WWDC Clues Hint at Apple's Post-iPhone Era

This year's WWDC felt different. While Apple's annual developer conference still showcased the company's software strategy for the coming year, last week's keynote also contained an unusual number of clues related to Apple's hardware ambitions. Apple's strategy for eventually moving beyond the iPhone is coming into focus.

Previous Apple Product Eras

One way to see where Apple is headed is to look at Apple through the rearview mirror. The Mac as Digital Hub era was Apple's first genuine product philosophy following Steve Jobs' return to Apple. The idea was simple. Instead of worrying about a growing number of dedicated peripheral electronic devices, Apple would focus its resources on positioning the Mac at the center of the universe. Users would then connect their growing collections of accessory devices to their Macs. 


As mobile devices became more powerful and occupied larger roles in our lives, Apple dedicated resources to designing Mac peripherals that had the most potential to be consumer blockbusters. First came the iPod, and this was followed by the iPhone. Selling more than just a few Mac models, Apple began thinking of its product strategy in terms of a stool on which each leg represented a different product category, as shown in the diagram below. At the same time, Apple continued to build out its services and cloud offerings to serve as the glue keeping the stool together.


At this year's WWDC, Tim Cook's message to developers was that Apple's current product strategy revolved around four "category defining and world changing" platforms: watchOS, tvOS, macOS, and iOS. While it may sound like these four platforms have replaced the old product categories found with the Apple Stool strategy, in reality, Apple's current product strategy looks very different. 

As shown in the diagram below, not all software platforms are viewed equally. iOS remains at the center of the universe given the iPhone's sheer dominance and is supplemented by continued iPad popularity. Meanwhile, watchOS is for a product that is still dependent on the iPhone while macOS and tvOS are much smaller platforms with cloudier long-term outlooks. 


When taking a look at nearly every financial metric, it's clear that we are still firmly in the iPhone as Hub era at Apple. There are nearly twice as many iPhones in the wild as every other Apple product combined. Despite slowing iPhone sales, Apple will still sell nearly five times as many iPhones as iPads in 2016. On a revenue basis, the iPhone is responsible for 65% of Apple's annual revenue and 75% of Apple's annual operating income.

WWDC Clues

Given such lopsided financial metrics, it has been very difficult to envision how Apple will eventually move beyond the iPhone. Some think Apple's only choice is to monetize the iPhone business using services. Others don't think Apple will actually be able to successfully come up with a post-iPhone strategy.

Fortunately, Apple's WWDC keynote last week contained clues as to where Apple's product strategy is headed. One theme found throughout management's slides was a focus on the user experience. Whether it was rethinking the iPhone lock screen or opening up additional iOS services to third-party developers, many of Apple's software changes were done with the user experience in mind. (I reviewed additional themes and observations from the keynote here and here). However, much more intriguing were the two fundamental shifts underpinning this focus on the user experience. Each shift portends an era in which the iPhone is no longer at the center of Apple's product strategy.

App Evolution. We are starting to use apps differently. Apple sees an era in which instead of downloading dozens of apps and arranging them in a grid pattern on our iOS devices, we rely on a number of services to handle our daily tasks. Apple's motivation for funneling developers into Siri, Maps, and Messages will end up making it that much easier for users to consume content and data across a number of hardware form factors. As a prime example of how this shift from an app-centric model to a service-centric framework changes Apple's product strategy, consider the Apple Watch. Apple has said that the Apple Watch is positioned within Apple's product line to handle tasks formerly given to the iPhone. In a world where content formerly found on third-party apps is eventually found within Apple services, while it may have made sense to use an app on our iPhone, it will now make just as much sense to use Siri or Messages on our wrist.

Services. Given the movement of third-party app functionality into services, Google is half-right when saying that it is time to move beyond the device. Services are becoming smarter as we give our devices additional tasks and data. This immense level of data ends up placing more value and capabilities with the glue that has traditionally held Apple's collection of gadgets together. However, Google and other services-oriented companies don't have it completely right. When services become more valuable, one consequence is the altering of how we use different form factors. Hardware does not lose relevancy. Rather, a world in which services are much more useful and valuable ends up elevating new hardware form factors that have access to these services. For example, tasks that may have traditionally been given to the Mac, iPad, or iPhone we will eventually be able to do on wearable devices because of more valuable and capable services. It is difficult to think of a form factor that is unable to utilize Siri in one way or another. 

