Expectation Meters for Apple's 1Q20 Earnings
My expectation is for Apple to report good 1Q20 results as the company benefits from a wearables platform that is gaining momentum with consumers around the world. Apple wearables are positioned to be the top story when the company reports 1Q20 earnings tomorrow.
Apple’s 1Q20 results and 2Q20 guidance may contain some financial noise. Accounting related to Apple's TV+ promotion and AirPods Pro supply issues will likely result in some revenue being pushed off to subsequent quarters. Meanwhile, anxiety surrounding coronavirus may add some complexity when it comes to Apple’s revenue guidance range for 2Q20.
My 1Q20 Estimates
The following table contains my estimates for Apple’s 1Q20 and revenue guidance for 2Q20.
An in-depth discussion of these estimates, including the methodology and perspective behind the numbers, is found in my 3,900-word Apple 1Q20 earnings preview available here. Above Avalon membership is required to read my earnings preview.
In what has become a quarterly tradition at Above Avalon, I publish expectation meters ahead of Apple's earnings. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's business performance.
Ahead of Apple’s 1Q20 earnings, I am publishing three expectation meters:
iPhone Revenue
Wearables / Home / Accessories Revenue
2Q20 Revenue Guidance
iPhone Revenue
In each expectation meter, the number found in the white shaded box reflects my official single-point estimate. A result that falls in the gray shaded area would be considered near my estimate. This signifies that the product or variable being measured is pretty much performing as expected. A result that falls in the green shaded area denotes strong performance and the possibility of me needing to raise my expectations for that particular item going forward. Vice versa, a result falling in the red shaded area denotes the possibility of needing to reduce my expectations going forward.
As shown below, my expectation is for Apple to report $51.9 billion of iPhone revenue for 1Q20. A result within $51.5 billion to $52.5 billion of revenue would be considered near my expectation. An iPhone revenue result that exceeds $52.0 billion would signal the iPhone business has officially returned to growth after four quarters of revenue declines.
Wearables / Home / Accessories Revenue
Apple’s “Wearables / Home / Accessories” catch basin stands to be the most intriguing product category when it comes to 1Q20 results. The category includes revenue from AirPods, Apple Watch, Beats, Apple TV, HomePod, iPod touch, and various Apple-branded and third-party accessories.
There are three primary revenue growth drivers in this segment (in the following order): AirPods, Apple Watch, and accessories. Each driver looks to have had a good 1Q20.
In what ends up saying a lot about today’s Apple, the “Wearables / Home / Accessories” category is well-positioned to be the top driver of the company’s year-over-year revenue growth (+$4 billion), exceeding Services year-over-year revenue growth (+$2 billion) by a wide margin.
As shown below, my expectation is for Apple to report $11.3 billion of revenue in “Wearables / Home / Accessories” with AirPods and Apple Watch responsible for the vast majority of that revenue.
2Q20 Revenue Guidance
Sell-side consensus expects Apple to report $62.5 billion of revenue in 2Q20. My estimate is for Apple to announce 2Q20 revenue guidance in the range of $57.5 billion to $60.5 billion. This range is a bit low as it includes a $2 billion negative impact from coronavirus in China. One near-term risk facing Apple in China is coronavirus resulting in less customer demand due to the various travel restrictions and reduction in retail foot traffic. While there are ways of mitigating those potential headwinds, Apple may not be able to escape without some impact.
Close attention to management commentary will be required when it comes to assessing whether or not guidance reflects coronavirus risk factors. In the event that Apple sees no discernible impact from coronavirus, having the low end of management’s 2Q20 revenue guidance end up closer to $60B would be considered a good result.
My full 3,900-word Apple 1Q20 earnings preview, along with my working Apple earnings model (an Excel file that also works in Numbers), are available here. Above Avalon membership is required to read the earnings preview. Access to my Apple earnings model is available to Above Avalon members at no additional cost.
My earnings review will be sent exclusively to Above Avalon members after Apple reports. To have the review sent directly to your inbox on Wednesday morning (ET), sign up at the membership page.
Above Avalon Podcast Episode 162: The Apple Question
At the start of a new year, there is less value found in coming up with predictions than there is in looking at questions facing the company. In episode 162, Neil goes over his list of questions for Apple in 2020, and the discussion culminates with one overarching question that covers Apple’s largest challenge and opportunity. Additional topics include why predictions contain so little value, the number of Apple users, and Apple in emerging markets.
To listen to episode 162, go here.
The complete Above Avalon podcast episode archive is available here.
The Big Question Now Facing Apple
Predictions are nothing more than attempts at manufacturing clarity for what is inherently a sea of unknown. With New Year predictions, two things need to happen. The person issuing the prediction needs to come up with what may happen, and the predicted event has to occur within an arbitrary time period. The probability of finding value in such an exercise is low.
Instead of coming up with predictions for Apple at the start of a new year, there is value found in embracing the unknown and looking at questions facing the company. This has led to my annual tradition of coming up with a set of questions facing Apple at the start of a new year. The irony found with questions is that asking the right ones is equivalent to coming up with a surf board for successfully catching waves in the sea of unknown.
Previous year’s questions are found below:
Questions for Apple in 2020
The topics that serve as source material for Apple questions in 2020 can be grouped into two buckets: growth initiatives and asset base optimization.
Growth Initiatives
iPhone Business. The narrative facing the iPhone business has been off the mark for years. Skepticism and cynicism has continued to mask what has been a resilient business. There is now too much talk of 5G kicking off some kind of mega upgrade iPhone cycle. Such a focus ignores what is ultimately taking place with the iPhone: The business is maturing. This presents a set of challenges that will require a fine-tuning of strategy. This involves changes to the device lineup, release schedule, pricing, and feature set.
Paid Content Distribution. Following a very busy 2019 for Apple’s content distribution arm, all eyes are on whether or not Apple will bundle its new paid content services. Ultimately, bundling is a tool that Apple has at its disposal to support a weaker service while increasing the stickiness found with its services.
Wearables. Apple’s wearables business is a runaway train with the company selling approximately 65M wearable devices in FY2019. Based on my Apple Watch installed base estimate (available here), just 7% of iPhone users own an Apple Watch. Similar ownership percentages are found with AirPods despite the product having been in the market for less time. The question isn’t if Apple wearables momentum will continue but instead how fast will adoption grow.
Margins. Apple follows a “revenue and gross margin optimization” pricing strategy. This has led to Apple’s products gross margin percentage declining by 10% over the past two years while products gross margin dollars have declined by only 2%. Apple is willing to let products gross margin percentages decline (via lower product prices and higher cost of goods sold relative to revenue) if it results in stronger customer demand for those products. Attention will be placed at determining the level at which Apple product pricing is too low in order to maximize gross profit dollars.
R&D. There have been two general themes found with Project Titan and Apple’s efforts related to developing a pair of AR glasses: 1) Continued progress and 2) Extended timelines.
Asset Base Optimization
Leadership. With Jeff Williams officially serving as the link between Apple’s design team and the rest of Tim Cook’s inner circle, it will be interesting to see if Apple makes any refinements to its leadership structure.
China. The boogeyman known as U.S. / China trade has been put to bed, for now. With rhetoric having been dialed back in a very big way, attention will shift to the various decisions Apple still has to make regarding its long-term approach to China. The company can continue to rely heavily on China for its supply chain and manufacturing apparatus, accelerate a diversification strategy away from the country, or follow more of a status quo approach that recognizes the benefits (and weaknesses) of being so dependent on one country.
Capex. In FY2019, Apple reported just $7.6 billion of capital expenditures (capex). This was a significant drop from the $16.7 billion of capex in 2018. The most likely reason for the decline in capex was a decline in tooling and manufacturing machinery. The company also slowed spending on corporate facilities. By not providing capex guidance for FY2020, the variable is accompanied by a greater level of intrigue as to what it means about Apple’s near-term product pipeline.
Capital Return. Apple shares were up 89% in 2019, exceeding the S&P 500’s 31% gain. For the first time with Tim Cook as CEO, Apple shares now trade at a premium to the overall market when looking at forward price-to-earnings multiples. This has led some financial writers to call for Apple to slow the pace of buyback and instead push a larger increase in the quarterly cash dividend. In the event that Apple’s market value exceeds intrinsic value, it’s not clear how Apple would remove tens of billions of dollars of excess cash still on the balance sheet in addition to nearly $60 billion of free cash flow generated per year. Special dividends aren’t great from a tax perspective while there are limitations found with simply funneling all of the excess cash into quarterly cash dividends.
The Big Question
Taking a closer look at the preceding list of unknowns facing Apple, the product categories that have served as the primary engines for Apple’s new user growth are quickly maturing while new product categories have been more ARPU (average revenue per user) drivers. There are more than 500 million people who own just one Apple product: an iPhone. This group represents a prime target market for Apple when selling additional tools. Apple is ending one growth phase and is about to enter into a new one.
Exhibit 1 shows the growth trajectory for the number of Apple users, also referred to as Apple’s installed base, over the past 10 years. Based on my estimates, the Apple installed base grew from approximately 90 million people at the end of 2009 to a little more than a billion people at the end of 2019. Apple’s new user growth has slowed dramatically. Thanks primarily to the iPhone, Apple saw spectacular new user growth in the range of 25% to 60% in the early to mid-2010s. More recently, new user growth has been trending in the mid single-digit range.
Exhibit 1: Apple Installed Base (Number of Users)
The methodology and math used to reach my estimate for the number of Apple users is available for Above Avalon members here.
Reaching a billion users is quite the accomplishment for Apple considering how the company doesn’t give away its products for free. It’s one thing to reach a billion users with a “free” service. However, to get a billion people to pay directly for a service or tool is an entirely different thing.
When thinking about Apple’s future, the big question facing the company isn’t about how it will sell additional tools to its existing user base. Instead, the major unknown facing Apple is found with management’s ability to continue expanding its installed base. This raises one overarching question that covers Apple’s largest challenge and opportunity:
How will Apple find its next billion users?
It may be tempting to classify Apple’s first billion users as the “easy” growth or low-hanging fruit. In reality, those billion users primarily came from the premium segments of the various industries that Apple competes in. This means that to find the next billion users, Apple will inevitably need some strategy adjustments.
The Strategy for the Next Billion
The major building blocks for Apple’s plan to find its next billion users are already in place. Apple will come up with tools capable of making technology more personal. This pursuit will involve new user interfaces and inputs that allow people to get more out of technology without having technology take over people’s lives.
Taking a look at the geographical makeup of Apple’s current installed base, developed markets still contain plenty of new users for Apple to target. However, the potential found with emerging markets is a completely different story. Indonesia, Brazil, the Philippines, and Vietnam have a total population that is twice that of the U.S. Meanwhile, there are more people in China and India (2.6 billion) than the next 20 most populated countries combined.
It may be easy to think that Apple can just cut product pricing in order to grab its next billion users. However, the situation ends up being more complicated. Socio-economic trends will contribute to tens of millions of people moving into Apple’s addressable market each year. In addition, relying on the gray market for allowing gently-used Apple products to flow to lower price segments is a more effective strategy for Apple. Not only does the gray market reduce the need for Apple to come up with low priced products lacking in features, but Apple can also benefit from continued product focus in terms of its supply chain and manufacturing apparatus.
As for some of the granular initiatives that stand to promote continued growth in Apple’s installed base:
A truly independent Apple Watch. Advancements such as a truly independent Apple Watch that doesn’t require another Apple device to activate and use will expand the device’s addressable market by nearly four times overnight.
Continuing to run forward with wearables. New product categories that allow Apple to break down the barriers between users and technology will allow the company to target a wider audience. New form factors such as glasses will be designed to make technology even more personal than what is possible with Apple Watch and AirPods.
Longer device longevity. By giving Apple devices longer lifespans via more durable hardware and additional years of software updates, devices will be able to have more owners over time. This will have a direct benefit on the gray market for Apple devices as more devices are recirculated and eventually able to reach customers in lower price segments.
Expanding device repair and support networks. Apple’s current retail store footprint is not capable of handing the additional product servicing and support associated with having another billion users in its ecosystem. This is especially true in developing markets. By building out a device repair and support network to include authorized third-parties, Apple will go a long way in ensuring the next billion users have access to many of the same experiences that are valued by Apple’s current users.
