Neil Cybart 2/12/19 Neil Cybart 2/12/19

Viral AirPods, Amazon to Buy Eero, Estimating Apple’s Google TAC Revenue

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February 12th, 2019: Viral AirPods, Amazon to Buy Eero, Estimating Apple’s Google TAC Revenue

Speaking of hardware start-ups getting acquired prior to IPO, Amazon announced it will acquire Eero, a mesh Wi-Fi router start-up. We will go over the development in today’s update.

However, we will kick things off with AirPods.

Viral AirPods

There is a fascinating story to tell about AirPods.

Two months ago, we discussed how interest in AirPods had started to surge. Search interest, as measured by Google Trends, was up 3.5x year-over-year this past Black Friday. That type of year-over-year change is abnormally high for an Apple product.

In the following weeks, I kept an eye on Google Trends data and things turned even more remarkable. During the holiday week (Christmas through New Year’s), search interest for AirPods was up 5x year-over-year.

This got me thinking, What is happening with AirPods?

After a few weeks of work, my conclusions are found in the latest Above Avalon weekly article, “AirPods Have Gone Viral.”

AirPods have been available for nine quarters. Here are cumulative unit sales as of the ninth quarter of availability (AirPods and Apple Watch figures are my estimates):

iPad: 84M
AirPods: 37M
iPhone: 34M
Apple Watch: 27M
iPod: 2M

iPad was an outlier when it comes to early adoption. The device was able to ride the iPhone’s coattails perfectly.

AirPods sales have exceeded Apple Watch sales at the same point after launch by nearly 40%. Some of that isn’t too surprising given AirPods' $159 price and the fact that the case for wireless headphones is easier to make than a new kind of utility on the wrist.

Upgrade trends make a big difference when thinking about cumulative unit sales. For AirPods, we can probably include replacement trends to account for people buying a second pair of AirPods after losing the first pair. Early iPhone sales benefited from a two-year upgrade cycle. We haven’t seen a similar upgrade pattern for Apple Watch. It remains to be seen how AirPodsupgrading will trend.

When taking into account upgrading, one way of thinking about the cumulative sales is the size of the installed bases by the end of the third year of availability.

iPad: 118M
iPhone: 55M
AirPods: ~50M
Apple Watch: ~30M

However, when it comes to the item that stood out to me the most from the article, we have to turn to the reasons behind AirPods going viral.

High Visibility. AirPods are literally hanging out of people’s ears. They are difficult to miss when worn.
New and Different. The product is intriguing, sparking curiosity.
Social Signaling. Wearing AirPods signal to others that the wearer likely has an iPhone and is able to pay $159 for a pair of wireless headphones despite a wired pair being included in the iPhone box.

There is a commonality found with the three preceding factors. It may sound incredibly simple and straightforward, but consensus has likely overlooked this item.

People want to wear AirPods and be seen wearing them. They're cool. They have the "it" factor.

It brings back memories of the iPod days.

The lack of genuine competition in the wearables space has caught many people by surprise. However, when thinking of reasons behind the lack of competition, many people in tech circles have pointed to technology (or the lack thereof) as the culprit.

In my view, Apple's most important competitive advantage with wearables hasn't been found with tech performance. Instead, it's been related to fashion and design. Apple Watch and AirPods adoption have been driven by people wanting to wear these devices and, maybe even more importantly, wanting to be seen by others wearing the devices.

What is going to happen when Amazon launches its own wireless headphones? Voice advocates may jump up and down in excitement. However, will people want to be seen wearing items known as digital assistant conduits before anything else? I'm skeptical.

For the past few years, Apple has demonstrated the capability to come up with cool products that people want to be seen using and wearing. While that may seem a bit superficial, for wearables it represents a key ingredient for success.

When thinking about a pair of lightweight smart glasses, the only way Apple will succeed with such a product is if people want to be seen in public wearing them. It's that simple. Yes, the value proposition has to be there to sustain interest. The technology has to be compelling in order for consumers to crave a space for the product in their lives. However, the value prop and technology will only matter as long as people want to wear the device in the first place.

The major takeaway from AirPods going viral is that Apple has a product on its hands that people want to be seen wearing. It's going to be very difficult for other companies to recreate the phenomenon.

Amazon to Buy Eero

Here’s Amazon in a press release:

“Amazon and eero today announced that they have entered into a definitive merger agreement under which Amazon will acquire eero. eero’s home mesh WiFi systems set up in minutes and blanket every room of a customer’s home in high-performing, reliable WiFi. eero is already delighting Amazon customers with its products and services, as indicated by eero’s 4.6-star product rating on Amazon.com.

‘We are incredibly impressed with the eero team and how quickly they invented a WiFi solution that makes connected devices just work,’ said Dave Limp, SVP of Amazon Devices and Services. ‘We have a shared vision that the smart home experience can get even easier, and we’re committed to continue innovating on behalf of customers.’

‘From the beginning, eero’s mission has been to make the technology in homes just work,’ said Nick Weaver, Co-Founder and CEO of eero. ‘We started with WiFi because it’s the foundation of the modern home. Every customer deserves reliable and secure WiFi in every room. By joining the Amazon family, we’re excited to learn from and work closely with a team that is defining the future of the home, accelerate our mission, and bring eero systems to more customers around the globe.’

eero uses multiple access points that work together as a system to blanket a home in high-performing, reliable, and simple home WiFi. Customers can customize an eero system to meet the needs of their home—regardless of shape or size—eliminating dead zones, ensuring perfect streaming video in every room, and delivering the bandwidth all connected devices need.”

This acquisition is all about Amazon grabbing user data within the home. Amazon wants to know more about you in order to then be in a better position to sell you stuff.

In a way, Amazon wants to know what you are going to buy before you even know it yourself. This will require knowing what devices you own, which devices you are using, and more importantly, how you are using those devices. When it comes to retail competition in the future, predictive purchasing will certainly classify as a competitive advantage.

The writing is on the wall.

We are moving to the point where a consumer will have the opportunity to go all-in on an “Amazon home” in which Echo speakers, microphones, locks, a security system, a Wi-Fi router, and various third-party smart appliances with Alexa built in are all connected to Amazon.

This is crucial for Amazon because the home has become an e-commerce engine. We are likely going to buy most of our stuff online within the confines of our home. In addition, our home is the delivery point for all of those goods. Said another way, Amazon needs to bet big on the home.

Being careful not to go off on too much of a tangent, this dynamic explains why Google’s home play feels less compelling. Amazon is a retailer looking to solidify its position in the place you are likely to buy most of your stuff. That makes sense. What’s Google’s message for the home? A vehicle to give you all of the information and knowledge you can ever want? It’s murky. Meanwhile, Apple’s aim is to sell you the most powerful and useful computing tools that you will use in the home.

The amount of pushback, at least on Twitter, to Eero announcing it was being acquired by Amazon was noteworthy. Consider the more popular responses to Eero’s tweet announcing the acquisition. Ouch.

(click/tap image to enlarge)

Something has definitely changed here because there would not have been a similar level of negatively if Amazon bought Eero a few years ago. Could we be seeing the first tangible signs of consumers being hesitant towards smart home devices given data privacy?

In my view, Eero was not a lost opportunity for Apple.

Apple could have acquired the start-up if it wanted. Eero has been around for a number of years and has more recently shown signs of struggling. The company’s products had plenty of press coverage, not all of it positive.

The more relevant issue is that there just isn't much rationale for an Apple acquisition here. It’s not as if Eero had significant share in the Wi-Fi router market or a product that Apple had to own.

There are a number of alternatives for consumers looking for mesh Wi-Fi routers (still pretty niche). For example, Apple currently sells Linksys Velop mesh Wi-Fi systems online for between $100 and $450.

Not surprisingly, this Amazon / Eero news has once again put a spotlight on Apple’s decision back in 2016 to get out of the wireless router business.

Apple's move was likely driven by a few factors:

Apple didn’t see the point in dedicating resources and attention to taking on chipmakers like Broadcom and coming out with a differentiated router.
Apple was planning on removing some of the features from AirPort routers that customers found valuable, like wireless music playback, and putting the functionality into a new kind of Apple device(s).

Over the subsequent two years, we saw the second point materialize with HomePod and AirPlay 2 supported speakers.

Following this Amazon / Eero news, there was a small, but vocal, group arguing Apple should get back into the wireless router business because of data privacy.

