple to the tune of tens of billions of dollars. More importantly, the tax changes will allow Apple to develop a sustainable long-term strategy for managing its cash and balance sheet.
Current Cash Strategy
Apple is a cash-generating machine. In FY2017, Apple reported $64B of operating cash flow, nearly as much as that of Alphabet, Facebook, and Amazon combined. On a free cash flow basis, which is a measure of how much cash is generated after taking into account capital expenditures and other costs associated with running the business, Apple's $50B of free cash flow was $2B more than free cash produced by Alphabet, Facebook, and Amazon combined. Apple has the best business model for generating cash.
Under the current U.S. tax system, Apple owes 35% tax to the federal government on all revenue earned, both in the U.S. and abroad. However, Apple pays tax on foreign profits only when the cash is repatriated, or brought back, to the U.S. This has led Apple, along with other Silicon Valley firms, to keep foreign cash offshore as it is the financially prudent thing to do for shareholders. Deferring repatriation to a later date reduces the present value of tax payments. In the meantime, Apple pays local taxes on foreign profits (a credit is provided for taxes paid to foreign governments) and accrues tax on the portion of cash deemed to be brought back to the U.S. at some point in the future.
With Apple unable to use cash held in foreign subsidiaries to fund share buyback and quarterly cash dividends, management has been facing quite the cash dilemma. Apple is generating cash internationally at a much faster rate than it is able to spend. This has produced a situation where excess cash that is not needed to run Apple's business has been building on the balance sheet. As of September 30th, 2017, Apple had $252B of cash, cash equivalents, and marketable securities in foreign subsidiaries. As seen in Exhibit 1, international cash now represents 95% of Apple's total cash, cash equivalents, and marketable securities. Meanwhile, Apple is unable to deplete its U.S. cash totals too much more without jeopardizing company flexibility.
Exhibit 1: Apple's Cash, Cash Equivalents, and Marketable Securities
One way management has handled Apple's cash dilemma in the near-term has been to turn to debt markets. By issuing debt at a pace roughly equal to international cash generation, Apple has essentially been using debt as a way to utilize its international cash. The company funnels cash raised via debt offerings into share buyback and quarterly cash dividends. This process becomes apparent when looking at Apple's net cash, which is the amount of cash, cash equivalents, and marketable securities on the balance sheet minus debt. Apple's net cash has plateaued at $150B as international cash generation has been offset by capital management and expenses needed to run the business. However, Apple hasn't been able to spend cash fast enough to actually lead to a declining net cash balance. Instead, Apple finds itself in a situation where it is unable to get rid of excess cash on the balance sheet in a prudent way.
Exhibit 2: Apple's Net Cash
Given Apple’s current balance sheet strategy and assuming no change to the U.S. corporate tax code, the company is on track to soon have $300 billion of cash, almost all of which is located abroad, and $150 billion of debt. Apple will need to carefully manage this growing level of debt as upcoming debt payments come due. This will only strain its U.S. cash needs even further. Simply put, the strategy of issuing debt in lieu of using international cash to fund capital management activity just isn’t sustainable, especially if interest rates rise or iPhone sales slow. Instead, management needs a solution to Apple's excess cash dilemma and an overhaul to the U.S. corporate tax code represents one of the optimal solutions.
Changes Are Coming
Assuming the U.S. corporate tax code is overhauled to include a territorial-based tax system and deemed repatriation at a 14% rate, Apple's cash and balance sheet strategy will undergo two significant changes:
- International cash is brought back to the U.S.. Management will bring Apple's $252B of international cash back to the U.S. After taking into account taxes, Apple will have at least $225B of cash, cash equivalents, and marketable securities in U.S. subsidiaries. Assuming foreign cash is taxed at 14.5%, Apple's decision to delay repatriation will have paid off to the tune of tens of billions of dollars as Apple would have needed to pay a higher rate to return the cash.
- Debt issuance pace slows. Apple is currently issuing approximately $30B of debt per year. The only reason Apple has been issuing so much debt has been to offset the ballooning amount of international cash. With at least $225B of cash in U.S. subsidiaries, Apple will no longer need to issue as much debt. A good argument can be made for Apple to continue issuing some low-cost debt in order to optimize the balance sheet and lower the company's overall cost of capital. One potential strategy is for Apple to issue debt at a pace equal to the amount of existing debt payments coming due ($6.5B of principal debt payments come due in 2018 and another $8.9B in 2019).
Spending Excess Cash
Following repatriation, Apple will have at least $225B of cash in U.S. subsidiaries. After taking into account Apple's $116B of debt and various cash needs including funding organic growth opportunities, SG&A, capital expenditures, R&D, and M&A, management will have at least $75B of excess cash in U.S. subsidiaries following a U.S. corporate tax overhaul. The company has never had more than $39B of cash in the U.S. at any one time. This raises an obvious question: What should Apple do with $75B of truly excess cash? Management has a number of options:
- Share Buyback. Apple has been spending approximately $30B per year on share buyback. Given the daily trading volume found with Apple shares, management could increase the pace of buyback without negatively impacting Apple's share price with excessive buying pressure. Apple could also rely on accelerated share repurchase (ASR) programs to handle additional buyback activity. Management has other buyback options at its disposal, including a modified Dutch auction tender offer, which allows Apple to repurchase a sizable portion of itself in a financially efficient and timely manner.
- Dividends. Apple is currently spending $13B per year on quarterly cash dividends. Management has telegraphed its intention to increase the quarterly cash dividend on an annual basis. Apple can use excess cash to fund a larger increase to the quarterly cash dividend. In addition, Apple can issue a special, one-time cash dividend. Such a dividend would end up being one of the more straightforward ways to quickly get rid of excess cash.
- M&A. Management can use excess cash to alter its M&A strategy and begin buying additional companies, targets with larger price tags, or a combination of the two trends.
- R&D. Similar to M&A, Apple can use excess cash to expand its R&D spending in terms of both breadth (i.e. new industries) and depth (i.e. greater number of bets in existing industries).
- Do Nothing. Apple can choose to do nothing and simply sit on the excess cash.
Out of the five preceding options, additional share buyback is the best use of Apple's excess cash, assuming shares are trading at an appropriate valuation. Management should funnel a significant portion of the cash bought back to the U.S. into share buyback. The other options either contain too many downsides and risks or just don't make sense for Apple.
For the past few years, Apple management has been using share repurchases (and quarterly cash dividends) to funnel excess cash from the balance sheet to shareholders. These actions have reduced the number of Apple shares outstanding, thereby giving each remaining share a larger ownership claim to Apple's future cash flows and earnings. It's not that share buyback is creating shareholder value as cash moves from the balance sheet to those selling their shares. Instead, share buyback has led to a more optimal balance sheet, which helps lower Apple's total cost of capital. Other benefits found with share buyback include strong signaling effects in the market and the increased probability of investors placing a higher value on future cash flows and earnings. (My stock buyback program primer is available for Above Avalon members here.)
Dividends. A huge increase to the quarterly cash dividend will limit Apple's financial flexibility in the future. Unlike share buyback, which can easily be dialed back at any time, there is more downside found with needing to cut a quarterly cash dividend when business prospects turn negative. It isn't wise from a financial perspective to use excess cash on the balance sheet to initiate a higher quarterly cash dividend, which amounts to a recurring expense stream. Instead, dividend payouts should be tied to earnings and cash flow generation. As for a special cash dividend, many Apple shareholders have no interest in paying the taxes associated with a special dividend.
M&A. Apple has been following a very particular M&A strategy. Over the past five years, Apple has spent $5 billion on M&A buying smaller companies. More than half of that M&A expense total relates to Apple's Beats acquisition in 2014. Instead of using M&A to buy revenue or users, which is a disastrous strategy in Silicon Valley, Apple looks to fill asset holes in terms of technology and talent. While Apple's existing M&A strategy doesn't exclude the possibility of big ticket acquisitions, it does reduce the likelihood of Apple buying sprawling companies with lots of baggage. There is little sense found with Apple altering its M&A strategy to pursue larger M&A deals because it has excess cash to spend.
R&D. There is a growing amount of evidence that Apple has been adapting its R&D strategy to the changing tech and design landscape. While the company remains remarkably focused in terms of R&D spending (Apple spent $12B on R&D in FY2017), management appears to be expanding its interests to include additional industries, manufacturing techniques and processes. Apple has also been moving in the direction of venture capital investing as seen with $1B investments in Didi and SoftBank's tech fund. The moves are part of Apple's effort to improve access to new ideas and upcoming technology. The major takeaway from Apple's evolving R&D strategy is that management is able to fund R&D with organic cash generation. There is no need for Apple to ramp R&D expenditures to get rid of cash.
Do Nothing. While management has the option to do nothing with the excess cash, such a decision isn't financially prudent. Investors are not valuing Apple shares based on management's skill at running the largest hedge fund in the world. Instead, shares are valued on the degree to which management utilizes Apple's assets to produce future cash flows. Sitting on excess cash ends up being a major liability for Apple. One of the largest risks found with holding too much cash on the balance sheet is Wall Street discounting the cash. In fact, Apple likely saw this scenario play out in the early 2010s, before the company's capital return program was launched. One fear that investors have with companies holding excess cash is that future management teams will waste the cash on frivolous M&A and other questionable investments. This results in the value of the cash being discounted, leading to a lower stock valuation.
Modified Dutch Auction Tender Offer
Apple management will need to dramatically increase its share buyback pace if the goal is to use $75B of excess cash to repurchase additional shares in a timely manner. On paper, this wouldn't seem to pose a problem. However, there are limitations as to how many shares Apple can repurchase without distorting the share price. The company is already repurchasing $30B of shares per year. It just isn't realistic to assume Apple can use open market transactions, or even ASRs, to repurchase an additional $75B of its shares over the next year or two.
Instead, Apple can turn to an alternative mechanism for share buyback. A modified Dutch auction tender offer jumps out as the most appropriate vehicle. In a modified Dutch auction tender offer, a company goes straight to shareholders with plans to repurchase a significant amount of stock. Shareholders are then given the means to indicate interest in selling their shares to the company, at a particular price range chosen by the company.
With a modified Dutch auction tender offer, Apple would be able to buy back $75B of its stock in just a few weeks at a relatively cost efficient manner. The repurchased shares would be retired and taken out of circulation. More importantly, Apple would be able to buy back a significant portion of itself without causing too much distortion in the marketplace. Modified Dutch auction tender offer announcements have a tendency to initially drive stock prices higher due to the strong signaling effect (i.e. management must be very optimistic about future prospects). On average, companies buy back 15% of outstanding shares with modified Dutch auction tender offers. A $75B tender offer would amount to Apple buying back about 8% of itself.
Light at the End of the Tunnel
An overhaul to the U.S. corporate tax means much more to Apple than just a different tax rate going forward. A territorial-based tax system will allow Apple to manage future cash generation much more efficiently. The days of Apple being stuck with too much cash in international subsidiaries are numbered. In addition, concerns surrounding Apple issuing too much debt will subside as the company will no longer need to rely on debt issuance to fund share buyback and quarterly cash dividend. These changes amount to a sustainable strategy for Apple to use when managing its massive balance sheet. There is finally light at the end of Apple's cash dilemma tunnel.
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A Stationary Smart Speaker Mirage
We are in the midst of a massive mindshare bubble involving stationary smart speakers in the home. While the press talk up the category with near breathless enthusiasm and positivity, there is a growing amount of evidence that stationary smart speakers powered by digital voice assistants do not represent a paradigm shift in computing. Instead, the stationary smart speaker's future is one of an accessory, and it will be surpassed in prominence by wearables. It's time to call out the stationary smart speaker market for what it is: a mirage.
Amazon Echo
Despite a number of companies competing in the stationary smart speaker space, Amazon is the undisputed leader. In November 2014, Amazon introduced the Amazon Echo to little fanfare. TechCrunch’s relative simplistic take on the first Echo ended up being very telling:
"Amazon has a new product that doesn’t really have any current equivalent from any other tech company – a connected speaker called Echo that’s always-on, listening for commands that its virtual assistant can then respond to with information or by triggering a task."
Instead of positioning hardware, software, or design as the most critical ingredient, Amazon positioned a digital voice assistant as the Echo's differentiator. Silicon Valley was intrigued, and it is fair to view that initial Echo as having single-handily kicked off today’s smart speaker market.
As shown by Google Trends, it took another two years for the Echo to go mainstream. Given how Amazon has supplanted a portion of Google search, one can safely assume Google Trends underestimates Echo interest, especially when considering Amazon Prime users.
Google Trends results for "Amazon Echo" in the U.S.
The 2016 holiday season stood out for Amazon Echo. The company went on to say it sold nine times more Echo devices during that holiday shopping period than during the previous year's. While Amazon didn't elaborate on the reasoning behind the dramatic jump in sales, the most logical explanations were that Echo sales were coming off a very low base in 2015 and consumers were enticed by the low-priced Echo Dot, unveiled in March 2016.
Sales
Since the leading smart speaker manufacturers avoid disclosing sales, there is a dearth of concrete sales data regarding the overall size of stationary smart speakers. Therefore, we are left to depend on questionable customer surveys and research firms using mysterious methodologies.
When it comes to the current market leader, it is not in Amazon’s best interest to disclose Echo sales. Given how Amazon already receives near universal praise in the press, there would only be downside found in Echo sales disclosure. Taking the few clues provided by Amazon management in the form of holiday press releases, my estimate pegged Echo sales at around 15M speakers per year during the first half of 2017. To put that sales number in context, Apple is selling approximately 20M Apple Watches per year. Earlier this week, Amazon said that “millions” of Echo devices were sold between Thanksgiving and Cyber Monday. It is reasonable to assume that the company has seen an increase in the Echo sales pace in recent months.
As seen by the massive resource shift occurring across the industry, other companies have taken note of Amazon’s Echo sales. Seemingly every consumer-oriented tech company is now coming up with its own offering for the stationary smart speaker market. Facebook is even rumored to be working on a stationary screen with a speaker.
A Mirage
On the surface, Amazon Echo sales point to a burgeoning product category. A 15M+ annual sales pace for a product category that is only three years old is quite the accomplishment. This has led to prognostications of stationary smart speakers representing a new paradigm in technology. However, relying too much on Echo sales will lead to incomplete or faulty conclusions. The image portrayed by Echo sales isn't what it seems. In fact, it is only a matter of time before it becomes clear the stationary home speaker is shaping up to be one of the largest head fakes in tech. We are already starting to see early signs of disappointment begin to appear.
A closer look at Amazon's Echo line reveals why people are apparently buying millions of Echo devices: they're cheap. Amazon has ushered in a race to the bottom within the stationary speaker space like we have never seen in consumer electronics. In just three years, the stationary home speaker market is now filled with mediocre speakers costing as low as $20. Google has followed suit with Google Home Mini, a cheaper version of its Google Home smart speaker. It is just as expensive to buy a specialty pizza as an Echo Dot or Google Home Mini. Similar races to the bottom were projected in smartphones, tablets, and wearables but never materialized.