The path to two billion users won’t be easy for Apple. The trajectory may very well end up looking quite different than the path to a billion users. However, there is nothing found with Apple’s long-standing mission to create products that can change people’s lives that limits its reach to a billion people.
Listen to the corresponding Above Avalon podcast episode for this article here.
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 membership, visit the membership page.
Above Avalon Podcast Episode 161: Apple's Spectacular Year on Wall Street
Something has clearly changed when it comes to the way Wall Street is treating AAPL. For the first time with Tim Cook as CEO, Apple shares are trading at a premium to the overall market. In episode 161, Neil discusses how changing behavior as it relates to passive versus active investing may be creating a type of perfect storm for AAPL shares. Additional discussion topics include Apple’s valuation, free cash flow, momentum shifting to passive investing, and Warren Buffett.
To listen to episode 161, go here.
The complete Above Avalon podcast episode archive is available here.
Apple's $500 Billion Year on Wall Street
Since the start of 2019, Apple’s market capitalization has increased by $500 billion or roughly the equivalent of Facebook’s market cap. For the first time with Tim Cook as CEO, Apple shares are trading at a premium to the overall market. Something has clearly changed when it comes to the way Wall Street is treating AAPL. However, the items that analysts, pundits, and the media positioned as catalysts for this dramatic change (Apple Services, iPhone sales rebound, 5G, improving U.S. / China trade sentiment) likely have little to nothing to do with Apple’s share price outperformance in 2019. Instead, changing behavior as it relates to passive versus active investing may be creating a type of perfect storm for AAPL shares.
Outperformance
It’s difficult to put a $500 billion market capitalization increase in context. Here are a few attempts:
Disney ($262B), Netflix ($146B), and three Spotifys ($78B) combined.
AT&T ($282B), Comcast ($196B), and a Spotify ($26B) combined.
Nearly two ExxonMobils ($588B).
Three Boeings ($558B).
Six Goldman Sachs ($498B).
Sixteen percent of the entire energy sector.
The market caps of the bottom 12% of the companies in the S&P 500 (60 companies in total).
When looking back over the past ten years of stock price performance, 2019 is on track to be the best one for Apple this decade (barring a stock market implosion in the next two weeks). Apple shares are up a whooping 77% in 2019. Comparing the S&P 500’s performance with that of AAPL, we reach Apple’s outperformance / underperformance relative to the broader market:
2010: 40%
2011: 26%
2012: 19%
2013: -22%
2014: 29%
2015: -2%
2016: 3%
2017: 29%
2018: 1%
2019: 50%
Apple shares have outperformed the market by 50% in 2019. For a company of Apple’s size, such outperformance is noteworthy.
Valuation
On a forward P/E multiple basis, Apple shares now trade at a 20% premium to the S&P 500. My preferred valuation metric for Apple is free cash flow yield, or the amount of free cash flow relative to enterprise value. Free cash flow is the amount of cash left over after management has paid all of the bills and maintained / funded capital investments. Enterprise value is market capitalization minus net cash (debt - cash).
In FY2019, Apple reported $58 billion of free cash flow. Apple is a free cash flow machine given its capex light business model. (More information on Apple’s free cash flow advantage is found in the Above Avalon daily update from March 13th available here.) While Apple’s free cash flow will fluctuate given the various moving parts, the combination of a stabilizing iPhone business and no major change in capex spending supports the idea of similar levels of free cash flow over the next 12 to 24 months. Accordingly, we can use $60 billion of free cash flow and Apple’s current enterprise value of $1.1 trillion. Apple is currently trading at a 5.2% free cash flow yield. The higher the yield, the lower the stock valuation.
One way of interpreting a 5.2% free cash flow yield is to compare it to other instruments such as government bonds and high-yield corporates. With those yields closer to 2.5%, a 5.2% yield suggests that Apple is still fairly attractive from a free cash flow yield basis. However, the days of Apple trading like a steel mill with just a few years left of operations are in the rear-view mirror. As recently as 2016, Apple was trading at a 17% free cash flow yield. For discussion purposes, AAPL would need to trade at $100 per share for free cash flow yield to once again be at a 17% yield.
What’s Driving AAPL?
Longtime Above Avalon readers and listeners will be familiar with my consistent stance on how to determine what is behind a stock price’s move. Unless every market participant is interviewed, we are unable to know the exact reason why a stock price behaves the way it does. Given the sheer difficulty found with such an exercise, the task of determining specific reasons behind a stock price move is ultimately a fool’s errand. The activity is nothing more than an attempt to add manufactured clarity to what is ultimately a lot of unknown. It is humans’ discomfort with the unknown that plays a role in the financial press’ never-ending quest to come up with exact reasons behind stock price moves.
When it comes to Apple, the list of “reasons” that analysts and reporters claim are behind the stock’s 77% move in 2019 continues to grow:
A stabilizing iPhone business.
Stronger services growth.
Apple management successfully navigating a tumultuous geopolitical landscape in both the U.S. and China.
Wearables momentum.
Continued ecosystem momentum with ongoing growth in terms of new users and the number of devices.
There is a rather glaring problem found with the preceding list of factors: None are significant enough on their own to justify a $500 billion increase in market capitalization.
Using a conservative measure as to what the iPhone business was previously valued at, Apple’s market cap increase would represent the iPhone business seeing its valuation double in just 11 months. That is unrealistic for a mature business like the iPhone. Expectations would have had to move from Wall Street thinking the iPhone was dead with just a few years of sales remaining (which was never the case) to the business demonstrating some kind of free cash flow bonanza (also not the case).
As for the idea that Services is somehow behind Apple’s spectacular rise, I’m skeptical. The problem with that theory is that there continues to be a lack of consensus as to what that narrative may even be. Apple isn’t becoming a services company, and there remains quite a bit of hesitation around that idea in terms of buy-side investors.
My suspicion is that Apple’s stock price run isn’t driven by any single business-related item. The move is simply too large. Instead, a $500 billion market capitalization increase points to a wide variety of investors wanting greater Apple exposure. This increased interest results in higher stock prices since a stock price is nothing more than the spot where demand for shares equals the supply of those shares.
Why do these investors want more Apple exposure? Instead of looking at Apple’s business for potential answers, we have to look at the multifaceted dynamic found with passive versus active investing.
Passive investing (index funds) are on the rise as investors are becoming increasingly disenchanted with mutual funds and active funds charging for underperforming the market. As more funds are poured into passive investment vehicles, all of the Wall Street giants (Apple, Microsoft, Amazon, Alphabet) benefit. By accounting for 4% of the S&P 500, 4% of every dollar put in an S&P 500 index fund is allocated to Apple. While this mechanism doesn’t necessarily lead to Apple’s share of the overall market increasing over time, it can lead to sustained demand for shares regardless of business fundamentals. This is key as active investors, and their constantly swinging perspectives on stocks, lose power to sway stock prices. While passive investing on its own doesn’t explain a $500 billion increase in Apple market cap in 2019, it likely is a contributing factor to what may be happening.
In a scenario where active investors (hedge funds, mutual funds, pension funds, etc.) were running with historically low exposure to Apple for whatever reason, a scenario in which Apple began to materially outperform the market would place pressure on these active investors given how they are often graded against a market benchmark. Given how Apple represents 4.3% of the overall S&P 500, a 77% move in the stock will likely make or break an active investor’s year depending on whether or not they own the stock.
The most likely explanation for Apple’s run up - however simplistic it may sound - is that active investors have been desperately trying to increase their exposure. The stronger demand for shares leads to higher stock prices in order for demand to match supply.
A crucial piece of evidence for my theory is found with Microsoft. The company is up 52% in 2019 with market cap gains of approximately $400 billion. We know Microsoft shares aren’t up that much because of iPhone sales. Instead, Microsoft is likely experiencing the same situation as Apple. Having shares of the two largest companies go up by 77% and 52% respectively means that active investors need to be overly exposed to these companies or risk underperforming benchmarks. For those active investors late to the party, the need for exposure only intensifies. Some may call this situation FOMO (fear of missing out). Others may call this forced buying - the opposite of forced selling.
Warren Buffett
Warren Buffett ends up being a symbol of this development. Back in 2016, Buffett began building his Apple stake after one of his portfolio managers introduced him to the idea. Buffett has been uncharacteristically quiet about his Apple investment. However, the past few Berkshire annual reports provide enough clues to suggest he is ultimately attracted by Apple’s robust free cash flow and balance sheet strategy in which free cash flow is poured into share buyback and dividends. Buffett took advantage of active investors shunning Apple to increase his own exposure. Buffett’s Apple stake is now worth $70 billion, marking an unrealized profit of approximately $34 billion (not including dividends).
During the period when Buffett was acquiring his Apple stake, the two largest Apple buyers in the market were Apple (via stock buyback) and Buffett. In some quarters, the buying from Apple and Buffett alone totaled as much as 10% of shares traded. That is astounding. As Apple and Buffett were buying shares, many other market observers remained on the sidelines for likely a variety of reasons (unease surrounding Apple’s business model, Apple’s exposure to China, and the list goes on).
What Next?
As for how this situation will end, no one knows. If someone proclaims to know, caution is needed. We can have much more confidence in saying that valuations will matter, eventually. It is also safe to assume that passive investment momentum will continue, which will likely only exacerbate current trends (both to the upside and downside).
Listen to the corresponding Above Avalon podcast episode for this article here.
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 membership, visit the membership page.
Above Avalon Podcast Episode 160: Let's Talk "Apple Tax"
Apple’s ability to grab monopoly-like share of industry profits isn’t a result of there being an Apple Tax. Rather, it's a byproduct of Apple following a design-led product strategy that ultimately marginalizes industries. In episode 160, Neil discusses the theory behind the “Apple Tax,” Apple’s pricing strategy, and why the days of there being an Apple Tax ended years ago. Additional topics include Apple gross margin trends, two major implications associated with Apple’s pricing strategy, and a few narrative violations found with Apple’s revenue and gross profit optimization playbook.
To listen to episode 160, go here.
The complete Above Avalon podcast episode archive is available here.
The "Apple Tax" Died Years Ago
Two weeks ago, Business Insider caused a stir with a video titled, “Why Apple Products Are So Expensive.” The video was part of Business Insider’s “So Expensive” series, which takes a look at why certain items are priced the way they are.
The video was troubling for the number of inaccuracies, falsehoods, and outright lies it included about Apple and its pricing strategy. According to Business Insider, Apple products are expensive because loyal users are willing to pay an “Apple Tax,” or a higher price attached to products containing an Apple logo. A closer look at Apple’s actual pricing strategy reveals a fundamentally different explanation for why Apple products are priced the way they are. The days of there being an “Apple Tax” ended years ago.
The Video
The following video was pushed out to Business Insider’s 2.3M YouTube subscribers on November 23rd, 2019. The video currently has a little more than 660,000 views.
The video included a long list of claims regarding Apple, its product pricing strategy, and the company’s overall positioning in the marketplace.
Apple was said to be bringing in huge profits by charging higher prices for its products. The progression of pricing from iPhone 6 to iPhone 11 ($649 to $999) and the Mac mini ($499 to $799) were used as examples of Apple charging more for basically the same product. These higher prices are said to be part of Apple’s strategy to squeeze as much profit as possible from loyal customers “unwilling to switch out of the Apple ecosystem.”
Apple products were said to contain components that are standardized and comparable to what is found in competing products. Accordingly, higher-priced Apple products are more expensive than products from competitors despite not including additional functionality. An iPhone’s bill of materials was positioned as a useful tool for tracking how profitable an iPhone is for Apple.
Apple was said to rely on “sneaky” tactics to grab additional profit from these loyal users by charging more for higher-end configurations and requiring users to buy expensive dongles, keyboards, mice, and cables.
When assessing the video’s long list of issues, the primary problem was found with how much long-standing narratives about Apple guided Business Insider’s talking points. Numbers and data were cherrypicked to support false narrative after false narrative while Business Insider ignored or brushed aside evidence that would prove its narratives wrong. For example, Apple’s downright aggressive pricing with Apple Watch and AirPods was ignored. Meanwhile, strategies that have proven to be flat out wrong, such as relying on a product’s bill of materials to figure out profitability, went unchecked.