While that may make sense on the surface, is that enough for Apple? I’m not convinced.

It’s not as if the market environment today was terribly different two years ago when Apple decided to get out of wireless routers. One has to imagine Apple’s decision was made knowing competitors may decide to approach the Wi-Fi router market for other reasons, such as data collection.

There are other factors at play here when it comes to Apple and Wi-Fi routers, such as recent market trends in which a good number of people likely rent their router from their internet provider rather than set up a $400 mesh Wi-Fi network.

Another longer-term consideration includes Apple's philosophy regarding wireless connectivity in the home as we move into the wearables era. It is conceivable that every wearable device will one day require wireless connectivity in and out of the home.

My suspicion is that Apple is thinking more about connecting devices in and out of the home instead of just in the home.

Estimating Apple’s Google TAC Revenue

Alphabet, Google's parent company, reported earnings last week. From our perspective, the most interesting number is Google’s traffic acquisition costs (TAC). This is a key variable driving Apple's Services revenue line item.

As defined in Alphabet’s 10-K: one component of TAC includes “amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers.”

Google TAC (related to distribution partners)

2016: $5.9B (9.2% of Google properties revenues - the TAC rate)
2017: $9.0B (11.6% of Google properties revenues)
2018: $12.6B (13.1%)

According to Alphabet, the increase in TAC to distribution partners from 2017 to 2018 was a result of an increase in Google properties revenues and the associated TAC rate. The increase in the Google properties TAC rate was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points.

Read between the lines, and Google is referring to the new arrangement with Apple regarding positioning Google as the default search provider for web searches from Siri. In addition, it looks like Google is simply paying more for access to the same premium users.

We know that Google didn't pay Apple $12.6B in licensing fees in 2018. However, that's not telling us a whole lot. Consensus assumed Apple received a lower total than $12.6B from Google in 2018. Instead, the key variable to estimate is Apple's percentage of that $12.6B.

In 2014, Apple represented 28% of Google’s TAC to distribution partners.

My estimate is that Apple now represents closer to 60% of Google’s TAC to distribution partners.

Accordingly, Google likely paid Apple somewhere around $7B to $8B in TAC in 2018. In 2017, the total was closer to $4B. The strong year-over-year growth would explain Apple listing licensing as the largest driver of Services revenuegrowth ($3B to $4B year-over-year) in its most recent 10-K and 10-Q filings. As a comparison, App Store revenue growth was likely closer to $1.5B to $2.0B year-over-year.

In summary, roughly half of Apple's Services business is driven by two items:

App Store: ~$12B of revenue per year ($2B growth year-over-year)
Licensing (Google TAC and other revenue): ~$10B of revenue per year ($3B to $4B growth year-over-year)

My estimates match Apple's recent commentary that the single largest Services line item was less than 30% of overall Services revenue.

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Neil Cybart 9/18/18 Neil Cybart 9/18/18

Jony Ive Talks with The Washington Post, Apple Products Removed from Tariffs List, Sonos Earnings

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September 18th, 2018: Jony Ive Talks with The Washington Post, Apple Products Removed from Tariffs List, Sonos Earnings

Today’s update will begin with a rare Jony Ive interview over at The Washington Post.

Jony Ive Talks with The Washington Post

Last week, Jony Ive sat down with The Washington Post’s Christina Passariello for a post-event interview. Passariello talked with Jony last year for her huge profile on Apple Park when she worked for the WSJ.

Here’s Passariello:

“Jony Ive, Apple’s design chief, on Wednesday unveiled a new iPhone, the biggest deal at the biggest gadget launch of the year. But a different product is closest to his heart: the Apple Watch.

Ive, Apple’s chief designer, gave Apple’s original wearable device a complete makeover in form and function. The Apple Watch Series 4, which Apple also introduced Wednesday as part of its annual product event, is slimmer and has new health tracking features such as the ability to take an electrocardiogram and detect hard falls — and is increasingly independent from the iPhone. That gives it a more profound purpose, in Ive’s vision, and sets it apart from other technology.

‘Every bone in my body tells me this is very significant,’ Ive said in an interview in the Steve Jobs Theater at Apple’s headquarters following the event. Ive, like the former Apple CEO who was his close friend, speaks of Apple innovations with fervor. The new watch ‘will be a more marked tipping point in understanding and adoption of the product.’”

Were the new iPhones really “the biggest deal” from last week’s event? Judging from various reactions to the unveiling, Apple Watch stole the show.

Also, it would have been helpful if Passariello discussed a little bit of the background regarding Apple Watch development. There is no other product in Apple’s lineup that is more closely connected to Jony than Apple Watch. The trials and tribulations associated with developing Apple Watch contributed to Jony coming close to burning out, which partly explained his move to Chief Design Officer a few years back.

The most interesting quote found in the piece was Jony saying Apple Watch Series 4 marks a “tipping point in understanding and adoption of the product.”The key word in that sentence: understanding.

For the past four years, a fair amount of the criticism and cynicism facing Apple Watch came from people not seeing the point of the device. Why should Apple Watch exist when we are glued to our iPhones? After all, it was only a few years ago when consensus thought watches faced extinction given how we turned to our smartphones for the time.

Jony is claiming that the combination of hardware and software found in Series 4 will begin to dispel any remaining confusion and mystery as to why Watch exists. More importantly, Series 4 will go a long way in showing how Watch fits in with the rest of Apple’s product line.

This is where our attention can turn to items like the Watch’s larger display (useful for viewing notifications and messages) and the improved optical heart sensor and digital crown (crucial for better health monitoring).

Here’s more from Passariello:

“Ive won’t give away how Apple wearables could spiral beyond the watch, though company watchers expect an augmented reality device could be in the works. He hints that the watch, on the other hand, could evolve in the years to come.

‘The clues for the future are when you can have a high degree of confidence that you personally are connected to the Net — not your phone, you,’ said Ive. Sporting a new watch with a white rubberized band, Ive said the gadget has helped him lessen his dependence on his phone.”

Turning back to Jony’s Watch video from last week’s event, he mentioned how the Watch is liberating. It’s clear that one form of liberation comes from reduced iPhone dependency. However, the other form of liberation is found with this idea of being personally “connected to the Net.” The Watch ends up serving as one of the smallest barriers we have ever seen when it comes to utilizing technology without having it take over our lives.

Apple Watch is a proactive digital assistant. Up to now, many people would probably classify Siri as that digital assistant. In reality, the entire watch represents the proactive assistant. For example, Apple Watch can now monitor your activity to determine if you experienced a hard fall. Not only that, but the device will also call for help on your behalf. Heart rate monitoring is another example of Apple Watch proactively helping you throughout the day by alerting you only when there is something you should know. These are tasks that the iPhone will never be able to handle. More importantly, they represent a new way of interacting with technology. This gets to the heart of why Apple Watch is such a big deal.

One random tidbit:

According to Passariello, Apple had to remove the red dot on the Series 4 Digital Crown in order for it be conductive for a pulse (for ECG). Regardless of the motivation behind the change, Apple sure has embraced Digital Crown design as a Watch branding opportunity.

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Apple Products Removed from Tariffs List

The saga involving U.S. tariffs and Apple continues. Here’s Bloomberg:

“The Trump administration spared a category of high-tech products that includes the Apple Watch and AirPods headphone from the next round of tariffs it has imposed on Chinese goods, according to the office of the U.S. Trade Representative.

President Donald Trump announced the tariffs in a statement on Monday, as the government released the final list of about $200 billion of Chinese products that will be hit with a new 10 percent tariff.

A product code that covers Apple Inc.’s Watch and AirPods -- as well as similar smart watches, fitness trackers and other goods made by competitors including Fitbit Inc. -- was not on the list. A separate code that covers the Mac mini was also not on the list of new tariffs…

The first product code covers wireless devices, and it was included on a preliminary list the administration released in July. Other Apple products under the code include the HomePod speaker, BeatsWL headphones, and AirPort and Time Capsule internet routers. The value of such imports from China is about $12 billion, according to one of the people…

White House economic adviser Larry Kudlow, speaking at the Economic Club of New York on Monday, said the administration frequently consults with Cook and takes his views seriously.

‘We’ve spoken to Mr. Tim Cook many times. He’s a really smart guy. He’s given us some good advice,’ Kudlow said.”