Aside from cheap Echo speakers, there is no clear evidence of other speaker manufacturers seeing significant traction. Google Home sales are estimated to be a fraction of Amazon's speaker sales. Meanwhile, there is a similar lack of evidence supporting the idea that higher-end speaker alternatives like Sonos have been able to move beyond niche.
It’s not just that smart speaker prices have collapsed. If the primary value of an Echo speaker is access to Amazon's digital voice assistant, Alexa, there is little additional value found in higher-priced Echo alternatives. While Amazon is not in a rush to provide a sales breakdown by Echo model, my suspicion is that the vast majority of sales are found with the Dot, the cheapest Echo.
Silicon Valley calls this race to the bottom the commoditization of hardware. Services companies like Amazon and Google use low-cost hardware to seed rich, data-capturing services in our lives. The end goal for these companies is accessing valuable customer data while the vehicle of choice to capture this data is a digital voice assistant.
Mobile Trouble
It is not a coincidence that the companies placing the largest bets on stationary speakers in the home have either failed or run into trouble with previous mobile strategies. Amazon's entry into smartphone hardware with the Amazon Fire phone was one of the colossal failures in smartphone history. Similar attempts by Facebook to come up with its own smartphone went nowhere. Meanwhile, Google now finds itself running into trouble as Android continues to lose power in the premium end of the smartphone market.
The commonality among the three preceding examples is that each has seen its dependence on Apple grow over time. The lack of a viable, standalone smartphone offering means Amazon, Facebook, and Google have had to rely increasingly on iPhone and iOS to reach their customers. This scenario has irked Jeff Bezos for years and plays a big role in Amazon's hardware strategy. Facebook's Oculus acquisition was born out of a similar mindset with Mark Zuckerberg looking to control Facebook's destiny by owning hardware. Meanwhile, Google has resorted to using the Pixel smartphone to reach premium users becoming disenchanted with Samsung. In addition, Google has begun ramping up its traffic acquisition costs (TAC) to ensure it remains the default search option on iOS.
These companies are not moving into stationary devices for the home because they represent the next frontier in tech or an upcoming paradigm shift. Instead, these companies are incentivized to figure out a way to reduce smartphone usage by unbundling the device. The result is smart speakers piping digital voice assistants that are also available through our smartphones, tablets, and smartwatches.
The fact that companies that did not succeed with smartphone hardware are increasingly betting on stationary devices has been described as a moment of opportunity. Some in the tech community have looked at low-cost hardware powered by digital voice assistants as some kind of hardware disruption – commoditized hardware powered by closed-based services to handle tasks we used to give smartphones and tablets. I disagree. Stationary home speakers aren't a disruption. Instead, they are proving to be a distraction.
Crossroads
The past 10 years of technology can be boiled down to one overarching theme: mobile devices with a multi-touch interface (smartphones and tablets) becoming alternatives to traditional laptops and desktops. While there have been a few side shows here and there, nothing has come close to matching this one paradigm shift.
While smartphones and tablets continue to get smarter and more advanced, there is no denying that sales growth reflects mature product categories. With already high adoption rates, upgrade trends and platform switching are increasingly becoming the only remaining sources of sales growth. This has led to acceleration in resources being shifted to other product categories in search of the next big thing.
We now find ourselves at a crossroads. The competitive tech landscape is changing. The battle for our attention is broadening into a massive land grab for the most valuable real estate in our lives. Tech battle lines are now being redrawn around three pivotal aspects of daily life: body (health), home, and transportation.
It would be a mistake to assume that these three categories have jobs and use cases that will require three completely different sets of products. At the same time, it would be equally incorrect to assume the smartphone will remain at the center of our lives. Instead, there will likely be new products and some overlap as to how those products are used. One of the major sources of this kind of overlap is found with the body and home.
Future
In some ways, the stationary smart speaker market resembles the early wrist wearables market. There was a significant amount of unknown found with where the wrist wearables market was headed: low-end fitness trackers, high-end smartwatches, or some combination in between. It took a few years and Apple’s entry into the market for the landscape to change.
There are three distinct possibilities as to the stationary smart speaker's future.
Low-cost hardware to push digital voice assistants. Consumers purchase cheap smart speakers solely based on the accompanying digital voice assistant. Smartphones, tablets, and smartwatches ultimately lose value in this scenario. The winners are services companies betting on intelligent digital voice assistants to capture as much customer data as possible.
High-end accessory. Given how digital voice assistants are already found in smartphones, tablets, and smartwatches, consumers look for standalone speakers to offer something more. That additional capability would likely be superior sound quality.
Disjointed space waiting for unknown catalyst. A number of players are able to coexist despite relying on dramatically different strategies and core competencies. While market share will likely be used to denote winners and losers, in reality, success will be determined by usage patterns and access to premium users.
Consensus currently thinks the first option is the most likely outcome for the stationary smart speaker market. This explains the sheer amount of skepticism pointed toward higher-priced speakers like Apple’s HomePod speaker. Meanwhile, Apple is placing its bet on the second or third options coming true. When introduced at WWDC 2017, HomePod was marketed as an iOS accessory that will serve as the best speaker people have ever owned. The $349 price certainly reflects this accessory mindset. While Apple briefly went over how HomePod will be able to serve as a type of smart home hub, it was almost more of an afterthought. At its core, Apple does not think the only function for stationary smart speakers is to pipe digital voice assistants.
Wearables
I don’t think stationary smart speakers represent the future of computing. Instead, companies are using smart speakers to take advantage of an awkward phase of technology in which there doesn’t seem to be any clear direction as to where things are headed. Consumers are buying cheap smart speakers powered by digital voice assistants without having any strong convictions regarding how such voice assistants should or can be used. The major takeaway from customer surveys regarding smart speakers usage is that there isn’t any clear trend. If anything, smart speakers are being used for rudimentary tasks that can just as easily be done with digital voice assistants found on smartwatches or smartphones. This environment paints a very different picture of the current health of the smart speaker market. The narrative in the press is simply too rosy and optimistic.
Ultimately, smart speakers end up competing with a seemingly unlikely product category: wearables. In fact, stationary smart speakers and wrist wearables share a surprising amount of similarities. Each is ultimately based on handling tasks formerly given to smartphones and tablets. Two examples are delivering both digital voice assistants and sound. If the goal is to rely on a digital voice assistant, an Apple Watch wearer has access to Siri at pretty much every waking moment. When simply wearing an Apple Watch, Siri is instantly available everywhere in the home. The same kind of access to Alexa would require five, ten, or maybe even 15 Echo speakers spaced strategically throughout the home (another reason why Echo sales are becoming increasingly misleading - some consumers may be buying a handful of $20 speakers at one time). With a cellular Apple Watch, Siri is now available outside the home even when users are away from their iPhones. Meanwhile, Alexa is stuck within four walls - at least until Amazon unveils its Alexa smartwatch.
Wearables contain a much more attractive long-term value proposition than stationary smart speakers that have to be connected to a wall outlet. In addition, the presence of a screen provides even more value as it has become very clear that voice-first or voice-only interfaces just aren't that efficient.
The writing is on the wall. The stationary speaker market is a stopgap measure taking advantage of relatively low wearables adoption. My estimate is that Apple Watch adoption stands at 3% of the iPhone user base (10% to 15% of iPhone users in the U.S.). As that percentage increases, my suspicion is we will start to see the stationary smart speaker market begin to experience usage and retention troubles. Just as every company seems to be moving into the smart speaker space today, pain and lackluster results will begin to spread, ultimately leading to most companies exiting the space.
There may still be a future for stationary smart speakers, but not as some kind of future computing paradigm. Instead, stationary smart speakers will become accessories to the very same wearables that they are competing against today. For example, when an Apple Watch wearer wants to listen to music, HomePod will be positioned as a way to provide a much better sound experience. In addition, the very same HomePod can be positioned in the home as a type of smart home hub for controlling devices while away. If voice interfaces evolve to the point of becoming more useful, wearables will be able to easily support an increased reliance on digital voice assistants. The current fascination with standalone smart speakers may end up being labeled as a stepping stone to mass-market wearables adoption.
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It's Time for Apple to Disclose Apple Watch Sales
Apple Watch is a resounding success, and it's time for Apple to make it official by providing quarterly sales data. The question of whether Apple should disclose Apple Watch sales has never had a simple "yes" or "no" answer. Instead, the positives and negatives found with disclosure have to be weighed against each other. There is now more upside found in Apple disclosing quarterly Apple Watch sales than in keeping them private and just providing sales clues.
The Initial Decision
In late 2014, six months before Apple Watch went on sale, Apple announced that it would not be disclosing quarterly Apple Watch revenue and unit sales. The company would include Apple Watch in a new financial line item. The category, called "Other Products," would serve as a catch basin for a variety of products including iPod, Beats, Apple TV, other Apple accessories, and a range of third-party accessories sold through Apple Retail.
Apple's decision to withhold Apple Watch sales was a controversial one. Apple Watch represented Apple's first genuine new product category in the Tim Cook / Jony Ive era. Expectations were high as observers positioned Apple Watch as a litmus test for Apple's ability to innovate following iPhone and iPad. The lack of disclosure meant analysts would have to back into Apple Watch sales estimates using their own earnings models. This process guaranteed there would be a discrepancy when it came to Apple Watch estimates.
A number of theories were put forth regarding why Apple made the initial decision to lump Apple Watch in with Other Products. The official reasoning according to Apple management was that given how Apple Watch was a new product with no revenue, it made sense to lump the product with other products. In addition, the lack of disclosure was said to make it difficult for competitors to assess Apple Watch demand and market trends. The much simpler explanation was that Apple just didn't stand to benefit from disclosing Apple Watch sales out of the gate. Apple faced a number of benefits associated with keeping Apple Watch sales hidden, such as:
- Keeping competitors in the dark.
- Avoiding negative press coverage focused on the wide discrepancy between Apple Watch and iPhone sales.
- Avoiding investor and analyst disappointment if Apple Watch sales missed very high expectations.
- Moving the Apple narrative on Wall Street beyond unit sales growth.
Meanwhile, the downsides associated with keeping Apple Watch sales hidden included:
- Portraying a lack of confidence in Apple Watch.
- Being unable to control the Apple Watch narrative in the press.
In early 2015, there was very little upside for Apple found with disclosing Apple Watch sales. While management was confident that Apple Watch would become a hit product, there was no reliable way of converting that optimism into multi-year sales projections. The product had an unknown adoption curve, and Apple did not have a recent product to use as a proxy to estimate adoption. The iPad was released five years earlier, but the product had proven to be a sales outlier by riding the iPhone's coattails. In addition, management knew initial Apple Watch sales would pale in comparison to iPhone sales, potentially leading to negative stories in the press. Apple made the correct decision to keep initial Apple Watch sales hidden.
Sales Clues
On the surface, Apple's decision to withhold quarterly Apple Watch sales data would make it difficult to assess performance. As seen in Exhibit 1, Other Products revenue, which includes Apple Watch sales, doesn't provide many clues regarding Apple Watch demand. If anything, the most likely takeaway is that Apple Watch sales haven't been impressive. However, this assessment is grossly inaccurate.
Exhibit 1: Apple "Other Products" Revenue
In what came as a surprise, soon after Apple Watch launched, Apple management began to provide clues regarding Apple Watch sales. The sales clues have now become so helpful at reaching Apple Watch sales estimates, management appears to be systematically undermining its initial decision to withhold sales data. Some of the more noteworthy sales clues over the past two-and-a-half years include:
- Apple Watch revenue accounted for "well over 100% of the growth" in Other Products in 3Q15 (two months of sales). In addition, Apple Watch sell-through was higher in 3Q15 than in the comparable launch periods for iPhone and iPad.
- Apple Watch unit sales were up sequentially in 4Q15 and once again in 1Q16.
- Apple Watch unit sales exceeded sales of iPhone during its first year. Apple Watch was the second best-selling watch brand in CY2015 (revenue).
- Apple Watch experienced a unit sales and revenue record in FY1Q17. Apple Watch sales "nearly doubled year over year" in 2Q17 and have been up "over 50%" in 3Q17 and 4Q17.
- Apple Watch was the best-selling watch brand over the twelve months ending in June 2017 (revenue).
Taking the preceding clues into consideration and adding them to my Apple financial model leads to the Apple Watch unit sales estimates found in Exhibit 2. Apple has sold 30M Apple Watches to date. More detail on the size of the Apple Watch installed base and user base is available for Above Avalon members here.
Exhibit 2: Apple Watch Unit Sales (Above Avalon Estimates)
In order to remove the seasonality found with Apple Watch (sales are concentrated in the holiday quarters - 1Q16 and 1Q17), Exhibit 3 shows Apple Watch sales on a trailing twelve month basis. Apple Watch momentum becomes much easier to observe. Apple Watch unit sales have been steadily increasing over the past year with unit sales up nearly 50% year-over-year on a trailing twelve month basis.
Exhibit 3: Apple Watch Unit Sales - TTM (Above Avalon Estimates)
Time for Change
Four major changes have swung the disclosure debate in favor of Apple providing Apple Watch data on a quarterly basis.
- There is no smartwatch market. After more than two-and-a-half years of competition, it is clear that Apple Watch doesn't have much genuine competition. Instead of there being a smartwatch market, there is just an Apple Watch market. In the beginning, some thought low-cost, dedicated health and fitness trackers would pose a major long-term sales risk to higher-priced, multipurpose wearable devices like Apple Watch. This has proven to be incorrect. Apple Watch is seeing growing sales momentum while dedicated fitness trackers are quickly fading in the marketplace. Samsung, Garmin, Fossil are the only companies selling at least 100,000 smartwatches per quarter on a regular basis. The rationale for withholding Apple Watch sales data "due to competitive reasons" is getting weaker as time goes on. In addition, competitors already have a very good idea of how Apple Watch is performing in the marketplace thanks to the sales clues provided by Apple. (In addition, I have been providing Apple Watch sales estimates to Above Avalon members for years.)
- Additional Apple Watch sales data. Apple has a much better handle on Apple Watch demand trends given 10 quarters of Apple Watch sales data. Management is well aware of the seasonality found with Apple Watch sales. In addition, much of the unknown found with the quarterly swings in Apple Watch sales has been removed. Year-over-year growth projections for Apple Watch now serve as a more reliable way of forecasting sales.
- Low Apple Watch expectations. Wall Street no longer has high expectations for Apple Watch sales. Accordingly, Apple is no longer facing the same level of risk of missing Apple Watch sales expectations.
- New Wall Street focus. There is evidence of Wall Street focusing much less on Apple's unit sales growth. Instead, Wall Street is increasingly focused on Apple's balance sheet. The result is an environment in which Apple doesn't have to worry as much about slowing Apple Watch unit sales posing a threat on Wall Street.
Apple has been trying to play both sides of the Apple Watch disclosure debate. On one hand, the company still doesn't want to face the pressure and scrutiny found with disclosing Apple Watch revenue on a quarterly basis. However, management is providing increasingly detailed sales clues in an effort to tell the world that Apple Watch is selling well and gaining momentum.