In an effort to come off as more authoritative, Business Insider relied heavily on commentary from Mohan Sawhney, a marketing professor at Northwestern University. The problem was that Sawhney viewed Apple through a marketing prism - the company was said to be nothing more than a luxury brand selling nice-looking tech gadgets. Sawhney claimed the only reason Apple is able to extract so much profit from the industries it operates in is because people are willing to pay more for the Apple logo. There was no mention of Apple controlling much of the profit within an industry by purposely avoiding the low end of that market while also offering a wide range of devices with different amounts of technology.
Apple Tax
The theory of there being an Apple Tax has been around for more than a decade. The term was coined during the mid-2000s to refer primarily to Apple laptops (iBooks and then MacBooks). A MacBook was said to cost more money than a Windows laptop with similar specifications because of there being a premium built into the MacBook’s price. Said another way, the MacBook was more expensive than other products since it included an Apple logo.
The “Apple Tax’ phrase became a way to poke fun at MacBook users for their apparent cluelessness in paying more for a product despite cheaper alternatives being available. In recent years, the Apple Tax definition has morphed to merely refer to higher-priced Apple products like the iMac Pro and new Mac Pro.
There has always been a glaring hole in the Apple Tax narrative: Since Apple does not license its Mac operating system to OEMs, a MacBook running Apple software ends up being very different than a Windows laptop said to have similar specs. In addition, while Apple made a number of content creation applications available for free on the Mac, Windows laptops positioned as direct competitors lacked such free applications. It may be more correct to say that the Apple Tax reflected the price of Mac software instead of some kind of premium created out of thin air.
Apple’s Pricing Strategy
Apple’s pricing strategy is not based on the idea of forcing users to pay an “Apple Tax.” Instead, Apple follows a revenue and gross profit optimization strategy. Here is Apple’s CFO Luca Maestri talking about the strategy on various Apple earnings conference calls:
4Q17: “We tend to think about maximizing gross margin dollars because we think that's the most important thing for investors at the end of the day. When we look at our track record over years, I think we've found a good balance between unit sales growth and gross margins and revenue, and we will continue to do that as we go forward.”
2Q18: “Our primary consideration is always around maximizing gross margin dollars, and that is the approach that we take around pricing decisions.”
4Q18: “[W]e make our decisions from a financial standpoint to try and optimize our revenue and our gross margin dollars.”
1Q19: “It is important for us to grow gross margin dollars. And if at times we grow services that are at a level of gross margins, which is below average, as long as this is good for the customer and as long as we generate gross margin dollars we're going to be very pleased.”
2Q19: “[W]hat really matters to us and what we look at -- when we look at the elasticity of these [iPhone upgrade] programs is to see the impact on our gross margin dollars.”
While “revenue and gross margin optimization” may sound like loaded terminology, the idea underlying the strategy is straightforward. Instead of Apple including a certain amount of “tax” or premium in a product’s price to maintain a specific gross margin percentage, Apple prices its products in a way that maximizes gross margin and revenue on an absolute basis. Gross margin is cost of goods subtracted from revenue.
The strategy requires Apple to come up with forecasts for how a product’s price will impact customer demand for that product. Price a product too high, and the lower unit sales (as a result of weaker demand) may more than offset the higher amount of revenue and gross margin found with each device. Price a product too low, and the higher unit sales (as a result of stronger demand) may not offset the lower amount of revenue and gross margin found with each device.
Gross Margin Data
A closer look at Apple’s gross margins demonstrates this “revenue and gross margin optimization” strategy in action. Exhibit 1 highlights Apple’s gross margin percentage going back to 2000.
Exhibit 1: Apple Gross Margin (Percent of Revenue)
As shown in Exhibit 1, Apple’s gross margin as a percent of revenue has been steady since 2013. On the surface, such stability would seem to validate Business Insider’s claim of there being some kind of price premium automatically added to Apple products - as if management determines a product’s price by adding a certain premium on top of the cost of goods sold.
However, Apple’s overall gross margin doesn’t tell the full story. There are notable shifts underway when looking at the two components that make up overall gross margin. A decline in Apple’s products (hardware) gross margin percentage is being offset by an increase in services gross margin percentage. This dynamic is seen in Exhibit 2.
Exhibit 2: Apple Gross Margin (Percent of Revenue) - Products vs. Services
In just the past two years, Apple products gross margin percentage has declined by 10% (350 basis points). That is noteworthy. This means that Apple hardware has become less profitable when looking at gross margin as a percent of revenue. The decline is due to two factors:
Apple is lowering product pricing which is eating into the delta between revenue and cost of goods sold. Most of these price cuts are designed to roll back the impact from foreign exchange. However, another factor is that Apple is willing to run with lower gross margin profiles for certain products with the goal of selling more products.
Apple is including more technology in its products while not increasing prices enough to maintain gross margin percentages. As with the first factor, Apple is becoming more aggressive on price in an effort to sell more products and generate more revenue and gross margin dollars.
The decline in products gross margin percentage doesn’t become apparent when looking at overall gross margin because Apple Services is offsetting the decline. Services gross margin is up a very strong 16% (870 basis points) over the past two years as services with naturally higher margins (licensing, AppleCare, paid iCloud storage) gain momentum.
While Apple’s products gross margin percentage has declined by 10% over the past two years, products gross margin dollars declined by only 2%. This tells us that Apple is willing to let products gross margin percentage decline (less profit found with each device) if it means stronger customer demand results in more units being sold. This is the epitome of Apple’s revenue and gross margin optimization strategy.
Implications
There are two major implications associated with Apple’s revenue and gross profit optimization strategy:
Apple’s product portfolio has become increasingly competitive from a pricing perspective. In the case of Apple Watch and AirPods, pricing is downright aggressive compared to the competition. A $159 pair of AirPods sent shockwaves around the industry as competing products were priced in the $200 to $300 range. Even today, it’s difficult for genuine competitors to come close to AirPods pricing. A similar dynamic is found with wrist wearables as Apple Watch pricing remains highly competitive.
Apple has embraced a bifurcation strategy in which product lines have been expanded to include a broader range of models and corresponding prices. This dynamic applies to most of Apple’s products including the iPhone, iPad, Mac, Apple Watch, and AirPods. The primary benefit of Apple becoming aggressive both at the low end and high end of the pricing spectrum is more choice for consumers. Products like the 10.2-inch iPad represent the gateway into the iOS ecosystem for millions of people each year. The MacBook Air remains the most popular Mac. The end result is that products with various margin profiles may end up offsetting each other.
Accessories
When it comes to how Apple prices various accessories like dongles, Watch bands, and iPad keyboards, the company isn’t relying on an Apple Tax. Instead, accessories by their very nature have high gross margins given that the items are sold to customers looking to personalize their experience. A similar philosophy applies to Mac memory and storage upgrades. While those upgrades are indeed profitable for Apple, the fact that Apple charges the prices they do is not a sign of Apple users being held hostage and forced to pay an Apple Tax. Instead, positioning certain items as accessories or upgrades plays a role in Apple keeping entry-level product pricing low for the mass market.
Narrative Violations
A new school of thought positions Apple as a monopoly not because it has significant market share, but because it has loyal and engaged users. The idea is that since these users would apparently face such a dreadful experience by moving outside the Apple platform, it’s as if they have no alternatives. Apple is said to be taking unfair advantage of this situation and its position as the only provider of a premium experience. A byproduct of this stance is that certain Apple actions, such as the way the App Store is managed, are viewed as uncompetitive.
There is no question that Apple has loyal, satisfied users. However, the premise that these users are in some way held captive or hostage by Apple, and therefore forced to pay high Apple prices, just doesn’t hold up to scrutiny.
Contrary to popular opinion, a new Apple product doesn’t sell simply because it has an Apple logo. Apple users are discerning when it comes to determining what products are worth buying. We see this when it comes to upgrade rates for existing products as well as adoption trends for new products.
Apple’s declining products gross margin percentage is driven in part by lower iPhone profit margin percentages. This has occurred despite iPhone ASPs rising, which goes against nearly every narrative that has been put forth about higher iPhone prices.
The App Store is run at just a 10% gross margin (my estimate). This goes against the idea that Apple is being unfair to developers when charging 15% or 30% revenue share. While some developers want Apple to charge them more like 5% to 10% of revenue, or nothing at all, such revenue share arrangements would likely lead to the App Store being operated at a loss considering that a majority of apps do not share any revenue with Apple.
It’s easy to look at Apple pricing and take a cynical view that management is trying to squeeze as much profit as possible from its users. However, Apple’s incentive isn’t to milk users for all they can but rather to expand the Apple user base and provide users great experiences. Apple’s ability to grab monopoly-like share of industry profits isn’t a result of there being an Apple Tax but rather a byproduct of Apple following a design-led product strategy that ultimately marginalizes industries.
Listen to the corresponding Above Avalon podcast episode for this article here.
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 membership, visit the membership page.
Above Avalon Podcast Episode 159: AirPods as a Platform
Apple is turning AirPods into a platform for what comes after the App Store. AirPods will augment our environment by pushing intelligent sound. In the first episode of Season 6, Neil goes over how AirPods have evolved from an iPhone accessory into the early stages of a platform well positioned to reshape the current app paradigm for the wearables era. Additional topics include the AirPods Pro launch, AirPods Pro initial impressions, AirPods sales, examples of AirPods as a platform, and the three sources from which AirPods will derive its platform power.
To listen to episode 159, go here.
The complete Above Avalon podcast episode archive is available here.
AirPods Are Becoming a Platform
If AirPods were magical, AirPods Pro are supernatural. Apple’s newest pair of AirPods continues to make waves with “augmented hearing” entering people’s vocabulary. However, the broader implications found with Apple’s AirPods strategy are just as impressive. Apple is quickly removing all available oxygen from the wireless headphone market, and competitors find themselves at a severe disadvantage. In just three years, AirPods have evolved from an iPhone accessory into the early stages of a platform well positioned to reshape the current app paradigm for the wearables era.
Another “Quiet” Launch
One of the more fascinating aspects found with AirPods Pro was how the product was unveiled. Instead of receiving stage time at Apple’s big product event at Steve Jobs Theater one month earlier, AirPods Pro received the press release treatment. When contemplating potential sales, AirPods Pro may end up being the best-selling Apple product that has ever been unveiled with just a press release.
The subdued unveiling given to AirPods Pro is consistent with Apple’s prior approach to AirPods. Instead of receiving the red carpet treatment as the Apple Watch did two years earlier, AirPods were unveiled to the world over the course of just five minutes at Apple’s iPhone and Apple Watch event at Bill Graham Civic Auditorium in San Francisco. In a sign of just how nonchalant Apple was with the unveiling, AirPods were positioned merely as an iPhone 7 and 7 Plus feature. The product was said to be an additional option that consumers had for handling the transition away from dedicated headphone jacks. (Remember those?)
Earlier this year, AirPods with wireless charging case was unveiled via press release as well.
AirPods Pro
It’s easy to gloss over many of the selling points found with AirPods Pro given the familiarity with AirPods. Items such as seamless pairing and the carrying case that doubles as a charging station play crucial roles in giving AirPods Pro such a high-quality and enjoyable user experience.
However, the features that have gained the most attention, and rightly so, are Active Noise Cancellation (ANC) and Transparency mode. For many people, AirPods Pro will be their first pair of ANC headphones. Those users are in for a treat as Transparency mode addresses the largest negative found with ANC headphones - the user is seemingly removed from his or her surroundings. A press and hold on one AirPod stem switches between ANC and Transparency mode. The functionality is a great example of how Apple’s engineering and design teams, through collaboration, can produce a great user experience.
Sales
In FY2019, Apple sold 35 million pairs of AirPods at an average selling price (ASP) of $162 (both are my estimates). On a revenue basis, the AirPods business is on a $6 billion per year run rate that is doubling year-over-year.
One way to put those sales numbers into context is to compare AirPods to other Apple products at the same point in time after launch. As shown in Exhibit 1, AirPods are trending similarly to iPhone sales when looking at unit sales out of the gate. After three years of sales, Apple has sold 61 million pairs of AirPods on a cumulative basis. During the first three years of sales, Apple sold 60 million iPhones.