The Apple Experience Era

Apple will look to move beyond the iPhone by offering users the ability to create custom Apple experiences. These experiences will involve a range of hardware form factors, the software platforms running on those form factors, and the Apple services connecting each form factor. The following diagram depicts this new Apple Experience era. Depending on the user, each form factor will hold varying levels of importance as depicted by the blue circle's size. The dotted lines represent the Apple services connecting all of the form factors. The solid lines represent situations in which there may be a greater level of dependency between form factors. 

Users will then choose which form factors make the most sense for their daily schedules and lifestyles. For some, an Apple Watch equipped with Siri, Messages, and Maps combined with a pair of not-yet announced wireless Apple EarPods will handle most of the tasks formerly given to an iPhone. For others, it may continue to make the most sense for an iPhone to be at center of their digital lives. It is not a stretch to think of more unusual combinations such as an Apple Watch and iPad as someone's two primary computing devices. Meanwhile, an eventual Apple Car will represent another point of contact for customers interacting with the Apple experience and range of Apple services. 

The key aspect of this new Apple Experience era will be Apple's ability to sell an experience tailored to the user. Instead of having a static web of devices in which the iPhone is at the center and everyone uses the other form factors in a similar fashion, this web of Apple products will change depending on the user. In the diagram below, notice how User A places much more value on an Apple Watch and wireless EarPods (depicted by larger circles). However, for User B, the iPhone and iPad hold a greater amount of importance.

Key Tenets of the Apple Experience Era

There are three major tenets of this new Apple product era. 

Hardware plays a crucial role. While nearly every Apple peer wants customers to begin thinking beyond the device and instead focus on the data-rich services connecting various types of hardware, Apple's future will contain plenty of hardware. We need hardware to record and then consume data. In addition, there will always be a human desire to interact with products. Apple will likely position hardware as the variable that makes its services that much more attractive than competing services. Look no further than Apple's decision to locally do all facial recognition as well as object and scene recognition processing in Photos on the device. Being able to use a service on a range of well-designed devices is something that Apple can excel at while other companies would need to rely on partners or others to make this happen. 

Services represent the glue. Apple will position products such as Siri, Messages, Maps, Apple Music and an eventual Apple Video service as the glue that holds various form factors together. 

Experience matters. From Apple's perspective, the key to moving beyond the iPhone is to offer users the option to personalize their technology needs with hardware and services. Apple will use certain criteria such as mass-market appeal to pick and choose which product categories and services end up getting precious Apple resources.

Apple's Challenges

At first glance, it would appear that Apple has all the ingredients in place to move beyond the iPhone. Apple's industrial design capabilities continue to be industry-leading, and WWDC began to peel away some of the mystery surrounding Apple's path for incorporating deep learning into its services. However, there are two big risk factors that need to be monitored very closely. 

Apple remains a resource-strained company. The most valuable resource is time and energy. Given the company's functional organizational structure, management has tangible limitations as to the number of projects that can be undertaken at any one time. As seen in the Apple Experience era diagrams, it would not be a stretch to see the number of blue circles, representing Apple hardware form factors, to increase. However, at a certain point, Apple will begin to find that it is unable to expand in new areas while still supporting legacy industries or products. Management is quite vocal that Apple says "no" much more than "yes" when it comes to new products. In addition, the company is not afraid to cannibalize its own products. These statements will likely be tested in the coming years.

The second risk factor involves Apple being able to learn how to add chaos to new industries. Apple has no experience in the transportation industry. Yet, the company will need to not only place a bet as to where the industry is headed, but also be prepared to pivot in order to potentially use different business models, including different ownership models

Moving Beyond the iPhone

Apple's plan to move beyond the iPhone won't be to come out with another pocket-sized computer that is capable of bringing in $200 of profit per device. Instead, Apple will look to build an Apple ecosystem containing various form factors and services that are well positioned to take advantage of the evolving app ecosystem. As the company enters new industries and sectors with new hardware form factors and services, the company will need to embrace new business models and ways of doing business. However, despite this tall order, the focus on the product and user experience will be the guiding light for Apple's goal of establishing a new product era after that of the iPhone.

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No One Wants to Be Apple

Something has changed in 2016. As the smartphone growth era winds down and we begin to look for the next big thing in tech, there has been a surge in pessimism pointed towards Apple's business model. With many of Silicon Valley's software and services giants doubling down on their core competencies and becoming more vocal as to where technology may be headed, one thing is clear: No one wants to be Apple. 