Apple now stands to benefit more from disclosing Apple Watch sales than keeping them hidden. What were once incentives for not disclosing Watch sales have reversed and now represent reasons to provide sales data.
- Apple is missing positive press coverage associated with strong Apple Watch sales figures.
- Apple can improve its Wall Street narrative by talking up Apple Watch as a primary computing platform. Sales data will help Apple in such efforts.
The recurring theme found with Apple's disclosure philosophy is providing numbers when doing so benefits the company. A few recent examples include Apple beginning to disclose the number of paid subscriptions across the various App Stores and more detailed numbers related to Apple Retail traffic. The paid subscriptions disclosure goes a long way in painting Apple as having the best ecosystem for paid third-party services. Meanwhile, the Apple Retail and online store traffic disclosure paints a picture of an expanding Apple ecosystem in China and emerging markets.
Best of Both Worlds
Since Apple won't be required to disclose Apple Watch sales in the near-term given their small percentage of overall revenue, there is a way for management to have the best of both worlds when it comes to Apple Watch disclosure. Management can begin disclosing quarterly Apple Watch unit sales while keeping revenue lumped in with "Other Products." By disclosing unit sales, Apple is able to receive all of the upside found with Apple Watch disclosure. However, by not disclosing revenue, management would be able to keep Apple Watch average selling price (ASP) data hidden for competitive reasons. While the world would know how many Apple Watches are sold every quarter, estimating would still be required to assess which Apple Watch models are selling well. Apple has done something similar in the past with Apple TV when the company periodically disclosed unit sales without breaking out revenue.
By providing just Apple Watch unit sales on a quarterly basis, Apple can beginning taking back the Apple Watch narrative. As of today, there is still a remarkable amount of skepticism pointed toward Apple Watch. Since there is no rational reason for such skepticism to exist given management's Apple Watch sales clues, the lack of official Apple Watch unit sales data is likely a contributing factor. Official Apple Watch unit sales would go a long way in positioning Apple Watch as a compelling computing platform. Some consumers may become interested in Apple Watch once knowing how many other people are buying and wearing the product. Compared to the lack of sales disclosure from companies like Amazon, Google, and Samsung, providing quarterly Apple Watch unit sales would garner much more positive press for Apple Watch.
Meanwhile, there is a declining number of downsides and risks found in disclosing Apple Watch unit sales. Apple Watch has significant momentum in the marketplace, and Apple's engineering and design teams are running as fast as they can with the product category. Apple is leading the market with a cellular Apple Watch and being able to apply fashion/luxury attributes to design and technology. These items will very likely continue to fuel sales momentum for Apple Watch. No other company is close to Apple when it comes to selling multipurpose computers on the wrist at volume.
Financial Disclosure
Apple will eventually have no choice but to disclose Apple Watch revenue. Once "Other Products" begins to account for 10% to 15% of Apple's overall revenue, pressure will build for management to break up the line item to make it easier for analysts to model. Other Products currently accounts for 6% of Apple's overall revenue. The iPad represented close to 15% of Apple's overall revenue immediately after going on sale. Apple likely had no choice but to break out iPad sales. Meanwhile, Apple stopped reporting iPod sales once it declined to 1% of overall sales.
The Other Products line item has been effective up to now since it represents a small fraction of overall Apple revenue. This was the primary motivation behind Apple creating the category in the first place - to serve as a catch basin for products bringing in a small percentage of overall revenue. If Apple Watch continues to see significant revenue growth, pressure will build for Apple to rearrange its financial disclosure in order to break out Apple Watch revenue. While this scenario won't happen in the near term, a few more years of strong Apple Watch sales growth will make it a very real possibility.
Holiday Quarter
Apple's next earnings report marks a great opportunity for Apple to begin disclosing Apple Watch unit sales. Apple will likely sell more than 9M Apple Watches during the holiday quarter, which would represent a sales record and exceed Mac sales by a wide margin. Looking ahead, Apple Watch is on track to reach a 25M unit sales per year pace in 2018. It's time for Apple to begin disclosing Apple Watch unit sales data and become much more vocal in telling the Apple Watch story.
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iPhone X
After 10 years, the iPhone business is displaying signs of maturity. The days of significant sales growth are in the rearview mirror. The upgrade cycle is getting longer as it becomes that much harder to get people to upgrade their iPhones.
Apple was faced with a choice: Stick with the familiar and milk the iPhone business for all it’s worth, or throw familiarity out the window to pave a new iPhone journey for the next 10 years. Apple chose the latter, and iPhone X is the byproduct.
I’ve been using an iPhone X since Monday. Accordingly, this is not a comprehensive review. Instead, the focus is on my initial impressions and thoughts from using the device. My expectation is for additional iPhone X observations to materialize over the coming days and weeks.
iPhone X is without question an inflection point for the iPhone business. This new iPhone era won’t necessarily materialize in the form of stronger iPhone sales growth. Instead, the iPhone user experience is now on a different trajectory. In some ways, iPhone X places iPhone firmly in the direction of the original vision Jony Ive and Apple’s industrial designers had for iPhone when it was still an R&D project 12 years ago. Apple wants iPhone hardware to melt away, leaving just the user interacting with software.
Not Your Typical Update
The first thing that becomes apparent after using iPhone X is that this isn’t just any iPhone update. (Most people will probably call it iPhone “ex” instead of “ten” – I doubt Apple cares too much since people are going to buy this device in droves).
Historically, Apple has strived to have two or three marque features for each iPhone release. These features have to be substantial enough to frame a marketing campaign around. Some of these features, such as larger screens and fingerprint readers, have been hardware-related while other features, such as Portrait Mode and the dual camera system, have been a combination of software and hardware. In addition, new case colors have become a reliable way of enticing some iPhone users to upgrade. A few of the more noteworthy updates over the years include:
- iPhone 5: Larger 4-inch screen
- iPhone 5s: Touch ID / Gold finish
- iPhone 6 / 6 Plus: Larger 4.7-inch and 5.5-inch screens / Apple Pay
- iPhone 6s / 6s Plus: 3D Touch / Live Photos / Rose Gold finish
- iPhone 7 / 7 Plus: Dual camera system (Portrait Mode) / Jet Black finish
- iPhone 8 / 8 Plus: Glass back / Gold finish
When looking at the preceding list, no one feature jumps out as single-handily changing the way we use iPhone. Instead, each feature played a supporting role in a much bigger production. Apple’s broader goal has been to improve the iPhone experience ever so slightly with each new iPhone. Management has seen more success in reaching that goal in some years than in other years.
With iPhone X, two design changes stand out: the removal of the front-facing home button and Face ID replacing Touch ID. The changes amount to nothing short of an entirely new iPhone experience. The best way to describe the feeling found when using iPhone X is that it’s the closest thing to using an iPhone from an alternative universe. There is this fresh, or reinvigorating, feeling to it – as if the home button was holding the iPhone experience back, representing a barrier to interacting with software. No other iPhone update has been able to elicit such a strong feeling. It is also easy to see where Apple wants to take iPhone over the next ten years (more on this shortly).
Learning Curve
Much to my surprise, there really isn’t much of a learning curve with iPhone X. While it will take a few minutes to get used to not having a home button, the memory reflex adjusts incredibly quickly. I was expecting to keep pressing the bottom of the screen as if there was still a dedicated home button, but it just never occurred.
The remarkable thing about this is that considering how engrained the home button has been in our lives, to just move on after a few minutes says something about the intuitive user interface found with iPhone X. The home button wasn’t just a way to unlock our iPhone the dozens of times throughout the day or to get back to the home screen. Instead, the home button represented familiarity and safety. In case of trouble, a quick tap would drop us back into the comfort found with the home screen. In case of an extra sticky situation, a quick double tap would bring up the multitasking window as a form of escape.
With iPhone X, the swiping gesture has replaced home button pressing, and it feels more natural than a home button ever felt. A swipe up from the bottom of the screen in both a horizontal and vertical position brings you back to the home screen. Control panel is a swipe from the upper right corner.
Why No Home Button?
There is a rather straightforward question to ask about iPhone X: Why did Apple remove the iPhone home button in the first place? It’s all about coming up with a different way to interact with technology – removing extra bezel to just leave you and the screen. A byproduct of this is that Apple is able to fit more screen in the same form factor. iPhone X has a little bit less screen real estate (in terms of area) than iPhone Plus. The 5.8-inch screen has a more vertical element than its iPhone Plus sibling.
While the iPhone Plus has been gaining sales momentum in recent years, culminating with iPhone 8 Plus outselling its smaller iPhone 8 sibling, the form factor is a bit large for a certain portion of the iPhone user base. Apple went with the iPhone X’s particular form factor because it felt the best in hand. Of course, Apple will likely sell different iPhone X sizes over time, but the company had specific reasons for going with the current iPhone X form factor.
Face ID
Touch ID is a thing of the past. If it wasn’t for needing to use Touch ID on my iPad Pro, I doubt I will give the fingerprint recognition technology much thought going forward.
The Apple rumor cottage industry had a wild 2017 when it came to Touch ID and iPhone X. Many Apple rumor finders and reporters were extremely confident that Apple actually wanted to put Touch ID under the screen and due to technological roadblocks had to settle for Face ID. While it would not be surprising for Apple to investigate trying to put fingerprint recognition under a screen (why wouldn’t they kick the tires?), Apple is no way settling with Face ID. In addition, the claim that Face ID is in some way a stop gap is just wrong. Instead, Face ID represents the next reiteration of Apple’s quest to push biometric authentication forward.
Face ID set-up is ridiculously smooth, easy, and quick. We can probably throw the word magical into the mix as well – it would qualify. While Touch ID signup has improved over the years, Face ID blows it out of the window in terms of simplicity and intuitiveness.
There are a few notable drawbacks to Face ID – which do seem like low-hanging fruit for Apple to address down the road. (These drawbacks were discussed in my accompanying iPhone X initial impressions video.)
- You need to look at the iPhone X TrueDepth camera system basically directly on for Face ID to work. The days of laying your iPhone on the desk and just reaching over and pressing the home button are over (for now). Instead, you will either need to shift so that your face is directly over the TrueDepth camera system, or you have to lift up the iPhone from the flat surface. You can just tap the screen to see notifications.
- Face ID requires access to your eyes, nose, and mouth. For some people, this will limit Face ID availability. It is important to point out that Touch ID has its fair share of issues as well including wet fingers.
- In my initial tests, Face ID on iPhone X was slower than Touch ID on an iPhone 8 Plus when used to get to the home screen.
All in all, Face ID is impressive. It’s not a perfect replacement for Touch ID but it’s more than adequate. iPhone X will place Face ID as the first genuine technology that will make facial recognition go mainstream in a smartphone.
The Screen
A few hours with the screen is all you need to begin understanding why Apple chose to remove as much bezel as possible. The way Apple wraps the iPhone X screen around the TrueDepth camera system (a.k.a the notch) has been a polarizing topic in the run up to this week’s launch. Some people think the notch is bad design. This camp argues Apple shouldn’t have included a visual gap in the screen. Renderings showing various iPhone X apps in portrait mode, which clearly look odd at first, have given this camp a decent number of supporters.
However, in what likely isn’t a coincidence, the “notch is bad design” camp has been quiet when it comes to offering or suggesting better alternatives. Including extra bezel to the left and right of the TrueDepth camera system, like every other smartphone manufacturer currently does with their front-facing camera, isn’t a better solution. One wouldn’t be able to use that space to display information such the date, time, battery indicator, carrier signal, etc. In addition, the whole point of iPhone X is to get rid of as much bezel as possible.
Much like the home button, the “notch” will be quickly forgotten. It just melts away after a few hours of use. Let’s not beat around the bush – an iPhone X without any notch would obviously be the closest representation to Apple’s vision of hardware melting away to just leave the user interacting with software. However, the technology for such a feat just isn’t available today (although Apple R&D suggests the company is working at it). But Apple sure comes close to that perfection, even when taking into account the notch.
I don’t think it’s fair to say that the way Apple wraps the screen around the TrueDepth camera system was some kind of major compromise. Instead of Apple redesigning iPhone to remove the notch next year or the following year, there is a much higher likelihood of Samsung and other smartphone manufacturers embracing some version of the notch as the extra bezel found on Galaxy S8 or Pixel 2 XL really does stand out in a negative way when positioned next to iPhone X.
The debate over the notch is not about whether Apple should have included a notch or not with iPhone X. Instead, the debate comes down to screen real estate. Along those lines, the notch comes out ahead. Regardless of the pros and cons found with the notch, Apple is fully embracing it. In fact, the notch replaces the home button as a defining characteristic of the device – a way for the phone to stand out from competitors. The notch ends up being iPhone X branding.
Thoughts on Sales
Beginning Friday, Apple will be selling three new iPhones simultaneously for the first time (iPhone X, iPhone 8, and iPhone 8 Plus). After using both an iPhone 8 Plus and iPhone X, I don’t think it’s completely right to label each as Apple’s flagship iPhone. Instead, iPhone X has the exclusive rights to that title.
While iPhone X shares some similarities with iPhone 8 and 8 Plus, the differences are just too much to place the three phones on the same plane. However, it would be a mistake to cast iPhone 8 and 8 Plus as the forgotten iPhones.
Conventional wisdom positions iPhone X as targeting iPhone users focused on the latest and greatest technology. Meanwhile, everyone else is thought to be interested in the lower-cost iPhone 6s, 7, or 8. After using iPhone X and taking into consideration how most consumers buy iPhones, I’m not sure such a generalization is correct.
The question of how an iPhone user will choose between an iPhone X and a different kind of iPhone (most existing iPhone users will stick with iPhone for their next smartphone) won’t come down to one’s desire for the latest and greatest technology. Instead, it will likely come down to one’s comfort level with change and the desire for familiarity.
For a portion of the 800M iPhone users in the wild, iPhone X will represent change that isn’t essential at this time. This isn’t to say anything about iPhone X not appealing to the mass market or the device not being intuitive enough. Instead, the iPhone user base is increasingly heterogeneous when it comes to views and thoughts regarding technology and iPhone. For many people, iPhone 8 and 8 Plus are worthy upgrades to their existing iPhones. A very strong case can be made that iPhone 8 and 8 Plus will sell just fine next to iPhone X. In subsequent years, these users will eventually be in a better position to embrace the design changes found with iPhone X as Apple extends that design language to different screen sizes.
Approximately 80% of iPhone sales in the U.S. occur through mobile carriers. This means that for many iPhone users, the purchase decision between iPhone 8 and iPhone X may come down to how each iPhone looks next to each other in a Verizon or AT&T store. The iPhone X would probably win if it were a beauty contest – the screen just can’t be beat. However, the home button may give iPhone 8 and 8 Plus some points with a portion of consumers. At the end of the day, sales may end up a draw, which would be a big win for iPhone X considering its higher price.
Speaking of iPhone X pricing - which will likely go down as the most talked about Apple topic of the year – concerns of iPhone X pricing being too high are misplaced. This phone is going to sell well in U.S. and China. In fact, iPhone X will sell well in all of Apple’s established markets. Emerging markets will likely be a different story, which explains Apple’s consumer segmentation strategy for iPhone pricing. The iPhone SE, 6, and 6s are clearly targeting emerging markets where pricing is a much bigger sticking point.
