Above Avalon Podcast Episode 134: Let's Talk Netflix
The Netflix machine seems unstoppable. Strong paid subscriber growth and rising content budgets have given Netflix a commanding lead in the paid video streaming market. However, change is in the air. Episode 134 is dedicated to discussing Netflix’s business model and why calls suggesting Netflix has won the paid video streaming war are grossly premature. Additional topics include Netflix’s keys to success, upcoming paid video streaming competitors, lessons from the music streaming industry, and things to watch out for in paid video streaming over the coming years.
To listen to episode 134, go here.
The complete Above Avalon podcast episode archive is available here.
Netflix Isn't Invincible
Netflix has been on a roll. The company is adding approximately two million paying subscribers per month while its original content portfolio grows by leaps and bounds. However, calls suggesting Netflix has won the paid video streaming war are grossly premature. In fact, the battle hasn’t even begun. We are still in the early stages of what will likely become a brutal stretch for many players as competition for paying subscribers and our time intensifies. New players, including Disney and Apple, are about to enter the scene as different direct-to-consumer business models are put to the test. Many prevailing assumptions about the paid video streaming industry will end up being proven wrong.
Netflix Growth
It’s easy to see why Netflix has been a Wall Street darling. The company has seen years of sustained paid subscriber growth in an intriguing new market. While a few disappointing earnings reports, including 2Q18 results, have led to sporadic bouts of investor jitters, Wall Street has rewarded Netflix’s paid subscriber growth with a market cap roughly equal to that of Disney. Instead of judging Netflix on profitability or sales, Wall Street has only cared about one metric: the number of paid subscribers.
Exhibit 1 highlights both Netflix’s steady increase in the total number of paid subscribers and robust growth in the international segment offsetting slowing U.S. subscriber growth.
Exhibit 1: Netflix Paid Subscribers
As depicted in Exhibit 2, year-over-year growth in the number of paid Netflix subscribers on an absolute basis stands at an all-time high. In 2Q18, Netflix saw a 25M year-over-year increase in paid subscribers. This is roughly equal to the number of Hulu subscribers. Netflix now has close to 125 million paying subscribers, and the company’s momentum seems unbeatable.
Exhibit 2: Netflix Paid Subscriber Growth
Netflix Keys to Success
A few factors explain Netflix’s strong momentum over the years:
Original video content. Netflix’s decision to bet on original content has been a game changer, helping to maintain paid subscriber momentum from the early 2010s. Shows like House of Cards and Stranger Things have single-handily helped boost Netflix’s paid subscriber tally.
Low pricing. Compared to the price of a large cable bundle, Netflix’s low monthly subscription pricing is viewed as attractive by consumers. Netflix is also running with low pricing options in international markets.
Superior user experience. Consumers want to decide when to watch their favorite shows instead of being told when to tune in.
Netflix’s business model is ultimately dependent on the number of hours subscribers spend watching Netflix content. As long as subscribers are watching an increasing amount of content, the Netflix model works marvelously. Strong paid subscriber and engagement trends give management the green light to spend an increasing amount on original content, which then contributes to additional user and engagement momentum. This produces a positive feedback loop, as shown in Exhibit 3.
Exhibit 3: Netflix Feedback Loop
Netflix Competition
Competition has been a recurring theme on Netflix’s quarterly earnings calls. Management’s response has included a carefully-crafted, cautious tone, although the takeaway has been consistent: Instead of spending time worrying about the competition, Netflix remains focused on coming up with a better user experience. The aim isn’t to deny that Netflix faces competition, but rather to claim that Netflix doesn't look at the competition to figure out what to do next.
Up to now, Netflix has faced two primary competitors: legacy cable and our time. Netflix is a media company selling a video bundle to consumers. The company has seen much success in going up against the traditional cable bundle given innovation surrounding distribution. The way we consume video is undergoing a sea change, and Netflix has been able to ride the wave while legacy video struggles to stay afloat.
As shown in Exhibit 4, ESPN’s subscriber count, which serves as a proxy for the health of the large cable bundle, has declined by about 11% from the peak. Given how a growing number of slimmed-down cable bundles include ESPN, the large cable bundle has likely experienced even steeper subscriber declines.
Exhibit 4: ESPN Subscribers
Netflix’s fight against our time has been the more intriguing competitive battle. Netflix’s success is directly related to the amount of time users spend on the platform. Accordingly, the more Netflix video is consumed, the brighter Netflix’s prospects look. Given the finite amount of time available each day, Netflix ends up competing against everyday tasks for our time and attention. This battle has placed Netflix up against work, chores, errands, and even sleep. The battle for our time, not Amazon or even YouTube, has proven to be Netflix’s most formidable competitor to date.
New Battles
While it may seem like Netflix already has quite the nuanced battle on its hands going up against the clock, competition will only intensify. Up to now, Netflix has been running away with the ball with little to no competitive response from other paid video streaming players. When it comes to paid services other than Netflix, the list isn’t long with Amazon, HBO, and Hulu possessing the most mindshare. Things are about to change in a big way. In fact, we haven’t even seen a genuine battle yet in the paid video streaming space.
Three notable competitors are about to enter the paid video streaming scene:
Disney. The company’s existing intellectual property portfolio, combined with assets acquired from 21st Century Fox, position Disney as a formidable force in the direct-to-consumer paid video streaming space. The company plans to have three video bundles: a Disney-branded bundle with family-friendly content, a Hulu bundle with content that isn’t as family friendly, and ESPN+. It is not a question of if Disney will succeed over the long run, but rather how aggressive Disney will be out of the gate in terms of grabbing paying subscribers.
Apple. The new kid on the block. We are seeing what it looks like for Apple to go all-in on developing its own video streaming service. There are still questions surrounding Apple’s video strategy. However, the stream of reports regarding new shows and movies points to Apple building a decent-sized (at least a dozen shows) portfolio out of the gate.
AT&T / Time Warner (HBO). After buying Time Warner for $85 billion, AT&T has a strong incentive to leverage its crown jewel, HBO, to gain a stronger footing in the direct-to-consumer paid video streaming landscape. AT&T seems interested in tinkering with HBO’s strategy of valuing quality over quantity. Such a content strategy is being questioned when compared to Netflix chasing both quality and quantity at the same time.
The three preceding companies will likely unleash a brutal paid video streaming war over the next five years. There will be intense bidding wars for the best ideas and shows. Talent will become even more scarce. Consumers will have more in the way of choice when it comes to watching high-quality shows. This battle will be so intense, free video streaming players, like YouTube, will likely be pulled into the mix. The significant momentum found with the paid video space is a direct threat to ad-based video models. Google may feel pressure to wade even further into the paid video streaming space.
Netflix’s Problems
Netflix’s grip on the paid video streaming market is not as strong as it may appear. The company’s competitive advantages in the marketplace are being oversold.
Netflix’s video catalog is underwhelming. Aside from its one to two dozen original hit shows, Netflix’s broader content portfolio isn’t compelling. Much of the legacy content is stale while a surprising number of original movies feel off - as if they are low-budget despite having household stars. While Netflix’s growing efforts with original shows may be enough to keep viewers as monthly subscribers, more is needed on the content front if Netflix wants to grow viewer engagement.
Switching between video subscription services is easy. The idea that consumers will stick with one video streaming platform has not been fully thought out. While companies like Netflix are incentivized to keep viewers on their own platforms, attention is easily transferrable to other video streaming services. Apple’s TV app breaks down the barriers between video streaming services to the point of there not being any barriers at all. It is not surprising that companies like Netflix have little desire to fully participate in such a service.
Netflix’s technology advantage is misrepresented. As Ted Sarandos, Netflix’s chief content officer, discussed in a recent interview, gut represents around 70 percent of the equation when it comes to Netflix determining what makes great content. The narrative that Netflix is actually a technology company masquerading as a media company ends up being a stretch. Instead, Netflix is a media company that must continue to come up with popular hit shows.
Subsidized subscription pricing helps the competition. Netflix continues to subsidize paid memberships in order to grab as many users as possible. An unintended consequence of this practice is that Netflix ends up leveling the playing field for competitors by devaluing paid video content. By keeping pricing artificially low, Netflix makes it that much easier for new competitors to enter the market with pricing that isn’t too far off from that of Netflix. Disney has telegraphed that it will likely price its family-oriented video bundle at around $5 per month, which isn’t too much lower than Netflix’s pricing, despite Disney having a content portfolio that will be a fraction of the size of Netflix’s.
Business Models
Paid video streaming does not have the characteristics of a winner-take-all industry. No one company will have a monopoly on good, compelling video content. Netflix is not going to become “the new cable bundle.” Instead, it’s very likely that consumers will subscribe to multiple paid video streaming services. We may very well see a handful of video streaming services have more than 100M paying subscribers around the world. This reality is made that much more likely given the significant financial resources found with industry players including Disney, Apple, Amazon, AT&T, and Google.
There have been two primary business models in the paid video streaming space:
Direct subscription fees (Netflix, Hulu)
Larger entertainment bundle fees (Amazon)
The two business models haven’t been put to the test. Direct subscription fees continue to be subsidized in order for companies to grab users. It is very obvious that Netflix will have to raise its subscription pricing in a big way, especially if engagement hours plateau.
Meanwhile, companies that position video as merely one of a handful of services for subscribers don’t need to turn a profit with video streaming. By bundling video into Prime, Amazon doesn’t have to worry about video streaming pricing. Ultimately, this dynamic will pressure companies dependent on direct subscription fees. We haven’t seen what the video streaming industry looks like with another major player bundling video as part of a larger entertainment package. Apple is expected to offer a comprehensive entertainment package containing music, video, news, and even cloud storage.
Mindshare
Paid music streaming provides a sneak peak of what may unfold in the paid video streaming industry. In some ways, the music streaming industry is a few years ahead of the video streaming when it comes to having genuine competition.
There are key differences between the music and video streaming industries. With music, the same content is available on multiple paid streaming platforms. This has resulted in streaming companies positioning music discovery and the listening experience as the primary forms of differentiation. In what is a new development, hardware is also now being positioned as a differentiator with stand-alone stationary speakers, in addition to wearables, increasingly paying a role in how consumers pick between music streaming services.
Meanwhile, differentiation for video streaming comes in the form of original content. For example, Stranger Things is available only on Netflix and will likely remain so for the foreseeable future. Based on Netflix subscriber trends, original programming plays a major role in driving subscriber growth. This has led to a type of arms race when it comes to content budgets. Netflix is reportedly spending close to $10 billion per year on original content. Amazon is spending near $5 billion per year.
There are similarities between the two industries as well. Both music and video streaming began with a clear first-mover. Spotify was the undisputed leader in paid music streaming, similar to how Netflix now holds the same title in the paid video streaming space. This title gave each company significant mindshare, which corresponded to strong early momentum in terms of grabbing new users.
However, with a genuine competitor in the music streaming market, Spotify’s mindshare has suffered. Exhibit 5 compares the growth in paid subscribers for Apple Music and Spotify. While each company continues to benefit from the music streaming pie getting larger, Spotify now has to share the stage with Apple for mindshare.
Based on company disclosures, Apple Music’s new user growth is indeed accelerating as time goes on. In what is likely a worrying development for Spotify, Apple Music is now said to have more paid users than Spotify in the U.S. Similar trends are unfolding in other developed markets.
Exhibit 5: Apple Music vs. Spotify
Meanwhile, Spotify’s stronghold appears to be in Brazil and emerging markets, locations in which Apple’s market penetration is low. This dynamic doesn’t give one confidence in Spotify’s long-term opportunity. Instead, Apple will continue to chip away at Spotify’s mindshare.
While Netflix is able to use original content as a way to set itself apart from the competition, the company hasn’t needed to share the paid video streaming stage with such household names as Disney and Apple.
The Key Variable
The number of paid subscribers is not the key variable to monitor with Netflix. Since the paid video streaming market faces a number of tailwinds, it is certainly possible that Netflix will continue to grow its subscriber count over time. The overall streaming pie will continue to grow. Instead, the Netflix item to watch is subscriber engagement.
Netflix’s business model is ultimately dependent on the number of hours subscribers spend watching Netflix content. As discussed up above with Netflix’s feedback loop, as long as subscribers consume an increasing amount of content, the Netflix model works marvelously.
Based on Netflix’s 2Q18 earnings commentary, viewing/engagement hours are still up year-over-year. What will happen to Netflix engagement once Disney and Apple launch their own video bundles? Questions surrounding future competition are legitimate for Netflix. While consumers may very well end up subscribing to multiple video bundles, there is only so much time that can be split among each bundle. Time spent watching Disney or Apple content will be time not spent watching Netflix content.
As shown in Exhibit 6, the hole in Netflix’s armor will likely be found with the item circled in red: engagement. Any sign of plateauing engagement could lead to a domino effect as Netflix loses pricing power and the ability to run with higher content budgets. Any slowdown in new original content could then begin to impact new user trends, especially in international markets. Less content could then lead to even lower engagement.
Exhibit 6: Netflix Feedback Loop (Potential Problem Circled in Red)
The Big Picture
Given how Netflix is viewed by many as unstoppable, it probably shouldn’t come as a surprise that consensus expectations remain muted for Disney and Apple in the paid video streaming space. This will likely end up being a mistake. Various publications have been solely focused on casting doubt on Apple’s video efforts instead of highlighting how the paid video streaming market remains attractive for a company like Apple. The cynicism surrounding Apple Video brings back memories of the doubt facing Apple Music in the early years.
Tim Cook and Eddy Cue are reportedly taking a very hands-on approach with Apple’s video initiative, highlighting the service’s importance to Apple. Video will end up being a key ingredient of an Apple entertainment bundle containing various services. The company ends up building not just a video streaming service, but a Hollywood arm. Meanwhile, Disney has the strongest intellectual property out of any video player. The company’s problem up to now has been found with distribution. Those problems are now being addressed.
As for Netflix’s future, management appears to be well-aware of the risks found with being just a paid video streaming company. Netflix management will likely focus on two items in particular:
Acquire or build a strong portfolio of intellectual property. It would not be surprising to see Netflix embrace M&A (the company has only acquired one company - Millarworld) in an effort to beef up its intellectual property.
Expand beyond video content. Netflix reportedly considered buying a chain of movie theaters. Recent reports have Netflix moving into radio as well. These efforts are designed to move Netflix beyond being just a paid video streaming company.
Disney and Apple don’t have to go toe-to-toe with Netflix to do well in the video streaming space. Instead, each company is ultimately focused on grabbing viewer attention with compelling content. The ingredients are in place for both Disney and Apple to do very well.
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Above Avalon Podcast Episode 133: The Big Picture from Steve Jobs Theater
Earlier this month, Apple Watch was the star of Apple’s second major product event at Steve Jobs Theater. Episode 133 is focused on looking at the big picture following Apple’s event. The discussion begins by going over Tim Cook’s comments regarding Apple’s mission statement and then quickly puts the iPhone and Apple Watch updates into context. We then turn to my Grand Unified Theory of Apple Products. Additional topics include my user base estimates for Apple’s various product categories, my rationale for why Apple Watch and Apple Glasses will one day have a larger user base than iPhone will, and the power associated with new form factors that are capable of handling new tasks.