Declining Apple Envy

The iPhone has been a one-of-a-kind product for Apple. With 35% net operating margins and an average selling price of more than $600, the 948 million iPhones sold to date have resulted in more than $200 billion of profit for Apple. The fact that tens of millions of users upgrade to new iPhones every other year has been the financial icing on the cake. Apple's profit from iPhone has contributed to the company's annual net income increasing nearly 15x since 2007. 

While Apple was making more than $200 of profit per iPhone sold, Apple's peers were making much less from the software and services running on those iPhones. Even when taking into account the much larger Android user base, we see that other forms of smartphone monetization just haven't been able to match the profit Apple has received from hardware margins. Of course, Apple's bundled software and services contributed to those high hardware margins.

As iPhone profits grew, Apple envy increased. Meanwhile, Apple's hardware and software integration resonated with premium smartphone users, the most attractive segment for advertisers. As a result, Apple peers began to dabble with hardware along with other Apple strategies. The thinking was that maybe Apple's hardware and software integration strategy was finally seeing validation after nearly three decades of losing. 

The environment has changed in 2016. Apple's quarterly revenue declined for the first time in 13 years as iPhone sales fell year-over-year for the first time. In addition, there are various warning signs beginning to show in the iPhone business.

Accompanying this iPhone sales growth slowdown has been a marked change in attitudes toward Apple's business model. Many have turned pessimistic about Apple's strategy of relying on periodic hardware margins for a majority of its earnings. Peers are now focusing on the downside and risks of being Apple. The prospects of coming up with new products that rival the iPhone seem daunting. Apple competitors have made the decision to end their quest to be like Apple and are now doubling down on their own core strength: recurring revenue associated with advertising and services.

Fading Hardware Envy

The clearest sign of changing attitude towards Apple is Silicon Valley's declining fascination with hardware. While Google made it crystal clear last month at its developer conference that it was ready to begin moving beyond devices, the company had spent the past few years displaying a serious flirtation with those same devices and the idea of recreating Apple's hardware and software integration business model.

Google's $3.2 billion acquisition of Nest in 2014 was positioned as a game-changing transaction that could give Google a formidable head start in the smart home arena. Nest CEO Tony Fadell was even positioned as a potential Google CEO successor to Larry Page. Having a hardware whiz in charge of a data-driven ad company seemed to be quite the intriguing proposition. Just three years earlier, Google had purchased Motorola for $12.5 billion, a transaction that was positioned as a patent defense play but ultimately was born from the fact that Google did not do its own hardware.

In reality, Google's foray into hardware has been nothing short of a complete failure. Google ended up selling Motorola Mobility to Lenovo. Meanwhile, Tony Fadell just announced he is leaving Nest, an ominous sign that Nest's future within the Alphabet web of subsidiaries is now up in the air. 

Google wasn't the only company to flirt with Apple's hardware and software integration model. Microsoft showed a clear interest in copying Apple and controlling both hardware and software. While the strategy was largely a legacy play from the Steve Ballmer era, Microsoft seemed to believe in it enough to have a big hardware-focused NYC event just last October. Eight months later, it is clear that consumer reception to Microsoft hardware hasn't exactly caught the world by surprise. The quest to rethink the laptop with Surface Book went nowhere. 

We can also rope in Facebook's and Amazon's infatuation with producing its own smartphone as additional data points about Silicon Valley's previous interest in hardware over the years. Much, if not all, of this interest had been based on Apple's sheer success with the iPhone and iPad. While it was possible to beat Apple in terms of smartphone unit sales or market share, the fact that Apple was making nearly 45 percent gross margins on its hardware gave the company a monopoly on industry hardware profits, a statistic still true today. 

Things are very different now. Slowing smartphone sales and the ongoing tablet market implosion have resulted in mobile hardware having a much less rosy outlook. Apple peers are now becoming much more vocal that it is time we move beyond hardware and focus on the services and networks running on hardware. No one wants anything to do with Apple's hardware business.  

Fading Retail Envy

Another example of a change in attitude towards Apple strategy relates to brick and mortar retail. While Sundar Pichai was on stage at Google I/O 2016 explaining why it was time to move beyond mobile devices and embrace an "AI-driven" world, Apple was putting the finishing touches on its new Union Square Apple Retail store a few miles away in San Francisco. The juxtaposition of these two events symbolized just how different Apple is thinking from the rest of Silicon Valley when it comes to technology in 2016. 