Apple’s Goal
In many ways, iPhone X is the kind of product you would expect from Apple. Instead of settling with the existing iPhone paradigm and watching iPhone sales and profit gradually decline over time, Apple is determined to move on to the next thing. iPhone X is that the next thing. We are seeing the foundation for the next ten years of iPhone. All iPhones will eventually look and feel like iPhone X.
There are a few rough items around the edges. Face ID has some drawbacks when compared to Touch ID, although these are pretty much offset by its positives. In addition, some iPhone Plus users may be left a bit unsatisfied with iPhone X screen real estate (I would be interested in trying an iPhone X in the size of an iPhone Plus).
Apple is laying the foundation for a new user interface paradigm in which we rely much less on multi-touch to control our iPhones. Instead, we will rely on glances and looks. With wearables increasingly positioned as Apple’s product priority, an iPhone that serves as an augmented reality navigator controlled by glances is the future. The technology underpinning such a product can then one day be applied to other wearables controlled by glances and looks: Apple glasses.
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Apple Is Facing a Double Standard
Apple is a Silicon Valley and Wall Street leader. The company has the most profitable and best-selling smartphone, tablet, smartwatch, and wireless pair of headphones in the market. Apple has grown its user base by 10x over the past 10 years and is bringing in nearly more revenue than Amazon, Alphabet, and Facebook combined. This level of success places a bull's-eye on Apple’s back and rightly so. Leaders should be held to a higher standard.
However, a trend has developed where a number of tech companies are said to be outperforming Apple. Despite being cast as leaders, these companies aren't judged by the same high standards as Apple. Microsoft, Samsung, and Google are said to be one-upping Apple in core competencies like hardware and design. Yet, these companies don't face anywhere near the amount of criticism thrown at Apple.
Even when looking at companies that deserve to be put on a pedestal, such as Amazon, Tesla, and Tencent (WeChat), a double standard becomes apparent. While these companies are doing great things in terms of building promising customer relationships, none are exposed to the level of cynicism facing Apple. A company that is heralded in the press as surpassing Apple as a leader should face the same high standards used to judge Apple. Unfortunately, this never happens. The bull's-eye is never removed from Apple's back and given to another company.
Grading on a Curve
A massive curve is being used to grade companies not named Apple. The list of recent examples is extensive.
Samsung. Samsung released its Galaxy S8 flagship smartphone to near unanimous praise this past April. Tech media positioned the phone as a sign of Samsung taking the smartphone design baton from Apple. The phone was said to be an engineering marvel, standing apart from iPhone, and every other smartphone for that matter. YouTube vloggers, some with financial ties to Samsung, couldn’t say enough positive things about the phone. Samsung had beaten Apple to market with a smartphone lacking a dedicated home button and having reduced front bezels.
Only a few days after launch, Galaxy S8 problems began to appear. In what has become a perennial occurrence with Samsung, smartphone features that were positioned as key attributes of the device were shown to be gimmicks. Samsung’s facial recognition software was easily spoofed with pictures. The company was forced to backtrack in terms of positioning facial scanning as a secure biometrical identification method. These problems should have led many to reassess claims that Samsung was the smartphone design leader.
Due to the home button being removed, Samsung decided to move the Galaxy S8 fingerprint reader to the back of the phone. It quickly became apparent that the decision was a questionable one. Instead of being labeled as a major design compromise, many reviewers brushed off the awkwardly positioned fingerprint reader as just a Samsung quirk. If the same scenario happened to Apple, leadership would be questioned and the company's strategy would be put into doubt. For Samsung, it was business as usual.
Microsoft. Microsoft has enjoyed two years of unanimous media praise for its Surface products. The company is said to push the boundaries of personal computing forward with Surface. Unlike Apple, Microsoft is viewed as giving consumers something they want before they even know they want it. Microsoft’s Surface business is being graded on a curve. The product category is losing in the marketplace as consumers show little to no interest in tablet/laptop hybrids. Despite poor sales, there has been no discernible change to the Surface narrative in the press. The same kind of sales decline for iPad led many to question Apple's entire strategy and vision. The goal posts continue to move for Microsoft. Surface success is now said to be found with enterprise adoption despite Microsoft spending the better part of the past five years positioning Surface for consumers.
Amazon. No company is currently receiving more praise than Amazon. While some of this is justified, a strong case can be made that Amazon's product strategy is being graded on a curve. Stationary speakers powered by Alexa are positioned by many as the future of personal computing. The lack of retort or debate regarding this claim is astounding. The tech community has elevated Amazon Echo on one of the tallest product pedestals around. Boilerplate language referencing Echo's success and popularity are found in every smart home article despite Amazon providing very few clues as to how the devices are selling or being used. Newer Echo devices such as the Echo Show and Echo Look led some tech reviewers to bend over backwards in an attempt to avoid the appearance of not "getting it." This behavior stands out when compared to the sheer level of skepticism thrown at Apple's HomePod, a device that isn't even available for sale.
Google. The company is said to be getting better at hardware, and a few people are starting to declare Google the new design leader. Google Pixel is positioned by some as a sign of Google even beating Apple at hardware. In reality, there are a growing number of signs indicating Google continues to fumble forward when it comes to hardware. While Pixel's growing number of issues are well-covered in the press, the degree to which Google received the benefit of the doubt in the first place is something not afforded to Apple.
Tesla. While Tesla receives its fair share of criticism from Wall Street, the tech community rarely pushes back against the company. Tesla's growing manufacturing struggles and missed deadlines are written off as typical Elon Musk antics. Meanwhile, Apple's manufacturing struggles are viewed as a sign of bad decision-making.
Snap. One word: Spectacles. The sunglasses with camera was looked at as a sign of Snap innovating faster than Apple. Long lines in front of a Spectacles vending machine were said to demonstrate how Snap was grabbing just as much buzz and interest as Apple during one of its global product launches. Not surprisingly, Spectacles flopped in the marketplace.
Apple Watch
The stark difference in how Amazon Echo and Apple Watch have been portrayed in the press highlight the double standard facing Apple. Neither Amazon nor Apple officially disclose product sales for each respective product, although Apple provides many more helpful Apple Watch sales clues. This makes it interesting how Amazon Echo has been declared a resounding success while Apple Watch receives doubt and criticism.
Amazon Echo and Apple Watch were likely selling at roughly the same pace during the first half of 2017. When considering Apple Watch sells at average selling price that is more than 5x that of Echo's, it's clear Apple Watch has been the revenue winner. In addition, given how some people have purchased four or five Echo devices, Apple Watch likely has wider user adoption.
Why is Apple Watch momentum and sales success not reported while Amazon Echo is positioned as the next big computing platform? Amazon doesn't have the same kind of bull's-eye placed on its back compared to Apple. Amazon Echo doesn't receive any where near as much criticism or cynicism as Apple Watch does.
China
Nowhere is the double standard Apple faces on display more than when China is discussed. Apple is the best-selling western brand in China. The company will bring in $45B of revenue this year in Greater China, selling upwards of 50M iPhones. According to Apple management commentary, Apple is seeing solid sales growth through its App Store in China. In addition, the iPad and Mac continue to sell well. Apple Retail store traffic and sales are also up year-over-year. However, judging by the press, Apple is one step away from implosion in China. Whether it is competition from the low-end, which is not new or unique to China, or services companies like Tencent (WeChat) stealing Apple users, a narrative with lots of holes, Apple’s strategy in China is being severely questioned.
While Apple has clearly experienced trouble in China, which likely played a role in Apple appointing Isabel Ge Mahe as VP of Greater China, the lack of criticism facing other companies regarding China is noteworthy. Amazon, Facebook, and Netflix, three companies considered to be among the most innovative entities today, have little to no presence in China. In some cases, it’s not a stretch to say these companies will never have a presence in the country. Yet, this reality is not viewed as a problem or hindrance for these companies. Instead, China is positioned as a wildcard opportunity containing just upside and little to no downside. For Apple, China is viewed in the exact opposite way, representing a lot risk with little to no upside opportunity.
Theories
Why is a double standard applied to Apple? Why are competitors being graded on a curve? I have a few theories:
1) People like underdogs. It's not that people necessary want to see Apple fall, but rather people want to get behind the underdog. It makes for a good story. A recent example of this is found with Andy Rubin's Essential getting into the smartphone market. Despite Essential's smartphone being positioned right next to iPhone, there was a notable lack of skepticism and proper analysis facing both the company and smartphone. Essential should never have been positioned as a genuine iPhone threat. Microsoft Surface's battle against Mac and iPad represents another underdog story that some people just don't seem to get enough of. In reality, there isn't much of a battle when looking at sales. Similar underdog stories are found with Amazon's Alexa outpacing Siri, Samsung beating iPhone in terms of design, Google matching up with Apple hardware, and Tesla grabbing more buzz than Apple.
2) Founder bias. There is a tendency for people to give companies run by founders the benefit of the doubt, while companies like Apple have a much higher bar to jump over. Few have made much out of Mark Zuckerberg's growing list of bad product bets and lack of vision. Zuckerberg's fascination with VR is at worst merely laughed off. Larry Page's and Sergey Brin's lack of focus are widely known and mentioned, but rarely questioned in terms of Alphabet's grand vision. Jeff Bezos can do no wrong, despite plenty of examples of Amazon making mistakes. Tesla has become all about Elon Musk's vision with few discussing the company's strategic blunders and holes. Meanwhile, each step Tim Cook and Jony Ive take is questioned more than the previous step. The only difference between these companies: Facebook, Alphabet, Amazon, and Tesla are led by founders, while Apple isn't.
3) Apple is misunderstood. Apple lacks a strong narrative in Silicon Valley and Wall Street. While much of this is due to Apple's own doing, the situation leads to unknown regarding how to judge Apple's performance. Many still view and grade Apple as if it is a technology company. In reality, Apple is a design company. This likely contributes to an elevated amount of skepticism and cynicism being applied to Apple's actions.
Solutions
The high standards applied to Apple should not be lowered in an effort to remove the double standard applied to the company. Leaders should receive an outsized amount of attention and criticism. Instead, the bar needs to be raised for companies not named Apple. If a company is said to be outpacing Apple, that company deserves to have a bull's-eye placed on its back. When it comes to the underdogs, stories should not romanticize David slaying Goliath, but detail the challenges and risks found in going up against Apple. Once problems and issue emerge, which they undoubtedly will, they should be covered as closely as the initial stories filled with optimism.
Apple is a polarizing company. This guarantees that the company will continue to face an outsized amount of skepticism and cynicism going forward. It's time that the same level of criticism be given to companies said to be giving Apple a run for its money as a Silicon Valley and Wall Street leader.
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Apple's Grand Vision
Apple's product strategy has been receiving more attention lately as voice-first and AI-first become buzzwords in Silicon Valley. Questions regarding whether Apple even has a coherent product vision are on the rise. While Apple is no stranger to receiving skepticism and cynicism, the degree to which people are discounting Apple's product strategy is noteworthy. There is mounting evidence that Apple's industrial designers are following a product vision based on using design to make technology more personal. It is becoming clear that such a vision extends well beyond just selling personal gadgets.
Product Strategy
Apple's financials paint a picture of a company following an iPhone as Hub product strategy in which iPhone is the sun and every other product revolves around iPhone. Apple generated $140B of revenue and approximately $60B of gross profit from iPhone over the past year. These totals amounted to 60% and 70% of Apple's overall revenue and gross profit, respectively. As seen in Exhibit 1, over the past year, Apple sold 2.5x more iPhones than iPads, Macs, Apple Watches, Apple TVs, and AirPods combined.
Exhibit 1: Apple Product Unit Sales
Upon closer examination, Apple is not following an iPhone as Hub strategy. In fact, the company has never followed such a product strategy. Apple is instead following a strategy based on selling a range of tools containing varying levels of personal technology. Management is placing big bets on four product categories: Mac, iPad, iPhone, and Apple Watch.
Apple leaves it up to the consumer to determine the amount of personal technology that fits best in his or her life. For hundreds of millions of people, iPhone is the device that has just the right mix of power and functionality in a convenient form factor. This plays a major role in explaining the iPhone's oversized impact on Apple's financials. When looking at the number of new users entering each product category, it becomes clear that iPhone is Apple's best tool for gaining new customers. (The math behind Exhibit 2 is available for Above Avalon members here, here, and here.)
Exhibit 2: Growth in Installed Base
In addition to the four primary product categories, Apple also sells a line of accessories. HomePod, AirPods, Beats, and Apple TV are positioned to add value to Apple's primary computing platforms. The bulk of these accessories are designed to control sound. AirPods and Beats handle sound on the go while HomePod is tasked with controlling sound in the home. Apple TV is unique because it is given the job of controlling both sound and video on the largest piece of glass in the home. This uniqueness is also evident with Apple launching the tvOS platform for third-party developers.
The Grand Unified Theory of Apple Products
While Apple's four primary product categories share a few obvious attributes such as possessing screens, there is a more important connection. Each is designed to be an alternative to the next most powerful device as detailed in The Grand Unified Theory of Apple Products (shown below).
Apple's quest to make technology more personal involves using design to remove barriers preventing people from getting the most out of technology. Instead of positioning new products as replacements for older ones, Apple is focused on coming up with alternatives. One way to accomplish this goal is to take complicated tasks and break them down into more granular tasks, which can then be handled by smaller and simpler devices.
- iPad is given the job of being powerful and capable enough to serve as a Mac alternative.
- iPhone is given the job of handling tasks that may have otherwise gone to iPad.
- Apple Watch is tasked with doing enough things on the wrist that it can serve as an iPhone alternative.
Multitouch computing represented a giant leap in Apple's quest to make technology more personal. Based on unit sales, it's fair to say hundreds of millions of people think iPhone and iPad are adequate Mac alternatives. In a similar vein, Apple Watch isn't designed to replace iPhone. Instead, Apple Watch is given the job at handling some of the tasks given to iPhone. The ability to put digital voice assistants on the wrist represents Apple's latest personal technology breakthrough.
Evolving Product Priorities
While Apple designers and engineers have shown the willingness to push Apple's four primary product categories forward, change is in the air. Apple Watch and the broader wearables category represent Apple's best chance to make technology more personal. One of the highlights from Apple's inaugural event last month at Steve Jobs Theater was a cellular Apple Watch. In fact, the Apple Watch portion of the event was the strongest part of Apple's presentation. After spending the past two years refining its Apple Watch messaging, Apple now has a more appealing and convincing Watch sales pitch for consumers.
It's becoming clear that Apple's product priorities are shifting.
- Release an Apple Watch that is fully independent of iPhone.
- Position Apple Watch to handle more tasks currently given to iPhone.
- Release accessories that complement Apple's expanding wearables strategy.
- Position iPhone as an AR navigation device.
- Position iPad as a genuine Mac alternative.
- Position Mac as a VR/AR content creation machine.