Based on the initial proposal, Apple products were directly impacted by 13 tariff codes. It looks like two codes were removed - the codes covering wireless devices like Apple Watch, AirPods, and HomePod (85176200) and the Mac mini (84715010). The other codes are still found on the finalized list. This means that the Apple Pencil, Magic Mouse and Trackpad, Apple adapters, and leather cases / covers may still be impacted by tariffs. There is the possibility that certain products are exempt even if their respective tariff code is on the list.

In addition to a few Apple accessories potentially still being on the list, it looks like a number of inputs for Apple U.S. operations remain on the list.

According to the Office of the United States Trade Representative (USTR), 286 tariff lines were removed from the final list (just 5% of lines). The removals were driven by the comments and testimony sent to the USTR.

The tariffs will kick off at 10% effective starting September 24, 2018. The tariffs will increase to 25% on January 1, 2019.

The USTR removed the most visible consumer products from the list (smartwatches and wireless headphones). At the same time, to have tariffs begin at 10% and increase to 25% in January 2019 is an obvious move to limit the impact on the U.S. holiday shopping season.

It is dangerous to rely on too many assumptions when it comes to U.S. tariffs. However, given how smartwatches were removed from the list, it would seem very unlikely that smartphones and tablets will be impacted by the third tranche of tariffs that is supposedly in the works. In addition, Tim Cook apparently was given reassurances that the iPhone would be exempt from tariffs.

Where does this leave Apple?

At this point, the tariffs risk is primarily found with slightly higher R&D and SG&A costs. Higher input costs for various R&D activities may pressure Apple’s net margins. However, management has shown the ability to remain pretty aggressive when it comes to keeping SG&A expense contained. A 10% tariff on select inputs may not even be noticeable when it comes to Apple. A 25% tariff would be more difficult to offset.

Apple would have received only a glancing blow if 25% tariffs were placed on Apple Watch, AirPods, and HomePod. As it stands now, it’s more appropriate to say that Apple will face minimal exposure to tariffs.

Sonos Earnings

Last week, Sonos reported its first earnings report as a public company. If this report was a sign of things to come, Sonos should prepare for a rocky road ahead. Here’s a snippet from the company’s earnings letter:

“We sold 886,514 products, representing 11.4% growth year over year, and generated $208.4 million in revenue. Despite the double-digit percentage increase in products sold, revenue declined 6.6% compared to Q3 of FY2017. This dynamic between year-over-year product unit growth and year-over-year revenue decline can be caused by our new product launches and/or product mix. When we launch a new product, two things happen that can impact quarterly comparability: 1) initial new product channel fill can create higher revenue levels relative to a typical quarter; and, 2) although channels are typically filled two to six weeks before general availability, revenue is not recognized until the date of general availability, which can push revenue resulting from channel fill into one quarter, thus accentuating new product launch impact.

In Q3 FY2018, the largest driver impacting our year-over-year revenue decline was the Q3 FY2017 launch of our PLAYBASE product. PLAYBASE revenue was approximately $18 million lower in Q3 FY2018 than Q3 FY2017, the quarter in which PLAYBASE launched.

In addition to the product launch dynamics discussed above, overall product mix also impacted quarterly comparability. Our Q3 FY2018 product unit growth was driven by a 25% increase in wireless speaker products sold, and primarily by the Sonos One, a product launched in Q1 FY2018 which carries a $199 U.S. manufacturer’s suggested retail price (U.S. MSRP). The decreasing share of the $699 U.S. MSRP PLAYBASE and increasing share of Sonos One further explains the difference between quarterly product unit growth and the decline in revenue, compared to Q3 FY2017.”

There was nothing too shocking or surprising found in this earnings report. Sonos was able to report year-over-year unit sales growth by selling lower-priced speakers.

Speaker Unit Sales

2013: 1.5M
2014: 2.9M (99% growth) – growth driven by Playbar and Play:1
2015: 3.4M (16% growth)
2016: 3.5M (3% growth)
2017: 3.9M (12% growth)
9M18: 4.0M (25% growth) - includes the 2017 holiday season

Revenue

2013: $442M
2014: $775M (75% growth) – growth driven by Playbar and Play:1
2015: $844M (9% growth)
2016: $901M (7% growth)
2017: $993M (10% growth)
9M18: $864M (11% growth) - includes the 2017 holiday season

Management commentary regarding business conditions was on the light side with not much in the way of additional details regarding how its newest products, the Beam and Amp, are performing in the marketplace.

As for why Sonos shares are down 35% over the past week, there probably wasn’t any one particular data point from the earnings report that led to the drop. While the year-over-year revenue decline may have spooked some people, management’s explanation for the decline was logical. Backing out the impact from product launches associated with the PlayBase, revenue would have been closer to flat year-over-year. Meanwhile, management’s FY18 guidance implies 15% revenue growth in FY4Q18 (July to September) with speaker sales landing somewhere around 900,000 to a million units. For comparison purposes, Apple sold somewhere around 600,000 and 700,000 HomePods last quarter.

Instead, Sonos may be suffering from an overall lack of enthusiasm. There just isn’t a compelling financial narrative here. It’s clear that Sonos isn’t even going to be like Fitbit in terms of having a few years of easy growth before trouble appears. Instead, Sonos management had to explain away a year-over-year decline in revenue on the company’s first earnings report as a public company.

At this point, attention has already moved to the very important holiday quarter. The consumer is strong, while the user base of people with stationary speakers in the home has never been larger. However, those tailwinds are being offset by an increasing number of questions regarding speaker usage trends and the competitive landscape. This should make for an interesting buying season in terms of stationary smart speakers in the home.

Neil Cybart 7/11/17 Neil Cybart 7/11/17

Thoughts on New iPhone Pricing and Naming

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July 11th, 2017: Thoughts on New iPhone Pricing and Naming

Hello everyone.

Today's update will take a deep dive into my thinking regarding new iPhone pricing and naming.

Thoughts on New iPhone Pricing

Apple is expected to unveil three new iPhone models in September:

A completely redesigned OLED iPhone
An updated 4.7-inch iPhone 7
An updated 5.5-inch iPhone 7 Plus

It is also widely expected that Apple will price the OLED iPhone higher than any previous iPhone. (The iPhone 7 Plus starts at $769.)

John Gruber, over at Daring Fireball, thinks the new OLED iPhone won’t just be priced higher than the iPhone 7 Plus, but will be priced significantly higher - to the tune of $1,200 with certain configurations running as high as $1,400. Those prices set off a firestorm around the web.

Gruber discussed his logic behind those price estimates.

Here’s the crux of Gruber's argument:

"It sounds to me like the OLED iPhone is a phone which Apple can’t make 40 million of per quarter, at least not today. And if that’s true, that means it should be more expensive. Not should in any moral sense, but simply because that’s how the principle of supply and demand works. When supply is constrained and demand is high, prices go higher. The higher prices alleviate demand...

The prices for these [OLED] iPhones need to be high enough so that tens of millions of people still want to buy the iPhone 7S and 7S Plus. If the 'iPhone Pro' or 'iPhone Edition' or whatever it is that Apple is going to call this phone starts at $800 or even $900, who is going to buy an iPhone 7S or 7S Plus? Not enough people, that’s who. Apple needs tens of millions of people to buy the 7S and 7S Plus because they aren’t going to be able to produce the 'Pro/Edition' model in sufficient quantity."

I think Gruber is overthinking this (which isn’t a bad thing – Apple pricing is a very interesting topic to muse on).

Gruber’s stance is that since Apple won’t be able to produce enough OLED iPhones, they need to price them artificially high to make sure people don’t buy them. Instead, consumers will be forced to pick the lower-priced updated iPhones in plentiful supply.

At first, this seems like completely new territory for Apple. However, there is a recent example of Apple doing something similar with the original Apple Watch Edition. Apple priced 18-karat Gold and Rose Gold Apple Watches artificially high to drive up their scarcity value. Sure, the gold and rose gold cost more to make than the other Apple Watch models, but not to the tune of up to $17,000.

The key difference between gold Apple Watches and iPhones is that Apple likely never had any intention of shipping Apple Watch Edition in bulk. In fact, Apple may have only been able to produce a certain number of Edition Watches - which goes back to raising pricing to account for that lack of supply. Regardless, a little over a year after unveiling the Edition collection, Apple completely changed its strategy. The Edition collection is now represented by the much lower-priced $1,249 white ceramic Apple Watch.