Apple's Union Square wasn't just any new Apple Retail store. Instead, the location showcased Apple's new Retail store design strategy. Along with a fresh, new look thanks to input from Jony Ive, one of the store's main features is a reimagined customer service area. The infamous Genius Bar had been replaced with a Genius Grove since "Bar" may bring up unpleasant connotations. Apple wanted to improve the experience customers received when getting help with Apple products. A customer can now chat with an Apple Retail store employee while literally sitting under a tree in Genius Grove. 

In many ways, rebranding Genius Bars into Genius Groves is very Apple. While some may just see a subtle name change, the very different atmosphere created by the new setup can go a long way in making Apple stores feel less crowded, more approachable, and relaxing. All three of those attributes denote improvements to what had been increasingly positioned as friction points in Apple Retail stores in recent years. 

Apple's continued investment in brick and mortar retail isn't surprising. However, many of Apple's peers who envied the company's success in retail are now having second thoughts. Microsoft's aggressive retail expansion has led to nothing more than lots of empty retail stores. Samsung's store strategy has no rhyme or reason as the company struggles to produce a cohesive product strategy following the Galaxy line of smartphones. There were ongoing rumors that even Google was close to jumping into brick and mortar retail. We can't forget those mysterious Google barges that popped up in 2013 with the best guesses being that Google was interested in unveiling Google Glass showrooms.

The only tech company other than Apple still showing a genuine interest in brick and mortar retail is Amazon and even then, Jeff Bezos isn't so much looking to be like Apple but instead eventually establish a web of locations to pick up and drop off Amazon packages.  

The New Envy

Instead of wanting to be like Apple by doing hardware and getting into brick and mortar retail, Silicon Valley is now infatuated with data and the services meant to capture such valuable data. Google's vision of a world moving beyond hardware seems to represent a significant threat to a company like Apple. It's not just Google. The Amazon Echo has turned into a poster child for this "post-device" world in which some users could theoretically do less on their iPhones and iPads and instead use their voice to interact with a bunch of speakers and a microphone in a stationary tube. In addition to Amazon and Google, Microsoft and Facebook have extensive resources and attention focused on similar types of data collection and aggressive plans with artificial intelligence. 

It should come as no surprise that companies with no formidable hardware strategy are now more vocal about tech's future not revolving around hardware.

A growing number of industry observers think if the device doesn't matter as much going forward, Apple's core competency when it comes to hardware becomes less valuable. The argument then extends to Apple's business model not being suited to produce best-of-breed services geared towards data capture. This seems to give Apple an even more dire outlook. 

In reality, Apple envy has flipped. Companies once jealous of not doing their own hardware are now doubling down on their core competency: data collection. Facebook has spent more than a decade building a curated version of the web in order to have users stay on a Facebook property and in the process, share more data. A similar dedication to data collection can be found at Google, Microsoft, and Amazon. 

Finding the Puck

With all of this change swirling in the air, there is increased uncertainly as to how Apple will proceed. As peers move away from envying Apple's position in tech, will Apple management feel the need to change or adapt and become more like everyone else to compete? 

There is no question that Apple has holes or deficiencies in its product strategy. While some of these holes have been, and continue to be, filled by M&A and outside hires, Apple has historically seen much success by changing the game and narrative. Along those lines, we have still not seen Apple's response to Facebook's and Google's developer conferences. This is why Apple's developer conference next week takes on a different tone than that of previous years when Apple envy was much higher. With that said, Apple management will likely take its time to respond to the growing number of criticisms lobbed towards Apple's business model.

At the end of the day, Silicon Valley and Wall Street are figuring out how to connect some of the last remaining dots found with the smartphone growth era. While some will want to say that the future has already been determined and either machine learning or even voice will quickly replace much of the current smartphone and tablet paradigm, in reality, the future has not yet been determined. AR and VR still have a long way to go before reaching mass-market appeal. Voice interfaces are in their infancy and contain a number of troubling aspects and problems. Artificial intelligence and machine learning are still mostly buzz words with plenty of time and room left to see where technology trends. Wearables are quickly moving to the point of being the de facto evolutionary next step for the smartphone. And of course, the smartphone is ushering in a revolution in the transportation industry. 

As Apple envy winds down in Silicon Valley and Apple peers no longer see the allure of being like Apple, Tim Cook and the executive team are familiar with finding ways to prove skeptics wrong. The next big thing after the smartphone has not yet been figured out, and Apple has a few ideas on where it thinks the puck is headed. While everyone is headed in one direction, Apple thinks the intersection of technology and liberal arts will be found in a different place. 