Exhibit 1: Unit Sales out of the Gate
Apple likely crossed an important AirPods sales milestone last quarter. For the first time, Apple sold more than 10 million pairs of AirPods during a three-month stretch. While the preceding observation came from my earnings model (access to my Apple earnings model is a benefit associated with Above Avalon membership at no additional cost), the math checks out with Apple management’s commentary and clues provided on the 4Q19 earnings conference call. It’s likely that AirPods sales will exceed 10 million per quarter for the foreseeable future.
When contemplating AirPods unit sales trends going forward, too many people are stuck in a mobile mindset. Instead of seeing someone buy and use just one pair of AirPods, we may see a new kind of usage pattern develop in which a growing percentage of AirPods owners will use more than one pair of AirPods. This will help boost AirPods unit sales.
On Apple’s 4Q19 earnings conference call, Tim Cook was asked about the potential upgrade trajectory for AirPods. Cook commented that he thought current AirPods owners would be in the market for AirPods Pro to “have a pair for the times that they need noise cancellation.” The clear implication found in Cook’s comment was that Apple expects some AirPods owners to use multiple pairs of AirPods with differing levels of functionality.
After just three years of sales, we are already starting to see the early stages of this trend develop with people upgrading their AirPods but keeping their old pair as a backup.
In an unscientific poll conducted via Twitter poll through my account, 30% of respondents said they use more than one pair of AirPods. Interestingly, 41% of people who said they purchased a pair of AirPods with wireless charging case claim to still be using their older pair of AirPods as well. It helps that AirPods last years before poor battery life takes its toll. My initial pair of AirPods from 2016 are still used daily. It's early, but it looks like people using more than one pair of AirPods is a thing.
Platform Building
The current app paradigm primarily consists of downloading an app to our smartphone, tablet, smartwatch, smart TV, or laptop / desktop. We then interact with the app to “pull” information and context at a time of our choosing. App notifications are not very smart and instead represent mostly useless distractions more than anything else.
The Apple Watch was the first device to genuinely begin questioning the current app paradigm. The Siri watch face on Apple Watch is all about providing the wearer glanceable amounts of information, data, and context in the form of cards chosen by a digital assistant. These cards are personalized to the wearer based on the time of day and schedule. In essence, we are moving away from pulling data from various apps to receiving a curated feed of data that is dynamic - always changing and tailored to our needs.
Apple is turning AirPods into the second platform built for what comes after the App Store. Instead of being about pushed snippets of information and data via a digital voice assistant, something that will likely remain ideal for mobile screens, AirPods will be all about augmenting our environment by pushing intelligent sound.
AirPods Pro wearers are able to experience the early days of this dynamic with Transparency mode. Switching between Transparency mode and ANC is equivalent to augmenting our environment. We are receiving two different experiences despite being in the same location.
This dynamic could be extended so that a simple tap of an AirPod or a quick voice command can take us to a different location via sound. Utilizing HomePods as sound receivers, an AirPods wearer would be able to “move” from the kitchen to family room. A quick tap of one AirPods, or Siri voice command could bring the wearer from the family room to kitchen to answer a family member’s question or simply to be “in” the room.
App developers would be able to take part in this revolution by building experiences that further augment people’s hearing. “Apps” would amount to tools capable of adding context to our hearing. Fitness can be rethought by adjusting the AirPods wearer’s hearing during workouts and exercise based on his or her activity. As an example, AirPods music playbook can be adjusted based on the users’ heart rate obtained by an Apple Watch. Such adjustment would amount to the AirPods wearer being “removed” from his or her environment when close to reaching a maximum heart rate during a run or track workout. Of course, such health tracking and monitoring may one day be brought directly to AirPods in subsequent editions.
Another example involves utilizing AirPods to deliver different sound experiences to different people despite being in the same location and looking at the same thing. As an example, a single presentation shown in a school or office setting can end up delivering a dozen different experiences to those in attendance.
Platform Power
AirPods will derive its platform power from three sources:
Technology advantage
Design focus
Massive adoption
Apple is pulling away from the competition when it comes to building mini computers worn on the body. AirPods are computers for the ears. Years of learning how to manufacture 2.1 billion iPhones and iPads is now helping Apple to build nearly 70 million wearable devices per year.
This technology prowess and manufacturing acumen goes to waste if people don’t actually want to be seen wearing the devices. Apple’s success at redefining luxury, combined with the company’s design-led culture, gives the company a large advantage in the area of understanding what people will want to wear on the body.
The final source of platform power will come from massive adoption. There are currently 45 million people wearing AirPods. At the current rate, more than 100 million people will be wearing AirPods at some point in 2021. As to how Apple is able to see such strong AirPods adoption, Apple is busy removing all available oxygen from the wireless headphone market.
The company is utilizing a masterful combination of price and features to establish multiple beachheads in the market.
AirPods Pro do not replace AirPods in the product line. Apple is instead embracing a strategy of expanding the product line according to functionality. AirPods Pro represent the expansion of the AirPods line into a higher-end segment that places value with ANC. The end result is that Apple now has three different AirPods model, each targeting a different price segment of the wireless headphone market. It is certainly reasonable to expect Apple to continue pushing this strategy in the coming years so that we see a pair of AirPods go for as low as $99 and as high as $500.
We see similar product strategies with the iPad and Mac lines. With these, Apple sells a range of flagship products with varying degrees of functionality, and of course, price.
There are some unique attributes seen in Apple’s campaign to remove oxygen from the wireless headphone market. Unlike what they did with the iPhone or iPad playbook, Apple didn’t launch AirPods at one price and then begin to lower pricing once all of the profit had been sucked from that initial market segment. Instead, Apple has been doing the opposite. Apple unveiled AirPods at a very aggressive $159 price, which sent shockwaves across the industry as the competition was priced closer to $300. Three years later, competitors are still struggling to match AirPods' $159 entry-level price.
Something Big
This AirPods evolution into a platform does not come as a surprise. Here was the opening paragraph from my initial Above Avalon article on AirPods shortly after being unveiled in September 2016:
“AirPods will turn out to be one of the more strategically important hardware products Apple has released this decade. However, you would never know it judging from the way Apple unveiled the device last week. I suspect that was intentional. While the press remains focused on the short-term debate surrounding the iPhone's lack of a 3.5mm headphone jack, few have realized that Apple just unveiled its second wearables platform.”
Three years later and that paragraph still rings true. AirPods have turned into a cultural phenomenon while dedicated headphone jacks on smartphones have become relics. Meanwhile, Apple’s wearables train continues to gain momentum as the company grabs real estate on our wrists and in our ears by bringing a new level of personal computing to the masses.
Listen to the corresponding Above Avalon podcast episode for this article here.
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 membership, visit the membership page.
Above Avalon Podcast Episode 158: Forced to Sell
How did Fitbit go from being considered the wearables leader to viewing a $2.1B acquisition as its best hope for shareholders to recoup any value? What led Fitbit to run out of options as an independent company? In episode 158, Neil discusses how Apple Watch forced Fitbit to sell itself. Additional topics include Google’s acquisition offer for Fitbit, how Apple Watch redefined the wrist wearables industry, and the most damning evidence of Fitbit’s demise.
To listen to episode 158, go here.
The complete Above Avalon podcast episode archive is available here.
Apple Watch Forced Fitbit to Sell Itself
Saying that a company with an agreement to be acquired for $2.1 billion was killed may sound like an exaggeration. Many start-ups aim to one day be “killed” in such fashion. However, Google’s decision to acquire Fitbit amounts to a mercy kill, putting an official end to Fitbit’s implosion at the hands of Apple Watch. In just three years, the Apple Watch turned Fitbit from a household name as the wearables industry leader into a company that will eventually be viewed as an asterisk when the wearables story is retold to future generations.
The Offer
When news first broke that Google LLC had offered to acquire Fitbit for $2.1 billion, or $7.35 per share, many observers noted how low the offer price was compared to Fitbit’s earlier valuations. This was a company that had its initial public offering at a $4.1 billion valuation and had seen its stock price peak at a $13 billion valuation ($51.90 per share).
My initial reaction was that Google was being extremely generous with its offer. On an enterprise value basis, which excludes $565 million of cash and cash equivalents on Fitbit’s balance sheet, Google is valuing Fitbit at $1.5 billion. For a hardware company with $1.5 billion of annual revenue and declining ASP and margins, questionable intellectual property, a dying ecosystem, and a non-existent product strategy, Google looks to be overpaying for Fitbit.
Industry observers speculate that Google’s offer price reflects the company seeing something in Fitbit that the marketplace missed. Instead, Google’s generous offer price has the makings of being a goodwill gesture aimed at Fitbit employees who have wealth tied to Fitbit stock. The $7.35 offer price represents close to a three-year high in Fitbit’s stock price. Holding Fitbit’s feet to the fire in terms of valuation wouldn't have helped Google retain Fitbit employees for beefing up its fledging hardware team.
On the flip side, Fitbit co-founder and CEO James Park and the board deserve a round of applause for securing such a generous offer from Google. The acquisition can be viewed as Google offering Fitbit a dignified and gracious death and Fitbit’s board as correct to take the opportunity.
Fitbit’s Story
There are two chapters to Fitbit’s life as an independent company. From 2013 to 2016, Fitbit leveraged low-cost, relatively rudimentary fitness tracker bracelets worn on the wrist to consolidate what had been a fragmented market for quantifying one’s physical movement. Fitbit even managed to move into the realm of coolness. Wearing a Fitbit in public contained positive connotations as the user was viewed as being on the forefront of technology. The smartphone revolution also played a role in Fitbit’s rise as people became comfortable giving a new crop of mobile devices an increasing number of roles to handle.
During the early years, Park successfully navigated Fitbit through a tumultuous period that included the company recalling the Fitbit Force for causing skin rashes and burns on nearly 10,000 people. Park also competed effectively against other early wearables pioneers. An ugly battle with the well-funded Jawbone regarding intellectual property theft ended in a settlement. Fitbit became a household name for health and fitness tracking.
Everything changed in 2016. Fitbit’s unit sales, as shown in Exhibit 1, peaked. On the surface, the subsequent decline in unit sales may not have looked too bad considering that demand stabilized around 15M units per year. However, for a hardware company dependent on rising unit sales, the development was alarming. Once again, Fitbit management did the right thing and quickly cut expenses at the first sign of demand weakness. The belief was that Fitbit could manage its way out of the sales slump.
Exhibit 1: Fitbit Unit Sales (Annual)
What management did not realize at the time was that Fitbit was beginning to feel the consequences of one giant mistake that Park had made years earlier. Park did not foresee the fundamental change that would take place on the wrist in the form of dedicated fitness trackers turning into full-fledged computers. Smartwatches aren’t just gloried fitness trackers. Instead, smartwatches are alternatives to smartphones and tablets.
After dragging his feet for far too long, Park knew that the only way forward for Fitbit would be to come out with a smartwatch. With the $300 Ionic, Fitbit launched its first smartwatch in 2017. The device flopped. Fitbit quickly pivoted to a lower-cost smartwatch with the $200 Versa. Once Fitbit had established channel inventory and satisfied pent-up demand for the Versa in its existing installed base, demand evaporated. Despite an even lower price, the Versa has failed to catch in the marketplace.
Why Sell?
In early 2019, Fitbit management began waving the white flag when it decided to pivot yet again, this time into services. In an effort to grab more users who could be monetized via paid services, Fitbit management began to cut into hardware pricing and margins. With the all-important 2019 holiday shopping season quickly approaching, Fitbit’s situation looked dire. Enter Google last week to officially put Fitbit out of its misery.
The only alternative for Fitbit, which was far from unproven, would be for the company to become a much smaller company, essentially a shell of its former self, in order to sell a certain number of dedicated fitness trackers each year to a declining installed base. Even if successful, Fitbit would have looked and acted like nothing that the world had come to know Fitbit as - a leader in the wearables category. Fitbit would instead become something of a zombie company.