IIf Apple was to actually follow a strategy of basing product pricing on supply, quite a few Apple products would be priced significantly higher. AirPods would have launched at $299 or even $399, not $159. Seven months after release, there is still a six week wait for AirPods at Apple Retail. Apple could have launched Apple Pencil in late 2015 at $149 or $199, not $99. The Apple Watch Series 2 could have been priced higher since it took a few months to get demand and supply balanced. Apple is more likely to underprice new products, not raise prices artificially.

Read between the lines, and I think Gruber is making a more subtle point in his piece. If Apple can increase the screen-to-bezel ratio on the OLED iPhone, the device can fit an iPhone 7 Plus screen into an iPhone 7 form factor. In that case, why would anyone be interested in buying an updated iPhone 7 Plus or iPhone 7? It would seem like the OLED iPhone is the perfect combination of screen and form factor. Everyone may want the OLED iPhone. According to Gruber, since supply will be very tight, Apple will price the OLED iPhone artificially high to make it less accessible and to temper demand. This would then cause people to settle for the lower-priced updated iPhone 7 or iPhone 7 Plus. If that strategy sounds extremely crummy to the user, it’s because it is.

My thinking on new iPhone pricing is quite a bit different.

The OLED iPhone may very well turn out to be the most popular model in the iPhone line. Ming-Chi Kuo is estimating 50% of new iPhone sales in 2017 (part of FY4Q17 and the entire FY1Q18) to be the OLED iPhone. If true, that would be a huge percentage. In the beginning, the iPhone Plus had close to 30% of overall iPhone sales (now more like 40%). As we discussed last week, Ming-Chi Kuo's sale estimates don't contain the same kind of accuracy as detailed iPhone and iPad product information.

Turning to OLED supply, rumors from Apple's supply chain actually point to better OLED supply than originally thought. (We discussed this topic last month in the email from June 13th.) If we take these rumors and combine them with Ming-Chi Kuo's estimates (which may very well simply be based on the same rumors), Apple will ship close to 40M OLED iPhones in FY1Q18. Those aren't sales belonging to a $1,200 to $1,400 iPhone. Instead, those sales are for an iPhone that may have a higher price tag than any other iPhone but is still in reach to most of the iPhone user base. That's an OLED iPhone priced to sell.

Another way to think about this topic is to look at the current iPhone line. Demand for the higher-priced iPhone 7 Plus is exceeding Apple’s expectations while iPhone 7 (and iPhone 6s) demand has been disappointing. This tells us that an increasing number of consumers are willing to pay an additional $120 for the differentiating features found in the iPhone 7 Plus, including the dual camera system and larger screen. However, it is extremely important to point out that the iPhone 7 is still outselling the iPhone 7 Plus in absolute terms. Not everyone wants the features found in iPhone 7 Plus, at least not at current prices. My takeaway from this is that Apple can increase iPhone pricing as long as it is commensurate with added features. Meanwhile, a significant portion of consumers will base their purchase decision on price. These users want an affordable iPhone.

If Apple prices the OLED iPhone at $1,200, we are looking at a $430 premium to the iPhone 7 Plus. That's huge. What features will the OLED iPhone have to drive such a premium? An OLED screen that is roughly the same size as that found in the iPhone 7 Plus? 3D camera technology? It's tough justifying a $430 premium, especially when you consider that the iPhone 7 and 7 Plus will receive their own updates as well.

Here are my thoughts regarding new iPhone pricing (these would be starting prices):

iPhone X (the OLED iPhone): $999 ($1,099 for the special case color that everyone will want)
iPhone 8 Plus: $669 ($769 for Jet Black)
iPhone 8: $549 ($649 for Jet Black)
Wild card: Apple will drop the price of iPhone SE to $349 (from $399).

(We will go into more about iPhone naming down below.)

A couple of items to consider:

1) It is important to point out how talking about iPhone pricing without knowing the features found in each model contains risk. While it sure sounds like the OLED iPhone will lack fingerprint recognition and Touch ID, what about the other two new iPhone models? There is still quite a bit of unknown found with those iPhones in terms of new features.

2) My projections have Apple reducing the price of LCD iPhones (iPhone 8 and iPhone 8 Plus) by $100. This would address Gruber's question regarding who would actually want to buy a LCD iPhone when there is an OLED model in the lineup. A $100 price cut for new 4.7-inch and 5.5-inch LCD screen models would certainly get people interested. As for the precedence this may set, there likely won't be any as Apple is expected to sell three new OLED screens next year. In terms of overall iPhone ASP - it will still go up thanks to the iPhone X.

3) If the iPhone X ships later in 2017, many people will need a new iPhone before that point and will choose a new iPhone 8 or 8 Plus. This may be why Ming-Chi Kuo is still thinking 50% of new iPhone sales will be the LCD models. In addition, for those consumers basing their purchase decision on price, the iPhone 8 or 8 Plus will be their preferred option.

4) Every iPhone is launched into a severe demand/supply imbalance. That's just the nature of the iPhone business. The iPhone X won't be any different. Apple may very well push back the launch until later in the year (even as late as November or early December). However, my suspicion is that Apple won't price the device high in order to reduce demand. Instead, the higher price will be justified by the added value and functionality. There will likely be a considerable wait for iPhone X delivery.

5) At $999, we are looking at the iPhone X having a $230 premium to the iPhone 7 Plus. That's manageable for many people. On a monthly basis, that comes out to something like an additional $10 per month.

6) Apple can take a page from the Jet Black playbook and price the hottest iPhone X case color at a $100 premium. Storage configurations can also be modified to boost profit margins. This same strategy can be utilized for the iPhone 8 and 8 Plus. Apple can use storage configuration options to get consumers to pick the higher-margin storage options, offsetting the adverse impact on margin from a $100 price cut.

Thoughts on New iPhone Naming

The current iPhone numeral nomenclature has lost all of its meaning. Consider the iPhone naming timeline:

iPhone
iPhone 3G
iPhone 3GS
iPhone 4
iPhone 4s
iPhone 5
iPhone 5s & 5c
iPhone 6 & 6 Plus
iPhone 6s & 6s Plus
iPhone 7 & 7 Plus

The iPhone “S” cycle actually ended years ago, around the iPhone 5s. This is when the year-to-year changes seemed to be in many ways more significant during S years than non-S years. From that point forward, the S basically just represented the filler year between whole numbers.

Consider how the iPhone 7 could have easily been called the iPhone 6ss in terms of feature set. Instead, Apple stuck with the existing strategy and gave the model that next whole number. The intention was for the new whole number to signal to consumers that the model was a considerable upgrade from the iPhone 6s.

My thinking regarding new iPhone naming:

iPhone X
iPhone 8 Plus
iPhone 8

Apple could change things up and instead call the two new LCD models the iPhone 8 and 8 Plus. However, there is risk in this strategy. Judging by iPhone 7 sales trends, the intention of using whole numbers to signal bigger iPhone changes may already be getting a bit stale.

As for the OLED iPhone, I’ve always had a thing for calling it “iPhone X.” The name would stand for the 10th anniversary iPhone. However, the name is a bit risky. It would be pronounced “iPhone Ten” just as Mac OS X was pronounced “Mac OS Ten”. However, some people may think it is pronounced "iPhone X" as in the letter X. Is that a big enough reason to not pursue iPhone X? No.

The idea behind naming the OLED iPhone iPhone X is that Apple would eventually rename the model anyway the following year as two new OLED iPhone models are introduced - one bigger and one smaller than this year's OLED iPhone. In that case, calling this year's OLED iPhone the "iPhone Edition" or "iPhone Pro" seems even messier. What happens next year? Apple just calls the largest iPhone, the iPhone Edition?

My theory is still that over time Apple will drop the numbers altogether and just go to a simple:

iPhone Plus
iPhone
iPhone mini

This will likely make much more sense once Apple ships three iPhone models where the major cosmetic difference is screen size. As the iPhone upgrade cycle gets longer, this new naming nomenclature will also make more sense.

One can also make a case for Apple taking the "pro" route with iPhone (like they have done with Mac and iPad). However, I still have issues with using "pro" in product naming these days as the definition of professional has changed. Will we get to the point where only one iPhone model is for "pros"? That doesn't seem right. Meanwhile, the pro in iPad Pro seems to stand more for productivity. What does that then mean about the non-pro iPad models? Are they for less productivity? This is the downside of using "pro" in naming in an era when mobile gadgets redefined consumer and professional computing.