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Apple M&A Is Entering a New Phase

Apple's mergers and acquisitions (M&A) strategy is misunderstood. Consensus has settled on the view that Apple needs to change its rigid philosophy towards M&A and begin using its $233 billion of cash to buy larger competitors and find new sources of revenue. These suggestions are misplaced. Apple's M&A strategy has actually seen quite a bit of change over the years, and there is evidence that we are about to see even greater change going forward. Apple's investment in Didi Chuxing marks the official start of Apple M&A entering a new phase as the company pivots into transportation. 

Apple M&A Activity

The best way to begin analyzing Apple's M&A strategy is to look at the company's acquisition activity. There is a perception that Apple does not acquire many companies. The numbers tell a different story. Since 1997, Apple has acquired more than 70 companies. When including the smaller transactions that were never disclosed, Apple's acquisition list likely exceeds 80 companies over the past nineteen years. Exhibit 1 breaks out Apple's publicly disclosed acquisitions by year. 

Exhibit 1: Apple Acquisitions (Publicly Disclosed)

One reason why it seems like Apple has not kept pace with its peers in terms of M&A is that Apple often purchases technologies and small teams of talent. A consequence of this strategy is that Apple's acquisition activity doesn't garner the same type of press coverage as a big, headline-grabbing transaction would receive. In addition, no single M&A transaction has ended up representing a significant percentage of Apple's cash levels, which leads many to conclude that Apple is not placing as significant of a bet with any one acquisition. To quantify these statements, I turned to Apple's cash flow statements.

Each quarter, Apple discloses the amount of cash spent on M&A as "payments made in connection with business acquisitions." While the line item may not catch the full amount spent on acquiring teams of talent and assets when taking into account stock-based compensation, or intangible assets like patents, and of course investments in machinery, it does a good job at estimating the amount spent to acquire companies. As shown in Exhibit 2, while Apple has clearly been spending more on M&A in recent years, the absolute totals are still low compared to Apple's growing cash levels.

Exhibit 2: Apple M&A Activity (Business Acquisitions Payments)

Note: Inflation adjusted

* Includes $1 billion investment in Didi 

Apple M&A Observations

After analyzing 19 years of Apple M&A activity, I reached two primary observations that are useful for determining where Apple's M&A strategy is headed. 

Apple M&A Is Evolving. Contrary to popular belief, Apple M&A has actually experienced quite a bit of change over the years. The first major difference is that management has increased the M&A pace. Apple acquired more companies from 2013 to 2015 than they did in the previous 16 years leading up to 2013. When looking at the amount spent on M&A, the purchases between 2013 and 2015 accounted for 70% of the total amount Apple spent on M&A since 1997.

Another example of a changing M&A strategy involves price. Apple management is not opposed to paying a large sum of money for an acquisition. Apple's $3 billion Beats acquisition in 2014 was six times as large as the second-highest price paid for a company (NeXT in 1997). In fact, Beats represents 40% of the total spent on M&A over the past nineteen years. Excluding Beats, the average price paid per acquisition was less than $30 million.

Management's M&A Strategy Is Very Focused. Despite a changed strategy, there is evidence that management is still guided by the same principles and ideals when acquiring companies. There is no evidence that Apple purchases companies in order to directly boost revenue or earnings. Instead, acquisitions continue to be used to enhance Apple products. This product-focused mindset is one reason why most Apple acquisitions are eventually incorporated into Apple's product line. While some deals, such as Quattro Wireless, a mobile advertising company, may not pan out exactly as management envisioned, there are very few acquisitions that have turned out to be failures leading to significant write downs. In addition, there are no signs that Apple management has used M&A for pet projects or to appease foreign governments or regulators.  

M&A Phases

Given that Apple's M&A strategy has undergone a significant change in recent years, I took a closer look to find the fundamental driver behind this change. Adding a bit more context to the first exhibit ended up providing much clarity. The iPhone was the catalyst that ended up driving much of the change in Apple M&A. As seen in the table in Exhibit 3, which categorizes each Apple acquisition by the product category it ended up benefiting, there have been two distinct M&A phases (Mac and iOS) with the iPhone's launch in 2007 marking the bridge between the two.  