How did Fitbit go from being considered the wearables leader to viewing a $2.1B acquisition as its best hope for shareholders to recoup any value? What led Fitbit to run out of options as an independent company?
Two words: Apple Watch.
Redefining the Industry
Apple didn’t just steal customers away from Fitbit. In such a scenario, Fitbit may actually have had a chance to survive as the company could have had a means to respond competitively. Apple ended up doing something that ultimately proved far worse for Fitbit. The Apple Watch altered the fundamentals underpinning the wrist wearables industry. This left Fitbit unable to remain relevant in a rapidly-changing marketplace.
Apple placed a bet that wrist real estate was being undervalued. The Swiss had dropped the ball and were primarily selling the wrist as a place for intangibles with high-end mechanical watches. Instead of following Fitbit and selling a $99 dedicated fitness tracker, Apple looked at the wrist as being a great place for additional utility beyond just telling time or tracking one’s fitness and health. Apple turned health and fitness tracking from a business into a feature. The Apple Watch redefined utility on the wrist.
This change led to consumers wanting more from wrist wearables. Apple Watch established a stronghold at the premium end of the market. Taking a page from its product strategy playbook, Apple then methodically began to lower entry-level Apple Watch pricing, which had the impact of removing oxygen from increasingly lower price segments. Fitbit was squeezed as the company had no viable way to compete directly with Apple Watch. Fitbit’s existing business wasn’t profitable enough for management to ramp up R&D in an effort to go up against Apple. Fitbit had generated just $200M of free cash flow over the past five years. Apple spends that much on R&D in a few days. Meanwhile, competition remained intense at the low-end of the market, which only added pressure to Fitbit’s existing business of selling low-cost dedicated fitness trackers.
Exhibit 2 highlights the number of active Fitbit users compared to the Apple Watch installed base (the number of people wearing an Apple Watch). The Apple Watch figures are my estimates. The exhibit ends up being the most damning evidence of Fitbit’s demise. Fitbit’s installed base lost all momentum just as Apple Watch began to take off. Unit sales trends continue to hide this deterioration in Fitbit’s installed base fundamentals. While Fitbit claims to have 28 million active users, that total isn’t enough to sustain a thriving ecosystem. In addition, there are valid reasons to question the loyalty and engagement found with those users.
A good argument can be made that Fitbit died a while ago, and the company is merely running on fumes from the dedicated fitness tracker glory days. With Fitbit, Google is acquiring a dying wearables platform.
Exhibit 2: Number of Active Users (Fitbit versus Apple Watch)
Fitbit and Google
There is no rationale argument in support of Google buying Fitbit. Both companies lack a workable strategy in wearables. Fitbit doesn’t bring anything to the table for Google. Buying a fitness and health tracker going off of fumes is not a legitimate way to find success in wearables. Not only did Fitbit lack a sustainable product strategy going forward, but it’s fair to assume that Fitbit products will become even less attractive following a Google acquisition.
When a services company with data-capturing tools buys a dying hardware ecosystem built on tools that weren’t just data-capturing tools in disguise, an exodus of users is likely. Judging by how Fitbit decided to include the following paragraph in the press release announcing the acquisition, both companies are acknowledging the exodus risk:
“Consumer trust is paramount to Fitbit. Strong privacy and security guidelines have been part of Fitbit’s DNA since day one, and this will not change. Fitbit will continue to put users in control of their data and will remain transparent about the data it collects and why. The company never sells personal information, and Fitbit health and wellness data will not be used for Google ads.”
That paragraph won’t provide any comfort to Fitbit users concerned about their privacy in a post-Google acquisition. However, that didn’t matter to Fitbit’s board when accepting Google’s offer as their concern was found with Fitbit shareholders, not Fitbit users.
Success in Wearables
Many industry analysts, possibly in an effort to appease Google’s ego, have been going around talking up Fitbit as having a treasure trove of data for Google. The narrative concludes with Google somehow turning this data into an ingredient for success in wearables. This line of thinking makes no sense and is nothing more than wishful thinking.
Google’s problem in wearables isn’t due to a lack of data. In addition, Google’s lack of silicon expertise and dependency on Qualcomm aren’t fatal issues either. Ultimately, Google’s problem in wearables is that it isn’t a design company. At Google, designers are not given control over the user experience. Even if Google ramps up investment and hiring so that it is able to one day ship custom silicon that is competitive with Apple, the company would still need to come up with wearables that people want to be seen wearing. These products need to be born from a design culture in which the way people use technology is given more importance than just pushing technology forward.
Instead of acquiring Fitbit to find success in wearables, Google should work on changing its internal culture to empower designers at the expense of engineering. However, that change isn’t likely to materialize as the people who would be tasked with making such a decision would themselves hold less power and importance as a result of the change.
Fitbit will serve as a case study for what happens to a company underestimating Apple’s ability to redefine not just a product category, but an entire industry. Apple’s culture allows it to succeed in wearables. The company has spent decades learning to make technology more personal, and those lessons are being used to establish the most formidable wearables platform in existence. Apple Watch redefined what it meant to put utility on the wrist, and Fitbit simply wasn’t built to succeed in such a world.
Listen to the corresponding Above Avalon podcast episode for this article here.
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 membership, visit the membership page.
Apple 4Q19 Earnings Expectation Meters
There is increased attention around Apple’s 4Q19 results. Apple shares are up 19% since the company reported 3Q19 results back on July 30th. Since the start of the year, AAPL shares are up 58% while the S&P 500 is up 21%. For a trillion dollar market cap company, such outperformance is noteworthy.
Apple’s strong stock performance has led to questions regarding what management will have to announce on Wednesday to meet or exceed expectations. At the same time, Apple’s 4Q19 results have the potential of containing some noise as Apple works through its flagship iPhone and Apple Watch launch. For example, the iPhone was not in demand / supply equilibrium by quarters end.
The following table contains my overall estimates for Apple’s 4Q19. My expectation is for Apple to report strong 4Q19 results and 1Q20 revenue guidance.
A detailed discussion of these estimates, including the methodology and perspective behind the numbers, is found in my Apple 4Q19 earnings preview available here. Above Avalon membership is required to read my earnings preview.
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 business performance. In each expectation meter, the white shaded area reflects my official single-point estimate. The gray shaded area represents a result that is considered near my estimate. A result that falls within this gray area signifies that the product or variable being measured is pretty much performing as expected. A result that falls in the green shaded area denotes strong performance and the possibility of me needing to raise my expectations for that particular item going forward. Vice versa, a result falling in the red shaded area denotes the possibility of needing to reduce my expectations going forward.
Over the years, the expectation meters have evolved with Apple’s changing business and financial disclosures. Ahead of Apple’s 4Q19 earnings, I am publishing three expectation meters:
Products vs. Services Revenue
iPhone vs. non-iPhone Revenue
1Q20 Revenue Guidance
Products vs. Services
Apple breaks out revenue into two categories: products (i.e. hardware) and services. The iPhone likely weighed on Apple’s 4Q19 products revenue due to both declining unit sales and a lower average selling price (ASP). The end result is products revenue that will show little to no growth. Partially offsetting lackluster growth in products, Apple’s Services revenue is expected to grow in the vicinity of 15%. This dynamic will likely improve in FY2020 as both products and services will once again contribute to Apple revenue growth.
iPhone vs. Non-iPhone
Another way of thinking about Apple’s business is to allocate the company’s various products and services into two buckets: iPhone and non-iPhone. Last quarter, Apple’s non-iPhone business registered more revenue than the iPhone business for the first time since 2012. It is unlikely that this dynamic will repeat itself in 4Q19 as the iPhone business gains revenue momentum due to the flagship iPhone launch.
Guidance
Consensus expects Apple to report $86B of revenue in 1Q20. That seems on the light side. My estimate is for Apple to announce 1Q20 revenue guidance in the range of $88B to $91B. Apple has to report more than $88.3B of revenue in 1Q20 to reach a new all-time record for quarterly revenue.
Apple has two tailwinds for issuing strong 1Q20 revenue guidance:
Apple is facing one of the easier year-over-year quarterly compares in years given the demand implosion in China seen in November and December 2018. This will make it that much easier for Apple to report revenue growth in 1Q20.
The environment is conducive to both Apple Watch and AirPods selling well during the 2019 holiday shopping season. Apple not only faces a lack of genuine smartwatch or wireless headphone competition, but also has strong product lines with attractive entry-level pricing available.
On the flip side, one headwind worth monitoring is declining iPhone ASP. Apple cut pricing of its lowest-priced flagship iPhone by $50. In addition, Apple remains aggressive with pricing outside the U.S.
Despite Apple’s strong stock price outperformance so far this year, the company continues to have the lowest forward valuation multiples among the Wall Street giants. A good argument can be made that Apple’s strong stock price outperformance in 2019 hasn’t been driven by expectations of strong 4Q19 numbers or even solid 1Q20 guidance. Instead, the marketplace may be betting on improved visibility around Apple’s financials through FY2021. The environment is becoming more hospitable for iPhone revenue growth to return in FY2020. At the same time, Apple wearables continue to gain momentum. There is then growing smoke around the idea of Apple potentially having a busy first half of CY2020 from a new product perspective.
My working Apple earnings model as well as my granular 4Q19 estimates including unit sales, ASP, and margin expectations, are available here. Above Avalon membership is required to read my full 4,000-word earnings preview. Access to my model is available to members at no additional cost.
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Above Avalon Podcast Episode 157: Let's Talk Apple and China
Apple finds itself amidst another controversy regarding removing HKmap.live from the App Store in Hong Kong. However, Apple is facing a different kind of backlash this time. Episode 157 is dedicated to discussing Neil’s thoughts on Apple doing business in China. Additional topics include Tim Cook’s engagement philosophy, Apple’s tool-making mission, and kowtowing to governments.
To listen to episode 157, go here.
The complete Above Avalon podcast episode archive is available here.
A Different View on Apple and China
Last week, a firestorm erupted over Apple’s decision to remove HKmap.live from the App Store in Hong Kong. Apple claimed the app, which mapped crowd-sourced information regarding police activity, broke App Store guidelines and local laws. Hours earlier, Apple had been threatened by China’s People’s Daily newspaper about continuing to make the app available.
In the past, such a decision would have been accompanied by a debate regarding Apple’s decision to continue to do business in China. However, things are different this time. Instead of a debate, virtue signaling is rampant. U.S. ideologies are being weaponized in a broader U.S. versus China debate, and Apple is finding itself caught in the middle.
Based on narratives in the U.S. press, Apple should become some type of political entity tasked with undermining political institutions. iPhones and iPads are to be used as indoctrination weapons for Apple’s beliefs. If such objectives represent Apple’s future, the company will first need new management, employees, customers, and a different board of directors, as Apple is not in the business of waging political wars.
How did we get to this point? Are we seeing a byproduct of U.S. and China trade tensions boil over? Did the NBA versus China clash a few days prior to Apple removing the app in Hong Kong touch a nerve in the U.S.?
Instead of publishing an article on Apple and China last week, I used the Above Avalon daily updates to share my initial thoughts on the developments. After sending out updates last Wednesday and Thursday, I received comments from Above Avalon members who live outside the U.S. They saw the situation from a different perspective. Simply put, they saw the complexity associated with the latest developments in Hong Kong and China. That same complexity is missing from U.S. press coverage of the situation.
There are pros and cons associated with Apple doing business in China just as there are pros and cons found with doing business in a long list of other countries. Even Apple’s decision to engage with the U.S. administration on certain issues can be debated. In some countries, like the U.S., Apple can discuss where it stands on social and political issues. In other countries, like China, such openness is not possible. This has led some to call Apple a hypocrite for “pontificating” on certain ideals only to be willing to do business in a country that doesn’t follow the same ideals.
Apple is no stranger to criticism regarding its decision to do business in China. Back in 2016, Cook said the following in response to critics who said he shouldn’t engage with the government:
“From my American mindset, I believe strongly in freedoms. They are at the core of what being an American is, and I have no confusion on that. But I also know that every country in the world decides their laws and regulations.”