To listen to episode 133, go here.
The complete Above Avalon podcast episode archive is available here.
Connecting the Apple Dots
Apple is following a clear and defined product strategy. Last week, Apple provided the latest look at this strategy by unveiling new iPhones and a redesigned Apple Watch. These products represent clues that help paint a picture of where Apple is headed.
Mission Statement
Tim Cook kicked off Apple’s most recent product event at Steve Jobs Theater with an overview of the company’s mission statement. Here’s Cook:
“Apple was founded to make the computer more personal. Of course first with the Apple II, and then later with the Mac. Over the years, we’ve taken this mission further than anyone could have imagined. We’ve created several categories of technology that have had a profound impact on people’s lives - from the iPod to the iPhone to the iPad to the Apple Watch…
Of course we aim to put the customer at the center of everything that we do. That’s why iOS is not just the world’s most advanced mobile operating system. It’s the most personal. We’re about to hit a major milestone. We are about to ship our two billionth iOS device. This is astonishing. iOS has changed the way we live - from the way we learn, to the way we work. To how we’re entertained, to how we shop, order our food, get our transportation, and stay in touch with one another. And of course, how we capture the moments of our lives and share them with those we love. It’s amazing how our mission started with personalizing technology for the desktop to now seeing the many ways that we’ve made it more personal in so many aspects of our lives.
So it’s only fitting that today, we’re going to tell you about two of our most personal products - the ones that are with you everywhere that you go - and how we are going to take them even further.”
Along with announcing three iPhone X successors, Apple unveiled the most significant year-over-year change to Apple Watch since its unveiling in 2014.
My full review of Apple’s event is available for members here (major themes and takeaways) and here (full notes).
iPhone XS / XR
In order to push the iPhone X experience forward, Apple focused on three items:
Larger screens (A 6.5-inch screen with the iPhone XS Max and s 6.1-inch screen with the XR.)
Smarter brains (The A12 Bionic gives Apple an even larger lead over the competition.)
Better eyes (The dual-camera system is giving iPhone the ability to see the surrounding world with a more intelligent perspective.)
The following image does the best job at describing the current state of the iPhone business:
There is a reason Apple spent nearly 10% of the presentation talking about the A12 Bionic chip. Apple has spent the past decade working to control the core technologies powering its devices. The end result is an Apple chip that is providing the company a significant competitive advantage in the marketplace. With each new iPhone release, Apple’s custom silicon is responsible for an increasing portion of the iPhone experience. Apple didn’t just announce three new iPhones last week. Instead, thanks to the A12 Bionic and increasingly capable cameras, Apple announced three AR navigators serving as laptop and desktop alternatives.
Apple Watch Series 4
While the new iPhones were impressive, Apple Watch Series 4 stole the show. Two slides from the Apple Watch portion of the presentation stood out. The first of these covers improved optical heart sensor on the back of Apple Watch. The second shows Jeff Williams demonstrating some findings from Apple's multi-year research into falls.
Both slides depict Apple Watch as a proactive digital assistant. The device is capable of monitoring everything from our heart rhythm to whether we have fallen and need help. By being worn on the body, Apple Watch is able to handle tasks that will never be given to iPhone. When combined with the independence found with cellular, Apple Watch contains an incredibly powerful value proposition.
Apple Product Theory
The iPhone and Apple Watch represent the two most personal devices in Apple’s product line. While it may seem like these products lack any obvious connection with their larger siblings, there is a single philosophy connecting each of Apple’s major product categories. Introduced in 2015, my Grand Unified Theory of Apple Products is worth revisiting given the significant changes that have taken place within Apple’s product line.
Apple’s major product categories are interconnected by the roles they play in making technology more personal. Each product is given a goal that ends up describing its design attributes.
Mac desktops. Designed to be powerful and capable enough to push the boundaries of a computer.
Mac portables. Designed to handle tasks that may have traditionally went to a desktop.
iPad. Designed to serve as an alternative to laptops and desktops.
iPhone. Designed to be powerful enough to reduce the need for iPad and Mac.
Apple Watch. Designed to handle an increasing number of tasks so that less time has to be given to iPhone and iPad.
Apple’s product strategy is based not on coming up with replacements for existing products, but on using personal technology to come up with alternatives to more powerful computers. By relying on new form factors in addition to new user inputs and outputs, Apple has seen much success in coming up with products that contain less in the way of barriers between the user and technology. Intuitiveness is used to harness technology’s potential. Apple’s goal with iPhone has been to give the product enough functionality to serve as a Mac and iPad alternative. Meanwhile, Apple’s goal with Apple Watch is to give the product enough functionality to reduce the need for an iPhone.
The Grand Theory also does a good job of explaining why Apple uses a hands-off approach when it comes to telling consumers which product(s) fit best in their lives. While some think this has been a strategic error on Apple’s part, ultimately management wants customers to determine the degree of personal technology that makes sense for their needs. For some customers, a Mac may be required. For others, an iPhone is the only computer needed. Based on the most recent Mac and iPad Pro ad campaigns, Apple management has become comfortable in allowing each product category to stand on its own and not necessarily lift up one category at the expense of the other.
Connecting the Dots
Based on the most recent iPhone and Apple Watch updates, Apple’s longer-term ambition has become crystal clear. This is a company that believes Apple Watch will serve as a viable alternative to iPhone. As a result, the environment will become more hospitable for new form factors capable of making technology even more personal than is possible with Watch. As shown below, the Grand Unified Theory will likely expand to include a new product category beneath Apple Watch: Apple Glasses.
Apple Glasses fit perfectly within the theory as a product category given the job of handling tasks currently given to Apple Watch and iPhone. This would be accomplished by new user inputs (such as glances and voice) and outputs. The work Apple is doing with its custom silicon, along with miniaturization techniques it is using on Apple Watch will come together to make a pair of lightweight smart glasses possible. With the iPhone continuing to gain new capabilities as an AR navigator and the Watch becoming a new kind of proactive digital assistant, there will be room for a simpler device. This device will be designed to break down technology even further to provide an enhanced view of the world around us. There won’t be too many things as intuitive as a pair of smart glasses.
Consequences
One of the major consequences of the Grand Theory is shown below. Apple’s various product categories have dramatically different user base sizes based on the amount of personal technology found with each product. While the Mac has a combined user base of around 100M users, the iPad has almost three times as large of a user base. Meanwhile, the iPhone will soon exceed a user base that is nine times as large as that of Mac.
For more information on the methodology and calculations used to derive these estimates, visit here (iPhone), here (iPad), and here (Apple Watch).
Apple Watch’s user base has grown to 40M in just three years. For context, the iPhone user base stood at 55M after three years. Considering that an Apple Watch still requires an iPhone, the 40M user base figure is that much more remarkable.
As shown below, my expectation is that Apple Watch and Apple Glasses will one day be used by more people than will the iPhone. Such a radical idea may seem like fantasy, especially given how pivotal of a role the iPhone is playing in our lives. However, the appeal found with intuitive devices capable of making technology more personal will prove too powerful.
As new form factors allow Apple to harness technology’s potential, the scope to which those products are able to connect with humans intensifies. Multi-touch was a leading factor in iPhone having a user base that is nine times larger than that of Mac. A proactive digital assistant on the wrist will give Apple Watch a user base that eventually exceeds that of iPhone. The key to my projection is the eventual decoupling of Apple Watch from iPhone. This is an inevitable development. The only question is found with timing.
When it comes to glasses, a product that will be tasked with making technology more personal than iPhone or Watch, providing enhanced vision will be one of the more attractive value propositions in existence. While a user base of 900M people may seem impossible for Apple Watch or Apple Glasses to surpass, there are 7.5B people on Earth. Everyone can benefit from a device that delivers an enhanced view of the world around us.
The Current Era
With smarter brains and better eyes, the iPhone XS and XR will continue the trend of iPhones gaining functionality. It is not a surprise that we see iPhone pricing begin to move higher as a result. However, despite these advancements, the Apple Watch Series 4 was the star of the show at Apple’s recent product event. While this may have come as a surprise to some observers, there have been signs that this day would come. The Watch’s ability to proactively monitor our life is game changing.
When we look back at the late 2010s for Apple, we will likely refer to this as the early stages of the Apple Watch and Apple Glasses era. Apple’s multi-decade quest to make technology more personal is based on using intuitiveness to knock down the barriers that exist between humans and technology. One way of accomplishing this is push the boundaries found with today’s most personal products. The faster Apple runs with iPhone and Apple Watch, the closer the company will get to announcing its most personal product yet: glasses.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on memberships, visit the membership page.
Above Avalon Podcast Episode 132: Titan vs. Tesla
In episode 132, we take a closer look at Apple's Project Titan. The discussion begins by going over the signs pointing to Apple expanding Titan initiatives in recent months. We then turn to Apple's goal with Titan and the automobile's changing value proposition. Tesla enters the discussion as we look at why the company isn't a realistic acquisition target for Apple. Additional topics include Tesla's struggles, poaching, Doug Field's move from Tesla to Titan, and the most interesting things to watch for in the auto space.
To listen to episode 132, go here.
The complete Above Avalon podcast episode archive is available here.
Poaching Tesla
Apple and Tesla share some similarities. Both companies possess remarkably strong brands, loyal customer bases, and products capable of maintaining that loyalty. Each also has a visionary product leader. Apple has Jony Ive while Tesla has Elon Musk. Accordingly, some have concluded that Apple should acquire Tesla as a way of quickly jumping into the transportation industry.
A Tesla acquisition doesn't make sense for Apple. However, Tesla does have something that Apple has a use for: talent.
Project Titan
Apple's ambition with Project Titan, a catch basin for the company's transportation R&D endeavors, continues to be underestimated. The number of signs pointing to Apple expanding Project Titan initiatives in recent months is on the rise.
Apple currently has the third-largest test fleet of autonomous vehicles on the road in California. In just a few months, the number of test vehicles has expanded from 27 to 66.
Apple reportedly is expanding its vehicle testing presence in Arizona, another hotbed of autonomous driving research.
Apple is reportedly working with Volkswagen on developing autonomous shuttles for Apple employees. The partnership includes Apple developing both hardware and software for the autonomous shuttles.
Apple recently hired two high-level auto industry executives (Jamie Waydo and Doug Field). Waydo played a key role in the safety program Waymo uses to test and develop its self-driving technology while Field was one of Tesla's most important engineers overseeing vehicle engineering and Model 3 production.
One word to describe Apple's Project Titan strategy is "methodical." Apple appears to be gradually doing everything one would expect of a company establishing a large test fleet of autonomous vehicles on public roads. All the while, Apple's hardware ambitions remain intact. The company appears to still own a web of buildings across the Sunnyvale / Santa Clara / San Jose area that are dedicated to heavy manufacturing and have open space for future growth. (A map of the various locations is available for Above Avalon members here.) This is a company that wants to come up with new transportation solutions consisting of hardware, software, and services.
When news of Project Titan's existence broke in early 2015, many people were skeptical because Apple had no expertise in the auto industry. Apple would be starting from scratch.
In what was a departure from the iPhone development playbook, Apple looked outwardly for Titan talent. Specifically, Apple turned to the auto industry for hardware expertise. As shown below, a list of select Titan members (as of mid-2015) served as a wakeup call to skeptics. Apple was indeed working on a vehicle.
In late 2015, Project Titan began to hit speed bumps as friction between designers and engineers intensified. In order to come up with a truly new user experience, Apple designers wanted to skip human-driven vehicles and instead go straight to an autonomous vehicle. Others argued the better strategy was to begin with an electric car and then position autonomy as a future feature. Not surprisingly, the designers won.
Bob Mansfield, a hardware engineering guru who is arguably one of Apple's most successful liaisons between the design and engineering teams, was brought in to right the Titan ship. The initiative was refocused on developing the core technologies that would power a variety of transportation hardware options. The refocus on autonomous driving led to a culling of hardware talent.
At least 40% of the outside hires listed in the table above are no longer at Apple (based on LinkedIn updates). Most of the departures took place between August 2016 and early 2017, which fits with the reported timeline of Mansfield overseeing Titan changes. In addition to turning to outside auto hires, Apple ended up poaching itself by taking veteran Apple product design managers off of other teams. There doesn't appear to be much turnover with those Titan additions. Recent reports peg the number of people working on some aspect of Project Titan to be between 2,000 and 2,500.
Apple's Goal
The best way to understand Apple's goal with Project Titan is to think about the company's design-led culture. Apple's strength lies in taking existing product categories and using design to rethink our assumptions about that category. By rethinking how we use products, Apple is able to come up with products that can change the world.
Apple wants to rethink the automobile. While electric powertrains, autonomy, and ridesharing will help in Apple's efforts, something more is needed. Our fundamental assumption of what a car is (and isn't) is still in need of being reimagined. Without fresh thinking when it comes to design, we are still left with most of our prevailing assumptions about cars.
This lack of fresh perspective in automobile design is one factor likely fueling the growing interest in bikes and scooters in high density areas. However, the problem with automobile design goes beyond city centers. People are increasingly tired, frustrated, and bored with cars. The dramatic shift to SUVs in the U.S. is driven by consumers caring less about traditional car value metrics such as performance. Instead, consumers are craving personalization in any form possible. Unfortunately, personalization options, especially when it comes to driver and passenger compartments, remain limited in the auto industry.
Tesla did something extremely well: It developed electric cars that people actually wanted to drive. Talk of other luxury car makers competing with Tesla is likely more fantasy than reality. However, it's not clear if Tesla is actually on the right path given the car's changing value proposition.
One way Tesla has been able to do so well in the luxury segment is by competing on old-school value metrics like performance and style. The problem for Tesla is that these values won't matter in the future. Instead, the focus will shift to convenience and personalization. While iPhone relies on software to become a personalized computer for 900 million people, we will demand a similar personalized experience from automobiles. As it stands now, personalization when it comes to the automobile amounts to CarPlay, moving the driver seat back and forth a few inches, and folding down a row of back seats.
Why Not Acquire Tesla?
Given Apple's interest in transportation and Tesla having the most popular, highest-rated car on the road, many have positioned Tesla as an Apple acquisition target. Apple's strong balance sheet adds fuel to the fire. With $129B of net cash, Apple could pay $70B+ to acquire Tesla and instantly become a player in the auto space.
However, Tesla isn't a realistic acquisition target for Apple. More importantly, Apple doesn't need to acquire Tesla in order to meet its goals. The best way to understand why is to look at the key components of Apple's M&A philosophy:
A strong brand and product aren't enough for an Apple acquisition. There has to be more to an Apple acquisition target besides strong branding and a popular product in the marketplace.
Apple doesn't use M&A to acquire revenue. Apple doesn't use M&A as a tool to grow revenue.
Apple doesn't use M&A to acquire users. Apple doesn't acquire companies simply to grow its user base. This tenet has become that much stronger in recent years as Apple's user base has grown. Apple currently has one billion users. When considering how the vast majority of those users comprise the premium segments of the smartphone and tablet markets, Apple has no need to acquire what ends up being its own users.