Combining the six preceding priorities into one cohesive product strategy leads to the following diagram.
Resources and attention are flowing to the devices at the right end of the spectrum, the products most capable of making technology more personal. A cellular Apple Watch Series 3 is the latest step in Apple's journey to an Apple Watch that is completely independent from iPhone. Such a product will represent a watershed moment for Apple Watch as it would more than triple the product's addressable market. When it comes to Apple Watch serving as a genuine iPhone alternative, the addition of a selfie camera one day and an increased role played by Siri intelligence will go a long way in allowing Apple Watch to handle additional tasks formerly given to iPhone.
Grand Vision
There is a grand vision behind Apple's product strategy of selling a range of personal devices. Apple believes design is the ingredient that allows people to get the most out of technology. Even though Apple's industrial designers oversee this vision, the entire company ranging from engineers and product designers, to Apple retail specalists believe in focusing on the user experience. Apple views core technologies not as products in of themselves, but as ingredients for something else. Instead of copying other companies and chasing after technology's raw capability, Apple is more interested in technology's functionality as it relates to the user experience.
It is easy to look at Apple's current product line of personal devices and wonder where the company will turn next. Additional wearable devices like AR glasses are inevitable and fit within a product line of personal gadgets. On the other hand, Apple's growing interest in transportation has been a head scratcher for many observers as a car doesn't seem to fit within Apple's product strategy. This has led some to wonder if Apple is getting away from its mission or vision in an attempt to chase revenue or users.
Instead of assuming a self-driving car would be tacked onto the end of Apple's product line next to Apple Watch, the much more likely scenario is that transportation would represent a brand new product paradigm for Apple. The same idea applies to Apple's growing interest in architecture and construction.
As shown below, Apple would have multiple product paradigms, each comprised of a range of products. This is the primary reason why Project Titan shouldn't be thought of as just a self-driving car initiative, but rather Apple building a foundation for its transportation ambition.
In essence, Apple's transportation strategy would begin with a self-driving car but then eventually lead to the company developing more personal modes of transportation based on new user interfaces, fewer wheels, and different seating arrangements. This process would be equivalent to Apple starting with Mac and then using new user interfaces, technology, design, and manufacturing techniques to create products capable of making technology more personal. Apple would take a self-driving car and strip away capabilities in order to improve functionality. The same goal can occur with architecture and the broader concept of smart homes. It's difficult to see homes becoming truly smart until Silicon Valley begins building housing. The major takeaway is that Apple's quest to make technology more personal doesn't just apply to personal devices. Instead, there is a role for design to play in entirely new industries such as transportation and construction.
Issues
Apple has run into its fair share of issues and roadblocks following its grand vision. As resources and attention flow to devices most capable of making technology more personal, Apple has made some questionable design decisions. The Mac Pro and Apple's overall approach to pro Mac users has not fared well in recent years. This serves as the basis for my "The Mac is Turning into Apple's Achilles' Heel" article earlier this year. Management was forced to back track in order to stem growing backlash within the pro Mac community. Even today, the amount of criticism pointed at the Mac, some of which is genuine, is trending at multi-year highs.
The Mac debacle also ends up revealing some of the downsides associated with Apple's functional organizational structure. The company practices a focus mantra when it comes to product development, which may result in certain products getting left behind or not getting as much attention as they may need. This may make the jump into new product paradigms like transportation that much harder for Apple.
While Apple's product line is still incredibly focused for a $825B company, there is no denying that additional models and SKUs have led to an expanding product line over the years. Apple's entire product line is shown below. Apple relies on a consumer segmentation strategy to target as broad of a market as possible for each of its four primary product categories. Apple has learned a lesson or two from the dark days in the 1990s. A byproduct of this strategy has been complexity being added to the product mix in recent years.
Inevitable Path
Apple puts much effort, care, and deliberation into marketing. This makes one of the animated videos found on Apple's website so intriguing. As shown in the screenshots below, the animated video is meant to highlight HomePod's spatial awareness capability. The only two Apple products shown in the room are HomePod on a table and the two individuals wearing Apple Watches. There is no iPhone, iPad, or Mac in sight. For some companies, this can be brushed off as a simple oversight, but not for Apple. It's intentional.
Apple looks at Apple Watch as the natural evolution of personal computing. Having Siri intelligence on the wrist throughout the day, in addition to receiving and consuming information via a screen, is powerful. Meanwhile, HomePod is positioned as an Apple Watch accessory capable of delivering sound in a way that just isn't feasible for a device worn on the wrist. While some companies are advocating new product strategies such as voice-first or AI-first, Apple is taking a different path with a product strategy evolving into one based on wearables. Voice and AI are then positioned as core technologies powering these wearable devices. To a certain degree, this is the inevitable path Apple has been on for the past 40 years. Going forward, the largest opportunity for Apple will be found in using its product vision to create personal technology paths in new industries.
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iPhone Courage
iPhone pricing has garnered more attention in recent months than any other Apple topic. However, pricing is not the most important variable impacting the iPhone business. With iPhone X, Apple is taking what previously worked with iPhone and throwing it away in an effort to create a better user experience. For Apple to take this much risk with the product responsible for the vast majority of its cash generation and new user growth is noteworthy.
iPhone X
During its inaugural event at Steve Jobs Theater last month, Apple unveiled three flagship iPhones. Management dedicated 20 minutes of stage time to iPhone 8 and 8 Plus, models clearly positioned within the existing iPhone paradigm. Attention then turned to iPhone X, which garnered nearly twice as much stage time. While the "X" stands for ten, it could have very well stood for extreme. iPhone X will be the most radical iPhone Apple has sold to date. The home button has been removed to fit a larger screen in a smaller form factor. This change, which was years in the making, ushers in a completely new iPhone experience. Users will have to retrain their finger reflex to not press the bottom of the screen and instead, get used to swipes. In addition, the removal of fingerprint recognition in favor of facial recognition represents a very big change in how we will use iPhone. A strong argument can be made that removing the home button is the single-biggest change Apple has made to iPhone. The sheer amount of risk found in the move is being grossly underestimated.
iPhone Strategy
Apple is launching iPhone X at a critical juncture for the iPhone business. A slowing upgrade rate among existing iPhone users has led to overall unit sales plateauing, as highlighted in Exhibit 1.
Exhibit 1: iPhone Unit Sales (Trailing Twelve Months)
Despite weakening sales growth trends, Apple is still selling more than 200M iPhones per year, bringing in $140B of revenue and $60B of gross profit. In addition, the iPhone installed base grew by approximately 110 million users in 2017. iPhone remains Apple's most effective tool for grabbing new users.
Apple's iPhone strategy can be broken into three parts:
- Pricing
- Product marketing
- Design
While much of the attention has been focused on Apple's move at the high-end of the iPhone pricing spectrum, the company is making just as interesting of a change at the low-end. Apple is following a consumer segmentation strategy. Management is cutting iPhone pricing at the low-end to improve accessibility. The $399 iPhone price floor that had been in existence for years was shattered last month. A $350 iPhone SE is the lowest-priced "new" iPhone Apple has sold to date. Management's decision to continue selling iPhone 6s and 6s Plus, and even iPhone 6 in select markets, positions additional SKUs for customers focused on value and price. Meanwhile, at the other end of the pricing spectrum, Apple is running with higher-priced models targeting consumers who value the latest and greatest technology.
Underlying this pricing dynamic is a product marketing strategy focused on positioning the iPhone as the best camera people have ever owned. The dual-camera system found in iPhone 7 Plus is one of the more noteworthy iPhone features in years. With iPhone 8 Plus and iPhone X, Apple introduced Portrait Lighting, which adds a new element to Portrait mode. Apple then went further to include Portrait mode and Portrait Lighting on the iPhone X front-facing camera.
Apple saw how cameras are becoming much more than memory capture tools. Cameras are turning into smart eyes powering the dawn of the augmented reality era. Apple spent years dedicating resources to the effort and is now at the point where iPhone cameras are being powered by Apple silicon. This provides Apple's cameras additional differentiation and the ability to stand out from peers.
Apple has seen quite a bit of success with its iPhone pricing and product marketing strategy over the years. However, these two variables are not the most important items impacting iPhone's evolution. Design, or the way consumers use the product, has a much larger impact on iPhone's future, and Apple is making big changes to how we will use iPhone going forward.
The Headphone Jack
iPhone X demonstrates how Apple is willing to move beyond legacy design constraints and thinking. The home button has come to represent safety for hundreds of millions of people. In just a few years, Touch ID and fingerprint recognition became universally accepted because of their connection with the convenient iPhone home button. Apple is taking this familiar design and throwing it out the window in an attempt to push the iPhone experience forward. Although Apple is confident consumers will embrace the changes, the confidence sure isn't a result of consumers demanding or wishing for these changes. Instead, Apple designers and engineers are throwing away legacy thinking in order come up with something new. Upon closer examination, Apple has previously demonstrated this willingness to let go of legacy design.
In September 2016, Apple unveiled iPhone 7 and 7 Plus. The two flagship models contained the typical assortment of new features and upgrades. However, one change stood out from the others. Apple removed the dedicated headphone jack despite no one having asked for such a move. Instead of including the traditional pair of EarPods in the box, Apple unveiled a new pair of EarPods that used the Lightning connector. In addition, Apple included a small adapter so that older headphones would connect with Lightning.
When explaining Apple's decision, Phil Schiller, Apple SVP worldwide marketing, said "it really comes down to one word: courage. The courage to move on, do something new that betters all of us."
To say that removing the headphone jack was a controversial decision would be an understatement. The mere thought of removing the dedicated headphone jack from smartphones drove the tech community up a wall with some declaring the move as "user hostile" and "stupid." Schiller's explanation for the removal did not sit well with many. Some referred to it as tone-deaf, and others used arrogance and greed to describe the situation. There were then some who thought Schiller should have said "courage of convictions" in order to better encapsulate his meaning.
In reality, Schiller was right in calling Apple's decision to remove the dedicated headphone jack courage. As it turns out, Apple displayed additional courage last month by removing the home button from iPhone X.
Courageous
The reason these iPhone design choices can be called courageous is that Apple is not afraid to risk sales in order to make technology more personal. It is not easy to take a product that is bringing in more than $140B of revenue per year and change the way people fundamentally use the device. While this situation may seem too self-centered to deserve being called courageous, iPhone is used by 800 million people. (The math behind my iPhone user base estimate is available for Above Avalon members here.) A design decision capable of improving or advancing the iPhone experience will have a tangible impact on many lives. It's not an exaggeration to say that society as a whole can benefit from these iPhone design choices. We are empowered by having a mobile computer in our pockets, and additional power will flow to users as smartphones evolve into augmented reality devices.
The headphone jack is one of a handful of examples of Apple displaying courage by taking what seemed to be working fine and throwing it away to improve the iPhone user experience.
- 30-pin dock connector removal
- Headphone jack removal
- Home button removal
These design choices share a few common traits:
- Deliberate. Apple doesn't make changes for the sake of making changes. Instead, the company is deliberate with its choices. A headphone jack is not removed in order to merely have iPhone 7 stand out from iPhone 6s. Instead, the move is an early step in Apple's long-term mission to remove wires from our lives. Schiller's inability to discuss the long-term goal found in removing the dedicated headphone jack is one reason his courageous comments came off as tone-deaf. A number of years and iPhone versions often have to pass before the motivation behind some of Apple's design decisions becomes clear.
- Decisive. Apple doesn't sit on the fence when it comes to design. One should not bet on a dedicated headphone jack returning to iPhone. In what is still a raw and polarizing topic for some, dedicated home buttons with fingerprint readers are on their way out over the coming years. Dedicated home buttons don't have a future at Apple.
- Design. All of these significant iPhone changes are made with design in mind. By removing the dedicated headphone jack and home button, Apple is changing the way we interact with iPhone. While some of these changes occur through a new user interface, other changes involve how we use iPhone in relation to other products. While the user experience change is less clear with some changes, such as Apple swapping the 30-pin dock connector with Lightning, other examples, like the home button removal, are much more apparent.
It's All About Design
Avoiding change out of fear of angering users or customers can cripple an otherwise successful product and company. Fear of throwing away design artifacts and legacy tendencies represents one of the biggest risks facing iPhone today. This is why design, and not pricing or product marketing, is the most important variable when thinking about iPhone's future.
Fear of embracing change would make it impossible for Apple to accomplish its long-term goal of making technology more personal. When it comes to iPhone, this goal manifests itself in a design that blends hardware and software. Apple's willingness to take big design bets allows iPhone to evolve over time. As buttons and ports are removed to make room for the latest camera, battery, and screen technology, iPhone morphs from a multi-touch computer into an augmented reality navigator controlled by glances and looks.
This behavior of killing off features, components, ports, and technology in an effort to push the user experience forward is a carryover of Apple's approach with the Mac. The difference this time around is that Apple is making these changes to a product that is used by 8x more users.
Samsung vs. Apple
Apple is not alone in pushing smartphone changes like removing a front-facing home button or dedicated headphone jack. In fact, making changes for the sake of change is relatively easy in the smartphone industry. The difficult part is leveraging these changes to push the user experience forward.
Samsung was able to beat Apple to market with an OLED smartphone lacking a front-facing home button. However, the difference in how Samsung and Apple leveraged these design changes is noteworthy. By removing the home button, both companies had to come up with an alternative to having a fingerprint reader positioned in a convenient location. Samsung chose to place the reader in a much more awkward location on the back of the device. Meanwhile, the company's facial recognition alternative ended up being a bust as it quickly became apparent it just wasn't as good as fingerprint recognition. It is tough to argue that the Samsung Galaxy user experience was improved with such changes. Instead, Samsung serves as an example of making changes for the sake of change.
Meanwhile, Apple is positioning Face ID as the alternative to having Touch ID and the home button. If done correctly, Apple will be the company to bring facial recognition as a form of biometric authentication to the masses. Based on the company's success with Touch ID, Apple deserves the benefit of the doubt that Face ID can follow suit and see massive customer acceptance. In fact, Apple's removal of the home button and embrace of Face ID will likely kick off a new era at the company involving facial recognition. It is only a matter of time before every Apple product with a camera has the TrueDepth camera system. Such a development may seem trivial, but it will lead to a new era of health monitoring to which we haven't even contemplated the implications yet.
TrueDepth camera system in iPhone X.
The other implication found with Apple taking design risks is that unlike every other smartphone manufacturer, Apple sells very few smartphone models. The company does not have the benefit of taking risks with a much less popular model and only then bringing new features to the mass market once market adoption has been proven. Instead, Apple spends years and multiple iPhone versions systemically preparing for a major design change included in a flagship model.
Putting Fear Aside
The amount of risk Apple is taking with iPhone X should not be underestimated. There is a reason why management is positioning iPhone X as a glimpse of the next 10 years of iPhone. The model is dramatically different to iPhone 8 and 8 Plus. While Apple is confident that consumers will embrace these changes, it sure isn't due to consumers demanding or wishing for these changes. Instead, Apple designers, engineers, and marketers are showing a willingness to break down legacy thinking in order to come up with something new. By not letting fear of change and customer rejection dictate iPhone design decisions, Apple is displaying courage. While Apple stands to benefit financially from these design changes, iPhone users also stand to benefit. iPhone is empowering hundreds of millions of people in ways that were never before imagined. Courage is putting fear aside and taking bold risks in order to empower others.