Cook then alluded to “The Man in the Arena” passage from U.S. President Theodore Roosevelt’s “Citizenship in a Republic” speech:
“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”
In most politically dicey situations, Cook has followed Roosevelt’s advice and picked engagement. While Cook has become more comfortable talking about the ideals that guide Apple’s culture such as environmental responsibility, privacy, and equality, he doesn’t weaponize them to issue ultimatums to foreign governments. Instead, Cook uses his position as CEO to explain to the world which ideals guide Apple employees and the company’s mission to create tools for people.
This brings up a few questions: What drives Cook to follow Roosevelt’s advice and engage? Why does Apple put itself in what appears to be compromising positions in terms of doing business with certain countries if it doesn’t intend to leverage its position to push for immediate change?
My suspicion is that Cook doesn’t want Apple to become an idealistic mirage of itself with closed-mindedness reigning supreme. If Apple only did business in countries that have laws matching its beliefs, Apple would operate in just a handful of countries. Such a strategy would represent a big step back in Apple’s toolmaking mission as the biggest loser would be the Apple customer. In my view, that is a good enough reason for Apple to remain engaged with China and other countries rather than retreat into some kind of self-imposed bubble. The fact that the preceding opinion is now viewed as extremist in the U.S. shows just how far the narrative involving China has shifted. Ongoing issues between China and the U.S. regarding intellectual property theft and economic prowess have taken over the discussion, making Apple’s “engaged” strategy seem naive and out of date.
Another factor that likely plays a role in Cook’s engaged strategy is how Apple views its customers. I don’t think of Apple as a U.S. company. Instead, Apple is a global company headquartered in the U.S. That may seem like a subtle difference in terminology, but it speaks volumes. Apple doesn't look at its customers as Americans, Chinese, Russian, or German. Everyone is an Apple customer. This becomes apparent when attending an Apple product event at Apple Park. The cultural diversity found in the audience isn’t visible when watching the keynotes online. English ends up being just one of many different languages spoken at Apple events.
While governments around the world play a role in how Apple is able to reach its customers, as seen with Apple’s most recent app removal controversy in Hong Kong, that doesn’t take anything away from the ideals that guide Apple’s toolmaking mission. Those who think Apple should abandon China at whatever cost fail to recognize that China is now home to approximately 15% of Apple’s customers. Advocating that Apple should succumb to various pressures and shun anyone who may disagree with its ideals is the very definition of closed-mindedness.
As for the increasingly popular claim that Apple isn’t just doing business in China but is instead going so far as to kowtow to the government, the supporting evidence is underwhelming. Following local laws is not kowtowing. For example, removing an app that delivers news from a publication banned in a country is not kowtowing to China. Apple would do the same in any other country with similar laws. Instead, kowtowing would involve breaking other country’s laws merely because China told Apple to do so. Another example of kowtowing would be Apple telling its employees to change their ideals because China told them that is the only way to do business in the country. We simply don’t see Apple exhibiting such behavior, contrary to what is being reported in the U.S. press.
One example of kowtowing to China would be international companies agreeing to refer to Hong Kong, Macau, and Taiwan as part of China. However, the uniqueness found with that example is duly noted. Given how following economic sanctions imposed by the U.S on other countries end up being another example of companies kowtowing to a government, it’s clear that the topic deserves a much more nuanced debate.
While Apple executives struggle at times with how best to do business in China, the company has shown little to no hesitation in its broader engagement strategy. For example, Apple’s apparent final decision to pull HKmap.live from the App Store in Hong Kong took nearly a week to play itself out. Apple initially pulled the app only to reinstate the app and then pull the app again. However, at the end of the day, it was Cook who wrote a message to Apple employees explaining his decision - a decision that was met with intense skepticism by those in Hong Kong and the U.S.
There is no playbook for Apple management to follow when it comes to leading a trillion dollar company with a billion customers around the world. Cook’s decision to engage Apple will mean that there will be more controversies such as HKmap.live. Apple may not be completely ready for such controversies, but the company will likely be willing to confront them. Such a stance shouldn’t take anything away from Apple’s steadfast pursuit to leave the world a better place.
I don’t know what will unfold politically in China in a month, a year, or a decade from now. No one does, not even Apple. However, I am confident that Apple will continue to develop tools for improving people’s lives. It was this tool-making mission that initially led Cook to begin building Apple’s supply chain and manufacturing apparatus in China in the late 1990s. Cook saw how China, not the U.S., could support such a global apparatus capable of making a lot of high-quality products in a short amount of time.
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 membership, visit the membership page.
Above Avalon Podcast Episode 156: Apple's Content Distribution Arm
Content distribution has been a major theme for Apple in 2019. In episode 156, Neil goes over how Apple’s revised content distribution arm is structured. Neil also goes over his estimates for how much revenue and gross profit Apple’s content distribution arm can generate by FY2022. Additional discussion topics include the difference between Apple’s paid content bundles and content platforms, Neil’s initial estimates for the number of subscribers Apple will be able to grab for Apple TV+, Apple Arcade, and Apple News+, and why Apple’s new paid bundles will likely have lower profits than the App Store.
To listen to episode 156, go here.
The complete Above Avalon podcast episode archive is available here.
Measuring Apple's Content Distribution Arm
Apple has had a busy year expanding its content distribution arm. With the addition of Apple News+, Apple Arcade, and Apple TV+, Apple has revamped its paid content bundle offerings. Combining these new bundles with platforms like the App Store and iTunes, Apple will be in a position to have a content distribution arm bringing in more than $30 billion of revenue per year by FY2022.
Mapping Out Apple’s Content Distribution Arm
There are two parts to Apple’s content distribution arm: paid bundles and platforms. Paid bundles offer users access to third-party content (first-party content in the case of Apple TV+) for a set price each month. Platforms offer users the ability to consume a wide range of third-party content via paid and free downloads, in-app purchases, and paid subscriptions.
Exhibit 1: Apple’s Content Distribution Arm
Paid Bundles
Apple Music. Launched in 2015, Apple Music now has more than 60 million paying subscribers in more than 100 countries. In the U.S., an individual membership that includes a music catalog of 50 million songs goes for $9.99 per month ($99.99 per year) with student ($4.99 per month) and family ($14.99 per month) pricing also available.
Apple TV+. Apple’s new direct-to-consumer paid video streaming service will launch on November 1st in more than 100 countries. Built into the Apple TV app, Apple TV+ will include nine original video series and movies at launch, and new series and movies will be added each month. Apple is spending approximately $2 billion per year on original video content. An Apple TV+ subscription will go for $4.99 with Family Sharing although Apple is having a limited time promotion of one free year of Apple TV+ with a qualifying Apple device purchase. A detailed look at Apple’s TV+ strategy is available here.
Apple Arcade. Launched two weeks ago at $4.99 per month with Family Sharing, Apple Arcade offers subscribers access to approximately 70 exclusive games, and new titles will be added each month. Available in more than 150 countries, Apple Arcade utilizes a new business model for the App Store with Apple funding game development although ownership rights remain with the game developer.
Apple News+. Launched this past March, Apple News+ offers subscribers access to approximately 300 paid magazines and a handful of news publications. Built into the Apple News app, Apple News+ monthly subscription pricing of $9.99 includes Family Sharing with access for up to five other people. Apple News+ is currently available in the U.S., Canada, UK, and Australia.
Platforms
App Stores (iOS, tvOS, macOS). With 2.2 million iOS apps available to download, the App Store remains a cultural phenomenon. Various business models are supported through the App Store including paid and free apps, ad-supported, in-app purchases, and paid subscriptions.
Apple TV App. The new Apple TV app offers “channels” through which users can subscribe to approximately two dozen third-party video bundles.
iTunes. Despite Apple deemphasizing iTunes by breaking out functionality into different apps, the platform still represents a source of paid download revenue.
Apple Books. Apple offers a wide range of paid and free titles.
Apple News. Launched in 2015, Apple News offers users a wide selection of free and ad-supported written content from around the web. Apple News has 90M monthly active users thanks to prime real estate on Apple devices and a heavy emphasis on human curation.
Apple Podcasts. Apple is the leading distributor of podcasts with more than 600,000 available. Apple currently doesn’t directly monetize the Apple Podcasts app.
Subscription Estimates
In order to measure the size of Apple’s content distribution arm, one can first estimate the number of subscriptions Apple will generate from its four paid content bundles. Those totals can then be used to derive revenue estimates. The final step is to come up with growth trajectories for Apple’s various content platforms.
Exhibit 2 includes my estimates for the number of paid subscriptions Apple can achieve for its four paid bundles within three years, or by the end of FY2022 (September 2022). These estimates assume additional refinement and a certain amount of evolution such as an improved user interface for Apple News+, a larger video catalog for Apple TV+, and a continuously expanding number of games in Apple Arcade.
Exhibit 2: Apple Paid Content Bundle - Subscription Estimates (YE2022)
One important consideration found with these paid bundles is that each supports Family Sharing. While my estimates call for the four paid bundles to have a total of 188 million paid subscriptions, Family Sharing will mean that the number of Apple users having access to at least one paid bundle will likely exceed 350 million. This amounts to roughly one in three Apple users having at least one paid subscription to Apple Music, Apple TV+, Apple News+, or Apple Arcade.
Additional explanation regarding my paid bundle subscription estimates follows:
Apple Music. As shown in exhibit 3, it took Apple a little less than three years to reach 40 million Apple Music subscribers with the service available in more than 100 countries. Apple is currently adding 1.3 million to 1.4 million Apple Music subscribers per month. My 95 million Apple Music subscriber estimate by FY2022 reflects Apple being able to maintain the current growth rate over the next three years.
Exhibit 3: Number of Apple Music Subscribers
Tailwinds for Apple Music subscriber growth include the paid music streaming pie continuing to expand and Apple seeing continued success competing against Spotify in developed markets. Growth headwinds include Apple already experiencing some of the easier subscriber growth in the U.S.
Apple TV+. Apple has a few things going for it when it comes to grabbing a significant number of Apple TV+ subscribers in the coming years.
Netflix and Hulu have shown that many U.S. consumers see value in paying for direct-to-consumer video streaming bundles. In addition, the market will likely support a number of players and not just Netflix. A similar phenomenon is observed outside the U.S. as Netflix follows a localized content strategy.
Apple went with an aggressive $4.99 per month launch price for Apple TV+ as well as a limited time promotion of one year free with a qualifying Apple device purchase. Such a promotion will introduce quite a few Apple users to Apple TV+ in a very short amount of time.
My 55 million subscriber estimate for Apple TV+ assumes Apple sees stronger adoption for the service than it achieved with Apple Music over the same amount of time. For context, Disney expects Disney+ will be able to grab 60 million to 90 million subscribers by 2024. However, that range is likely conservative.
Apple Arcade. According to Apple, 500 million people visit the App Store each week. After taking into account Family Sharing, the number of families accessing the App Store each week may be closer to 350 million. My 30 million paid subscriber estimate assumes nine percent of families outside of China who frequent the App Store will sign up for Apple Arcade over the next three years.
Apple News+. My 8 million subscriber estimate reflects Apple continuing to evolve News+ in the coming years. Limited availability will remain a major headwind for subscriber growth as it reduces the addressable market to a fraction of Apple’s billion users. In addition, my 8 million subscriber estimate is influenced by larger headwinds found with consumers not seeing value in many of the magazines included in Apple News+. At the end of the day, the scale associated with paid written news simply isn’t in the same league as video and music streaming. For context, the two largest news sites in terms of the number of digital subscribers, the NYT and WSJ, have 3.0 million and 1.8 million digital subscribers, respectively.
Revenue and Gross Profit Estimates
When estimating revenue and gross profit for Apple’s four paid content bundles, the accounting treatment associated with revenue sharing arrangements needs to be considered. Apple reportedly relies on a 50% revenue share arrangement with Apple News+. Similar to how App Store revenue is reported on a net basis, Apple will only report its share of Apple News+ revenue. Apple will report Apple Music, Apple Arcade, and Apple TV+ revenue on a gross basis as those services do not include any type of revenue share arrangement.
Exhibit 4: Apple Paid Content Bundle - Revenue Estimates (FY2022)
For this exercise, my gross profit estimates reflect costs tied directly to each paid content bundle. For Apple Music, the approximately 70% of every dollar that is paid out to music rights holders is taken into consideration. For Apple TV+ and Apple Arcade, the amount of cash spent on content is taken into consideration. It is important to point out that SG&A costs are not reflected in these calculations.