In essence, Apple isn't interested in buying its way into new product categories. Instead, Apple positions M&A as a tool to either enhance its existing product line or plug holes in the product development process. M&A is used to a tool to supplement, not replace, Apple's design-led product development process. Accordingly, there are two things Apple looks for when acquiring companies:
Apple uses M&A to acquire technology. Apple looks at M&A as a tool for plugging holes in its asset base. Given how Apple is constantly working on new products, one hole is often the need for new technology.
Apple uses M&A to acquire talent. One area in which Apple is resource constrained is talent. As Apple moves from one industry to another, the company is always on the lookout for teams of talent that help boost knowledge and expertise.
A look at Apple's acquisition history demonstrates these core M&A tenets. Acquisitions such as P.A. Semi, AuthenTec, LinX, and Metaio were about technology and talent. Even acquisitions that included consumer-facing products like Beats, Beddit, and Shazam (pending approval) were ultimately about the technology behind the products.
Netflix
Netflix represents a great example of how Apple doesn't use M&A. In a Netflix acquisition, the two primary things Apple would have bought are a strong brand and lots of users, neither of which is enough to justify an acquisition. In addition, Apple users already had full access to Netflix. It's unclear how Apple owning Netflix would lead to an improvement in Apple products. Positioning Netflix's technology as justification for an acquisition is quite the stretch. Netflix is a media company, and the company's content library is grossly overrated when moving beyond the 15 to 20 marquee series.
Instead of spending $100 billion to acquire Netflix, Apple opted to poach talent from the entertainment industry and build something on its own. The result is a new "Apple Studios" division overseen by former Sony Pictures Television executives. Apple is reportedly planning to launch its new Apple Video streaming subscription service sometime next year.
Arguing that Apple should acquire Tesla because it has a great brand and popular product in the marketplace is faulty thinking. Instead, Tesla would need to provide resources that can either strengthen Apple's existing product line or plug holes in Apple's design-led product development process. Some will say that Tesla's fleet of human-driven cars ends up being the company's secret weapon when thinking about the race to autonomy. I'm not so sure about that claim. Others think Tesla's charging network or factories represent the company's crown jewels. Both claims are questionable. Instead, those items could end up being viewed as liabilities, which is one reason Apple embraced contract manufacturing nearly two decades ago.
Poaching
A Tesla asset that Apple may have an interest in is talent. Given Apple's ambition, Project Titan can benefit from having employees with experience developing cars that people love. However, instead of acquiring Tesla to bring on tens of thousands of employees, which would raise many red flags, a better strategy would include Apple selectively seeking out talent that would be the best fit for Titan.
When selling prospective hires on the Titan message, Apple is ultimately selling two things: vision and process.
Vision. Explaining Apple's mission to come up with products that can change the world. Even though new hires aren't likely given the full lay of the land when joining Titan, the Apple mission can still be telegraphed.
Process. Explaining the process in place for turning vision into reality.
It's not that Apple has necessarily struggled appealing to new hires for Titan. Instead, Tesla likely had the stronger message up to now. In the early 2010s, Tesla was successful at picking off members of the Mac, iPod, iPhone, and iPad teams looking for the next big challenge. At the time, Apple's focus was on Apple Watch, a product that ultimately had a relatively small development team. Project Titan was still a few years away. Doug Field was one of these employees who always had an interest in the transportation space and jumped at the Tesla opportunity.
Around the time Apple began ramping up Project Titan hiring in 2014 and 2015, the Apple versus Tesla talent wars began in earnest. Tesla was much farther along than Titan, with cars already on the road.
However, the environment has changed. The past few months have been a tough stretch for Tesla. The company's long-term goal is to usher in the era of sustainable transport. To reach such a goal, Tesla needed to take a luxury detour and sell cars to those most willing to pay top dollar for a high-performance electric sports car (which happens to have more than two seats). The problem is that Tesla finds itself having trouble getting back on track. A truly mass-market Model 3 remains missing in action. Tesla has become a case study of a company led by a product visionary struggling to turn vision into reality.
Elon Musk has consolidated power, and it's not clear that this is for the better. It's one thing for a product visionary to focus on details. It's a completely different story when a product visionary is being stretched too thin. Recent comments Musk gave to The New York Times regarding him being the only person that can solve Tesla's manufacturing problems is worrying.
These challenges may give Apple a potential opening for poaching Tesla for talent. Meanwhile, after leadership changes and some shaky times, Project Titan is now in a much more orderly state. Apple would make the case that it has a better process in place than Tesla. It's relatively easy to design a great car. The challenge is to build tens of millions of that car and to then be able to develop new versions over time.
Tesla's problem is ultimately its desire to do everything on its own. While such a decision was made given the lack of alternatives, Tesla faces less flexibility and financial capacity as a result. This has opened the door for Apple in terms of appealing to Tesla employees. Other factors may include being attracted by Apple ideals such as protecting data privacy and security, which will become a crucial topic in the auto space.
Doug Field
Tesla critics have been quick to point out the growing list of executive departures as a sign of major issues within Tesla. While the turnover does raise an eyebrow, Doug Field's departure stands out.
Field was Tesla's second-highest ranked engineer, behind CTO JB Straubel. Field was responsible for vehicle engineering and Model 3 production. Back in 2013, his hire from Apple was positioned as a huge win for Tesla. With experience that included Segway's CTO and Mac product design, Field had experience in both personal transport and shipping consumer products at scale.
Field's job at Tesla was to turn Musk's vision into reality. As recently as this past April, Musk viewed Field as one of the most talented engineering executives in the industry. Accordingly, it's telling that Field ended up quitting Tesla to join Titan. It will be interesting to see if any of Field's deputies at Tesla make the same move. Such a defection would end up being a major coup for Titan.
Elon vs. Jony
There will be a role for cars in the new transportation paradigm. Two visionaries to keep an eye on are Elon Musk and Jony Ive. Each is taking lessons learned from other industries with the goal of rethinking transportation. It is no surprise that Musk has thrown a few snide comments and jokes Jony's way in recent years.
Two of the more interesting things to watch in the auto space remain design and manufacturing. Instead of asking questions about legacy auto's software expertise, the more valuable question to ask is, Who is that company's Jony Ive? While auto manufacturers have teams of talented designers, such talent ends up being wasted as upper management and boards mitigate design risk out of fear of losing sales.
Over at Tesla, a company more geared towards engineering than design, Musk and company are learning the harsh realities of auto manufacturing. Many of Tesla's decisions won't be repeated by others.
Meanwhile, Apple's Project Titan is becoming a testbed of new technology that can be used to power new vehicle concepts from Apple's industrial design group.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (3 stories per day, 12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.
Above Avalon Podcast Episode 131: Growth Drivers
Apple's latest growth story is driven by three drivers: iPhone, Services, and Wearables. In episode 131, we discuss these three growth drivers to see how they are not created equal. After going over the factors fueling Apple's growth drivers, we spend time discussing how Apple's growth story may change in the near term. The episode concludes with a big picture overview of why Apple's long-term growth story won't just be about Services.
To listen to episode 131, go here.
The complete Above Avalon podcast episode archive is available here.
Apple's Growth Story
Apple is on a roll. The company is seeing record high iPhone ASPs, strong momentum with Services, and a wearables platform connecting with the mass market. Revenue growth has accelerated for the past seven quarters. Apple's growth story has returned with a vengeance. Upon closer examination, it becomes evident that Apple's three primary growth levers are not created equal. While some growth levers are at risk of slowing, others are still just getting started.
Growth Has Returned
In early 2016, Apple hit a rough patch. The company reported its first year-over-year decline in iPhone unit sales as the iPhone 6s and 6s Plus sales cycle proved quite different from that of iPhone 6 and 6 Plus. Overall revenue trends also turned negative with Apple reporting a double-digit revenue decline in 2Q16 and 3Q16.
Just as consensus began to throw in the towel on Apple as a growth story, iPhone unit sales stabilized. As shown in Exhibit 1, revenue bottomed in early 2017 and then once again began to increase. The most recent quarter marked a record high for Apple revenue on a trailing-twelve-month (TTM) basis and the seventh consecutive quarter of sequential growth in revenue.
Exhibit 1: Apple Revenue (TTM)
There are three drivers behind Apple's return to revenue growth:
- iPhone. The average selling price (ASP) of iPhone is up $100 year-over-year.
- Services. Apple is seeing strong revenue growth from the App Store, licensing, and AppleCare.
- Wearables. Apple's wearables platform is gaining sales momentum as Apple Watch and AirPods go mainstream.
Measuring Growth
The interesting thing about Apple's latest growth story is that few people were forecasting that Apple would grow revenue via hardware sales. Instead, many said that Services would be Apple's growth engine going forward. As it turns out, things are developing differently than consensus assumed.
For the twelve months ending this past June, iPhone was responsible for 57% of Apple's year-over-year revenue growth. Services was the second-largest revenue driver, responsible for 23% of Apple's year-over-year revenue growth. Wearables was responsible for 11% of Apple's growth. As seen in Exhibit 2, iPhone has been responsible for an increasing portion of Apple's revenue growth.
Exhibit 2: Measuring Apple's Revenue Growth Drivers
Details
It is helpful to take a closer look at the factors underpinning Apple's three revenue growth drivers.
iPhone. In 3Q18, iPhone revenue was up 20% year-over-year. The vast majority of this growth was due to Apple selling higher-priced iPhones. The iPhone 8 and 8 Plus are the highest-priced 4.7-inch and 5.5-inch iPhones, respectively, to date. Furthermore, the iPhone X is Apple's highest-priced iPhone yet. As seen in Exhibit 3, iPhone ASP experienced a step increase beginning in 1Q18, which marked the first full quarter of iPhone 8 and 8 Plus sales in addition to the iPhone X launch. Given strong flagship iPhone sales momentum, Apple has continued to report strong ASP trends. Apple reported a record high $119 year-over-year increase in iPhone ASP in 3Q18.
Exhibit 3: iPhone ASP
According to my estimates, Apple has sold approximately 120M higher-priced, flagship iPhones (8, 8 Plus, and X) since September 2017. Some of these devices were bought by former Android users switching to iPhone. However, there are only so many premium Android users out there. The majority of sales have likely gone to existing iPhone users upgrading their devices. With an iPhone installed base of approximately 750M users, less than 15% of the iPhone installed base bought a new flagship iPhone over the last nine months.
A small percentage of the iPhone installed base is responsible for driving much of the year-over-year increase in iPhone ASP. While this doesn't necessarily mean that iPhone ASPs are more fragile than they appear, it does add clarity to the current state of the iPhone business. The iPhone upgrade cycle continues to get longer while growth in customer demand for iPhone remains mediocre. Despite these challenges, the sheer size of the iPhone installed base makes it possible for Apple to sell close to 150M higher-priced, flagship iPhones in any given year.
Services. Apple's second-largest revenue driver, Services, is comprised of five items:
- Digital content (App Store, iTunes, Apple Music, etc.)
- Licensing
- AppleCare
- iCloud storage
- Apple Pay
A majority of Apple's Services revenue is associated with Apple distributing digital content to hundreds of millions of people via the App Store and iTunes. Accordingly, the increase in the number of people accessing Apple's content stores, combined with existing users spending more as time goes on, is a leading driver behind Apple's strong Services revenue growth.
Licensing revenue is another major contributor to Services revenue growth as third parties are paying Apple more to get their services in front of Apple's users. It helps that Apple's grip on premium users has gotten stronger over time. AppleCare revenue is also on the rise as the number of Apple devices in the wild increases and Apple expands its AppleCare distribution efforts.
Wearables. Apple is seeing strong unit sales growth for both Apple Watch and AirPods. In just three years, Apple Watch sales have exceeded 20M units per year with a user base nearing 40M. Despite extended supply issues, Apple likely sold more than 10M AirPods during the first year on the market, and coming close to 20M unit sales is a distinct possibility in CY2018. Apple Watch and AirPods sales are benefiting from aggressive pricing, strong mindshare, growing word of mouth, and increased distribution, especially with the cellular Apple Watch Series 3. As shown in Exhibit 4, wearables unit sales (the orange portion of bar) are no longer a footnote on a Apple gadget sales chart.
Exhibit 4: Apple Gadget Unit Sales
Future Growth
When it comes to thinking about how Apple's revenue growth drivers will perform in the coming quarters, it is important to assess the broader environment facing each driver. At the same time, a look at Apple's product strategy is required to the weigh the impact from new products and pricing decisions.
iPhone. Among Apple's three revenue growth drivers, the iPhone faces the most headwinds. While Apple can still grow iPhone revenue with modest unit sales growth, the company will likely see less of a revenue boost from huge iPhone ASP gains. It will be difficult for Apple to increase iPhone ASP by another $100 in 2019. Instead, iPhone ASP increases will likely decline.
Apple is expected to unveil three new flagship iPhones (6.5-inch OLED, 5.8-inch OLED, and 6.1-inch LCD) next month. Even if we assume the 6.5-inch OLED is priced higher than iPhone X, the model likely won't have as large of an impact on iPhone ASP as iPhone X, given a smaller share of overall iPhone sales. Instead, the majority of iPhone sales will be found with the 6.1-inch LCD and 5.8-inch OLED iPhones. These models will likely be priced similar to this year's flagship iPhones, making it that much harder for Apple to see another step increase in iPhone ASP.
Services. There are a number of factors supporting continued robust Apple Services revenue trends into 2019. Apple Services will benefit from continued growth in the iPhone installed base. At the same time, larger industry themes such as video subscription services gaining popularity stand to benefit Apple Services revenue in a few ways. In addition to earning a share of revenue via third-party video subscriptions, Apple is widely expected to launch its own paid video streaming service in 2019. Additional Services growth levers are found with higher licensing fees from third parties, more AppleCare revenue, and a larger number of iCloud storage subscriptions. In a scenario in which iPhone revenue growth slows, it is reasonable to expect Services will represent a larger portion of Apple's revenue growth in 2019.
Wearables. Apple's wearables segment will likely serve as an Apple revenue growth engine for years. The days of Apple wearables being considered a revenue footnote are over. Over the past 12 months, Apple sold over $10 billion of wearables (Apple Watch, AirPods, and Beats headphones). Assuming Apple is able to maintain at least 30% to 40% unit sales growth over the next few years, Apple's wearables platform will reach $20 billon of annual revenue within three years. Given the still relatively low adoption rates for Apple Watch and AirPods within the Apple user base, there are plenty of potential users left to fuel unit sales growth. Over the long run, Apple will likely expand the wearables platform to include new form factors and product categories. These developments will add even more growth potential to the segment.
Big Picture
On the last two quarterly earnings conference calls, Tim Cook has talked about the smartphone market being one of the best for a company like Apple in the history of the world. There aren't too many markets capable of supporting 215M+ annual unit sales at an average selling price exceeding $750. Read between the lines, and Cook's confidence signaled Apple's belief that nothing will displace smartphones as the most valuable computer in our lives in the near term. For example, Cook's answer to an analyst's question about tech in the home didn't make it seem like Apple management was worried about stationary smart speakers.