Exhibit 3: Apple Acquisitions Categorized by Product Category

For 10 years starting with the NeXT acquisition in 1997, all but one Apple acquisition were related to strengthening the Mac platform. While this may not come as a complete shock given Apple's product line at the time, it is noteworthy that M&A was not used for the iPod or to expand into other product categories or industries.

Apple then experienced five years of limited to no M&A activity from 2003 to 2007. While the outside world did not know it at the time, this "buffer" zone ended up being pivotal years for iPhone development. 

Since acquiring P.A. Semi in 2008, every acquisition but one has been focused on strengthening the iPhone and broader iOS platform. This new iOS focus ushered in a significant increase in both the pace of M&A and the amount of cash spent buying companies. In addition, Apple has shown an appetite for a wider range of target acquisitions to enhance iOS ranging from intelligent assistants, music streaming, and maps to mobile processors, cameras, and fingerprint sensors.

Connecting the Apple M&A Dots

Taking what we know about Apple's M&A activity and the significant change that has taken place as the iPhone ushered in a new iOS-focused M&A phase, there are a few logic explanations that help explain Apple's changing M&A strategy. 

Apple's M&A strategy is built much like the company's functional organizational structure in which the product is placed above all else. Management's primary goal for M&A is to support Apple's evolving product line. As the company moves from industry to industry, management relies on M&A to purchase new core competencies. The end result is that Apple M&A does indeed undergo changes in terms of pace, amount spent and scope. However, similar to how Apple's culture remains intact despite a different product line, Apple still relies on the same underlying philosophy when it comes to acquiring companies. 

In the early 2000s, Apple's M&A activity was dedicated to enhancing software that supported its Mac-as-the-hub product strategy. Apple acquisitions focused on video and photo editing in addition to music and other forms of content that were meant to strengthen the Mac and make it the center spoke for a range of peripheral devices. Once Apple pivoted into the phone industry with the iPhone, management began to use M&A to buy new core competencies in mobile. There was only one acquisition before the iPhone was unveiled in January 2007 (FingerWorks in 2006) that went on to play a major role in iOS development.

Management saw at a very early stage that owning the core technologies found in iPhone would end up giving Apple a competitive advantage over its peers. Some of this thought process was a carryover from the Mac. In order to have the Mac stand out from Windows in terms of content creation, Apple acquired Raycer Graphics. Similar motivation led to a number of acquisitions meant to set the iPhone (and iPad) apart, including P.A. Semi (mobile processors), Siri (natural language processing) and AuthenTec (fingerprint sensors). Instead of placing revenue generation as the primary motivation to own these companies, management's goal was to expand Apple's capabilities with mobile devices and strengthen the iOS platform.

As iOS devices began to handle a growing percentage of our daily computing tasks, Apple's M&A pace sped up to include a wider range of areas including search, mapping, and recently, AR, VR and AI. Each one of these fields represents a new chapter for Apple, something with which Apple may not have had much experience, and positioned M&A almost as a learning tool used to buy teams of talent and technology.  

The New M&A Apple Phase

Despite the iOS platform having plenty of runway left with Apple investing heavily in new wearables, Apple TV and continued iPhone and iPad updates, we are already seeing the beginning stages of a new Apple M&A phase.

Apple's $1 billion investment in Didi earlier this month marks the newest phase of Apple M&A (I went over the Didi deal in detail here.) The deal doesn't stand out because of its financial arrangements. Apple has purchased stakes in companies in the past with mixed results. In 1999, Apple invested $12.5 million in Akamai, a Internet content delivery service, making a sizable profit on its investment during the dot-com bubble. Also, in 1999, Apple invested $100 million in Samsung to help the company with flat panel display production. In 2000, Apple invested $200 million in EarthLink, an Internet service provider, leading to a business arrangement in which Apple would benefit from a Mac user subscribing to EarthLink. Apple later had to write down its investment. Apple also held a significant investment in ARM Holdings for years during the 1990s and early 2000s.

The Apple/Didi deal is intriguing because it is the first M&A signal that Apple is beginning to pivot into transportation. We know Apple is working on an electric car with Project Titan and I actually place the odds of Apple selling an electric car as much higher than most people assume. By investing in Didi, Apple is not only interested in gaining an early foothold in the Chinese auto industry, but also beginning to think about a likely source of demand for an eventual Apple Car. 