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The Significance Behind Steve Jobs Theater
On paper, Steve Jobs Theater doesn’t make complete sense. The price tag would lead many to question the rationale in building a massive underground theater for unveiling products. It’s difficult to envision any other company wanting to undertake such a project. However, after I attended Apple’s inaugural event at Steve Jobs Theater, Apple’s motivation behind the building became crystal clear. Steve Jobs Theater is an Apple product, and a closer look at the building uncovers a side to Apple that few have seen before.
Initial Visit
Steve Jobs Theater is located in Cupertino and positioned in the southeast corner of Apple's new $5 billion Apple Park headquarters. The 167,000-square-foot building consists of a 921-seat underground theater and accompanying product demo room. Apple plans on utilizing Steve Jobs Theater for product unveilings and the periodic corporate event. Apple hired Norman Foster and his firm Foster + Partners as the project's architect although Apple Chief Design Officer Jony Ive and other Apple designers played a pivotal role.
Steve Jobs Theater. Photo credit: Apple
Most visitors arriving at Steve Jobs Theater for the first time will be impressed by its seclusion and allure. Unlike the 2.8-million-square-foot ring building, Steve Jobs Theater cannot be seen from nearby streets surrounding Apple Park. Instead, visitors must walk along a path that winds its way through a series of carefully landscaped hills. It soon becomes clear that this short walk is actually part of the broader experience Apple was trying to achieve.
The path empties out into a basin containing Steve Jobs Theater’s lobby. The 22-foot curved panes of glass create a strong first impression. To the right is an unobstructed view of the giant, circular ring building. The entire experience is reminiscent of Disney World as it becomes clear that someone has created this specific experience to be consumed at this particular location. The lobby, the only part of Steve Jobs Theater that is above ground, is massive, intriguing, and even magical. It doesn’t take long to notice the lack of walls or support structure. This leads to the inevitable question of how the 155-foot roof is being held up. (Spoiler: the glass supports the carbon fiber roof.) Additional questions are raised regarding how plumbing for the water sprinklers and electricity for the lights and speakers are piped to the roof. As it turns out, a little magic is indeed at work. As reported by Lance Ulanoff over at Mashable, all of the necessary plumbing and wiring is found in 20 of the narrow gaps between the large panes of glass.
Steve Jobs Theater floor plans.
The other item that stood out about Steve Jobs Theater was the two sets of stairs on either side of the lobby that are used by visitors to walk down to the theater. The intriguing use of Castagna stone and handrails hand-carved into the stone walls reminded me of a mix between an Egyptian structure and something from space. Photos and videos don't do them justice.
(My complete review of Apple's inaugural event at Steve Jobs Theater is available for Above Avalon members here.)
Not Perfect
Steve Jobs Theater is far from perfect. A strong argument can be made that Apple outgrew the theater before it even opened. Apple's prior two iPhone launches took place in a venue that fit 50% more people, which allowed Apple to invite many more Apple employees than they did to the inaugural event at Steve Jobs Theater.
Despite the building's large footprint, the exhibit space felt incredibly cramped. While Apple may like the visual of hundreds of people bumping into each other to get their hands on the latest products, it's not exactly the best experience to go through. My suspicion is that the exhibit space needs a few modifications to reflect the new era of reporters wanting to live stream.
The Steve Jobs Theater exhibit space was still packed after an hour of hands-on time.
In addition, there were a number of odd design decisions found at Steve Jobs Theater. These range from the awkward paper towel dispensers in the restroom to uneven temperature control in the lobby and doors that are unusually difficult to open. There was also a decent probability of getting a little wet from water dripping off the carbon fiber roof in the morning. However, the building's accomplishments end up vastly outweighing these minor oddities.
Observations
Much of the discussion regarding Steve Jobs Theater up to now has been superficial. Most people agree that the building is impressive and fits within Apple's broader design focus. However, upon closer examination, Steve Jobs Theater provides a fascinating look at today's Apple. A number of items stood out to me.
An Apple Product. Apple is no longer a company that just ships consumer hardware powered by differentiated software. The unveiling of Steve Jobs Theater is the latest sign of this reality. The theater is an Apple product, in the same vein as Apple's redesigned Retail stores. Apple approached Steve Jobs Theater and the broader Apple Park headquarters in the same way that it would any other product. Significant time and resources were spent on modeling and prototyping before construction. An identical process occurs for Apple products that eventually end up on our desks, in our pockets, and on our wrists.
One of the most significant takeaways from Steve Jobs Theater is that Apple is no longer a company content in just focusing on making well-designed electronics. Apple is moving into bigger and bolder initiatives. Jony Ive has hinted in various interviews about his never-ending drive to make technology more personal and create tools for people. While this goal will inevitably lead Apple further into wearables, including glasses, there is a very high likelihood that Apple will focus on bigger tools like self-driving cars. These bigger tools will require Apple to move much further into construction and architecture. Apple reportedly owns and leases a collection of heavy manufacturing facilities close to Apple Park that includes some of the last remaining open space in the San Jose vicinity. (A listing and map of these Apple buildings are available for Above Avalon members here). The day when Apple designers build their very own state-of-the-art transportation R&D center minutes away from Apple Park is no longer a fantasy. All of this puts the PR photos with Tim Cook and Jony wearing Apple hardhats into a new light.
Tim Cook and Jony Ive at Apple Park. Photo credit: The Telegraph
We have arrived at a weird point in time. Silicon Valley giants are gaining unfathomable amounts of power yet remaining remarkable aloof when it comes to manufacturing and construction. Apple is the notable exception. Apple is the company most eager to step outside its comfort zone and experiment in construction and architecture realms. Apple sees the gap between architecture and design starting to shrink. According to Jony, architecture is "a sort of product design; you can talk about it in terms of scale and function and materials, material types. I think the delineation is a much, much softer set of boundaries that mark our expertise."
Experience. There's a reason why Steve Jobs Theater and the overall Apple Park campus is reminiscent of Disney World. Both locations provide an unmatched experience to the visitor. When walking around the grounds surrounding Steve Jobs Theater, it truly felt as if the building is meant to represent Earth while the large circular ring building off in the distance is the Sun.
Steve Jobs Theater symbolizes how Apple is doubling down on extending the Apple experience beyond just iPhones in our pockets and Apple Watches on our wrists. As Apple's Retail store strategy shows, the idea of using architecture and physical spaces to explain the Apple story isn't new. However, Apple has taken the idea further to include its headquarters and even the theater at which it plans to unveil many of its future products.
Focus. It's easy to look at Steve Jobs Theater and forget the amount of work and resources that went into the building. Jony and Apple's Industrial Design team reportedly worked alongside Foster + Partners on nearly every aspect of the theater and the entire Apple Park campus. Apple management likes to use every opportunity to reiterate its goal of remaining focused and saying no to a lot of great ideas. The company's product line demonstrates such focus. Accordingly, there is logic in considering how much attention went into Apple Park over the past few years and where that attention is now being placed. This brings us to the most crucial takeaway regarding Steve Jobs Theater: Jony Ive.
Jony Ive
In May 2015, Jony was promoted to Chief Design Officer. The transition kicked off a debate regarding the underlying motivation behind the move. Many argued that the promotion marked the beginning of the end for Jony's time at Apple. Some observers argued Apple is setting the stage for Jony's eventual retirement by shifting day-to-day responsibilities to Richard Howarth and Alan Dye. The degree to which Jony then took a less visible presence in subsequent months (which was clearly telegraphed by Apple in announcing his promotion) added oxygen to the fire.
Others said Jony's Chief Design Officer title is mostly ceremonial with little-to-no responsibility and compared it to Steve Jobs giving the Chief Software Technology Officer title to Avie Tevanian in 2003. Tevanian ended up leaving Apple a few years later. In reality, such a comparison is so off base it could classify as intellectual dishonestly.
I've held a completely different view of Jony's promotion. The day after Jony's promotion was announced (via a Stephen Fry article), I wrote:
"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."
Two years later, and with Steve Jobs Theater officially open, it is clear Jony holds the role closest to the one held by Steve Jobs. The promotion to Chief Design Officer represented sustainability for Jony. It has been reported that Apple Watch development, in addition to overtaking leadership of human interface, took its toll on Jony. The entire Apple Park project represents much of Jony's focus in recent years. Jony reportedly was the one who carried Apple Park on his shoulders. Its completion now gives Jony the freedom to focus on new initiatives and projects at Apple.
A Design Company
"[O]ne of the ways that I believe people express their appreciation to the rest of humanity is to make something wonderful and put it out there." - Steve Jobs
It's difficult to envision any other company building something like Steve Jobs Theater. Based on the reported $14 million price of the theater seating, my estimate for the overall cost of the building exceeds $100 million. Most management teams will struggle to find how such an initiative would ever come back to boost sales or benefit the company. The fact is that Apple is unlike any other Silicon Valley firm. Steve Jobs Theater symbolizes how Apple isn't a tech company but rather a design company. Apple believes that how we experience and interact with a product is more important than a single focus on the technology powering that product. Apple is now bringing that philosophy to the way we experience architecture. As for the why behind it all, Apple's answer would probably be to make something wonderful.
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Major Tech Trends Ahead of Apple's Big Event
With Apple about to host its largest product event in years, much of the attention continues to be focused on the details. Plenty of questions remain regarding the various changes Apple will announce across its iPhone, Apple Watch, and Apple TV lines. A closer look at the broader trends taking place in these product segments go a long way in adding much-needed context to Apple’s inaugural event at Steve Jobs Theater.
Smartphones
On the surface, the smartphone battle seems to be largely settled. Predictions calling for iPhone’s demise at the hands of Google and Android have subsided although some are now eager to replace Google with WeChat as Apple’s arch nemesis.
Behind this facade of relative calm, the smartphone market continues to evolve at a rapid pace. Three major trends are unfolding regarding how consumers view smartphones:
- Larger screens continue to gain momentum.
- Form factor size is hitting a ceiling.
- The pricing gap is widening.
With an increasing amount of content consumed on smartphones, consumers and manufacturers alike continue to get behind larger screens. Once deemed excessive and niche, large smartphones with 5-inch to 6-inch screens are seeing growing sales momentum. This large screen smartphone trend has materialized across the industry, indiscriminate of geography and even price.
While there is still evidence that a portion of the market is OK with smaller screens as seen by continued 4-inch iPhone SE sales, this segment is more likely to contract than expand over time.
The newest and most intriguing development in the smartphone space is found with the relationship between screen size and form factor. Historically, smartphone screen size faced a ceiling in terms of its relationship to form factor. Mobility is greatly reduced if a smartphone is so large that it is unable to fit comfortably in pockets, purses, and pouches. The trend of removing front-facing bezel and dedicated home buttons is eliminating this form factor limitation. Smartphone manufacturers are able to ship larger screens without increasing form factors.
The OLED iPhone is rumored to include a 5.8-screen, which is larger than the 5.5-inch iPhone Plus screen, in roughly the same form factor as an iPhone 7. This will have a major impact on how consumers think about smartphone size preference. It is inevitable that all iPhones will eventually contain the same design language - no home buttons and little to no front bezel. Large swathes of the iPhone user base will likely want to upgrade to these new iPhone models over time. It is the type of multi-year upgrade cycle that PC makers hoped would occur in the laptop space but never materialized.
As manufacturers increasingly bet on camera and screen innovation to stand out from the competition, smartphone pricing has been on the rise. While smartphone prices are increasing at the high-end, as seen with the $750 Samsung Galaxy S8 and $950 Galaxy Note 8, there continues to be a significant portion of the smartphone market desiring price accessibility. The key for smartphone manufacturers will be balancing higher-priced smartphone SKUs packed with the latest technology with increasingly lower-priced SKUs still offering a premium experience.
Wearables
The wearables market has had a rocky start. Some of the initial wearables players have retreated out of the space while others have taken a more cautious view. Only a handful of companies are seeing wearables sales success. It is fair to say everyone, including Apple, has seen their fair share of strategy changes over the years.
Three major trends are unfolding in the wearables space:
- Sales momentum is flowing to smartwatches.
- Fashion and luxury continue to gain importance.
- The wearables battle is slowly expanding beyond the wrist.
Dedicated fitness trackers have lost momentum while Apple Watch continues to outperform sales expectations. Fitness and health tracking is moving from being a product to a feature. Nowhere is this seen more than in a comparison of Fitbit and Apple Watch sales over the past year.
Exhibit 1: Fitbit vs. Apple Watch Unit Sales
Meanwhile, Fitbit’s new Ionic smartwatch is a "bet the company" type of move in an attempt to capitalize on this new wearables landscape. Garmin has seen similar trends with sales momentum flowing from dedicated fitness and health trackers to its smartwatch offerings. We are only seeing the initial fallout from this development.
One of the items Apple got correct out of the gate with Apple Watch was interchangeable watch bands. This dynamic is now viewed as natural and almost inevitable when discussing smartwatches. Going forward, technology companies will continue to face pressure in the wearables space given how consumers are demanding luxury and fashion options.
As the battle for the wrist evolves, the ear is shaping up to be the second major wearables battleground. Apple, Samsung, Fitbit, and a slew of smaller hardware companies and start-ups will have wireless or cordless headphone offerings in the market for the upcoming holiday season. Apple is the clear leader in the space with its W1 chip-equipped AirPods and Beats. More importantly, given the company's sales success with Apple Watch, Apple has the most formidable wearables platform. We are moving to a point at which the wearables narrative will evolve. No longer will it only be about wrist devices. Rather, it will also include platforms consisting of hardware and software solutions for different parts of the body.
Television
After years of unknown, we are starting to get a glimpse of TV's future. The large cable bundle's days are numbered. Netflix, Amazon, Facebook, Google (YouTube), and Apple are the new power brokers in the TV space. There is a long list of others including Disney (ESPN), HBO, and Hulu that would like to join that coveted list of influencers. Netflix and Amazon are the newest TV networks with massive budgets for funding scripted video content. YouTube and Facebook continue to reign supreme when it comes to offering ad-supported video content. Apple owns the most lucrative platform that involves consumers accessing paid video subscriptions.
Major themes unfolding in the space include:
- Price is playing a major role in the streaming set top box market.
- Momentum is found with smaller screens.
- New content players are holding optionality.
Roku is the current streaming video box leader with approximately 40% market share in the U.S. Amazon, Google, and Apple hold second, third, and fourth place, respectively. The market is unfolding largely based on price. Roku has been able to position itself as the cheapest way for people to access Netflix and YouTube on a large television screen. The company is going so far as to give away its Roku OS to TV manufacturers for free. Meanwhile, with Apple TV priced nearly five times higher than Roku, Apple's streaming TV box is bringing in nearly 6x more gross profit than Roku earns from its players.