Much of Cook's optimism around smartphones is supported by recent Apple financial trends as revenue growth has been driven primarily by iPhone, with Services and wearables serving in more supporting roles.
However, this doesn't mean that Apple is betting on iPhone over the long run. In fact, over the next few quarters, it is reasonable to expect that iPhone will become less of a growth driver for Apple, with the growth spotlight turning to digital content distribution and wearables as Apple's primary growth engines.
Apple continues to place bets on new products that have the potential to gradually serve as iPhone alternatives (not replacements). In essence, Apple wants to be the one to disrupt the iPhone. These iPhone alternatives, having to be powered or supported by iPhone out of the gate, will initially be viewed as rudimentary or even as toys. However, these products will be placed on the path to independency from iPhone. The Apple Watch is a great example of such a product. Apple Glasses have the potential to be an even bigger catalyst for growth.
At the same time, we are seeing Apple gain confidence in delivering services focused on distributing digital content and adding value to hardware used by a billion users. As the average number of Apple products per user increases, thanks to wearables, these services will prove essential in delivering personalized and proactive solutions to the Apple community. This strategy will provide Apple years of revenue growth opportunity and pave the way for Apple's eventual entrance into the transportation industry.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on memberships, visit the membership page.
Apple 3Q18 Earnings Expectation Meters
The ingredients are in place for Apple to report an all-around solid 3Q18. If Apple reports more than $52.5B of revenue, 3Q18 would mark the company’s seventh consecutive quarter of accelerating revenue growth. A higher iPhone average selling price (ASP) driven by iPhone 8, 8 Plus, and X will likely represent the largest driver behind Apple's year-over-year revenue growth. Services and wearables are positioned to represent Apple's second and third largest revenue growth drivers, respectively.
The following table contains my Apple 3Q18 estimates.
The methodology and data behind my estimates are available to Above Avalon members. (Become a member to access my full 5,400-word Apple 3Q18 earnings preview that is available here. To sign up, visit the membership page.)
Each quarter, I publish expectation meters ahead of Apple's earnings release. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's quarterly performance.
In each expectation meter, the gray shaded area represents my expectation range. A result that falls within this range signifies that the product or variable being measured is performing as expected. A result in the green shaded area denotes strong performance and the possibility of me needing to increase my estimates going forward. Vice-versa, a result in the red shaded area has the opposite effect, potentially leading me to reduce my assumptions going forward.
I am publishing three expectations meters for Apple's 3Q18:
- iPhone unit sales
- "Other Products" revenue
- 4Q18 revenue guidance
My 3Q18 iPhone sales expectation range is for Apple to report between 41M and 45M units. A result within this range would be viewed as expected. If Apple reports iPhone sales greater than 45M units, results would be described as strong. A sub-41M iPhone unit sales result would be considered weak and likely lead to a reassessment of my iPhone unit sales expectations going forward.
Apple's "Other Products" is a catch basin for a number of Apple products. "Other Products" include revenue from Apple Watch, AirPods, HomePod, Apple TV, Beats headphones, iPod touch, and Apple-branded and third-party accessories. If Apple reports close to $4 billion of "Other Products" revenue, the implication is that Apple Watch and AirPods were strong sellers in 3Q18. In addition, Apple would have likely sold a respectable number of HomePods. A result closer to $3 billion of revenue would reflect somewhat weak wearables sales.
Apple's 4Q18 revenue guidance will include the initial weeks of Apple's largest product launch of the year. In terms of new iPhones, Apple is expected to unveil three flagship iPhones. Even if Apple ends up needing to push the launch for one flagship iPhone into 1Q19, sales associated with the other two flagship iPhones will likely be strong enough for Apple to provide solid 4Q18 revenue guidance. Revenue guidance that exceeds $60 billion would be viewed favorably while revenue guidance closer to $56B to $57B would likely lead to analysts wanting additional clarification from management on the earnings call.
Above Avalon members have access to my full 5,400-word Apple 3Q18 earnings preview, which includes the methodology and data behind all of my financial estimates (four parts):
- Setting the Stage
- iPhone Estimates
- iPad, Mac, Apple Watch, Other Products, and Services Estimates
- Revenue, EPS, Share Buyback, 4Q18 Guidance
Members will also receive my exclusive Apple 3Q18 earnings review (two parts: major themes and my full notes) once Apple reports earnings.
To read my full Apple 3Q18 earnings preview and receive my earnings review, sign up at the membership page.
Above Avalon Podcast Episode 130: What's a Computer?
Episode 130 is dedicated to discussing how Apple has become comfortable in accepting, and even embracing, the awkwardness that exists between the iPad and Mac. The discussion begins with a closer look at the fascinating juxtaposition between Apple's recent Mac campaign and its iPad ads from earlier this year. We go over what the ads tell us about Apple's thought process regarding the iPad and Mac. Things then turn to how the iPad vs. Mac juxtaposition hasn't been static over the years. After briefly recapping the post-PC era debate, the episode concludes with my thoughts on where Apple will bring the iPad and Mac platforms and why the company faces a large screen paradox.
To listen to episode 130, go here.
The complete Above Avalon podcast episode archive is available here.
The iPad vs. Mac Juxtaposition
Apple has always publicly supported the iPad and Mac. However, that hasn't prevented questions regarding Apple's commitment to the two product categories from popping up. In recent months, Apple has shown a new level of openness when it comes to embracing both the iPad and Mac as unique and differentiated platforms for creative endeavors. The change is noteworthy when thinking about each category's future.
Ad Campaigns
A few weeks ago, Apple unveiled a new Mac ad campaign, "Behind the Mac." The ads were meant to elicit fond memories professionals have of using Macs to get their work done.
The main ad stood out because, aside from one shot showing the Touch Bar, it could have easily passed for something released by Apple a decade ago. Even the plastic white MacBook made a cameo appearance. After watching the ad, words like "familiar," comfort," and "nostalgia" came to mind. Apple was targeting long-time Mac users.
The song used for the ad, "The Story of An Artist," reinforced this point. Here are the beginning lyrics:
Listen up and I'll tell a story
About an artist growing old
Some would try for fame and glory
Others aren't so bold
The ads also gave a subtle nod to people using their Macs for a long time, which possibly served as a response to the recent uproar surrounding Mac keyboard reliability.
The Mac ads stood out that much more by being released a few months after Apple's "What's a computer" ad campaign for iPad Pro. That ad featured a young girl using her iPad (and Apple Pencil and Smart Keyboard accessories) around her neighborhood in various activities and adventures.
After watching the iPad ad, words like "new," "different," and "controversial" were the first to come to mind. Here was a young person using an iPad in different, and in some cases, fascinating ways, while drawing into question the traditional definition of a computer. The ad upset quite a few Mac users.
Apple relied on a similar message with the iPad ad shown at the end of its education event in Chicago back in March. A group of students use iPads (and Apple Pencil) to complete a group homework assignment about gravity. In each case, an iPad is being used for tasks that a Mac or PC wouldn't be able to handle.
With the Mac ad, Apple was selling comfort to a small percentage of its user base. Meanwhile, the iPad ads were selling newness to a different customer. The juxtaposition of the Mac and iPad ads symbolize the awkward relationship the iPad and Mac have within Apple's product line.
History: It's Complicated
This iPad vs. Mac juxtaposition hasn't been static. At launch, the iPad was like a rocket, fueled by apps and intrigue found with larger a touch screen powered by iOS. After just a few months, iPad sales surpassed Mac sales. The iPad went on to double and even triple Mac sales. In an iPad vs. Mac battle, the iPad seemed to be the clear winner.
While Apple management never publicly showed disdain for Mac, the level of attention given to the iPad in the early 2010s likely corresponded with a declining amount of time and focus dedicated to Mac. Some of the Mac decisions made around this time, like the Mac Pro's design, later came back to haunt Apple.
The iPad vs. Mac relationship started to change after iPad sales peaked at the end of 2013. Management's efforts to entice iPad users to upgrade proved futile as iPad sales declined from a 75M units per year run rate to a 40M units per year sales pace. While iPad sales were in free fall, the Mac remained a steady ship, not moving far from its 20M unit sales per year pace. The Mac demonstrated a level of sales consistency that management may not have expected given iPad's popularity.
Apple now finds itself with an iPad business that is twice the size of Mac in terms of unit sales, but smaller than the Mac when it comes to revenue. The iPad user base is nearly three time as large as the Mac user base and is growing by 20 million new users per year while the Mac user base is seeing more like 10 million new users per year. In a nutshell, both the iPad and Mac businesses have found stability and continue to connect with their respective user bases.
Different Tools for Different People
The fact that Apple gave such dramatically different Mac and iPad ad campaigns the green light provides clarity regarding management's approach to the two product categories. Apple has become comfortable in accepting, and even embracing, the awkwardness that exists between the iPad and Mac. Apple isn't trying to hide the differences that exist between the Mac and iPad as creation platforms. Instead, Apple is embracing the unique attributes found with each platform.
Instead of trying to come up with scenarios in which the average consumer will have a use case for both iPad and Mac in their lives, Apple is embracing its heterogeneous user base. For iPad owners, the Mac ads probably didn't connect on an emotional level. Meanwhile, the iPad Pro ad's hostility towards "computers" likely infuriated some Mac users. Apple is OK with such a situation. Their aim isn't to sell consumers on both the iPad and Mac as computing platforms, but rather to ship different kinds of tools that can improve people's lives.
Apple is betting that the Mac will appeal to some users, potentially those users with legacy workflows, while the iPad will appeal to a different set of users - a younger generation of creatives. Of course, the iPad is appealing to two to three times more people than the Mac, but the overall point still stands.
Post-PC Era?
For every Mac that Apple sells, the company sells approximately 15 non-Mac devices. This ratio is near an all-time high and is very likely to increase over time considering the growing momentum found with Apple wearables. If that doesn't describe a post-PC environment, it's difficult envisioning what would.
However, for many people, it doesn't feel like we are in a post-PC environment. There are at least 100 million people still using a Mac. More importantly, there are tens of millions of people with workflows that aren't handled by iOS. This group is unable to move beyond the Mac. The continued importance of Mac and PC have led some to conclude that the post-PC era has been a farce. However, this doesn't feel right either given how hundreds of millions of people have positioned their smartphones as the most valuable, and in some cases only, computers in their lives.
The reason the post-PC era has been so controversial is that smartphones and iPads have become Mac and PC alternatives, not replacements. This subtle, but important, distinction means tens of millions of people still need a Mac to get work done. However, for a much larger number of people, smartphones and iPads have been able to handle certain workflows formerly given to laptops and desktops. We are experiencing the post-PC era. It's just a bit more nuanced than initially imagined.
Looking Ahead
There's always been a grey area between the iPad and Mac within Apple's product line. Questions have swirled as to how Apple can best bridge the gap between iOS and multi-touch computing with macOS and the accompanying mouse and cursor. Some pundits have been vocal that Apple should follow Microsoft and ship hybrid devices that utilize elements from both paradigms. Others think a more practical solution is for Apple to ramp up its bet on the Mac as the iPad sees its use cases eaten by larger iPhones.
One way to address this grey area is to think about inspiration.
It's easy to think that Apple is getting inspiration for the iPad from the Mac. New multi-tasking features, an updated dock, and apps like Files would seem to bring up memories more reminiscent of Mac than iPhone. However, I think the opposite is true. Apple is using the iPhone as ultimate inspiration for where to bring its larger iOS sibling. Moreover, even the Mac is getting inspiration from the iPhone.
Apple is bringing things like its custom silicon and Touch ID to the Mac platform. It's not a stretch to envision Face ID eventually making its way to the Mac (after first being brought to the iPad). There is then Apple's focus on making it easier to port iOS apps to macOS. All of these efforts demonstrate Apple utilizing the iPhone (and the iOS developer community) as a catalyst to push both the iPad and Mac platforms forward. This makes sense given the iPhone's ability to connect with the mass market as seen with a user base of approximately 900M users.
In terms of where Apple will bring the iPad and Mac platforms, a few things stand out:
- Larger, more powerful, iPads that share many features with their iPhone siblings.
- Macs powered by Apple chips (likely starting at the low end of the Mac line) and gaining features made popular by iOS.
- Powerful Macs that push the boundaries of a Mac.
In essence, Apple will continue to dedicate resources to pushing both the iPad and Mac categories forward, even if it means the products target increasingly different types of users.
Where things aren't headed:
- Apple coming up with hybrid devices that amount to combining multi-touch tablets with laptops and desktops.
- An overall move away from iPad or Mac.
There is no evidence that Apple is growing frustrated or tired of the differences found between iPad and Mac. Instead, Apple's strategy for iPad and Mac is to position each as its own creative platform. The iPad ends up being a creative arm for iOS, while the Mac harnesses the potential with macOS to power the needs of a wide variety of creators. While this strategy doesn't prevent Apple from trying to share features between the platforms, Apple seems set on recognizing the key differences found with iPad and Mac - iPad's multi-touch user interface and Mac's cursor and mouse paradigm.
Large Screen Paradox
Three major computing themes have grabbed Apple's attention in recent years:
- Wearables
- Smaller, more intelligent screens
- More powerful and intelligent cameras
Apple is excelling in each of the preceding themes with clear vision and strategy. However, what about the largest screens in our lives? Is it a coincidence that these devices lack the compelling vision found with the smallest screens in our lives? If AR glasses were to become a mainstream Apple product one day, where would that leave the long-term trajectories for large screens like televisions, iPads and Macs? It's not entirely clear.
For now, Apple's strategy for iPad and Mac appears to be to position each as a tool for creators. While a growing number of people will be able to do more with smaller screens worn on the body, the iPad and Mac are allowed to handle workflows that require additional screen real estate and power. This doesn't mean Apple is free of challenges and risks.
The company's approach to Mac continues to be a controversial one as legacy users feel uncomfortable with the direction in which Apple wants to take the platform. At the same time, there are some who think Apple isn't moving fast enough with iPad as a tool capable of handling legacy workflows still given to the Mac. Many of these challenges will likely remain for Apple in the near term. However, by embracing the somewhat awkward iPad vs. Mac juxtaposition, Apple is revealing to the world that it will remain true to each platform and focus on the attributes that make the iPad and Mac stand out as creator platforms.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on memberships, visit the membership page.
Above Avalon Podcast Episode 129: Giants on Wall Street
A select group of corporate giants have been gaining influence and investor dollars on Wall Street. Episode 129 is dedicated to discussing today's corporate giants (Apple, Amazon, Alphabet, Microsoft, and Facebook) including the key differences and similarities between the five. The second half of the episode goes over why I think odds are good that today's giants won't be tomorrow's giants. The episode concludes with a closer look at Apple's quest to do the seemingly impossible - remain relevant.
To listen to episode 129, go here.
The complete Above Avalon podcast episode archive is available here.