Neil Cybart 1/31/17 Neil Cybart 1/31/17

Daily Email from January 31st, 2017

The following email was sent to Above Avalon members on January 31st, 2017.

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

January 31, 2017

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.

Today's stories: Fitbit Is in Trouble, Apple Watch Momentum Is Building, Deep Dive into Microsoft Surface Sales

Hello everyone,

Today is Apple earnings day. The company will release results at 4:30 pm ET. We will go over the results on Wednesday and Thursday.

Fitbit Is in Trouble

There has always been a feeling in the air surrounding Fitbit that the company was facing long odds. Not only did the company need to continue selling tens of millions of wearables devices per year (not an easy thing to do), but management would need to also figure out what to do about Apple entering its turf.

For a few quarters following the Apple Watch launch, Fitbit seemed to be actually doing OK. Management was seeing success when it came to marketing and branding. Fitbit was even growing its unit sales lead over the first generation Apple Watch. While there were some concerns brewing under the surface, such as worrying user engagement trends, Fitbit seemed to be making a name for itself in the health & fitness wearables market.

The situation changed dramatically with Fitbit's 3Q16 results this past October. (Fitbit's 3Q includes July to September.)

Here's the beginning of the Above Avalon daily update from November 3rd, 2016:

"The largest wearables company in the world has officially hit a brick wall. Fitbit reported very weak 3Q16 earnings yesterday. Management's conference call was one of the worst I have listened to this year. You knew it was going to be bad when CEO James Park kicked off his comments with: we are starting to see some headwinds in the business, including softening in demand.

At the heart of the issue is a company that just doesn't know what is going on in the wearables market."

The holiday quarter was supposed to include the best five week stretch of the year for Fitbit. The company would typically register as much as 40 percent of its annual sales from October to December. However, troubling signs began to appear as early as August and September. Demand for Fitbit products just wasn't materializing as management expected. Fitbit's awful sales guidance for the holiday quarter implied that the company was about to hit a brick wall in terms of growth.

Fitbit pre-announced those bad holiday results yesterday. The initial guidance range, released in October, called for $725M to $750M of revenue. Fitbit now expects to report revenue in the range of $572M to $580M range.

That is what you call a company in free fall. There just isn't any other way to describe it. Fitbit sold just 6.5M devices in 4Q16. To put that number in context:

Fitbit - Unit Sales

3Q15: 4.8M
4Q15: 8.2M
1Q16: 4.8M
2Q16: 5.7M
3Q16: 5.3M
4Q16: 6.5M new data point

Fitbit sold 21% fewer devices in 4Q16 than in 4Q15. More alarming, whereas the 2015 holiday quarter saw a 71% increase in unit sales quarter-over-quarter (i.e. from 3Q15 to 4Q15), Fitbit saw just a 23% increase quarter-over-quarter for the 2016 holiday season. To put these sales numbers more bluntly, consumers turned away from Fitbit in droves. As we will see, there is evidence that even this 6.5M unit sales number is artificially high.

Management's explanation as to what is unfolding is not reassuring. Here's Fitbit CEO James Park:

"Fourth quarter results are expected to be below our prior guidance range; however, we are confident this performance is not reflective of our brand, market-leading platform, and company's long-term potential. While we have experience softer-than-expected holiday demand for trackers in our most mature markets, especially during Black Friday, we have continued to grow rapidly in select markets like EMEA, where we grew 58% during the fourth quarter."

Just a few months ago, management was talking up the incredible opportunity remaining in the U.S. given Fitbit's penetration rate (~40M Fitbit devices vs. 230M smartphone owners). Historically, the U.S. comprised the vast majority of Fitbit sales. The company recently said Asia was becoming a headache. This leaves Europe as Fitbit's last remaining source of growth.

Fitbit decided to take a number of financial steps to shore up its business:

Write down tooling equipment and component inventory by $68M. Code: Weak customer demand caught Fitbit off guard. The environment has deteriorated to such a degree that Fitbit needed to reassess some of its asset values.
Increase rebates and channel pricing promotions by $37M. Code: Fitbit had to slash pricing in order to move product that wasn't selling. It looks like Fitbit's 6.5M unit sales for the holiday quarter was artificially high due to channel stuffing. Sell-through demand for Fitbit products was probably less than 6M devices. That's a nearly 30% decline in demand year-over-year.
Increase return reserves by $41M due to greater channel inventory. Code: The product that Fitbit was able to sell with discounts and promotions will likely face elevated returns.
Increase warranty reserves for legacy products by $17M. Code: People are having quality issues with older Fitbit devices.

As for 2017 guidance, management is looking for $1.5B to $1.7B of revenue. A few things jump out at me. Fitbit management has zero credibility on Wall Street. It's surprising that Fitbit is even bothering with guidance. The company misread near-term demand for its products by nearly 25 percent. How can Fitbit be in a position to estimate demand 12 months out? The second takeaway is that the guidance Fitbit did provide is downright awful. Fitbit reported $2.2 billion of revenue in 2016. Management is forecasting its business to decline 30 percent in 2017.

Three months ago, Fitbit said it expected to have $900M to $950M of cash right about now. A few Above Avalon members were quick to throw skepticism at such a claim. That skepticism proved correct. Fitbit actually had $700M of cash at the end of December.

In order to shore up its liquidity, Fitbit is looking to cut its annual operating expenses by 20% to $850M. Since sales & marketing and R&D make up the vast majority of Fitbit's operating expenses, those budgets are likely going to get slashed. Fitbit is also letting go of 110 employees (6% of its workforce). Unfortunately, history has shown that management teams in Fitbit's position often underestimate the degree of required downsizing.

Fitbit needs to downsize in response to declining sales. If we assume management was initially expecting sales growth in 2017, the company's new guidance implies that the company will likely have $400M less in gross profit to work with. (This is my estimate obtained by taking management's new 2017 revenue guidance, subtracting it from a hypothetical situation where Fitbit was able to grow revenue in 2017, and then applying a 50% margin to the difference.) This is money that would have funded marketing, R&D, and M&A (a form of employee acquisition).

The company appears to be afraid of a widespread brain drain as it wants shareholders to approve "a program under which certain employees may relinquish out-of-the-money options at the time of the exchange in return for a fewer number of restricted stock units."

Fitbit shares traded down 16% yesterday to $6. The company is now valued at $1.3B or 1.9x cash. The company's cash total is going to be a moving target going forward. For context, Apple is trading at 5.4x net cash. It seems like Fitbit is trading with some M&A premium. However, it's not clear who will want to step in as an acquirer at this point.

The most worrying thing for Fitbit is that its largest risks are beginning to materialize. Fitbit has some top engineering talent when it comes to wrist wearables. It is going to become that much harder for Fitbit to retain this talent. In addition, Fitbit's future was built on the premise that it would be able to release new products that customers wanted. If the company is forced to slash its R&D budget due to declining sales, how will the company compete with Apple? I'm not sure there is a genuine answer.

Apple Watch Momentum Is Building

It is impossible to talk about Fitbit without focusing on Apple Watch. Judging by public statements, Fitbit management is still in complete denial when it comes to the impact Apple Watch is having on its business.

Here's Park in Fitbit's press release from yesterday:

"As the overall wearable category leader, we exited the year with an engaged community of over 23.2 million active users, making us uniquely positioned to be the partner of choice for the healthcare ecosystem, which is a key component of our long-term strategy."

The problem for Park is that the Apple Watch ecosystem will likely surpass 23M active users in a few months. It is also becoming likely that Apple will soon earn the "overall wearable category leader" title from Fitbit as well.

However, if judging by actions, Fitbit management is very aware of the threat Apple Watch poses to Fitbit's long-term viability. Fitbit is running as fast as it can into the smartwatch market.

Here's more from Park:

"We believe we are uniquely positioned to succeed in delivering what consumers are looking for in a smartwatch: stylish, well-designed devices that combine the right general purpose functionality with a focus on health and fitness."

Park is describing Apple Watch.

In less than 12 hours, we will get some data as to how Apple Watch performed over the holidays. My estimate is that Apple sold 5.4M Apple Watches during the holiday period. This would be a very strong number for Apple. However, simply comparing Apple Watch to Fitbit sales may hide one of the more important developments in the wrist wearables space.