This next M&A phase will likely first include Apple buying additional stakes in ridesharing companies ahead of an Apple Car release. The most obvious candidates are those that have entered into a strategic partnership with Didi, including Lyft in the U.S., Grab in Southeast Asia, and Ola in India. Combined, these four ridesharing companies represent the vast majority of today's ridesharing industry as measured by drivers and rides given each day. 

The primary reason Apple would buy smaller, minority stakes in these companies instead of just forming business partnerships or alliances is that the ridesharing industry is still very much in the early innings where startups need capital to compete and gain market share. Along with gaining access to Apple's $230 billion of cash, having Apple has a strategic investor gives these companies an advantage over their peers. Meanwhile, at the other end of the spectrum, there is no clear rationale for Apple to acquire large, controlling stakes in these ridesharing companies.

By investing in ridesharing companies, Apple would be looking to form a demand source for an eventual Apple Car, similar to how they work with mobile carriers to sell iPhones. Ridesharing is changing how the world moves from Point A to Point B, and once electric cars with full level 4 autonomy become a reality, car ownership models will come under pressure. Ridesharing companies are not just taxi hailing services but transportation logistics companies. A case can me made that Apple is getting an early start investing in a core technology for the automobile: demand and supply logistics. 

Once an Apple Car has been released, Apple will then use M&A to further expand its core competencies in the auto space, and this new M&A phase will likely go on to last for decades.  

Apple M&A Embraces Change

Apple's culture embraces change. The only way Apple will remain relevant is to reinvent itself. Similarly, Apple M&A has displayed a similar type of change over the years, and this trend will only intensify when an Apple Car platform is introduced. Instead of buying a company such as Tesla to enter the auto industry with a new product, Apple will instead rely on Project Titan and its own resources to design and sell an electric car. Once a product has shipped, Apple will be in a better position to observe the biggest holes in its product offering and strategy. M&A will then enter the equation in earnest. 

One of the bigger unknowns entering this new M&A phase involves the degree to which Apple can transplant its expertise with iOS into a car. We already know Apple's focus on acquiring mapping assets will play a crucial role in its move into transportation. The same will likely apply to Apple's recent transactions with AR, VR, and AI acquisitions. 

Similar to the FingerWorks acquisition in 2006 (for iPhone in 2007) and Passif Semiconductor in 2013 (for wearables in 2014), Apple's Didi investment will eventually be looked at as evidence of Apple preparing to enter a new industry. The fact that Apple's stake in Didi marks the first time Apple has taken a stake in a company since Imagination Technologies in 2008 foreshadows how Apple M&A is going to change to reflect a new industry.

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Above Avalon Is Officially Sustainable

It has been one year since I launched Above Avalon memberships and began writing my daily updates about Apple. I wanted to take this momentous occasion to recap the first year and look toward the future.

I had two goals in launching Above Avalon memberships back on May 13, 2015. 

  1. Put Above Avalon on a path to sustainability.
  2. Begin to form a thriving community based on a different kind of Apple analysis. 

I am happy to report that I accomplished both goals over the course of the past year. Above Avalon is officially sustainable (and has been for a few months). In addition, I'm now getting to know quite a few Above Avalon members through daily interactions over email and the discussions taking place in the Above Avalon team in Slack. 

Officially Sustainable

There are two parts to sustainability for a company like Above Avalon. The first is tangible: the number of Above Avalon readers and podcast listeners becoming members. This number plays a big role in keeping the lights on at night. Not only was I able to meet my one-year membership sign-up goal in a few months, but I was also able to meet my revised goal. A big thank you goes out to everyone who has become an Above Avalon member over the past year. Members play an important role in making Above Avalon possible.  

The second aspect to sustainability is a bit more intangible: a publishing schedule that contains longevity and vigor. After publishing 200 daily updates for members in the past year, each containing two to three stories, I feel I have found a good balance between the amount of time spent writing about Apple and researching various topics and subjects.

The Daily Updates

My goal for starting Above Avalon was to introduce a different kind of Apple analysis in which all research and perspective originates from understanding how Apple thinks about the world. Only then should analysis focus on the broader Apple operating environment, including competitors. Over the course of the past year and a half, I am more confident than ever that this framework is the best way to analyze Apple given its unique culture.  In addition, it has contributed to Above Avalon research and perspective being one of the more accurate and informed sources available. 

I feel very confident that my perspective on key issues impacting Apple's future, including prospects of an Apple Car, Jony Ive's promotion to Chief Design Officer, and Apple's continuing investments in future products and technologies, were a result of dedicating all of my time and resources to understanding how the product guides Apple. At the same time, critical analysis has led me to be more hesitant and skeptical about certain parts of Apple's business, including iPad and iPhone unit sales growth. 