The Race to a Trillion
An arbitrary race that many have been following on Wall Street is, which company will be the first to reach a trillion dollar market capitalization? Currently, there are four legitimate contenders: Apple, Amazon, Alphabet, and Microsoft. However, the race to a trillion dollars ends up hiding a much more interesting development that has been unfolding on Wall Street.
A select group of corporate giants continue to gain influence and investor dollars. Their rise is drawing into question whether or not this time is different. Have these companies found a way to remain at the top indefinitely? Are we seeing the rise of a new breed of corporate giant?
Today's Giants
There are currently five giants on Wall Street:
- Apple: $924B
- Amazon: $848B
- Alphabet: $814B
- Microsoft: $782B
- Facebook: $587B
Combined, the five preceding companies total $4.0 trillion of market cap, representing 16.5% of the entire S&P 500. This development has raised concerns that we may be in some kind of tech bubble or, worse, that today's giants are gaining too much power over the broader market.
History offers a different viewpoint. Wall Street has been no stranger to corporate giants. In fact, power was much more centralized at the top in the 1960s and 1970s when the top five companies made up more than 20% of the S&P 500.
Exhibit 1: Market Capitalization of Top Five Companies in S&P 500 (% of Total S&P 500)
During the 1960s and 1970s, the largest company represented 7% to 9% of the overall S&P 500. Today, Apple represents approximately 4% of the S&P 500. As seen in Exhibit 2, no company has been immune from the eventual fall from the top. It seems like the surest way to not be the largest company in the future is to be the largest company today.
Exhibit 2: Market Capitalization of Largest Company in S&P 500 (% of Total S&P 500)
Diversification
Historically, there has been diversification among the largest public companies. For decades, the top five companies have included representatives from different segments of the economy such as the tech, industrial, energy, and financial sectors. Many have looked at today's giants and concluded such diversification has disappeared. However, upon closer examination, a different picture comes into focus. There is still diversity at the top:
- Apple is a design company selling tools that empower people.
- Amazon is a retailer intently focused on offering the best retail experience imaginable.
- Microsoft is an enterprise-focused services company focused on helping people get work done.
- Google is a services company aimed at delivering data-capturing tools to as many people as possible.
- Facebook is a services company providing curated versions of the web (Facebook and Instagram).
The preceding five companies rely on different business models to form unique customer relationships. More impressively, each company has gotten to where it is today without interrupting the others' business models. We see some skirmishes at the edges. (Facebook and Google are both offering prime real estate for advertisers while Amazon has entered Google's search territory.) However, things have remained shockingly benign when it comes to all-out wars among giants.
Narratives
The five giants aren't treated and viewed equally on Wall Street. Along with having different business models, each also possesses unique narratives with some stronger than others. Amazon currently has one of the strongest narratives. Out of the five giants, Amazon is viewed as having the most defensible business model with the company positioning itself as a type of utility that will eventually own the most cost efficient and effective way goods are transferred from merchants to people's homes. One way to verify this strong narrative is to look at the market's reaction to Amazon announcing M&A activity. News of Amazon entering a new industry (grocery and now pharmacy) is accompanied by significant market cap losses among that industry's existing players.
Meanwhile, Facebook and Google are viewed as being more susceptible to competition grabbing users' attention with different kinds of data-capturing services. Nevertheless, the market is still rewarding the two companies for their seemingly more predictable services revenue streams based on delivering ads.
Apple is viewed as the most susceptible of the group. There continues to be a significant amount of doubt regarding Apple's ability to keep coming up with new products that people love. This skepticism has surrounded Apple for decades and is used by the company as a factor motivating employees to surprise the world.
Valuation multiples afforded to each company reflect these different narratives. Amazon shares trade at the highest multiples among the group with Apple bringing up the rear, trading at a 10% discount to the overall market (according to forward P/E multiples).
The following valuation metric is operating cash flow yields (operating cash flow / market cap). The lower the yield, the higher the valuation metric. For example, the market is currently willing to pay 3x more for a dollar of Amazon operating cash flow (and Amazon's future cash flow stream) versus a dollar of Apple operating cash flow.
- Apple: 7%
- Microsoft: 5%
- Alphabet: 5%
- Facebook: 4%
- Amazon: 2%
Software
The five largest public U.S. companies do have one thing in common: software prowess. Three of the five were able to harness the power found with software in the mobile era to achieve a type of scale that was once unimaginable. All five relied on software advancements to come up with new customer experiences. Facebook and Alphabet cater to more than two billion customers each. Microsoft and Apple have more than a billion customers each.
Some market observers are wondering if the combination of software prowess and sheer scale has resulted in a different kind of corporate giant. Have today's largest companies gained so much power thanks to their capabilities and loyal customer bases that they will be able to avoid the inevitable fall from grace? Similar questions have been pointed towards non-U.S. companies as well, including Tencent and Alibaba.
Defining Power
Today's corporate giants hold considerable power in two ways:
- Cash
- Data
Four of the five largest public U.S. companies have remarkably strong balance sheets. The following totals reflect net cash (excludes debt) positions as of the end of March 2018:
- Apple: $145B
- Alphabet: $100B
- Microsoft: $55B
- Facebook: $44B
- Amazon: $6B
More impressively, each company is kicking off significant amounts of cash flow. The following totals reflect operating cash flow for FY2017:
- Apple: $64B
- Microsoft: $40B
- Alphabet: $37B
- Facebook: $24B
- Amazon: $18B
Strong balance sheets and superior cash flows provide management teams flexibility to fund and pursue ambitious ideas. Each company has seen a dramatic rise in R&D expense in recent years. Apple, historically known for its R&D expense frugality, will spend more on R&D in 2018 than it did from 1998 to 2011. The following totals are R&D expense in FY2017.
- Alphabet: $17B
- Microsoft: $13B
- Apple: $12B
- Amazon: $12B*
- Facebook: $8B
*Estimated as Amazon includes R&D within its "technology and content" line item.
Add topics like AI and machine learning into the discussion, and some think these giants derive value not from just having many users, but also from users' data. There is a growing number of market observers and pundits that see a new breed of monopoly being born, a "data monopoly." This group views data, or the lack thereof, as a formidable barrier to entry, preventing others from competing with today's giants. In such a scenario, government regulation would be the only thing capable of slowing down the giants.
Nothing Lasts Forever
This may be a controversial statement, but odds are good that today's giants won't be tomorrow's giants. Despite some companies being viewed as more defensible than others, each is fragile. New companies, some of which haven't been founded yet, will rise up and compete with today's leaders for market supremacy. Critics will argue this thinking is too old-school and that today's companies simply hold too much power (via cash and user data) to one day be disrupted. I disagree.
It is easy to think that today's giants are where they are today because of a particular product, feature, or core competency. However, this isn't the case. Instead, each company has developed a culture and process to create value for customers. It is this process, and the sheer level of difficulty found with changing such a process, that will serve as a roadblock for today's giants.
Over time, new forces will rise that will challenge existing processes and require giants to come up with new ways of thinking. The degree to which management teams can respond and adjust to these new forces will determine the amount of success in staying at the top. There is nothing inherently found with today's giants that prevents new companies from leveraging technologies to deliver customer value in new ways. Instead of there being some kind of innovation black hole where advancements can only come from the five giants, tomorrow's giants will likely use today's leaders as stepping stones to reach new heights. An example of this development would be the way companies have used smartphones to rethink transportation via ride sharing.
Start-ups will be able to innovate in the areas of A.I. and machine learning despite not having access to the quantity of data that the giants possess. In essence, too many people are positioning data and scale as moats that will protect today's giants. Neither will prove true.
The five giants are keenly aware of their fragility. No one wants to miss the next big thing and be left behind. Consider the following actions when it comes to avoiding irrelevancy:
- Apple is sprinting into wearables while continuing to embrace additional vertical integration by owning the core technologies powering its devices. Apple is mapping a post-iPhone path forward.
- Google's Alphabet reorganization was designed to better manage the various bets the company had placed. While the reorg doesn't appear to be going terribly well from a management / leadership perspective, Alphabet has become more financially-disciplined when it comes to its long-term bets.
- Facebook's annual developers conference has seen Mark Zuckerberg position different initiatives as the company's future. In 2016, VR was said to be Facebook's future. The implication is that the world will increasingly move beyond just text and photos. In 2017, AR was Facebook's future. Today, Facebook finds itself dialing things back to put more resources in cameras and video.
- Microsoft's shift away from consumer markets symbolized management's acceptance of missing the mobile revolution and instead staking out a differentiated path forward.
- Amazon's vertical integration into product and delivery is upending nearly every part of the legacy retail complex.
While the giants have become more ambitious and willing to take on challenges, there has been very little change to their cultures or processes.
Case Study: Apple
Apple management is well aware that they are trying to do the seemingly impossible - remain relevant. Aside from a few luxury brands, very few companies have been able to avoid what appears to be the inevitable fall from grace.
Apple's future won't be determined by the iPhone, Apple Watch, or Services. Instead, Apple's future will be based on the company's ability to come up with valuable tools for people. This reality is dependent on a few ingredients:
- Deep collaboration among teams within Apple.
- An intense focus on design (i.e. how Apple products are used).
- Correct market positioning and timing (Arguably, these attributes end up being a design offshoot as they relate to how people will use Apple tools.).
Tim Cook is misunderstood as Apple CEO. Many have been grading Cook as if he is Apple's product visionary. Instead, Cook is tasked with managing something more important than any one product. Cook is looking over the process used to develop products. He has overseen major changes to the way Apple is managed on a day-to-day basis while doubling down on positioning Apple's Industrial Design group as purveyors for the experience found with using Apple products.
As we move into the AI / ML era, it isn't a coincidence that Apple has been making internal changes to foster deeper collaboration between industrial designers (who oversee Apple's product vision) and other teams on the frontline of new technologies. The recent hiring of John Giannandrea as Chief of Machine Learning and AI Strategy emphasizes this last point. Apple's new headquarters house a design studio fostering a greater level of idea dissemination versus what was possible at Apple's old headquarters.
We also see Apple moving deeper into owning core technologies - a bet that will likely give the company a competitive advantage measured in decades. Not only is Apple working on developing the required technologies for new product categories, but management is also waiting for the correct market timing. The transportation industry isn't quite ripe for a company like Apple to enter. However, given the significant amount of change unfolding in the space, an Apple move into transportation is inevitable. Such a move may be associated with Apple relying on different processes to monetize premium experiences. It is this embrace of change that gives Apple the best chance of continuing to build tools for people. Waiting for the right time to move is a freedom that Apple never had twenty years ago.
A Trillion Dollar Reminder
Barring some kind of global slowdown in economic activity, there will likely be at least one trillion dollar company among today's giants. Over the next few years, it is certainly possible that there will be multiple trillion dollar companies.
Instead of this milestone representing the start of a new chapter for these giants, it should serve as a reminder of these companies' fragility and the never-ending supply of new companies coming up with new processes for delivering experiences and value to the world.
While many think there will be growing competition or wars between today's giants, such a scenario is unlikely. Instead, the competition will come from other directions, including new entrants possessing dramatically different business models and processes.
The strongest opponents in the giants' battle to remain relevant end up being themselves. The natural aversion to change will simply be too strong for most giants. Strong balance sheets, billions of users, and access to seemingly unlimited user data will all prove futile in their bids to remain relevant.
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Above Avalon Podcast Episode 128: Figuring Out What's Next
One of the major takeaways from this year's WWDC keynote was found with something not announced on stage. Apple finds itself announcing new technologies that make more sense on form factors that don't yet exist. Episode 128 includes a discussion of this year's WWDC, which demonstrated how Apple is figuring out what comes next. After quickly recapping the major WWDC 2018 announcements, Neil discusses how Apple is setting the stage for smart glasses. The second half of the episode goes over Apple's motivation for looking beyond current success to figure out what's next.
To listen to Episode 128, go here.
Apple Is Figuring Out What's Next
"If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next." - Steve Jobs
Apple used this year's WWDC to demonstrate a number of areas in which it is playing offense. This isn't a company content with letting others control the user experience found with its devices. However, one of the major takeaways from the WWDC keynote was found with something not announced on stage. Apple finds itself announcing new technologies that make more sense on form factors that don't yet exist. Management is increasingly focused on what comes next, and the answer is smart glasses.
WWDC 2018
The features and software unveiled at WWDC 2018 could be split into two categories. The first group included items targeting the way we use and consume content on Apple devices. This included everything from empowering users with information regarding how devices are used to improving the way we consume content via:
- An updated Apple News app.
- Apple Podcasts on Apple Watch.
- A completely redesigned Stocks app.
- A revamped (and rebranded) Apple Books.
Apple knows it holds a lot of power when it comes to content distribution given a user base of a billion people and 1.4 billion devices.
The other group of announcements was related to new technologies designed to make the cameras and screens in our life smarter.
- ARKit 2 introduces new ways of transforming smartphone and tablet cameras into smart eyes.
- Siri Shortcuts continue Apple's efforts to customize Siri to better suit a user's lifestyle.
- New machine learning (ML) capabilities are powering Memoji and various other applications made possible by smarter cameras.
There is a drawback found with most of the cameras and screens that stand to benefit from these new technologies: We still have to hold them. While AR makes for a cool on-stage demo, having to hold an iPhone or iPad up as an AR viewfinder for long periods of time isn't ideal. Items like Siri Shortcuts and Siri Suggestions are interesting on iPhone and iPad although they are incredibly more appealing on mobile displays worn on our bodies. ML applications on iPhone and iPad are useful, but the predictive and proactive nature of the technology can work wonders when combined with mobile cameras and screens that we don't have to hold. Apple is announcing new technologies that make more sense on form factors that currently don't exist.
My full WWDC 2018 review is available for subscribers here (major themes) and here (full notes).
What's Next?
While Apple management will never admit it, the company has been thinking and looking beyond iPhone for years. The Apple Watch's ongoing march to iPhone independency is clear evidence of this post-iPhone thinking. This isn't to say that the iPhone will lose its spot as the most valuable computer in hundreds of millions of lives anytime soon. In addition, the iPhone will likely remain Apple's top revenue-generating product for some time. However, those realities don't determine Apple's post-iPhone product strategy. Management isn't driven by the goal to come up with something that is more profitable than iPhone. Instead, the focus is on coming up with something that makes technology more personal and handling new workflows that were never able to be handled by iPhone.
Last month, Mary Meeker presented the latest edition of her Internet Trends presentation. Narrowing 294 slides into one major takeaway isn't easy, but such a task was possible this year - the smartphone industry is mature, and it's time to figure out what's next. Smartphone sales are flat as the average consumer is OK with holding on to his or her smartphone for longer before upgrading.
As seen in the chart below, Apple hasn't been immune to this trend as iPhone sales have plateaued. Apple is currently selling approximately 215 million iPhones per year, and sales are likely to remain in that ballpark in the near term.
When thinking about what comes next, it's difficult to miss the rising yellow line in the preceding chart. Apple is seeing significant sales momentum in its battle for our wrists with Apple Watch and our ears with AirPods. These new form factors are successful in making technology more personal for tens of millions of people. When combining Apple Watch and AirPods sales, Apple's wearables segment will soon outsell iPad in terms of unit sales.