Exhibit 5: Apple Paid Content Bundle - Gross Profit Estimates (FY2022)
Apple’s Other Content Distribution Businesses
With estimates for Apple’s content bundles in hand, attention turns to estimating the amount of revenue generated by Apple’s content platforms. While Apple does not break out the amount of revenue generated by the App Store or iTunes, management has provided various financial clues that allow one to back into accurate App Store revenue estimates.
In FY2019, my estimate is that the App Store will be responsible for approximately $13 billion of revenue and $8 billion of gross profit. Apple reports App Store revenue on a net basis, reporting only its share of revenue although the full costs to run the entire App Store (84% of apps don’t bring in any revenue) are passed through the income statement. After taking into account every other content distribution platform, including iTunes, my estimate is that Apple will bring in close to $15 billion of platform revenue and $9 billion of gross profit in FY2019.
When forecasting revenue trends for Apple’s content platforms over the next three years, it is important to consider the possibility of Apple’s new content bundle offerings cannibalizing a percentage of paid downloads and in-app purchases. For example, a portion of App Store revenue will likely flow to Apple Arcade over time while iTunes revenue continues to decline due to Apple Music. Assuming 10% of App Store revenue ends up being cannibalized by Apple Arcade, my estimate is that Apple’s various content platforms will see 6% growth year-over-year leading to $16 billion of revenue in FY2022.
Adding my $15 billion revenue estimate for Apples four paid bundles with my $17 billion revenue estimate for Apple’s platforms leads to an overall content distribution arm expected to bring in $32 billion of revenue and $15 billion of gross profit per year by the end of FY2022.
Exhibit 6: Apple’s Content Distribution Arm - Revenue and Gross Profit Estimates (FY2022)
Risks
The following items represent risk factors to my estimates:
Industry dynamics. The single largest risk factor is mostly out of Apple’s control – the degree to which people will be willing to pay for written content from traditional magazines, rent music and videos, and pay a set price each month to access games.
Competition. My estimates do not assume much adoption among users in China. Accordingly, China / WeChat do not represent risk factors to my estimates. Instead, Amazon’s digital content distribution aspirations represent a much larger risk.
Regulation. There are a number of parties looking to attack the App Store on antitrust grounds. At this time, my estimates do not reflect any material adverse change to App Store economics from these efforts.
Takeaways
Based on the preceding estimates, there are a number of takeaways:
A $32 billion revenue run rate per year is roughly double the amount of revenue Netflix currently earns in a year. However, when considering Apple’s overall business, the content distribution arm will likely represent approximately 11% of Apple’s overall revenue. This reinforces the view that content distribution will continue to represent a relatively small fraction of Apple’s overall business.
Apple’s paid bundles will likely have lower profit margins than Apple’s content platforms given how Apple is funding original content for Apple TV+ and game development. Apple Music revenue being reported on a gross basis also pressures overall margins found with the paid bundles.
The App Store will likely remain the most profitable piece of Apple’s content distribution arm for the foreseeable future given that revenue is reported on a net basis.
While Apple’s overall content distribution arm will be highly profitable, it likely still won’t be as profitable as Apple’s other services including AppleCare+, iCloud, Search Ads, and Licensing. While different accounting treatments (net vs. gross revenue recognition) play a role in driving down profitability, the larger factor is that Apple will need to continue investing in Apple TV+ and Apple Arcade.
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 membership, visit the membership page.
Above Avalon Podcast Episode 155: The Apple Keynote
Apple keynotes remain some of the most valuable marketing events in today’s media landscape. Episode 155 is dedicated to going over Neil’s thoughts on the Apple keynote. Discussion topics include the odd criticism facing Apple keynotes, the three primary benefits Apple derives from them, how the Apple keynote has evolved, and areas in which Apple can improve the keynote.
To listen to episode 155, go here.
The complete Above Avalon podcast episode archive is available here.
Apple Keynotes Still Matter
It didn’t take long for critics to go after Apple’s recent product event at Steve Jobs Theater. However, the backlash had a dramatically different tone this time around. Instead of focusing on the new products unveiled on stage, much of the criticism was aimed at the event itself.
The New York Times ran an opinion piece calling for the end of Apple keynotes and claiming there is no longer a place for such “pageants” in today’s polarizing world. Others took to Twitter to say how Apple’s dessert offerings suggested the company is tone deaf or to complain about members of the audience becoming too emotional while hearing Apple Watch users tell stories of how the device saved their lives.
While Apple cynicism isn’t new, the preceding opinions represent a new kind of outrage. Apple keynotes remain some of the most valuable marketing events in today’s media landscape. In addition, keynotes provide a number of intangibles that it would be difficult for Apple to communicate any other way. It is in Apple’s best interest to continue hosting keynotes and product events, especially as the company moves into the wearables era.
Odd Criticism
In an opinion piece titled, “The Last Apple Keynote (Let’s Hope),” Charlie Warzel wrote:
“But what started as a Steve Jobs TED talk has become a parody — a decadent pageant of Palo Alto executives, clothed in their finest Dad Casual, reading ad copy as lead-ins for vaguely sexual jump-cut videos of brushed aluminum under nightclub lighting. The events are exhausting love letters to consumerism complete with rounds of applause from the laptop-lit faces of the tech blogging audience when executives mention that you (yes you!) can hold the future in your hands for just $24.95 per month or $599 with trade-in.
The entire event is at odds with our current moment — one in which inequality, economic precarity and populist frustration have infiltrated our politics and reshaped our relationships with once-adored tech companies. But it’s not just the tech backlash. When the world feels increasingly volatile and fragile, it feels a little obscene to gather to worship a $1,000 phone. Serving journalists pastries topped with gold leaf doesn’t do much to help either.”
My initial reaction to Warzel’s article was that it must have been some kind of manufactured outrage piece since the “pageant” he describes didn't come close to describing an actual Apple keynote. The media doesn’t “worship” Apple at these events. The rounds of applause aren’t coming from the media / press.
The following screenshot from inside Steve Jobs Theater during the recent Apple event does a good job of showing who attends Apple keynotes at Steve Jobs Theater. Contrary to what some may think, the media and press, denoted by the laptops in use, make up 55% to 60% of the audience. The rest of the crowd is comprised of Apple employees, guests, and VIPs.
Apple’s decision to serve refreshments, which did include delicious desserts, isn’t obscene. Instead, it’s a courtesy extended to guests who wouldn’t otherwise have a chance to eat anything. Many tech writers and reviewers spend up to six hours on Apple event days doing their jobs (shooting videos, taking photographs, getting hands-on time with the products, filing reports by strict deadlines).
After reading Warzel’s piece a few times, the only logical takeaway was that the Apple keynote was a victim of a deeper discontent that he holds towards Apple. Warzel sounded uncomfortable with the idea of Apple having the audacity to sell approachable luxury in a world that is apparently turning against tech companies.
Value
Not surprisingly, Warzel failed to recognize any reason why Apple keynotes still matter and are of immense value in today’s media landscape.
Apple derives three primary benefits from its keynotes:
Earned Media. Apple keynotes command days of media coverage during an era when the news cycle is measured in hours. No other company is able to grab the kind of attention that Apple earns. When taking into account previews published ahead of Apple events and the various reviews in the days that follow, it is conceivable that Apple receives hundreds of millions of dollars of free press from a single keynote.
Theater and Design. Apple events are productions built and designed to provide an experience to those in attendance. This is one reason why Steve Jobs Theater is so important to Apple. The event venue ends up telling guests a little bit about the people who built the products announced on stage. The typical Apple keynote audience will include representatives from various Apple partners, industry leaders, and special guests.
Employee Morale Boost. No one wants the product that they have spent two or more years working on to be unveiled to the world in a press release. Instead, to have that new idea unveiled on stage at an event watched by a few million people provides an amount of satisfaction and accomplishment that goes a long way given the sacrifice that went into making that product a reality.
Any one of those items by themselves would be reason enough for Apple to continue putting on keynotes. With all three factors on display at most keynotes, there is no valid or logical reason for Apple to stop hosting these events. Holding keynotes is a smart and rational business decision for Apple.
Evolution
The Apple keynote isn’t a static entity. What used to be smaller affairs targeting technology writers and gadget reviewers have evolved into global events bringing together people from different continents and diverse backgrounds.
Although it is now difficult to believe, Apple keynotes weren’t even live-streamed as recently as a few years ago. Instead, event live blogs were the only way to find out what Apple was even announcing. Meanwhile, the recent event at Steve Jobs Theater was live-streamed on YouTube for the first time and reportedly had three million viewers.
The now iconic iPod unveiling at Apple’s Town Hall auditorium back in 2001 doesn’t look anything like the modern day Apple keynote.
Apple events used to be targeted toward tech writers and gadget reviewers who would publish the all-important “yes” or “no” decision as to whether or not a new Apple product was worthy of purchase. Walt Mossberg, the dean of gadget reviewers, symbolized this era. Things are dramatically different today. No single reviewer or publication holds enough influence to make or break a new Apple product.
The Apple keynote presentation itself has changed dramatically as well. Fifteen years ago, Apple keynotes consisted primarily of Steve Jobs going through slide after slide with a few demoes here and there. In January 2007, during the iPhone unveiling, Steve Jobs was on stage by himself for 88% of the 103-minute presentation. Much of his focus was spent on making the case for why a certain new Apple product should exist. Apple had a user base that was a fraction of its current size. Steve ended up selling more than just the product announced on stage. Steve was selling Apple.
In contrast, last week’s Apple keynote had nine different presenters, Apple employees who worked on the product being unveiled. Tim Cook, in what has become his usual role of a master of ceremonies, was on stage for approximately 14% of the time.
Leveraging Video
A few years ago, the Apple keynote was thought to be on its last legs. Thanks to the rise of social media, Apple events were expected to have trouble remaining relevant in the news cycle for longer than a few hours. In addition, it wasn’t entirely clear how Apple would handle critical product unveilings, demos, and “one more things” that had been handled by Steve.
As it turned out, the Apple keynote went on to not just maintain its influence, but to actually gain value in today’s media landscape.
What changed?
Apple bet big on video.
Apple keynotes now include a heavy reliance on video for handling many segments of the traditional presentation. Everything from showing off products for the first time to going over the product’s sales pitch is handled by video. It helps that these videos are very well done.
While Apple’s initial move to video was viewed as a way to handle the presentation role that had been given to Steve, the increased usage of videos began to serve other purposes. Videos shown during Apple events now go on to be watched and passed around on social media. In 2007, the iPhone unveiling consisted of six short videos, most of which were just clips of TV shows and movies, representing 2% of stage time. At last week’s Apple event at Steve Jobs Theater, 11 videos were shown, representing nearly 22% of stage time. Three of those videos, some of which went on to be included in ad campaigns, have a collective 55M views on YouTube.
Apple extended this bet on video to include 120-second comical recaps of its keynotes. The videos have been receiving rave reviews after each event. Such recap videos were unimaginable just a few years ago as they would have been looked at as Apple essentially telling people not to bother watching the full presentation. As it turned out, the recap videos have become a great way for Apple to bring the keynotes to life. Recap videos receive four to five times the number of views as the full keynotes. Relatively speaking, few people go back to rewatch a 100-minute Apple keynote. However, people do go back and watch a two-minute recap video of that 100-minute Apple keynote.
Improvement
Apple is in a league of its own when it comes to product unveilings. Amazon’s strategy of shipping duds and failures in an attempt to find something that people will like doesn’t support large-scale product keynotes and events.
Google has tried to get into the hardware event mindset, but the company just doesn’t seem interested in following Apple down the big keynote path. Microsoft and Samsung try to emulate Apple keynotes with both companies going heavy on the theatrical side of things. At the end of the day, keynotes from these companies just aren’t able to generate and sustain the level of buzz and interest that Apple creates.
There are two areas in which Apple can improve the keynote.
Onstage demoes need to be rethought.
Aim for greater secrecy.