Apple Watch may be seeing success in pushing the wearables market in a new direction. Instead of splinting into dedicated health & fitness trackers and smartwatches, the entire market appears to be moving towards smartwatches. This is why it is so strange that Park is quick to say that Fitbit is running towards smartwatches but has never commented that Apple Watch is impacting Fitbit. The simple fact that Fitbit is being forced into smartwatches tells us that Fitbit is merely leading Apple Watch, and that is not a position you want to be in.

Deep Dive into Microsoft Surface Sales

One of the more interesting questions facing Apple's Mac business has been whether a portion of the Mac user base would flee to an alternative platform. This transition could be linked to a few reasons, including frustration with Apple's update schedule for the Mac and/or excitement surrounding new hardware from competitors.

Recall Microsoft's recent claim of seeing a record number of people switching from Mac to Surface. The company provides up to $650 off Surface Book or Surface Pro to users who trade in a MacBook Pro or MacBook Air.

Late last week, we received the latest sales data for Microsoft's Surface products as part of Microsoft's earnings release.

Microsoft Surface Revenue

2Q15: $1,077M
3Q15: $715M
4Q15: $888M
1Q16: $672M
2Q16: $1,350M
3Q16: $1,110M
4Q16: $965M
1Q17: $926M
2Q17: $1,320M new data point
Sum: $11.711B

Microsoft reported $1.32B of Surface revenue over the holiday quarter. While unit sales are not disclosed, we can back into an estimate of around 1M to 1.2M devices sold based on average selling price.

Nearly every report focused on Microsoft's earnings positioned $1.3B of Surface revenue as a resounding success, especially since results didn't include much from new product categories.

My stance on Microsoft Surface has been consistent. While it may very well be serving its purpose as a way to motivate Windows OEMs, Surface sales do not match the narrative found in the tech press. Consumers are not embracing Microsoft Surface in droves. According to Microsoft, commercial demand for Surface was up 25%. Since overall Surface revenue was down year-over-year, this would seem to imply that consumer demand was also down year-over-year. This is odd since Microsoft had said that November was the best month yet for consumer Surface sales.

We have niche hardware that is seeing some adoption success in enterprise. Will wider availability of the $2,999 Microsoft Surface Studio change this narrative in 2017? It's doubtful.

This isn't to suggest that Apple should ignore Surface. There are some who think Surface is a slow, gradual movement that will take years to eventually reach a $10B revenue per year run rate. There may be a case to make for such a development. However, this is not what is being pushed in the press. Instead, it's labeled as a genuine Surface vs. Mac battle among consumers. Microsoft has been happy to build up that battle in recent months. However, sales numbers don't lie. If it's a Surface vs. Mac battle among consumers, the Mac is doing fine.

Each daily email is approximately 2,000 words and contains 2-3 stories (10-12 stories/week).

Story topics include:

Strategy and business analysis
Financial modeling and estimates
Perspective and observations on current news events, competitors, earnings, and keynotes

To become an Above Avalon member, visit the membership page.

Neil Cybart 11/16/16 Neil Cybart 11/16/16

Daily Email from November 16th, 2016

The following email was sent to Above Avalon members on November 16th, 2016.

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

November 16th, 2016

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.

Today's stories: Apple Releases New Design Book, Nostalgia vs. Inspiration, This Is Jony's Apple

Happy Wednesday. Today's update is going to be dedicated to Apple's new design book. There are a lot of layers to this product.

Let's jump right in...

Apple Releases New Design Book

Apple wasn't completely done with this year's product unveilings. Yesterday, the company unveiled a new design book that tells the story of design at Apple. Here's Apple in a press release:

"Apple today announced the release of a new hardbound book chronicling 20 years of Apple's design, expressed through 450 photographs of past and current Apple products. 'Designed by Apple in California,' which covers products from 1998's iMac to 2015's Apple Pencil, also documents the materials and techniques used by Apple's design team over two decades of innovation.

The book is dedicated to the memory of Steve Jobs."

The book comes in two sizes: small ($199) and large ($299), and is currently available through Apple's online store in nine countries, in addition to 13 Apple Retail stores in the U.S.

While the book is focused on Apple design, it is actually a reflection of the culture put in place by Jony Ive, Apple's Chief Design Officer. Here's Jony explaining why such a book exists:

"This archive is intended to be a gentle gathering of many of the products the team has designed over the years. We hope it brings some understanding to how and why they exist, while serving as a resource for students of all design disciplines."

This book set off a firestorm yesterday from all corners of the Apple punditry/analyst community. Some think it is a sign of major trouble at Apple. Others think it is an interesting idea that should have been done by a third-party. And you have a small group that sees this as yet another sign of Apple Industrial Design's (Apple ID) growing power and influence within Apple (more on this shortly).

Jony ended up doing more press for this design book than he did for the iPhone 7 and new Apple Watch back in September. I counted two interviews (one was with Wallpaper and the other was with a Japanese design blog called Casa BRUTUS).

If there was still a question as to how important this design book is to Jony, he also narrated a two-minute video containing behind-the-scenes footage of the Apple ID group (and there looked to be quite a few product designers as well) working in the designs labs. It was pretty remarkable. (The video is available via YouTube here.) The only other time we had gotten such an inside look at the design labs was during the Charlie Rose interview last year.

Historically, Jony has played a major role in producing product videos in which he narrates. It is likely he played a major role in putting together this latest video as well.

Apple spent eight years working on this design book. Many of the Apple products featured in the book actually had to be purchased. The design team treated the book just like any other Apple product. Apple developed custom forms of paper and custom inks in order to "accurately and objectively" portray the products. All of the photographs were taken by Andrew Zuckerman, specifically for the book. Some shots involved Apple using the same composition as product launch photos, such as recreating the scene of five colorful iMacs. Since Apple spent years on this project, some of the earlier photographs had to be retaken because photographic technology had improved over the years. The team even came up with special packaging to make the unwrapping "enjoyable."

Nostalgia vs. Inspiration

Soon after Apple published the press release announcing the design book, I saw more than a few people quickly look at this product as a sign of Apple going down memory lane, chasing nostalgia. I disagree.

As defined by Merriam-Webster: Nostalgia: pleasure and sadness that is caused by remembering something from the past and wishing that you could experience it again.

The book is not about Apple being nostalgic, taking time away from the future in order to soak up glory from the past. Instead, the book is designed to peel a few layers behind the mystery known as Apple design.

Notice how the book is both for the Apple ID group (a tool for inspiration) and the public (a way to better understand what drives Apple). The educational component explains why Apple is actually selling the book instead of just creating the book for Apple employees. Apple plans on giving the book to all of the major design schools around the world.

Jony listed a number of reasons for why this design book exists:

To see the objects out of their functional context.
To see the objects in a context of the subsequent products.
To educate people on how their manufactured environment came to be.

There is significance found with the timeline of products that are featured. Instead of chronicling Jony's time at Apple (he began in 1992), the book begins with the 1998 iMac. This is a very subtle, but important clue as to why this design book exists.

The iMac was the first product to benefit from Apple's design-led culture. Here's a brief backstory to the iMac from my piece "Jony Ive Is Making People Uneasy."

"Jony holds an incredible amount of power because Apple is a design-led company. Apple's functional organizational structure and culture are set up in order to give the Industrial Design (ID) group absolute power. ID holds more power at Apple than any other group.

This structure was put in place more than 15 years ago with the iMac being the first product to take advantage of this new culture. Up to the late 1990s, engineers held the most power at Apple. Designers were merely tasked with skinning Apple products created by engineers. With the iMac, ID was afforded the freedom to move ideas from conception to reality without compromise. While Steve Jobs was the primary architect of this new power structure, the relationship he had with Jony undoubtedly played a role."

Accordingly, this design book isn't about Jony Ive. It's not some type of "Jony's Greatest Hits" collection. Jony isn't trying to soak himself in nostalgia of better times (which doesn't even make sense since today's products are arguably the best designed products Apple has ever released).

Instead, this design book is about the philosophy and processes that have guided Apple ID for the past 18 years. There are actually Apple products that are not included in the design book, which sets this book apart from similar books from third-parties over the years.