While much attention continues to be placed on large screen televisions, such focus ends up being grossly misleading. Apple is actually selling more than 250M "TVs" per year called iPhones and iPads. These smaller screens are responsible for delivering an increasing amount of video content to consumers.
In a battle for our time and attention, content creators with formidable content budgets are winning. There is a brain drain underway in Hollywood as talent in front and behind the camera is moving to the new players in town. There are still genuine questions as to just how sustainable some of these streaming video business models are as independent entities. However, there is no question that a company like Netflix has earned itself optionality from providing a superior entertainment experience to more than 100M people.
Home
The smart home ended up being the surprise tech topic of 2016. Much of this was due to sheer fascination in Amazon's Alexa digital voice assistant and accompanying Echo speakers. The narrative has shifted in 2017 as mindshare is now splintered due to additional companies entering the scene. Apple is expected to discuss HomePod in detail at its upcoming product event. Major themes in the smart home space include:
- Voice is being positioned as an early user interface.
- Companies are basing their home strategy around core competencies.
- It is still early to declare definitive leaders and laggards.
As the number of smart items for the home available for sale increases, questions have swirled as to the best way to control these devices. Voice continues to grab much of the attention although the automation capabilities found in Apple's HomeKit hold much intrigue. At the same time, we are seeing pretty dramatic differences in strategy for the home based on a company's core competency. While Google and Facebook will look to monetize the data obtained via microphones and cameras through advertising, Amazon is looking for Alexa to serve as a better shopping assistant in order to drive Prime memberships. The preceding strategies include giving away hardware at or below cost. Meanwhile, Apple's strategy to sell the best-sounding speaker people have ever owned gives the company a good shot at becoming the most profitable device in the smart home space.
Even though Amazon has garnered much good press in the space, it is simply too early to declare winners and losers in the smart home. The way that Apple and pretty much every large consumer-facing technology company are running forward with stationary speakers and screens for the home brings back flashbacks to the early wearables rush. Many companies will end up being disappointed. At the same time, the attention given to stationary devices has taken the spotlight off the importance of mobile devices in our home. The smartphone remains the most valuable computer in our home and we should not underestimate it when contemplating the smart home's future. Of course, a home won't likely truly be a smart home until Silicon Valley firms begin building their own housing, but that topic is for another day.
Apple's Big Event
Apple's upcoming event at Steve Jobs Theater has the ingredients to be the largest Apple product event since the Apple Watch unveiling at the Flint Center in 2014. Apple will unveil at least three new iPhones in addition to new Apple Watches and a refreshed Apple TV. In some areas, Apple's goal will be to improve upon existing themes unfolding in the smartphone and streaming video arenas. In other areas such as smartwatches, Apple will likely take a true leadership role in pushing the market forward.
I will be attending Apple's inaugural event at Steve Jobs Theater. My full thoughts and observations on the event will be sent exclusively to Above Avalon members. To receive this analysis and perspective, visit the membership page. Members also receive my analysis and perspective on Apple throughout the week via exclusive daily emails (2-3 stories a day, 10-12 stories a week).
Apple in China
The narrative of Apple's China problem boiling down to a brutal battle with Tencent (WeChat) or local smartphone manufacturers is inaccurate. Apple's business in China is not imploding. Rather, it is experiencing growing pains. After more than a year of sales declines, positive signs are beginning to reappear in Apple's China business. China continues to represent more of an opportunity than a risk for Apple.
The Numbers
Greater China is Apple's third-largest operating segment and consists of Mainland China, Hong Kong, and Taiwan. As shown in Exhibit 1, the segment saw significant revenue growth in 2015 followed by a surprising decline in 2016. With Apple on track to report nearly $45B of Greater China revenue in FY2017, the segment will report its second consecutive annual decline.
Exhibit 1: Apple Revenue from Greater China
In 2013, Tim Cook looked at China as being well-positioned to eventually become Apple's top market. At the time, Greater China was Apple's third-largest operating segment, representing approximately 15% of overall revenue. Over the subsequent two years, it looked like Cook's prognostication would be proven correct. After a very strong 2015, Greater China bypassed Europe to become Apple's second largest operating segment, responsible for 25% of overall revenue. Observers soon began to forecast when Greater China would overtake the Americas to become Apple's largest operating segment.
As seen in Exhibit 2, the situation changed dramatically in 2016. Weakness in Greater China led to the segment falling back below Europe in terms of revenue. Meanwhile, the Americas firmly remains Apple's largest operating system with revenue nearly double that of Greater China.
Exhibit 2: Apple Revenue by Operating Segment
What Happened?
Apple's declining revenue in Greater China over the past six quarters can be attributed to a slowdown in iPhone sales. As seen in Exhibit 3, iPhone sales share in Mainland China saw a notable tick down beginning in early 2016. The data is courtesy of Kantar Worldpanel, an analytics firm relying on longitudinal surveys to track the same individuals and their smartphone habits over time. Kantar data provides a decent snapshot of how the iPhone is selling relative to other manufacturers (sales share). The sales share peaks experienced in early 2015 and early 2016 corresponded to new iPhone launches. The most recent iPhone launch (iPhone 7 and 7 Plus) clearly underperformed the two previous iPhone launches. This weakness undoubtedly led to much discussion at Apple HQ as it came as a surprise to management.
Exhibit 3: iPhone Sales Share (Mainland China)
A number of theories have been put forth in an attempt to explain iPhone sales weakness in China. Ben Thompson over at Stratechery made the case that WeChat's prominence in China has reduced the value and lock-in found with iOS, reducing Apple to "simply another smartphone vendor." According to Thompson, this situation has led to declining loyalty and retention rates among iPhone users. WeChat also seems to have become the consensus pick among western media when it comes to pinpointing Apple's problem in China.
Wired's Jeremy Hsu took a slightly different angle, saying Apple was "a victim of its own failure of imagination." The company's failure to adapt services such as Apple Music and Apple Pay to local culture has contributed to fading consumer interest in Apple hardware. Hsu argued Apple Music should have a free tier while Apple Pay's reliance on near-field communication technology isn't appealing in China.
While the preceding arguments contain solid points, they ultimately end up being dubious for explaining iPhone sales weakness. Both arguments position weak Apple services adoption, either due to a strengthening WeChat or Apple's own doing, as a sign of shifting customer perceptions facing Apple in China. Poor Apple services adoption is then said to lead to less brand loyalty and greater odds of switching away from iPhone. Such a claim ends up giving way too much credit to the influence Apple services play. It's as if Apple is a services company that just happens to sell hardware. This isn't the case. There is something more at play in China regarding weaker iPhone sales besides greater WeChat competition or lackluster Apple services.
The Smartphone Market in China
A closer look at the smartphone market in China provides the context needed to assess Apple's performance. There are three major smartphone trends:
1) Anemic smartphone sales growth. There continues to be a misperception that Mainland China is seeing 20% to 30% smartphone unit sales growth year-over-year. This just isn't the case. In reality, smartphone sales growth is much harder to find. According to IDC, the smartphone market in China grew 3% in 2015, 8% in 2016, and has been struggling to grow in 2017. Apple management likely contributed to the false perception of there being massive smartphone sales growth in the country by constantly talking up the opportunity tied to China's expanding middle class. While this shift is occurring, its impact on overall smartphone growth is less clear.
2) Massive consolidation. Given such anemic sales growth, there has been intense competition and consolidation, especially at the low-end of the smartphone market. In 2014, the "Other" category consisting of Samsung, Lenovo, and a number of smaller smartphone manufacturers, represented 238M smartphone shipments. Two years later, "Other" sales declined by 60M units to 178M smartphones. The big smartphone loser in China hasn't been Apple, but rather Samsung and smaller smartphone manufacturers.
Meanwhile, Oppo has experienced the strongest increase in smartphone sales on an absolute basis in China with Vivo and Huawei coming in second and third, respectively. On a combined basis, Oppo, Vivo, and Huawei saw an increase of 130M smartphone unit sales from 2014 to 2016. While it may be easy to look at Oppo, Vivo, and Huawei as winning at the hands of Apple, in reality, their sales gains have likely come from Samsung, Lenovo, and new customers entering the smartphone market at the low-end. Despite a very difficult 2016, Apple was still able to grow annual iPhone shipments by 8M between 2014 and 2016. This goes to show just how strong the iPhone performed in 2015.
3) ASP Divergence. The smartphone pricing gap in China is expanding. While Apple sits at the premium end of the market with an iPhone average selling price (ASP) exceeding $700, every other major smartphone manufacturer is reporting ASP that is a fraction of iPhone's. Pricing data would support the theory that Apple and those smartphone manufacturers with the strongest sales momentum are appealing to completely different customers. While overall smartphone growth remains subdued, whatever growth there is can be found at the low-end of the market.
Issues
Taking into account the unique trends found in the China smartphone market, my theory is that there are actually four distinct issues impacting Apple in China.
1) Lack of New Users. It is becoming that much harder for Apple to find pockets of premium users in China ready to buy their first iPhone. Apple's smartphone sales share in China peaked in 2015 right after China Mobile began selling the iPhone 6 and 6 Plus. While China Mobile had officially begun selling iPhone a year earlier, it was the iPhone 6 and 6 Plus that represented the first big iPhone launch for the carrier.
Apple experienced a big iPhone sales boost from the iPhone 6 and 6 Plus launching into an untapped reservoir of premium China Mobile users. Once these users purchased iPhones, there weren't similarly-sized pockets of new users elsewhere in China. Instead, Apple had to turn to Android switchers for new users. This is one reason why new users as a percent of overall iPhone sales has been on the decline.
2) Longer iPhone Upgrade Cycle. Considering how Apple saw a significant number of new iPhone users in China in 2015, these users were not ready for an upgrade in 2016 or even early 2017 for that matter. Instead, iPhone users in China are likely holding onto their iPhones for a longer period of time before upgrading. This trend is not unique to China but rather has occurred in various geographies.
3) Pricing Pressure. The significant smartphone pricing gap in China has placed a ceiling on Apple's iPhone target market. It looks like the number of Android users switching to iPhone is on the decline. According to Apple, switching outside of China was up year-over-year. The implication is that switching in China was down year-over-year. A similar dynamic does not exist in the U.S. where iPhone is actually priced at or below the Android competition. A better comparison for measuring iPhone sales share performance in China would be countries where the iPhone is similarly priced at a premium. As seen in Exhibit 4, in what may come as a surprise, iPhones sales share in these countries end up even worse than that of China.
Exhibit 4: iPhone Sales Share (2017)
4) Growing Pains. Although Apple has made much progress opening new Retail stores in China, the company still has an inadequate retail footprint in the country. There are only 40 Apple Retail stores in China, a country with 1.4 billion people. To put that number in context, Apple has seven retail stores in Connecticut, home to a little more than three million people.
Brick and mortar retail matters in China. According to Kantar, nearly 90% of Oppo smartphone sales took place through brick and mortar. Apple just doesn't have the retail penetration in Tier 1, 2, and 3 cities in China. For example, Apple has only three stores in Chongqing, one of the largest municipalities in China with a population of 30 million people.
While consumers have the option of buying Apple products through carriers or third-party retailers, there are drawbacks found with Apple relying on others to sell product. Despite selling the iPhone for years, iPhone sales share at Verizon remains lackluster compared to that at AT&T, Apple's initial partner in the country. Many have speculated that this lower sales share is due to the way smartphones are sold at Verizon where sales clerks have sway over consumer purchasing decisions.
Apple Retail stores represent one of the best ways for management to push the Apple experience. This is something not possible with third-party retailers. Considering it took management two years to open 20 stores in China, the lack of Apple Retail stores is an issue that will take Apple years to fix.
Apple's main issues in China are related to the underlying structure of the smartphone market, not greater WeChat competition. Why then is WeChat positioned as Apple's arch nemesis in China? If users spend all of their time and attention within the WeChat ecosystem, is Apple's ecosystem negatively impacted? Is WeChat cultivating a user base that views Apple as simply a premium-priced hardware provider, which will then result in less consistent hardware sales?
Unfortunately, quite a bit of the analysis regarding Apple and WeChat relies exclusively on anecdotal evidence. In an effort to move beyond this, we can use WeChat's most recent disclosures to gain a better perspective. The company disclosed that half of its 900M monthly active users spend 90 minutes a day on a WeChat property. That is a significant amount of time which likely makes Mark Zuckerberg and Evan Spiegel quite envious. WeChat is seeing success on a scale that simply isn't seen elsewhere by any other services company. However, we use our smartphones for more than 90 minutes a day. Current estimates peg average smartphone usage at five hours per day. This means the average WeChat user, while heavily invested in WeChat, is still relying on other services besides WeChat.
Meanwhile, App Annie recently pegged Chinese smartphone users as relying on ten apps on a daily basis. In terms of monthly usage, that number rises to 30 apps. Even if we assume these estimates are being generous, the narrative that WeChat users only use WeChat is exaggerated.
The WeChat topic raises a broader question: What is Apple actually selling in China? iOS? Services? Hardware?
Apple is selling the same thing in China as it does in every other country. Apple is selling an experience. The simple act of buying an iPhone, even if it is used for WeChat, is part of that Apple experience. While Apple management would certainly like to see customers using Apple services, in reality, Apple service usage is not a requirement for Apple to succeed in a market. Instead, services are meant to add even more value to Apple hardware. At the same time, Apple service usage doesn't necessarily lead to increased loyalty and retention. Instead, the dynamic is much more complicated. For example, Apple loyalty is doing just fine in the U.S. even though Apple Pay usage remains surprisingly low.
Light at the End of the Tunnel
Signs of a bottoming process are appearing for Apple in Greater China.
- Revenue trends are stabilizing. During Apple's 3Q17 earnings conference call (my complete review of Apple's 3Q17 earnings is available for members here), management commented that although Hong Kong sales were still down, revenue trends in Mainland China were actually flat year-over-year. Revenue trends have now been improving for the past two quarters. While Apple is clearly not out of danger, the Greater China operating segment appears to have found some stabilization.
- iPhone sales share is improving. As seen in Exhibit 3, iPhone sales share has now seen two months of improvement in Mainland China. For this to occur in the period leading up to Apple's largest iPhone release in years is actually remarkable. There are two possible explanations for this improvement: the Product Red iPhone 7 and 7 Plus and a natural bottoming process in which existing iPhone users are ready for an upgrade.
- Broader Apple ecosystem strength. Judging from Apple management commentary, Apple is seeing solid sales growth through its App Store in China. In addition, the iPad and Mac continue to sell well. Apple Retail store traffic and sales are up year-over-year as well. This sure doesn't look like a company seeing its opportunity in China slip away due to WeChat attacking the iOS ecosystem.
- Apple made a notable leadership change. Apple recently promoted Isabel Ge Mahe to the newly created role of vice president and managing director of Greater China, reporting to Tim Cook and Jeff Williams. While the move was an acknowledgement of issues and trouble in Greater China, it is reasonable to expect greater operating efficiency, including additional effort to localize products.