The next wearables battle will be for our eyes. This battle will revolve around a product that benefits from technologies currently found with ARKit, Siri, and Apple's ML efforts. Apple is setting the stage for smart glasses. A pair of smart glasses will essentially boil down to an ML playground cool looking and light enough to wear throughout the day. There's one problem for Apple: The world isn't quite ready for such a product. As Jony Ive put it a few months ago, "there are certain ideas that we have, and we're waiting for the technology to catch up."
Biding Time?
It's easy to think that Apple may simply be biding its time until the world is ready for AR glasses. However, WWDC gave us a glimpse of how Apple is busy behind the scenes, preparing for what comes next. With ARKit, Apple is using hundreds of millions of iPhone and iPads to inspire 20 million developers with the potentials found with AR. A similar dynamic is at play in getting customers comfortable with items like Animoji and Memoji - items that will likely one day be available via a pair of smart glasses.
In many ways, Apple is doing more than any other company to prepare the world for AR. Startups like Magic Leap have positioned themselves as being ambitious for wanting to control everything needed to develop a pair of mass-market AR glasses. However, Magic Leap is missing a few crucial ingredients needed for success. Unlike Apple, Magic Leap doesn't have a few hundred million devices for seeding early technologies that will eventually power a pair of smart glasses. Instead, Magic Leap is forced to conduct a portion of its R&D in public, releasing early prototype versions of AR goggles in an attempt to capture AR mind share that is increasingly flowing to Apple.
Another item that Magic Leap doesn't have, but which will prove to be incredibly useful for AR glasses, is Apple Watch. Apple has learned a significant amount about how personal technology can be worn on the body by having nearly 40 million people wear an Apple Watch on any given day. In addition, Apple Watch serves as a test bed for learning about proactive digital assistants. However, the most important aspect of Apple Watch is how the device will likely end up playing a key role in serving as a place to put tech on the body that will help power smart glasses. In fact, an argument can be made that Apple Watch will become more instrumental to Apple Glasses' success than any other Apple product.
Apple's Game to Lose
We see Apple pulling away from the competition when it comes to grabbing real estate on our wrists and ears. The company has a good shot at doing the same in the battle for our eyes. Consider the various ways Apple is well-positioned for AR glasses:
- Hardware and software integration. Apple has a few decades worth of experience while competitors have only recently realized that hardware/software integration is essential when it comes wearables.
- Controlling core technology. Apple's silicon efforts and broader ambition to control the core technologies powering its devices are giving the company a head start that will likely be measured in decades.
- Wearables manufacturing. Apple is learning a great deal about miniaturization with Apple Watch and AirPods. No other company is close to Apple in this area.
- AR technology. In just over a year, Apple has announced two major versions of its AR platform with hundreds of millions of supported devices. Years of extensive M&A activity in the AR arena is beginning to pay dividends.
- Developers. Apple has 20 million iOS developers focused on coming up with new experiences for a billion people. Companies like Magic Leap and Microsoft lack this critical piece of the equation.
- Fashion and luxury. Apple has learned a great deal about selling fashion with Apple Watch.
- Health/Medical. What may have started as an interest for Apple is turning into a strategic mission. A pair of smart glasses stand to improve the well-being of hundreds of millions of people as one of the key use cases for such a device is enhanced vision.
- Retail demoes. Apple has 502 retail stores around the world with plenty of space for glasses demoes.
There's an elephant in the AR room. This is Apple's game to lose.
Creating Tools
Five years ago, Apple management was facing growing pressure to announce something new. Wall Street and Silicon Valley were eager to see Apple unveil a new product category in the post-Steve Jobs era. To this group, the lack of a new product category from Apple meant that management was either struggling with innovation, or worse, suffering from a lack of imagination. The intense pressure to come up with something new likely played a role in Apple giving Apple Watch a huge product unveiling in September 2014.
Fast forward a few years, and Apple faces a dramatically different environment. There aren't as many calls for Apple to come up with something new following Apple Watch. Instead, Apple's ability to monetize the iPhone experience beyond hardware sales has made people think Apple is a different kind of company - one that is more focused on monetizing existing users instead of dreaming about what's next. In a way, many market observers are the ones now suffering from a lack of imagination when it comes to Apple.
Apple is a design company focused on creating tools for people. While some of those new tools may be positioned as accessories to existing products, other tools will be capable of ushering in paradigm shifts. The only way for Apple to remain relevant in the future is to disrupt itself by coming up with new tools consisting of a combination of hardware, software, and services. Such groundbreaking tools won't likely be released every two or three years. In fact, Apple may go more like five, six, or even seven years between announcing major new product categories. The point is that such paradigm shifts are needed.
Steve Jobs' quote calling for figuring out what's next and not dwelling on current success for too long was from a 2006 interview in which Jobs was asked where he sees himself within history's famous thinkers and inventors. Jobs was describing where the motivation for coming up with so many new products originated. For Apple, Jobs' quote serves as inspiration for not resting on its laurels and instead coming up with the next "pretty good" thing.
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Above Avalon Subscriptions Turn Three
Last week, I celebrated the third anniversary of launching Above Avalon subscriptions. Those who signed up on May 13th, 2015 began their fourth year as Above Avalon subscribers. In an environment where online publishing is being questioned and doubted like never before, Above Avalon subscriptions are working. Above Avalon is an independent source of Apple analysis, 100% supported by subscriptions. The lack of dependency on ads, sponsors, or other revenue streams has played a large role in what Above Avalon has become over the past few years. In addition, Above Avalon has given me a front-row seat for watching the changing Apple news industry.
Strategy
Above Avalon embraces a subscription model in which subscribers pay for access to my full analysis and perspective on Apple. Two subscription options are available: $20 per month or $200 per year. Along with publishing weekly articles and podcast episodes, which are available to everyone, I publish a daily email available exclusively to subscribers. These emails go over everything that I think matters in the world of Apple. On any given week, I will cover 10 to 12 topics, one of which is discussed in the weekly article and podcast. The remaining topics are covered in email.
Subscribers receive other benefits that include receiving the weekly Above Avalon article via email, accessing the subscriber forum in Slack (more on this down below), and utilizing an archive consisting of approximately 600 emails previously sent to subscribers.
Above Avalon is unique as a paid subscription site that focuses on analyzing one company. I am unable to name another paid subscription site that has the same objective. Most subscription sites focus on broader topics such as certain genres or entire industries. In an interesting development, the other paid subscription niche popping up has been in the sports world as writers and analysts launch sites focused on specific sports teams.
The paid subscription model for analysis is not new. Its pioneers can be traced back to the financial world in which publications sent monthly and quarterly correspondence to paid subscribers via postal mail. However, the major change that has taken place more recently is a diversification in the way we consume news and analysis. A number of independent sites, often run by one person or a small team of people, have been able to grab an increasing amount of mind share from larger, more traditional news publications and multinational research firms. This market dislocation was one reason that led me to leave Wall Street and launch Above Avalon in 2014. The harsh economics of online publishing, combined with social media and tools for accepting online payments, sending emails, etc., have made it possible for one-person operations to find their audience (i.e. sustainability) in a sea of giants.
Paid subscriptions afford me the ability to focus on quality, not quantity, when it comes to readership. There is no financial incentive for me to publish sensational articles as the primary byproduct is a temporary jump in page views. Instead, my incentive is aligned with my desire to write articles that inform, enlighten, and provide an alternate view of Apple and the world. This ends up producing trust and credibility with readers, which are important drivers for attracting new subscribers.
Over the years, I've received different versions of the same question: Why don't I expand my coverage to include companies other than Apple? There is a simple answer: As Above Avalon subscribers can attest, my coverage area is already large. Since Apple doesn't operate in a vacuum, there is a need to monitor and analyze Apple's various competitors and the industries in which the company plays. However, the difference between Above Avalon and other sites is that all of my analysis is positioned from the perspective of Apple. In my view, having it any other way tends to breed Apple cynicism given the company's unique attributes. This cynicism often leads to the conclusion that Apple's different way of approaching the world will lead to failure. In fact, unwarranted cynicism is one of the main characteristics that lead to faulty Apple analysis.
Highlights and Challenges
Highlights from the first three years of Above Avalon subscriptions include:
- Reaching sustainability. While there was a specific subscriber threshold that marked Above Avalon sustainability (reached in 2015), subsequent events over the years have served as milestones. For example, seeing the first wave of annual Above Avalon subscriptions renew back in May 2016 further validated the business model.
- Online community. One thing that I didn't necessarily expect to happen was an online community to develop around Above Avalon. The Above Avalon subscriber forum in Slack continues to see an increasing amount of interaction and discussion. Subscribers currently reside in 55 countries and hold a diverse range of backgrounds and occupations. They include Silicon Valley executives and investors, the largest Apple shareholders, and the leading Apple journalists and writers in the business.
- Member meet-ups. There have been three member-meets (two in San Francisco and one in San Jose). The fourth is scheduled for next month during WWDC. Each has been memorable as I've been able to meet subscribers and put faces to what were previously just names in email, on Twitter, or in the forum.
- Subscriber support. Since launching Above Avalon subscriptions, I've experienced quite a few life changes. My wife and I welcomed two boys into this world. Each time, the outpouring of well-wishes from subscribers has been great. However, there have also been difficult times, such as my mother's recent passing. Subscribers were there with condolences. I even received condolences via postal mail from subscribers. It may seem like a small thing, but it's something I will never forget.
The biggest challenges have been:
- New things. I'm self-taught when it comes to the world of online publishing, podcasting and videography. In my prior career, I was a Wall Street analyst. While it hasn't been easy, YouTube and Twitter have been great tools for finding answers to questions.
- Hesitancy to publish. As Above Avalon has grown in terms of readers, listeners, and subscribers, I've become more hesitant to publish on topics when my views on them are still in their fragile state. This hesitation has resulted in certain articles and podcast episodes taking a shockingly long amount of time to write and produce.
Requirements
Above Avalon is an example of a paid subscription site working. However, when it comes to the model being replicated, I don't think there is a particular recipe or path for success with paid subscriptions. While some will find success literally overnight, others may find success only after a number of years.
There are three requirements needed for paid subscription sites to work:
- A strong voice. The recurring theme found in every successful independent site, email, or podcast is that it contains a strong voice. Wishy-washy stances on positions won't go far. The strongest voices have an ability to support their opinions with facts.
- Perspective. Above Avalon subscribers aren't interested in simply reading about news events and topics that matter to Apple. Instead, subscribers want to know my perspective on those news events and topics. By having perspective, one possesses a certain kind of philosophy that transcends any particular topic or news event.
- Be the best. While "best" is subjective, in my view, being the best entails having a deep understanding of the subject matter at hand. In nearly every example of a successful subscription-based site, the founders / writers are experts in their coverage areas.
The Apple News World
Above Avalon has given me a front-row seat to the changing Apple rumors and news world, also known as the Apple blogosphere. There are three buckets:
- News / Rumor Aggregators. MacRumors, iMore, 9to5Mac, and AppleInsider are the most well-known. Others such as Cult of Mac, MacDailyNews, and MacSurfer have also been around for some time. The largest sites are characterized by having a team of writers and a business model consisting of various revenue streams (ads, sponsors, affiliate links, different forms of memberships). Many have moved into video, podcasts, and email newsletters. A vibrant online community in the form of active message boards and forums play a big role in these sites' sustainability.
- News Publications. These include Financial Times, The Wall Street Journal, The New York Times, Fast Company, CNBC, Recode, Bloomberg, Wired, The Independent, BuzzFeed, The Verge, and *insert your favorite news publication that covers Apple news here*. Most of these sites have one or two correspondents who write about Apple. However, it is becoming rare for news publications to have Apple-exclusive writers. Business models vary in this group but have increasingly been moving towards paid subscriptions. Only a select number of these sites have vibrant online communities.
- Curators / Analysis / Research. Above Avalon, Daring Fireball, Asymco, Stratechery, MacStories, Tech.pinions, Six Colors, The Loop, Apple 3.0, TidBITS, Wall Street sell-side firms, podcast-only ventures, YouTubers, industry research firms, VC firms, and popular Twitter personalities are included in this category. There is much diversity in this group. Some write exclusively about Apple while others write and talk about Apple from time to time. Meanwhile, others use Apple as a way to analyze broader business and disruption theories. Business models run the gamut and include everything from ads and sponsors to paid subscriptions, donations, and affiliate links. Other sites and accounts are run strictly for marketing purposes. Communities tend to play a major role in these sites.
While some sites have tried to play in more than one bucket, few have found success. News and rumor sites have made few inroads in terms of analysis and research while analysis sites have generally stayed away from the tough business of breaking news and scoops.
Over the years, there have been a number of major changes in the Apple blogosphere:
News / rumor aggregators have grown up and gained legitimacy. After years of rocky relations, Apple basically treats the leading Apple news and rumor aggregators like any other news organization. Aggregators have achieved sustainability by broadening coverage to include pretty much everything that is in some way connected to Apple or the large iOS ecosystem. In addition, each runs with super lean operating budgets. The stories themselves likely don't pay the bills. Instead, it's the repeat visitors that are interested in the comment sections and forums. Each publication relies on podcasts and video as ways to maintain mindshare in each respective news medium.
Apple rumor / scoop industry has dried up and consolidated. Ten years ago, there were a number of news publications that were in a legitimate position to break the next Apple scoop (some of which were likely controlled leaks from Apple). Today, there are only two or three sites that even publish Apple scoops. The consolidation in Apple scoops has been driven by Apple ramping up the amount of secrecy regarding unannounced projects. In addition, Apple "scoops" have increasingly come from research firms paying for confidential information coming out of Apple's supply chain. One byproduct of this rumor consolidation has been a relatively high degree of turnover among Apple reporters.
Ad-supported business models are struggling. It is becoming more difficult to find ad-supported business models on the web. While there are likely a few reasons for this change, one includes ad dollars being funneled away from blogs and into podcasts and videos. This explains what appears to be an exodus of resources away from written blogs and into podcasts and video-focused efforts. Unfortunately, my suspicion is this won't end well for many as increased competition in the podcast and video space will tend to push sponsors to those with the largest followings. Such an environment would make it increasingly difficult for independent ventures to find sustainability by chasing scale.
Paid news sites boost independents. Most news publications have embraced paid subscriptions as another way of boosting revenues. While a paid subscription to a multinational news organization may make sense for many readers, the value / price tradeoff becomes murky for readers interested in specific topics and niches. For example, the average news publications will only write about Apple once a week (if that much). This environment provides an even greater amount of oxygen to independent sites that can give the time and attention to niche subjects.
Donation / support route isn't promising. The transition from ad-supported business models to subscription-based models hasn't been easy for many independent sites. Going from a scenario in which all content was public to one in which only a fraction of content is public can be jarring. Most sites have handled this transition by keeping content free and instead giving paid subscribers a very marginal amount of exclusive content. In essence, sites are treating subscriptions and memberships like donations. This is not sustainable for or attractive to subscription-based models.