Here's Jony in his own words going into detail as to why he felt it was important that such a book existed:

"The biggest challenge for us was the fact that our focus and preoccupation is always on the future. So that tends to exclude much time to look back at the work we have previously done. Sometimes if we are struggling with a particular issue then that gives us reason to go back and look at the way we have solved problems in the past. But because we've been so consumed by our current and future work we came to realise we didn't have a catalogue of the physical products. So about eight years ago we felt an obligation to address this and build an objective archive."

One word: inspiration.

Here's more from Jony:

"We were intrigued how we could objectively describe, define and catalogue the objects and try to give people a sense of how they are made. Not how they were designed, but how they came to be. How they were manufactured and how you can transform these often-anonymous materials into something that is valuable and useful."

You can sense a theme here. The book is not about individual Apple designers or even the Apple ID group, but about the culture and environment that guides the Apple ID group. The key difference between those two entities is that by focusing on the product, the book actually ends up being about the design process. This turns the design book from containing page after page of nostalgia into something different.

However, one question that remains is "Why now?"

Jony even discussed how the design team had to purchase some of the older Apple products in a nod to the lack of nostalgia that exists within the design labs. We know the motivation behind the book, but why publish it in November 2016? Apple even says the book chronicles 20 years of Apple design, even though only 17 years of products are covered (1998 to 2015).

While watching the video for the design book, some of Jony's comments jumped out at me:

"This book captures a point in time of incredible transitions and quite shocking change. You understand the nature of an object so much more when you understand how it came to be. The book tells dozens and dozens of stories. You see momentum. You see learning. Of course, as designers you live in the future. It's not that we're not interested in the work we have done before, it's just that we are so consumed by what we haven't done yet."

Reading between the lines, this Apple design book is meant to serve as inspiration for an Apple ID group that is embarking on a new journey involving new materials, processes, and products. In a way, Apple is closing one chapter in order to open a new one. Apple's design language has not remained static (just look at the Mac over the years for evidence). It feels like given Apple's product direction, a new design language is being created.

This Is Jony's Apple

It is crucial for us not to miss one obvious point with this design book. Jony wanted this book to exist.

We are seeing Jony's Apple in full force.

That statement isn't meant to downplay Tim Cook's contributions or to imply that Jony has in some way taken Apple hostage. Instead, we are seeing an Apple that is comfortable placing complete control of the user experience in the hands of the Apple ID group. This design-led culture was installed in the late 1990s and all indications point to Tim Cook doubling down on the idea.

This design book probably would not have existed 10 years ago. Of course, we will never be able to know for sure. While some look at that as a source of concern for Apple, I look at it as merely a sign of change.

One example of this change is that Apple is much more willing to explain its story using the people developing Apple products. Circling back to the Charlie Rose interview from last year, Tim Cook had a short, but interesting comment about the motivation for providing Rose such a revealing look inside Apple:

"With a consumer company, people want to see the team behind it."

There is no question that Apple has embarked on a multi-year campaign to make the public become more familiar with the people and processes behind Apple products. We went from the era where Steve Jobs controlled nearly all public outreach to pretty much every senior Apple executive now taking part in various forms of PR.

Just take a look at last month's Mac event - Phil Schiller did a number of interviews, Federighi did a few video interviews, Jony even sat down for an interview. All of that was done for just one product. We then have PR opportunities given to additional Apple employees, including team managers. This is part of a well-thought out strategy meant to explain Apple's mission.

There is a very legitimate counter argument to this new philosophy within Apple. One can say that the product should speak for itself. Consumers should buy Apple products because the product will improve their lives, not because of being familiar with the design story or people behind the product.

However, I would push back against that narrative.

By sitting down with Charlie Rose in the design lab, or selling a design book, Apple is weaving a narrative that transcends any one product.

Saying "This is Jony's Apple" doesn't mean that Jony is single-handedly guiding Apple forward. In reality, after his promotion to Chief Design Officer, Jony has actually moved away from day-to-day managerial activities at Apple. Instead, we are seeing an Apple that is placing a bet that design will be the variable that leads the company forward.

There will be plenty of challenges and detours along the way. This design book is meant to help Apple find the path when those challenges arise. The book will help Apple move forward.

Each daily email is approximately 2,000 words and contains 2-3 stories (10-12 stories/week).

Story topics include:

Strategy and business analysis
Financial modeling and estimates
Perspective and observations on current news events, competitors, earnings, and keynotes

To become an Above Avalon member, visit the membership page.

Neil Cybart 8/30/16 Neil Cybart 8/30/16

Daily Email from August 30th, 2016

The following email was sent to Above Avalon members on August 30th, 2016.

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

August 30th, 2016

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.

Today's stories: Calculating the iPhone Installed Base, Segmenting iPhone Users by Upgrade Cycles, New 2016 and 2017 iPhone Sales Estimates

Hello everyone. Today's update will be dedicated to iPhone financials. I built a new iPhone sales financial model, and I want to go over some new numbers and assumptions for the iPhone installed base, upgrade cycles, and unit sales.

Before we get to the update, there are two other topics worth mentioning:

Apple Invites. Apple sent out invites yesterday for its September 7th keynote in San Francisco. I will be attending the event. The invitation (seen here) contains bokeh, which is the rendition of out-of-focus points of light, set within a very dark background. This likely hints at some pretty interesting iPhone camera upgrades. All signs point to a dual-lens camera for the iPhone 7 Plus. The invite also contains the words "See you on the 7th," where the "See you..." is another nod to cameras. The event looks to be centered on new iPhones (cameras and audio being the two big items) and new Apple Watches. We will have a much more in-depth preview of the event next week.

Apple/Ireland Update. The European Commission just ordered Ireland to recover $14.5B, plus interest, from Apple in back taxes. I am surprised. That total would seem to imply the Commission classified most of Apple's Irish tax structure as illegal (doesn't make much sense to me). As we talked about yesterday, late signals were pointing to a much lower amount. Even up to a few hours ago, the Irish Times was hearing the amount will be "billions of euro," so clearly there are some disappointed Irish government officials. Tim Cook is out swinging this morning (he just published a letter regarding the Commission's decision). At this point, it's unclear if Apple will actually ever end up paying the $14.5B. Since this news just broke, we will discuss the topic in greater detail tomorrow.

REMINDER: This email is from August 30th, 2016. The following estimates have since been updated. My current iPhone estimates are available for members here.

Calculating the iPhone Installed Base

A few months ago, it became clear to me that I needed a revised financial model for estimating the iPhone installed base. My old methodology involved tracking changes to the iPhone installed base on a quarter to quarter basis.

For the first few years of iPhone sales, this is a pretty manageable task. However, with the iPhone 6 and 6 Plus being released in 2014 and the resulting explosion in sales, the model began to get very complicated. When it was clear that the iPhone upgrade cycle was also extending, trying to track the installed base quarter to quarter just wasn't feasible.

I developed a new financial model for estimating the iPhone installed base that relies on annual iPhone sales. This methodology makes it much easier to track the change in the iPhone installed base since there are fewer variables to estimate. In addition, I suspect this new model contains much more accuracy as I can segment the iPhone installed base according to when a user enters the iOS ecosystem (more on this shortly).

In order to estimate the iPhone installed base, we start off with simple iPhone unit sales by fiscal year.

2007: 1M
2008: 12M
2009: 21M
2010: 40M
2011: 72M
2012: 125M
2013: 150M
2014: 169M
2015: 231M

Next, we divide these annual iPhone sales totals into two segments: sales to new iPhone customers and sales to iPhone upgraders (customers who were already iPhone users).

For the first few years, these calculations are rather simple as there weren't many iPhone owners in a position to upgrade in 2007 or 2008.

Jumping to 2010, things become more interesting. Apple sold 40M iPhones in 2010. In order to find the portion of those sales that went to iPhone upgraders, we look back to see which group of iPhone users were likely in a position to upgrade. It turns out that the 12M users who bought an iPhone 3G in 2008 celebrated their two-year anniversary in 2010. Running with an estimate of a two-year upgrade cycle, this means that a good portion of those iPhone 3G users likely upgraded to a new iPhone in 2010. Accordingly, Apple sold 10M iPhones to existing iPhone users in 2010. This is less than the 12M users who bought an iPhone 3G in 2008 because of churn. I include a 13% churn rate for the first upgrade cycle. We then subtract 10M from 40M to reach 30M as the number of iPhones sold to customers new to iPhone in 2010.