One question regarding Greater China is whether the operating segment still represents an opportunity for Apple or if it is more appropriate to look at the segment as a risk. Is the $45 billion of annual revenue from the region more likely to decline over time or can Apple be confident in looking at that total as a base for future growth?
China still represents an opportunity for Apple although management will likely need to make additional strategy adjustments:
- Continue fine-tuning products to better fit local culture. There is pretty much no downside to spending additional resources on this effort. New iOS features targeting China (QR Code support, SMS fraud prevention, etc.) are a clear sign that management looks at this fine-tuning as crucial.
- Embark on a massive Retail store expansion in Mainland China. A strong case can be made that Apple should have hundreds of retail stores located throughout China.
- Continue strengthening relationships with key partners, including Foxconn and Tencent. With future China government regulations representing an unknown, Apple's best strategy for handling the geopolitical environment is to strengthen its relationship with local companies, including Foxconn. Contrary to popular belief, Tencent is more of a partner than enemy for Apple.
- Remain steadfast on taking a long-term view on China. Apple should focus not on turning around quarterly iPhone sales by releasing a cheap iPhone, but instead on forming a foundation for the Apple brand in the country.
Apple ends up being graded on a curve in China. Apple is on track to report $45B of revenue in Greater China in 2017. Meanwhile, some of Apple's peers in the U.S. may never see much revenue at all from China. While Apple has its fair share of issues to overcome in China, fundamentals appear to be intact. Apple's ultimate goal in China is similar to its goal in every other country: Sell tools that are capable of improving people's lives. Apple is going to be just fine in China, even if customers use WeChat to enhance their Apple tools.
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Apple Has the Best Business Model for Generating Cash
Apple is generating obscene amounts of cash. The company recently reported nearly $6 billion of free cash flow during what is typically its weakest quarter of the year. Over the last 12 months, Apple earned $51B of free cash flow. This is more than any other company earned. It is easy to chalk up Apple's financial success to the iPhone and call it a day. However, upon closer examination, Apple's business model predisposes the company to cash generation unlike any other firm in Silicon Valley. In fact, Apple currently possesses the best business model in the world when it comes to generating cash.
The Numbers
Apple is in a financial league of its own. As seen in Exhibit 1, Apple's $224B of trailing twelve month (TTM) revenue was nearly as much as that of Amazon ($143B), Alphabet ($95B), and Facebook ($33B) put together.
Exhibit 1: Revenue (TTM)
The numbers become more daunting when moving down the income statement. As seen in Exhibit 2, Apple's $60B of TTM operating income was nearly 50% more than the combined operating income of Alphabet ($24B), Facebook ($15), and Amazon ($3B).
Exhibit 2: Operating Income (TTM)
Turning to the cash flow statement, Apple's numbers are just as remarkable. Apple's $64B of operating cash flow was nearly as much as that of Alphabet ($36B), Facebook ($19B), and Amazon ($17B) combined. In essence, Amazon is doing as well financially as Facebook. Google is generating as much cash as Amazon and Facebook put together. Apple is generating nearly as much cash as Amazon, Facebook, and Google combined.
Not only is Apple generating significant operating cash flow, but the company is also kicking off free cash flow at rates not seen elsewhere in Silicon Valley - or the world for that matter. Free cash flow is a measure of how much cash is generated after taking into account capital expenditures and other costs associated with running the business. Apple's $51B of TTM free cash flow is $3B more than the free cash flow produced by Alphabet, Facebook, and Amazon combined. In what may come as a surprise, Apple is bringing in 70% more free cash flow than Microsoft, who is still considered to possess one for the more lucrative business models in existence.
Exhibit 3: Free Cash Flow (TTM)
Superior free cash flow generation has played a major role in Apple's ballooning cash hoard, which now stands at $154B of net cash (excludes $108B of debt). Despite spending $216B on share buyback and dividends since 2012, Apple's net cash level has increased by $33B over the same time period. The company is generating so much cash, management can't spend it fast enough.
Exhibit 4: Net Cash
Profit Extraction
Most of the discussions involving Apple's finances position the iPhone as being responsible for the company's good fortune. While the iPhone accounts for approximately 60 percent of Apple's revenue, the device doesn't tell the full story.
Consider Apple's current product line:
The most profitable smartphone
The most profitable tablet
The most profitable laptop
The most profitable desktop
The most profitable smartwatch
The most profitable pair of wireless headphones
The most profitable streaming TV box
Few hardware manufacturers make money selling smartphones and tablets. The money found in the components business doesn't come close to Apple-like profitability. The best-selling laptop and desktop manufacturers can only dream of Mac margins. Apple is the most profitable wearables company. Even minor Apple products from a sales perspective, like Apple TV, are grabbing profit in an otherwise profitless industry.
It may be easy to look at these products and conclude that Apple must be overcharging its customers. How else can Apple sell so many profit leaders? However:
Apple Watch and AirPods are underpriced versus the competition.
MacBook is priced competitively with laptops with similar specs.
iPhone is priced competitively with Samsung's flagship Galaxy smartphones.
Apple's product line shows that there is more than just pricing behind management's ability to extract profit from an industry. Apple's entire business model predisposes the company to superior free cash flow generation.
Core Tenets
The best way to begin dissecting the Apple cash machine is to take a closer look at Apple's business model. There are three tenets, or beliefs, underpinning Apple's business model.
Placing the product above all else. Apple's superior cash generation begins all the way back in the R&D labs. Management is motivated by coming up with great products, not making massive profits. While Apple executives use every opportunity to reiterate this point, most outside observers think it's just talk or PR. However, Apple's financial performance backs up management's claim. Apple doesn't design and sell products to drive revenue. If Apple is able to make great products, management is confident that consumers will like the product and profit will follow. This motivation results in a much more unique product strategy than that of other companies.
Staying focused. Apple values the art of focusing, saying no to great ideas in order to concentrate the entire company on a few really great ideas. This intense level of focus extends all the way down to Apple's R&D efforts. The amount of money Apple spends on R&D as a percent of revenue is well below that of its peers. In addition, Apple's M&A strategy follows a similar protocol as management is very deliberate in its purchases, focusing on technology and people purchases capable of plugging holes in the asset base.
Relying on contract manufacturers. Apple is a product company that relies on others to assemble its products. While Apple brings in significant amounts of cash from hardware sales, the company's free cash flow generation receives a big boost from using contract manufacturers. Instead of owning an extensive web of factories around the world, Apple invests in equipment and machinery located in other companies' factories. This results in Apple spending much less on capital expenditures as a percent of revenue. Apple is on track to spend $15B on capital expenditures this year. Alphabet and Amazon spend nearly as much on expenditures despite having a much smaller revenue base. This means that a significant portion of Apple's operating cash flow ends up as free cash flow and can be considered truly "excess" cash.
These three factors play a big role in Apple selling highly profitable hardware that stands out from the competition.
Apple Is Different
The next item to investigate when dissecting the Apple cash machine is to see how the preceding core tenets come together to make the company's business model stand out from that of its peers.
In some cases, Apple hardware has gone on to hold monopoly-like market share in its respective product category (iPod, iPad, Apple Watch). For other products, Apple hardware remains the small player in town in terms of sales share (iPhone, Mac, Apple TV). However, in nearly every example, Apple ends up being the profit leader because management looks at scale differently than other companies view it. Apple doesn't view scale as a requirement to achieve success. This has major implications on Apple's pricing strategy in addition to how the company thinks about monetization.
Facebook and Google approach scale very differently. For both companies, scale is needed in order to reach as many people (and their data) as possible. The additional data enhances and improves their free services. Amazon's business model is also dependent on scale, albeit a different kind. Much of the company's ongoing investments (transportation, logistics, cloud, and artificial intelligence) are designed to get you to buy more and more goods through Amazon. This significant level of investment will likely be needed for the foreseeable future.
In summary:
Apple is a design company focused on selling tools capable of fostering superior experiences. Scale is considered a byproduct of a properly functioning business model.
Facebook and Google are service companies focused on offering free, data-capturing services to as many people as possible. The business models are dependent on achieving scale in order to access as much data as possible.
Amazon is a retail platform company focused on getting you to buy more stuff over time. Scale in terms of purchase volume is needed in order for the cash flow/reinvestment cycle to continue.
There are exceptions to these underlying themes such as Apple Music needing scale in order to become a better music streaming service. In addition, Apple Pay needs widespread retailer adoption to make sense for consumers. However, these examples only reinforce the uniqueness found with Apple's primary business model. Instead of being key revenue or profit drivers, Apple Music and Apple Pay are services meant to increase the value found with Apple hardware.
Putting It Together
Apple possesses the best business model for generating cash because the company is capable of monetizing premium experiences much more effectively and efficiently than anyone else. Instead of chasing scale with the goal of monetizing data or usage, Apple sells tools that management thinks people will want and are willing to pay for.
While Apple doesn't look at scale as a requirement for success, the company undoubtedly benefits from scale in a few ways. Greater economics of scale help drive down product costs over time, which both improves both product accessibility and Apple profitability. Scale also allows Apple to place larger component orders. There are a number of examples over the past decade involving Apple competitors being unable to ship competitive products due to Apple buying up all of the available component supply. These elements don't define Apple's cash machine but rather represent the lubricant that makes it run more smoothly.
Stationary Speaker Market
Apple's unique approach to the burgeoning stationary speaker market highlights how the company plans on using its business model to set the company up for cash generation. Amazon and Google currently have products in the marketplace. Apple's HomePod is scheduled to go on sale in December. Facebook is rumored to be entering the market next year with some kind of stationary screen/camera/speaker.
Amazon. The company's goal with selling Echo hardware is to get its digital voice assistant, Alexa, in as many homes as possible. Greater Alexa usage leads to more data being collected which then helps Amazon become a better, and smarter, retailer. In order to accomplish this goal, the company is willing to give away Echo hardware at cost, or even a loss. When it comes to monetization, instead of making money from Echo hardware, Amazon positions Prime subscriptions as the cash generator. While this strategy has been wildly successful for the company, it has been difficult to miss Amazon's lack of free cash flow. Unlike Apple, Amazon piles most of its operating cash flow right back into the business. Market observers have made the mistake of looking at this behavior as purely optional on Amazon's part. In reality, Amazon will likely need to maintain this high level of investment indefinitely to ward off competitors and keep people buying products from Amazon. This means that Amazon's business model, while successful in delivering valuable customer experiences, may just end up being contained when it comes to excess cash generation.
Google and Facebook. Both companies are interested in capturing customer data in order to power their free services. This will lead to the companies selling hardware at cost or even at a loss, similar to the way Amazon does. Instead of making money on hardware, Google and Facebook will look to monetize the data obtained via microphones and cameras through advertising. We have seen this model's profitability over time. Facebook and Google serve more customers than Apple, but the companies generate cash on a much smaller scale than Apple. Their business models just don't throw off the same kind of free cash flow as Apple. While the home will present different dynamics than mobile and there is room for each to grow the advertising pie, there is little reason to think the overall profitability picture will be much different in the near term.
Apple. Apple is positioning HomePod, its new stationary speaker, as the best sounding speaker people have ever owned. Apple is betting that controlling both the hardware and software while having the product work closely with Apple services such as Apple Music will lead people to want to own and use HomePod. Apple plans on making money from HomePod through hardware sales. Priced at $349, the device very likely contains a profit margin equivalent to that of other Apple hardware. It is worth pointing out how the device is aggressively priced compared to speakers with equivalent speaker quality. Over time, HomePod usage will help drive Apple services such as Apple Music and Siri. These services will then go on to add greater value to future Apple hardware. Apple's strategy will be to use HomePod to extract most of the profit from the standalone stationary speaker market. Additional profit will come from Apple expanding the speaker pie (i.e. bringing more people into the stationary speaker fold).
Even though it may seem counterintuitive, Apple stands to earn more cash through hardware sales at a smaller scale than companies giving away hardware at cost but looking to monetization in other ways. This is why the initial exhibits up above comparing Apple's financial picture to the leading consumer-oriented tech companies are so surprising.
The Big Question
Apple has built a spectacular cash machine kicking off remarkable amounts of free cash flow. There does not seem to be any other company that is close to copying this machine. Amazon, Google, and Facebook look at hardware as a way of improving data capturing services. Microsoft's hardware success in consumer markets is fading. This leaves companies such as Samsung, Huawei, Oppo, Vivo, and Xiaomi as the only large companies trying to make money from consumer hardware. Each is seeing various levels of mediocre success.
There is no question that the smartphone wave has been a good one for Apple to ride. As iPhone sales have stabilized, Apple's revenue, operating income, and free cash flow growth has also stabilized. Meanwhile, Facebook, Amazon, and Alphabet are seeing stronger growth trends.
The big question going forward isn't if Apple will find another product as profitable as iPhone to drive growth, but rather if Apple will need to find another business model in order to enter new industries. Will there come a time when Apple's business model will need to evolve into something else?
Growing Pessimism
It's been hard to miss the growing amount of pessimism surrounding Apple's cash machine. There is a large chorus in Silicon Valley that views Apple's business model as a liability given how artificial intelligence (AI) will infiltrate literally all aspects of our lives. Do Amazon, Facebook, Google, Microsoft, Tencent (WeChat), and Baidu actually possess early versions of the business models of tomorrow? Is Amazon's Echo strategy the more attractive way to handle hardware? Many people now think companies chasing scale and collecting as much data as possible are much better positioned for the future than Apple.
In some ways, concerns regarding Apple's cash machine are genuine. For example, it's not clear if Apple's current business model would do well in tomorrow's transportation industry without some modifications. Is the future of transportation based on people buying or leasing cars? A good case can be made that the future is found with ridesharing. The answer would likely impact the way Apple monetizes transportation tools.
However, there is also evidence that fears of Apple's cash machine imploding are overblown. Unlike the unknown found with the transportation question, the idea that AI will make Apple's business model irrelevant looks to be based on faulty logic. The entire thesis assumes the world is headed in a different direction that it actually is.
Over the past decade, one of the biggest revelations in technology has been design's increased role in how we consume and value technology. The mass market has bought into Apple's view of personal technology. There is nothing about AI that changes this reality. Instead, we have non-hardware companies pontificate how hardware won't matter in the future. In reality, the opposite will likely occur. Hardware will matter more going forward. The wearables industry represents a good example of this in practice. Meanwhile, the way smartphone and tablet components are mattering more now than ever to AR and AI is another hole in the "hardware won't matter" thesis.
Some Things Won't Change
As it stands today, Apple's business model is producing more excess cash flow than every other business model. Even assuming competitors see stronger growth than Apple over the next few years, it's not clear how any company will match Apple in terms of cash generation. There is also evidence to suggest Apple will continue to rely on its current cash machine in the wearables industry (Apple Glasses, Apple Watch, AirPods) as these products fit within Apple's current business model extremely well. In fact, the way Apple Glasses seems to match perfectly with Apple's current business model may end up elevating that product to likely be the next product category Apple enters.
However, even in a world that requires Apple to modify its cash machine, some things won't change. The core tenets that underpin Apple's business model will remain, and those are the key ingredients that make the cash machine tick.
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