Exciting Times
It's never been easier to start a paid subscription site. This reality has made it harder than ever to get a paid subscription site off the ground. While barriers to entry have been lowered in many content-focused genres, including blogs, YouTube, and podcasting, discovering your audience is becoming more challenging. At the same time, competition is intensifying. It's not realistic to assume the average consumer will subscribe to dozens of paid sites. However, there is no such thing as an "average" consumer. Instead, every consumer will subscribe to a different portfolio of paid sites. As an independent, the job is to earn a spot in some of those portfolios.
As I enter the fourth year of paid subscriptions, a big thank you goes out to Above Avalon subscribers. The past three years have been great and I'm looking forward to many more. I don't think there has been a better time to examine Apple.
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The Apple Services Machine
Apple's services business is remarkably strong yet surprisingly mysterious. A closer look at Apple Services reveals an apparatus, which can easily qualify as a Fortune 100 company, that isn't what it seems from the outside. Apple isn't becoming a services company focused on coming up with a myriad of ways to milk existing users. Instead, Apple's services strategy primarily reflects the company's long-held ambition of becoming a leading content distribution platform.
Momentum
Services represent Apple's second-largest revenue source behind iPhone. In 2017, Apple reported $31 billion of Services revenue, which represented 13% of overall revenue. As seen in Exhibit 1, Apple Services revenue has experienced steady growth for years.
Exhibit 1: Apple Services Revenue (TTM)
In recent quarters, Apple's services business has seen renewed momentum. As shown in Exhibit 2, Services revenue growth began accelerating in late 2015 and is now at multi-year highs. The growth likely coincided with very strong new user trends for the iPhone business. An acceleration in growth despite Apple's already large Services revenue base is that much more impressive.
Exhibit 2: Apple Services Revenue (TTM) Growth
The Services Machine
Services is a financial catch basin for Apple's non-hardware revenue. As disclosed in Apple's financial filings, Services consists of five categories: digital content, iCloud, AppleCare, Apple Pay, and licensing.
Exhibit 3: The Apple Services Machine
Digital content. This includes revenue from Apple's various content stores, including the App Store and iTunes. Apple Music is also included in this category. While Apple doesn't disclose the total amount of revenue associated with selling digital content, the company has provided the amount paid to app developers on an annual basis. This data point makes it possible to derive the total amount of App Store revenue. In addition, Apple regularly discloses the number of paid Apple Music subscribers, which can be used to derive Apple Music revenue.
iCloud. Apple offers three tiers of additional iCloud storage (50GB, 200GB, and 2TB). Prices vary depending on the geography. The 200GB and 2TB storage tiers are eligible for family sharing. While Apple has not disclosed the number of users on a paid iCloud storage plan, management recently disclosed that iCloud revenue was up over 50% year-over-year to a record high, which implies good new user growth.
AppleCare. Apple sells a number of service and support options for its products.
Apple Pay. Apple earns a small percentage of every amount transacted through Apple Pay. Initial reports pegged this percentage at 0.15% for U.S. transactions. For every $100 of Apple Pay purchases in the U.S., Apple earns 15 cents. However, in the UK, Apple reportedly receives a smaller fee. Given Apple Pay's prominence outside the U.S., a safe assumption is that Apple earns on average less than 0.15% of every Apple Pay transaction.
Licensing and other services. Apple earns revenue from third parties for offering their services as default options on Apple devices. One of the more well-known examples is Apple's contract to have Google be the default search provider for Safari on Mac and iOS. Apple recently expanded its Google relationship to include Google for web searches via Siri and YouTube for video searches. Microsoft Bing remains the option for Siri image searches.
Estimating Services Revenue
Apple doesn't disclose the amount of revenue generated by each Services category. However, after sifting through years of earnings call transcripts as well as recent news releases involving the App Store and Apple Music, it is possible to put together a few pieces of the Apple Services puzzle.
According to my estimates, Apple earns a majority of its Services revenue from delivering content to nearly a billion people using more than 1.3 billion Apple devices. In 2017, Apple earned an estimated $21 billion from selling digital content ranging from apps (especially games) to music and movies.
Back in January, Apple disclosed that it paid $26.5 billion to app developers in 2017. Apple keeps either 15% or 30% of app revenue, depending on the app and whether it is a subscription. This suggests that overall App Store revenue was approximately $37 billion. Since Apple reports App Store revenue on a net basis, recognizing only the commission it retains, the full $37 billion of App Store revenue is not reflected under Services. Instead, Apple reports just its $11 billion share of the revenue.
The remaining portion of Apple's digital content revenue came from iTunes and Apple Music. Apple reports Apple Music revenue and some digital content sold through iTunes on a gross basis. This results in iTunes and Apple Music representing a large portion of Services revenue despite bringing in significantly less revenue than the App Store. In fact, iTunes and Apple Music likely contribute close to the same amount of Services revenue as the App Store.
Exhibit 4: Apple Services Revenue Mix (2017)
To put the preceding revenue totals in context, Apple Watch generated $6.5B of revenue in 2017.
The primary reason Apple has experienced accelerating Services revenue growth since late 2015 is that the company has seen a dramatic increase in the number of people accessing its various content stores. The iPhone installed base grew by more than 100 million people each year from 2013 through 2017. These new users are spending an increasing amount of money buying various forms of content through Apple's stores.
One of the more interesting revelations from my estimated Apple Services revenue mix is the degree to which licensing is a key revenue driver. My estimate has Apple earning $4 billion per year from licensing. While Apple doesn't discuss its licensing business, recent reports of Google paying much higher TAC (traffic acquisition costs) suggests Apple has seen strong growth in its licensing revenue. The growth is a result of iOS gaining power at the premium end of the smartphone market. Companies like Google increasingly need access to iPhone users in order to feed their free data capturing services. According to my estimates, the $4 billion of revenue associated with licensing is roughly the same amount of revenue generated by AppleCare.
While Apple has built new services revenue streams in the form of iCloud and Apple Pay, neither come close to matching the revenue associated with content distribution. Given the economics surrounding Apple Pay, it's not likely the service will be a significant revenue driver for Apple in the near term. For every $1 trillion transacted through Apple Pay, Apple would generate just $1.5 billion. As for iCloud, while management boasts about record revenue, the total likely pales in comparison to content distribution.
Estimating Services Gross Margin
In addition to not breaking out Services revenue by category, Apple management has kept Services margins under wraps. We know from management commentary that Services end up boosting Apple's overall gross margins. This is a major clue suggesting Services gross margin exceeds 40%. One way of reaching a more specific Services margin estimate is to look at each revenue driver.
Exhibit 5: Apple Services Gross Margin Mix (2017)
As shown in Exhibit 5, each Services category has a different gross margin. Licensing is likely the most profitable for Apple, followed by Apple Pay and iCloud. Extended warranties, such as AppleCare, are also highly profitable. The fact that Apple reports some iTunes revenue and Apple Music revenue on a gross basis weighs on digital content gross margins. Overall, my estimate is that Apple's services business has a 55% gross margin.
The Services Strategy
Apple's services strategy is misunderstood. Many have looked at Apple's services momentum and concluded that Apple is turning into a services company. In addition, a growing number of people are positioning services as Apple's future. Neither viewpoint is true.
Apple has been pursuing two goals with services:
Deliver Content. Apple has a long-standing ambition of leveraging its platforms in order to become a leading content distributor for apps, music, books, podcasts, and video. To claim that Apple has only recently begun to focus on earning revenue from delivering content is incorrect.
Increase Hardware Value and Functionality. Management looks at services as a key differentiator that increases the value found in using Apple hardware and software. Services like AppleCare, iCloud storage, and Apple Pay are designed to improve the experience found in using Apple hardware and software.
A recurring theme found with Apple Services is hardware dependency. Apple's ambition to be a content distributor is intertwined with its hardware capabilities. Without more than 1.3 billion devices in the wild, Apple's digital content revenue would be a fraction of its current size.
In addition, AppleCare, Apple Pay, iCloud, and licensing are also heavily dependent on the number of Apple devices in the wild. It is this hardware dependency that makes it impossible to look at Apple Services as a stand-alone business. The relationship between services and hardware is one reason why an Apple Services narrative on Wall Street hasn't been able to stick. The Services narrative isn't compelling if it excludes Apple hardware from the equation.
Apple's future isn't about selling services. Rather, it's about developing tools for people. These tools will consist of a combination of hardware, software, and services.
Looking Ahead
Apple management recently reiterated its goal of reaching approximately $50 billion of Services revenue by 2020. The most likely way Apple will reach this goal is by growing the amount of revenue associated with digital content distribution. App Store revenue has been growing by approximately 30% per year. Assuming Apple Music revenue growth more than offsets a decline in paid music downloads, Apple stands to grow its digital content revenue by at least $15 billion over the next two years. This will push Apple very close to its $50 billion Services revenue goal by 2020. These calculations don't take into consideration any new content subscription offerings from Apple.
Apple currently has more than 270 million paid subscriptions across its services, up over 100 million year-over-year. My suspicion is that a good portion of those subscriptions are content subscriptions. Apple is currently developing two new paid services for delivering content: Apple Video and a paid tier to Apple News. Each service will likely be given a long-term target of having at least 100 million paying users. In addition, Apple is in a good position to benefit from growing momentum for video streaming services including Netflix, HBO, and Hulu. It is not a stretch to claim that Apple will one day have 500 million paid subscriptions across its services.
Apple isn't becoming a services company. Instead, Apple is building a leading paid content distribution platform.
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Apple 2Q18 Earnings Expectations
Wall Street has major jitters when it comes to Apple's upcoming earnings release. Sentiment has decidedly swung toward the negative as questions swirl around iPhone X demand. Despite the dramatic downturn in expectations, Apple's stock price has held up remarkably well. While many eyes will be on iPhone sales tomorrow, my suspicion is that the data point won't have as much influence as consensus assumes. Instead, Apple's capital return update has the potential to be the major takeaway from 2Q18 earnings.
The following table contains my Apple 2Q18 estimates. The ingredients are in place for Apple to report a slight EPS beat to consensus although 3Q18 revenue guidance will likely come in below consensus.
My full perspective and commentary behind these estimates are available to Above Avalon subscribers. (Become a subscriber to access my full 5,000-word Apple 2Q18 earnings preview available here. To sign up, visit the subscription page.)
Items Worth Watching
Here are the five variables worth watching when Apple releases earnings on Tuesday:
iPhone Channel Inventory. Given prior management commentary, iPhone unit sell-through growth and iPhone average selling price don't represent the major wildcards for 2Q18 earnings. Instead, the big unknown is found with iPhone channel inventory. A significant channel inventory drawdown will result in Apple reporting iPhone unit sales closer to 50M units. Vice versa, a relatively minor decline in iPhone channel inventory may lead to Apple reporting iPhone sales slightly ahead of my 52M unit expectation.
iPad ASP. The days of dramatic iPad unit sales declines are over. Accordingly, instead of unit sales, average selling price (ASP) stands to provide much more information regarding the latest iPad trends. A weaker-than-expected iPad ASP may support the view that the 9.7-inch iPad at the low end of the line is likely gaining momentum at the expense of the higher-end iPad Pro options.
Other Products. Apple's "Other Products" category has the sales momentum. The line item includes various products such as Apple Watch, AirPods, HomePod, Beats headphones, iPod touch, and Apple-branded and third-party accessories.
3Q18 Guidance. Apple's 3Q18 revenue guidance will likely provide a few clues as to how iPhone demand has been trending. One complicating factor when it comes to revenue guidance is that Apple's non-iPhone part of the business is seeing major momentum. iPhone weakness will be partially offset by strength in Other Products and Services.
Capital Return. Apple will announce changes to its capital return program. My expectations are for a $100 billion increase to share buyback authorization and a 20% increase to the quarterly cash dividend. Management commentary regarding timing associated with share repurchases will be closely monitored.
2Q18 Expectation Meters
Each quarter, I publish expectation meters ahead of Apple's earnings release. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's quarterly performance.
In each expectation meter, the grey shaded area is my expectation range. A result that falls within this range signifies that the product or variable being measured is performing as expected. A result in the green shaded area denotes strong performance and likely leads me to raise my assumptions and estimates going forward. Vice-versa, a result in the red shaded area has the opposite effect and leads me to reduce my assumptions.
I am publishing three expectations meters this quarter: iPhone unit sales, Other Products, and 3Q18 guidance.
My iPhone unit sales expectation range stretches from 50M to 54M iPhones. iPhone unit sales within this range would be labeled as expected. If Apple reports iPhone sales greater than 54M units, results would best be described as strong. A sub-50M iPhone result would lead me to reassess my sales expectations going forward.
For "Other Products," revenue that exceeds $4 billion would support the view that Apple Watch and AirPods were strong sellers during the quarter. HomePod sales will also likely contribute to the year-over-year growth in revenue.
Revenue guidance that exceeds $50 billion would likely be viewed positively while revenue closer to $45B would be viewed negatively. It is likely that Apple's 3Q18 revenue guidance will reflect a year-over-year revenue increase. The increase is due to momentum in Services and Other Products.
Above Avalon subscribers have access to my full 5,000-word Apple 2Q18 earnings preview (four parts):
- Setting the Stage
- iPhone Estimates
- iPad, Apple Watch, Mac, Services Estimates
- Revenue, EPS, Capital Return, 3Q18 Guidance
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Making the Case for Doubling Apple's Share Buyback Pace
Next week, Apple will provide an update to its capital return program. In what has become an annual tradition, the announcement will include a sizable increase to Apple's share repurchase authorization and a hike in the quarterly cash dividend. Given recent management commentary, Apple's overall thought process regarding capital allocation is already known. The only way Apple will be able to accomplish its capital return goals is by doubling the pace of share buyback from current levels.
Capital Return Update
For the past five years, Apple has used FY2Q earnings to announce updates to its capital return program. Here are the changes Apple announced to its share buyback authorization over the years:
2012: $10 billion buyback authorization
2013: $60 billion (increase of $50 billion)
2014: $90 billion (increase of $30 billion)
2015: $140 billion (increase of $50 billion)
2016: $175 billion (increase of $35 billion)
2017: $210 billion (increase of $35 billion)
In terms of the quarterly cash dividend, Apple has announced five increases over the years:
2012: $0.38 per share
2013: $0.44 (15% increase)
2014: $0.47 (8% increase)
2015: $0.52 (11% increase)
2016: $0.57 (10% increase)
2017: $0.63 (11% increase)
Excess Cash
In order to assess the most likely changes Apple will announce next week to its share buyback authorization and quarterly cash dividend strategy, we turn to recent comments from Apple CFO Luca Maestri:
"Tax reform will allow us to pursue a more optimal capital structure for our company. Our current net cash position is $163 billion. And given the increased financial and operational flexibility from the access to our foreign cash, we are targeting to become approximately net cash neutral over time."
Maestri's comments tell us three things:
Apple considers its current excess cash position to be $163 billion. After taking into account repatriation taxes, Apple's excess cash totals approximately $125 billion.
Apple wants to remove the vast majority of this excess cash from the balance sheet in order to reach "a more optimal capital structure." This isn't a management team that will sit on the excess cash indefinitely.