Giving precious stage time to game or app demoes is increasingly questionable. This isn’t meant to say that we have moved past demoes altogether and Apple should simply fill the time with more videos. There is a role for demoes to play if showing something in the flesh can prove a point more effectively than a simple video can - not an easy thing to accomplish given how good Apple’s marketing videos have become. However, a balance is needed between the tangible demo and video.
It’s been a while since there has been a memorable demo at an Apple keynote. One example that jumps out at me is from 20 years ago when Phil Schiller, Apple’s SVP marketing, jumped off a 20-foot ledge.
Another example is the Steve Jobs’ hula hoop demo. In both cases, the demoes were a clever way of highlighting the “freedom” associated with Wi-Fi on an iBook.
One reason the preceding demos worked so well was that they were performed in front of a massive audience of developers. Even today, Apple’s WWDC keynotes have a different vibe than events at Steve Jobs Theater given the 5,000 developers in the audience.
With on stage demos come risks, and it is understandable that Apple would want to de-risk its keynotes as much as possible. Two years ago, a minor mishap with a Face ID demo ended up being one of the most talked about items from Apple’s event with some going so far as to say the demo failure meant the feature wasn’t ready for prime time. Such a demo failure probably wouldn’t have been made into as big of a deal ten years earlier.
Well-done demos can give keynotes a certain amount of soul. During Apple’s Services event this past March, the “demo” involving Hollywood celebrities played out well from the perspective of being in the audience. Apple had a message that it wanted to push forward - it had the ability to grab the biggest names in Hollywood for Apple TV+, and the “demo” effectively reflected that message.
As we move further into the wearables era, Apple demoes involving smart glasses could prove to be a great way of unveiling new ideas and concepts to the world. The recent string of AR demoes at Apple keynotes have left much to be desired as people simply run around empty tables or desks with iPads in hand.
The other area that can always be improved upon is secrecy. There is something about seeing or learning about a product for the first time when it is announced on stage. Google’s decision to soft unveil the Pixel 4 removes much of the oxygen from its upcoming Pixel hardware event. While it’s not easy for Apple to maintain secrecy around unannounced products, the company has seen more success on the secrecy front recently. Last week, Apple was able to surprise the world by positioning an always-on display as a key feature of the Apple Watch Series 5. The feature didn’t leak beforehand.
Products
Apple keynotes end up reminding me a lot of Apple retail stores. The success found with each item ultimately depends on the product being sold. If Apple doesn’t have compelling products that people are interested in, the keynotes used to demonstrate such products will fall flat.
While some may hold cynicism towards a trillion dollar company unveiling $1,400 Apple Watches and $1,100 iPhones in an underground theater that cost more than $100M to build, such a stance ignores the impact Apple products are having on people’s lives. Apple keynotes end up being a way for the people building these tools to tell the world why such products should exist and how they can be used to improve the lives of a billion people. There is still a role for the Apple keynote to play in today’s always-changing world.
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 membership, visit the membership page.
Above Avalon Podcast Episode 154: Which iPhone Is That?
Naming iPhones is more art than science. In episode 154, Neil shares his thoughts on Apple’s iPhone naming strategy. The episode includes an oral history of iPhone nomenclature followed by a discussion of where Apple can bring iPhone naming in the future. Neil also goes over why the art of naming iPhones even matters when looking at the big picture.
To listen to episode 154, go here.
The complete Above Avalon podcast episode archive is available here.
Naming iPhones
Over the years, iPhone naming has had its ups and downs. There were the awkward names like iPhone 3GS and iPhone XS Max, and then there were strong industry-defining names like iPhone X. Based on the latest rumors, Apple appears to be in the early stages of moving away from an annual iPhone naming cadence altogether.
History
Most iPhones have an interesting story when it comes to nomenclature.
iPhone (2007). By going with “iPhone,” Apple relied heavily on consumers making the mental connection between a “breakthrough internet communications device” and a traditional cell phone. By relying on existing connotations, the iPhone sales pitch was made that much easier. Apple went on to use a similar naming strategy with Apple Watch.
iPhone 3G (2008). In retrospect, this may have been the most surprising iPhone name to date. Apple called the first update of its breakthrough mobile product after an industry term: 3G. The decision also spoke volumes about what drove iPhone adoption out of the gate. An iPhone with faster cellular connectivity was positioned as a key factor in customers' purchase decisions.
iPhone 3GS (2009). This is when things got weird with iPhone nomenclature. As explained by Apple’s Phil Schiller at the time, the “S” in iPhone 3GS stood for speed. The naming decision demonstrated how something that is now viewed as trivial - processor speed - was positioned as a key selling point for an early iPhone.
iPhone 4 (2010). Apple entered an iPhone naming scheme that would go on to last for years: a whole number characterized by a cosmetic redesign was followed by an “S” version the following year with more in the way of internal upgrades.
iPhone 4s (2011). An iPhone 4 with internal improvements. The “S” cycle provided Apple a few benefits. By sticking with the same overall iPhone design for more than a year, Apple was able to ramp up iPhone production quickly, and at a lower price, for “S” launches. The “S” cycle also reflected how consumers bought iPhones at the time. In the U.S., mobile carriers subsidized iPhones for $199 with the purchase of two-year contracts. The remaining price of the iPhone was recouped through higher monthly charges for data, texts, and service. This led to a two-year iPhone upgrade cycle and people choosing to either be on the whole number or “S” upgrade path.
iPhone 5 (2012). Arguably, this was the least noteworthy naming decision as Apple simply followed the existing pattern of using a whole number following the “S” model to denote a major cosmetic change. The iPhone 5 was the first iPhone to have a 4-inch screen.
iPhone 5c / 5s (2013). Apple faced its first major naming dilemma. In an effort to boost iPhone 5s sales and to maintain iPhone margins, Apple chose to replace the iPhone 5’s outer shell with lower cost colorful polycarbonate shells. Apple called this new model the iPhone 5c, and “c” presumably stood for color. Pundits ended up looking at the “c” as standing for cheap given the iPhone 5c’s lower price relative to iPhone 5s.
iPhone 6 / 6 Plus (2014). For the first time, Apple introduced two new flagship iPhones simultaneously - one with a 4.7-inch screen and the other with a 5.5-inch screen. Apple went with “Plus” for the model with the larger screen. The name worked as there was no other major difference between the two iPhone models aside from screen size (and battery life).
iPhone 6s / 6s Plus / SE (2015). This is where the iPhone “S” cycle began to lose much of its meaning from a feature and product development perspective. While the market would continue to look at “S” years as refinement years, Apple began to shift iPhone development so that every iPhone update contained a handful of useful new technologies and features. As for iPhone SE, Apple introduced a new model containing components from a few prior flagship iPhones in March 2016 with “SE” meaning special edition.
iPhone 7 / 7 Plus (2016). As was the year of iPhone 5, this was another uneventful year for iPhone naming. Apple followed the logical next step in an iPhone naming scheme that had been used for the previous six years.
iPhone X / 8 / 8 Plus (2017). iPhone naming seemed to cross the point of no return. Apple decided to call the first iPhone lacking a front-facing home button, something that had been rumored for years, iPhone X. For iPhone 8 and 8 Plus, instead of sticking with the “S” cycle, Apple skipped ahead to the next whole number. The decision was meant to have the new models be perceived as more advanced than what may have been implied with an “S” nomenclature.
iPhone XS / XS Max / XR (2018). Last year’s flagships were the most confusing from an iPhone naming perspective. Apple followed three general guidelines:
Apple reverted back to the “S” playbook to denote the model after a major redesign (iPhone X). Instead of this decision implying the return of the “S” cycle, in my view, Apple simply wanted to stick with the X branding for one more year.
“Max” was used to distinguish the larger iPhone model from its smaller XS sibling.
“R” was used for the lower cost alternative to the two iPhone XS flagships. According to Schiller, the “R” didn’t stand for anything, although some thought it stood for the model having a Retina display while “S” stood for Super Retina. Schiller mentioned that the letters R and S are used in the auto space to highlight special models.
The 2019 Lineup
Given Apple’s decision to go with the iPhone X naming scheme in 2017 and 2018, there aren’t too many logical paths that iPhone naming could follow unless Apple wants to try something completely new. There are two obvious choices:
iPhone XI (continue using roman numerals). Apple would say it’s pronounced “iPhone eleven” but everyone would call it “iPhone ex I.” While roman numerals could work if Apple were selling one flagship model, the fact that Apple has three flagships in the line would produce some confusion. Names like XI Max, XI Pro, or XIR aren’t as strong as the powerful iPhone X.
iPhone 11. This is a much simpler naming track. It makes more sense for Apple to use 11 than 12 as the implication is that the new iPhones are follow-ups to the iPhone X series. However, there is precedent for Apple to skip whole numbers as seen with the lack of iPhone 2 and iPhone 9.
The latest rumors point to Apple unveiling three new iPhones next week:
iPhone 11 Pro Max (successor to iPhone XS Max)
iPhone 11 Pro (successor to iPhone XS)
iPhone 11 (successor to iPhone XR)
The “Pro” would signal Apple wanting to draw attention to the differentiation between the two high-end flagship models and the lowest cost flagship. Apple has typically liked to use “Pro” to reflect models with greater specifications and capability as seen with iPad Pro, MacBook Pro, iMac Pro, and Mac Pro. In order to distinguish between the two “Pro” models, Apple would continue to use “Max” to denote the model with the largest screen.
Observations
Naming iPhones is more art than science. For example, the “R” in iPhone XR likely was chosen simply because it looked and sounded better than other letters. Meanwhile, Apple’s decision to go with “X” was likely heavily based on marketing, both in terms of marking the iPhone’s tenth anniversary and the fact that it looks cool and powerful from a branding perspective.
However, there is no question that iPhone nomenclature has been losing some of its usefulness and utility. Consumers are now routinely mispronouncing or misidentifying iPhone names and it’s easy to see why: iPhone XS Max doesn't exactly roll off one’s tongue. A similar issue will be seen if Apple ends up going with “iPhone 11 Pro Max.” People are increasingly saying “the new iPhone” or “the biggest one” when referring to the latest flagships.
It’s difficult to say if these changes have had a negative impact on iPhone sales. The iPhone business is being impacted by a number of developments including a longer upgrade cycle as people become content with what they currently have. It’s doubtful that a particular letter or number in the name would entice users to upgrade en masse to a certain iPhone model.
Future Considerations
Based on my calculations regarding the iPhone upgrade cycle, the next marginal iPhone buyer will likely hold on to his or her iPhone for a little over four years before upgrading. As the iPhone upgrade cycle continues to extend, the case for coming up with new iPhone naming every year declines.
There are subtle clues that suggest we may be approaching the point when Apple will do away with the annual iPhone naming cadence altogether. This wouldn’t mean that Apple would just go with “iPhone.” Instead, Apple would still need a way to distinguish iPhone models with different sizes and capabilities. In such a case, one likely option would be:
iPhone Pro (iPhones containing the most capability)
iPhone (the middle of the road option for the masses)
iPhone mini (the iPhone containing the smallest screen and fewest features)
One possibility is that Apple will expand the iPhone line to include more than three flagship models. For example, an updated iPhone SE would be a prime candidate for “iPhone mini.” Meanwhile, a larger model in the $699 to $799 range would make sense for “iPhone” while Apple would have more than one “Pro” model at the high end of the line. This naming strategy would be similar to how Apple currently names iPads: two “Pro” models, iPad mini, and iPad. (The iPad Air is positioned as a lower-cost iPad Pro.)
As for timing, 2021 may be a good bet for the earliest point when Apple would use this iPhone nomenclature. Consider the following:
By 2021, “Pro” will have likely been used in iPhone nomenclature for two years.
The latest rumors have Apple unveiling both a flagship iPhone with a smaller screen and an updated iPhone SE in 2020. These models would make it easier for Apple to use a simpler iPhone naming scheme. As it stands now, it would be difficult for Apple to position the middle-priced $999 model as just “iPhone.” Instead, the iPhone XR has been the best-selling model.
In the event that Apple plans on sticking with whole numbers for iPhone naming, the 2021 iPhones would potentially be called iPhone 13 - one of the more superstitious numbers in existence. Apple could use that occasion as a way of moving past numbers and letters altogether.
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