We repeat this exercise for each year, keeping track of which bucket of iPhone owners was likely in a position to upgrade. For example, iPhone 3GS users were ready for their first upgrade in 2011. In addition, original iPhone owners were ready for their second upgrade in 2011. As the years progress, the calculations become a bit more intense although it still beats the craziness found with quarter-to-quarter gyrations. By time we get to 2016, we have nine different buckets of iPhone owners to keep track of in terms of upgrade cycles.

After running this exercise for each year, we arrive at estimates for the number of iPhones sold to new customers. This data is valuable because we can then add each year together to reach an estimate for the current iPhone installed base.

iPhone Sales (Units) to New Customers

2007: 1M
2008: 12M
2009: 19M
2010: 30M
2011: 54M
2012: 95M
2013: 88M
2014: 82M
2015: 102M
2016: 106M
Total: 589M users (this is the iPhone installed base as of year-end FY2016 - the end of September).

One of my previous estimates for iPhone installed base was 554M users as of February 2016. This means my new installed base model is a bit more conservative. Diving into the model in greater detail, I think I am able to capture the full extent of repeat iPhone upgrade behavior much better than before. Since I am including a larger portion of iPhone sales to upgrades, this ends up reducing the number of iPhones sold to new customers.

Do these numbers pass the litmus test? Let's check with Apple's disclosures.

Here's Tim Cook on Apple's 3Q16 earnings conference call:

"[W]e added millions of first-time smartphone buyers in the June quarter, and switchers accounted for the highest percentage of quarterly iPhone sales we've ever measured. In absolute terms, our year-to-date iPhone sales to switchers are the greatest we've seen in any nine-month period, and our active installed base of iPhone is up strong double-digits year over year."

Those comments are extremely helpful. Cook went on to say the majority of iPhone sales in China were to people new to iPhone. My 106M iPhone unit sales estimate to new customers in 2016 represents an all-time high for Apple, which matches Cook's comments. In addition, China Mobile likely led to a boost in iPhone sales to new customers beginning in 2015 with the iPhone 6 and 6 Plus. My estimates reflect a 25% bump in sales to new customers in 2015. My previous model for the iPhone installed base had the number of iPhones sold to new customers falling in 2016.

My estimates also reflect a 22% increase in the installed base year-over-year in 2016, which compares to Cook's "up strong double-digits year over year."

EXTRA: If we bring the topic of the iPhone user base into this discussion ("user base" is different than "installed base" because the iPhone user base includes used iPhones and hand-me-downs), we are probably looking at something around 670M to 690M total iPhones out in the wild as of the end of September 2016. Once again, this is a bit lower than my earlier estimates, but it seems to better match Apple's latest disclosure of more than one billion Apple devices in the wild. The following numbers are my estimates (as of September 2016):

iPhone: 680M devices
iPad: 225M devices (we discussed this number back in the daily update from August 8th)
Mac: 95M devices
iPod touch: 40M devices
Apple TV: 27M devices
Apple Watch: 15M devices
Total: 1.08 billion devices

Segmenting iPhone Users by Upgrade Cycles

One issue that many analysts have been having is figuring out what to do with iPhone installed base data. If we assume the installed base is 589M iPhone users, how do we use that data to figure out upgrade cycles? This is important because once we have estimates for the number of iPhones sold to upgraders, we can then combine that data with sales to new customers to arrive at overall iPhone unit sales estimates.

In the past, one very quick method of using installed base figures was to simply multiply the total by a certain ratio depending on iPhone upgrade cycles. For example, if we assume the average iPhone user upgraded their iPhone every 2.5 years, we multiply the overall iPhone installed base by 40% (1/2.5) to reach an estimate that Apple will sell 235M iPhones (40% x 589M) to existing iPhone users each year.

However, there is a big problem with that calculation. It is assuming that all iPhone users are equal in terms of how they view their iPhones and upgrade patterns. In reality, that 589M iPhone installed base includes nearly 200M iPhone users who just bought their first iPhone within the last two years. I suspect these people are less likely to upgrade their iPhones as frequently as someone who bought the original iPhone or iPhone 3G/3GS. (There are much fewer of those early adopters included in the iPhone installed base).

My answer for navigating this trickiness is to segment the iPhone installed base by iPhone upgrade cycle. I run with shorter iPhone upgrade cycle estimates for iPhone early adopters (people who bought their first iPhone in 2007, 2008, 2009, and 2010) while I use longer upgrade cycles for those users who just recently bought their first iPhone. In addition, I included a lengthening process across the board to reflect a maturing iPhone product.

These are the iPhone upgrade cycle estimates that I used when calculating the iPhone installed base, grouped by the year a user purchased their first iPhone: (As an example, if my first iPhone was a 3GS purchased in 2009, I would be part of the 2009 line item.)

2007: 2 years (the average user upgrades their iPhone every two years)
2008: 2.2 years increasing to 2.4 years
2009: 2.2 years increasing to 2.5 years
2010: 2.2 years increasing to 2.5 years
2011: 2.2 years increasing to 2.8 years
2012: 2.5 years increasing to 3.1 years
2013: 2.6 years increasing to 3.1 years
2014: 3.1 years
2015: 3.4 years

Notice how I have users who bought the original iPhone in 2007 as remaining on an average two-year upgrade cycle. However, for recent new iPhone buyers (2015), I assume an average 3.4-year upgrade cycle. Previous calculations that I did for the average iPhone upgrade cycle pointed to an overall average of 33 to 34 months. My current assumptions reflect an overall iPhone upgrade cycle of 36 months.

One caveat: The 106M new customers to iPhone in 2016 end up playing a very crucial role in this subject as they represent 18% of the entire iPhone installed base. If these users upgrade to a new iPhone much sooner than my 3.4-year average, the overall iPhone upgrade cycle will be more like 33 months.

New 2016 and 2017 iPhone Sales Estimates

Four months ago, I published my revised 2016 and 2017 iPhone estimates following Apple's difficult 2Q16 earnings report. My iPhone estimates were:

FY2016: 205M (down 11% from FY2015)
FY2017: 174M (down 15% from FY2016)

At the time, I stated that these estimates represented what I thought to be sales numbers that Apple had a very good chance of reaching (i.e. they were conservative).

After looking at my revised iPhone sales model, I think my FY2017 sales estimate was too conservative.

My new iPhone unit sale estimates are:

FY2016: 211M (down 9% from FY2015)
FY2017: 200M (down 5% from FY2016)

For my FY2016 estimate, the iPhone SE is helping to offset very weak iPhone 6s sales. I raised my FY2017 unit sales estimate by 14% due to one reason: I underestimated the number of customers new to iPhone in 2016.

I am now expecting Apple to add 75M new customers to iPhone in 2017. Previously, I was assuming Apple would add 40M new iPhone users in 2017. That 35M user difference was the primary driver for my higher iPhone unit sales estimate in 2017. The underlying reason for this discrepancy is that my revised iPhone installed base model has Apple adding significantly more new users in 2016. If Apple is adding more than 100M new people to the iPhone installed base in 2016, there is no reason to assume there will be an implosion to just 35M new users in 2017. Instead, I am running with a 30% drop to 75M new users. That is still a substantial decline, representing the steepest decline in new iPhone users that Apple would have ever experienced. The reasoning behind that can be found in my article "iPhone Warning Signs."

In terms of iPhone upgraders, back in May 2016, I estimated 135M to 145M iPhone users will upgrade to a new iPhone in FY2017. My revised iPhone model pretty much arrives at the same estimate for iPhone upgrades. This would be an improvement from 2016 when Apple did not do as well with iPhone upgrades (the 6s and 6s Plus just didn't connect with consumers as management expected). The reason I am including an improvement in upgrade patterns in 2017 is due to the strong growth in the iPhone installed base. In 2015 and 2016, I estimate Apple added close to 200M new people to the iPhone installed base (Apple can thank China). While a majority of those users will not upgrade their iPhone in 2017, even a small portion (20-30M people) can move the needle.

Looking out beyond 2017, the overall theme for iPhone will likely be weakening new user growth trends offset by improving iPhone upgrade patterns built on the back of iPhone installed base growth. While slowing new user growth will eventually catch up with upgrade rates, that likely won't happen for a few years. As long as iPhone users continue to upgrade their devices periodically (my current assumption is 36 months, on average), an implosion in iPhone sales over the next few years is off the table.

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