Apple's "net cash neutral" target implies management is okay with holding debt on the balance sheet. It's not likely that Apple will use excess cash to reduce its debt obligations significantly.
In addition to holding $125 billion of excess cash (after taxes), Apple is also kicking off significant amounts of cash. A successful capital return strategy needs to account for this ongoing cash flow generation. The company is currently generating approximately $50 billion of free cash flow per year. This total reflects approximately $60 billion of operating cash flow per year and between $10 billion and $15 billion spent on property, plant, & equipment. Over the next five years, it is conceivable that Apple will generate more than $200 billion of free cash flow. Management has been funneling nearly all of its free cash flow into capital return initiatives.
Combining Apple's $125 billion of excess cash currently on the balance sheet with its $200 billion of free cash flow generation, Apple is on track to have $325 billion of excess cash over the next five years. Without record-breaking increases to share buyback authorization and quarterly cash dividends, Apple will have trouble spending this excess cash prudently in a timely manner. Since 2012, Apple has spent just shy of $250 billion on capital return initiatives. Assuming Apple maintains its current share buyback pace and cash dividend payouts, it would take Apple close to ten years to spend $325 billion of excess cash. Big changes are needed in order for Apple to reach an optimal capital strategy in a reasonable amount of time.
Changes
Apple has a number of options at its disposal when it comes to spending $325 billion of excess cash over the next five years. The company can utilize mechanisms like a Dutch auction tender offer to repurchase a significant number of shares in a very short amount of time. There are also various cash dividend strategies that management can follow involving special dividends. However, the odds of Apple utilizing such strategies are not high. Instead, Apple will likely follow its existing capital return strategy but at much higher levels. Such a strategy is realistic, achievable, and financially prudent for shareholders.
One possible path Apple can follow includes announcing the following changes next week:
Increase share buyback authorization by $100 billion (would represent a record increase).
Increase the quarterly cash dividend by 20% to $0.75 per share (would represent a record increase).
Buyback Changes
Apple is currently buying back approximately $30 billion of shares per year. While this is a significant amount for any company to spend on share repurchases, Apple will have to materially increase this buyback pace to spend its excess cash in a timely manner. At the same time, there are limits as to the number of shares Apple can realistically buy back before distorting the market. (My Apple stock buyback program primer is available for Above Avalon subscribers here.)
Increasing share buyback authorization by $100 billion would give Apple the best of both worlds: the ability to buy back substantially more shares over the next two years while avoiding much market dislocation. In fact, a $100 billion authorization would allow Apple to double its buyback pace to $60 billion per year. Given Apple's daily trading volume, a $60 billion annual share buyback pace amounts to about 10 days of AAPL buying pressure. In subsequent years, Apple could announce smaller increases to buyback authorization in the range of $50 billion to $75 billion. This would be done to maintain the $60 billion per year buyback pace.
As shown in Exhibit 1, Apple can continue to utilize both open market transactions and accelerated share repurchase arrangements (ASRs) to buy back shares. The ramp in buyback from 2017 to 2020 reflects the amount of time Apple will utilize to bring back foreign cash to U.S. subsidiaries.
Exhibit 1: Apple Share Buyback
In the above scenario, Apple will have spent $275 billion on share buyback over the next five years. While Apple could certainly announce a larger increase to share buyback authorization next week such as $125 billion or even $150 billion, it's not likely that such authorization would result in a significantly higher buyback pace as Apple must still back its foreign cash to U.S. subsidiaries. In addition, a significant higher pace of share buyback would begin to raise questions about market dislocation.
Dividend Changes
A scenario that includes doubling its share buyback pace will have a major impact on Apple's dividend strategy. The company has been following a dividend strategy of conservative year-over-year increases in dividend expense. Due to the share buyback program, Apple has been able to grow dividends per share by larger margins each year given the reduction in the number of shares outstanding. Whereas Apple's dividend expense has increased by 21% since 2013, Apple's quarterly cash dividend has increased 66% during the same time period.
By ramping share buyback to $60 billion per year and increasing dividend expense gradually to $16 billion per year in 2021 (from the current $13 billion a year), as shown in Exhibit 2, it is possible for Apple to increase its quarterly cash dividend per share by as much as 80% over the next five years. In this scenario, Apple's dividend expense would increase by only 25% during the same time period.
Exhibit 2: Apple Dividend Expense
In the above scenario, Apple will have spent close to $75 billion on dividend expense over the next five years. The exact magnitude of Apple's dividend increase will be dependent on the price at which the company buys back its shares in the coming years. However, there is no question that Apple's quarterly cash dividend stands to benefit from a large increase in share buyback pace. An 80% increase over five years would bring Apple's quarterly cash dividend to $1.10 per share by the end of 2022.
Summary
Apple's balance sheet objective is to reach an optimal capital structure by giving excess cash back to shareholders. This goal will be achieved via the continued use of share repurchases and quarterly cash dividends. Following U.S. corporate tax reform, and assuming continued robust free cash flow generation, Apple will possess as much as $325 billion of excess cash over the next five years.
As shown in Exhibit 3, a realistic and prudent way for Apple to remove this excess cash from the balance sheet is to double the pace of share buyback (from $30 billion to $60 billion) while gradually increasing the amount spent on dividend expense over time.
Exhibit 3: Apple's Capital Return Program
By spending $75 billion per year on capital return initiatives, up from the current $45 billion per year pace, Apple will be on track to spend more than $325 billion of excess cash in order to reach an optimal capital structure.
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Apple Found a Wall Street Narrative
After months of iPhone sales estimates being slashed by analysts, expectations have been reset. The iPhone mega upgrade cycle of 2018 that so many were calling for is not going to happen. One assumes such a reset would have been accompanied by a significant decline in Apple's stock price. Instead, Apple shares have outperformed the market and continue to trade near all-time highs. The resiliency in Apple's stock price reflects the company finally finding a narrative on Wall Street, and it's not centered on the iPhone. Apple has become a capital allocation story.
Narratives
Narratives matter on Wall Street. A compelling and easy to understand narrative allows companies to navigate rough waters such as a disappointing earnings report. Amazon and Netflix currently possess some of the strongest narratives on Wall Street. Amazon is all about coming up with the best retail experience for customers. Wall Street is OK with Amazon funneling a good portion of its operating cash flow back into the business with the intention of becoming a better retailer. Netflix is focused on delivering a superb entertainment experience in which subscriber dollars are used to fund additional video content. Profits are not as important as subscriber growth.
Apple has long struggled with Wall Street narratives. A good argument can be made that Apple has never had a true Wall Street narrative. Instead, the company was judged merely by unit sales growth of whatever its best-selling product was at the time. This posed a challenge as unit sales growth will inevitably slow. In addition, a narrative revolving around unit sales growth ignores attributes that make Apple's business model unique. Apple is viewed merely as a hardware company.
In early 2016, Apple management began disclosing new data points in an attempt to find a Wall Street narrative and in the process, get investors to think about the company differently.
Installed base related purchases. Instead of relying on the Services line item to denote the amount of revenue driven by Apple's installed base, management disclosed the amount of installed base related purchases. The much-higher total included revenue retained by third-party app developers and digital content owners.
Number of paid subscriptions. In an effort to demonstrate Apple's ability to monetize the iOS base beyond hardware sales, management began disclosing the number of paid subscriptions across Apple's various services. The data point also reinforced the idea of Apple possessing a stream of consistent revenue.
Number of devices in use. Apple disclosed the total number of devices in use to highlight the strength of its ecosystem.
While a narrative revolving around services or ecosystem strength seems attractive for Apple, the stories contain major holes. A significant portion of Apple's Services revenue is tied to growth in the iPhone installed base. According to my estimates, Apple has grown the iPhone installed base by more than 100 million users per year since 2013. Once this new user growth slows, which has already begun to occur, Apple's Services revenue growth will likely face a headwind.
A narrative involving the Apple ecosystem and the number of devices in use addresses some of the downsides found with a services narrative. Even in an environment of slowing product sales, the number of active devices in use could still increase. However, an ecosystem narrative lends itself to Apple being judged by growth rates in terms of the number of devices in the wild. Both narratives lack sustainability. In addition, neither is able to capture the attributes that make Apple unique.
Stock Price Outperformance
Evidence is building that Wall Street has begun looking at Apple differently. As shown in Exhibit 1, Apple's stock price began to outperform the market in 2017. Apple shares were up 48% in 2017, more than double that of the S&P 500. Apple has continued to outperform the broader market in 2018 despite a sharp increase in market volatility.
Exhibit 1: AAPL vs. S&P 500
Many look at Apple's recent stock price outperformance as a sign that Apple management's efforts to weave a new narrative are working. Wall Street must be paying more attention to Apple Services or the broader Apple ecosystem. In addition, lofty iPhone sales expectations leading up to the iPhone X launch were repeatedly cited in the press as driving Apple's stock price increase in 2017. None of these explanations for Apple's stock outperformance sit well with me. Instead, there's likely something else at play.
A New Narrative
In July 2017, two months before the iPhone 8, 8 Plus, and X were announced, I published "Wall Street Has Begun to Think About Apple In a New Way" with the following thesis:
"The iPhone no longer has the same kind of influence over Apple shares as it once did. Instead, Apple has turned into a balance sheet optimization story on Wall Street. Apple's growing net cash balance (now standing at an all-time high of $158 billion) has taken the place of iPhone unit sales growth as the most influential variable impacting Apple shares."
With no new evidence disproving my theory, it is time to expand on my thinking. Apple has found a narrative revolving around capital allocation. Instead of iPhone sales or Apple Services revenue gaining importance, Apple's balance sheet strategy is driving the company's new Wall Street narrative.
There are three core tenets to Apple's capital allocation narrative:
Superb cash flow generation. Apple's business model predisposes the company to superior cash flow generation. Apple is able to monetize premium experiences more effectively and efficiently than anyone else. Instead of chasing scale, Apple sells tools that management think people will want and are willing to pay for. Scale ends up being merely a byproduct of a successful strategy. Apple is generating more than $60 billion of operating cash flow per year.
Capital efficiency. Apple's business model is remarkably efficient in terms of the amount of capital required to generate these cash flows. Instead of owning a complex web of factories, Apple has built a network of third-party suppliers and assemblers that are second to none. In addition, the company remains focused when it comes to funding capital expenditures for organic growth. As a result of these actions, Apple reports more free cash flow than Alphabet, Facebook, and Amazon combined.
Returning excess capital to shareholders. Given such strong free cash flow generation, Apple is kicking off more cash than management needs to fund growth opportunities. Instead of sitting on the excess cash or spending the cash on unattractive projects, management has shown the willingness to return excess cash to shareholders via share repurchases and quarterly cash dividends.
Apple is a capital utilization machine spitting out more than $50 billion of free cash flow every year, nearly all of which will be used to fund the company's capital return program. This capital allocation narrative is not driven by any one product. Weaker iPhone sales won't derail the narrative. In addition, new revenue streams such as Apple Watch, AirPods, or growth in Apple Services don't represent holes in the narrative. Apple's new narrative is all about management's unique philosophy regarding how shareholder capital is used to generate future cash flows. Stronger product sales will lead to additional cash flows and consequently more cash for buyback and cash dividends. The opposite will be true as well with weaker product sales leading to a reduction in cash flow and less cash for share repurchases and cash dividends.
At its core, Apple's capital allocation narrative describes the company as a design-led organization tasked with developing tools for people. Apple doesn't develop products to drive revenue. Instead, many ideas are passed over to focus on a few really great ideas. Maintaining a focused product line and working closely with contract manufacturers on new processes to build products are key attributes of Apple's design culture. A narrative involving Apple's capital strategy rather than any story based on one particular product like iPhone or iPad ends up doing a better job of describing the company's design story.
Implications
There are a number of implications found with Apple possessing a capital allocation narrative on Wall Street.
Quarterly iPhone sales won't matter as much. While there will continue to be value in monitoring iPhone sales trends, Wall Street will increasingly not care about the quarterly gyrations in iPhone unit sales growth. This is my theory for why negative iPhone reports have simply been tossed aside by the market.
The level of free cash flow will gain influence. The emphasis won't be on any one particular product but rather on the collective result of new products such as Apple Watch, AirPods, HomePod, and new services contributing to Apple's overall cash flow picture. It is certainly possible that wearables and Services revenue growth will offset any weakness in the iPhone business.
Apple's capital return program will continue to matter. New disclosures related to Apple's share buyback and cash dividends have the potential to move the share price higher or lower depending on how new revelations compare to expectations.
New initiatives may be judged more strictly. Traditionally, Wall Street hasn't cared much about new Apple products and initiatives since they were financial rounding errors next to iPhone. However, with a capital allocation narrative, increased attention may be given to new strategies that have the potential to change Apple's thought process regarding capital and the balance sheet.
Apple's capital allocation narrative has also led to changes in the way the market is valuing Apple shares. As shown in Exhibit 2, Apple's stock price is up more than the percentage increase in market cap. This is likely due to two factors: The market is valuing Apple's future cash flows at a higher multiple, and Apple's cash on the balance sheet is being priced differently since the share buyback program was launched. Both developments are likely a result of Apple's capital allocation strategy taking hold.
Exhibit 2: AAPL vs. Apple Market Cap vs. Apple Enterprise Value
Nearly all of the increase in Apple's enterprise value over the past five years has come from the market attaching a higher valuation to Apple's future cash flows (i.e. a higher market capitalization). Apple shares are currently trading at a 13.5x forward price to earnings multiple. Two years ago, this multiple was closer to 10.5x. Apple has experienced a nearly 30% increase in valuation multiple.
As shown in Exhibit 3, Apple's market capitalization and enterprise value are up by approximately $330 billion since the beginning of 2016. These are significant moves that are indicative of a major shakeup in Apple's shareholder base and the market's view of the company. Investors are focused on Apple's ability to generate significant free cash flows and then return excess cash to shareholders via share repurchases and cash dividends.
Exhibit 3: Apple Market Cap vs. Apple Enterprise Value
Offsetting Pessimism
Despite the sharp increase in share price and valuation, Apple shares are still trading at a 20% discount to the S&P 500 when comparing forward price-to-earnings multiples. Some of this valuation discount may be due to Apple's capital allocation narrative not being as simple as other stories on Wall Street. However, the more likely reason is that the narrative is polarizing. Not every investor or market participant is behind Apple's story. Some investors may not have confidence in Apple's ability to continue generating robust levels of free cash flow. Various theories involving greater competition or Apple's inability to innovate can lead to more pessimistic cash flow projections. This is where the impact from Apple's share repurchase program enters the discussion.
Apple has likely seen massive turnover in its investor base since launching its share buyback program. Over the past four years, Apple has used share repurchases to reduce the number of shares outstanding by 23%. Stories are everything on Wall Street, and Apple is using its share repurchase program to buy back shares from existing shareholders not buying into Apple's capital allocation story. Apple has been the largest buyer of Apple stock in recent years thanks to the share buyback. There is no question that this dynamic has likely played some role in Apple's stock price outperformance.
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