New Archive & Slack Team

One way to foster an Above Avalon community is to establish a place for members to communicate with each other and discuss Apple trends. Four months ago, I created an Above Avalon team in Slack. I am quite pleased with how things have turned out and feel even more confident today that Slack is the future of team communication. With the member archive and various channels placed within Slack, members now have an easy and convenient way to access previous updates and meet other members. 

Positioning the Slack team as an optional feature for Above Avalon members turned out to be the right call as I have been able to maintain the value of every Above Avalon membership regardless of participation in the Slack team. 

Goals for Year Two

While the past year has been great for Above Avalon, there are a few things that I plan on focusing on over the next year. 

1) A new kind of Apple financial analysis. Above Avalon members have experienced four Apple earnings cycles. While I am confident that each has proven to be quite valuable and enriching, one goal for the next year is to develop a new kind of Apple financial analysis that does a better job of judging how Apple is performing in relation to its goals. Wall Street is guided by narratives and near-term expectations while Apple is guided by intangible factors such as product satisfaction and long-term thinking. This division produces friction, and I want to work on removing some of this friction when analyzing Apple's financial trends. This process begins by determining the numbers and data points that matter and creating new ways of measuring and analyzing that data.

2) Continue to learn about Apple. On one hand, Apple is a creature of habit, using pages from the same playbook that have gotten the company to where it is today. However, there are plenty of signs that changes are afoot and that the Apple of tomorrow is going to look quite different than the Apple of today. The more I learn about Apple, the greater appreciation I have that this is a company that is reinventing itself every day. There are plenty of aspects of the company that I want to dedicate much more time and energy to better understanding.

3) Increase value found with Above Avalon memberships. I am convinced that Above Avalon's future goes hand in hand with building a strong membership base. While a growing number of people agree that Above Avalon memberships contain an incredible amount of value ($10 per month or $100 per year) , I want to focus on making memberships even more valuable going forward. One method for accomplishing this goal is continuing to focus on relevant topics and subjects pertaining to Apple's business and future. The daily update format gives me a great avenue for fostering this discussion over an extended period of time and using current news events to augment the discussion and assess changes to strategy. 

As Apple begins to pivot into new industries, there has never been a more exciting time to study the company.

The past year flew by, and I am excited to begin the second year and look forward to welcoming new faces as Above Avalon members. (More information on membership can be found here.

Thank you for a great first year.

Neil Cybart

Apple R&D Reveals a Pivot Is Coming

People are focusing on the wrong thing when analyzing Apple's path forward in the face of slowing iPhone sales. Instead of debating how much Apple will try to monetize the iPhone user base with services (not as much as consensus thinks), the company is instead planning its largest pivot yet. There are only a handful of logical explanations for Apple's current R&D expense trajectory, and all of them result in a radically different Apple. In a few years, we are no longer going to refer to Apple as the iPhone company. 

Apple R&D: By the Numbers

As I pointed out last May, Apple's R&D expense saw a significant bump up beginning in mid-2014. It was clear Apple was up to something big. However, after looking at Apple's 2Q16 results, it appears I underestimated the situation. As depicted in Exhibit 1, Apple is now on track to spend more than $10 billion on R&D in 2016, up nearly 30% from 2015 and ahead of even my aggressive estimate. This is a remarkable feat considering that Apple was spending a little over $3 billion per year on R&D just four years ago.

Exhibit 1: Apple R&D Expense (Annual)

One of the more interesting aspects of Apple's R&D expense trajectory in recent years is that the increase has been outpacing revenue growth. As seen in Exhibit 2, given my current iPhone sales expectations for FY16 and FY17, Apple is on track to approach a multi-decade record in terms of amount spent on R&D as a percent of revenue. 

Exhibit 2: Annual Apple R&D Expense (Percent of Revenue)

Unusual R&D Perceptions

The most shocking aspect about the amount of money Apple is spending on R&D is how little attention it has garnered in Silicon Valley and on Wall Street. Other than my R&D post last year, there is rarely any mention of Apple's R&D, and this doesn't seem to make much sense.

I suspect most of this has been due to the fact that Apple does not draw attention to its product pipeline and long-term strategy, choosing instead to embrace secrecy and mystery. Now compare this to Mark Zuckerberg laying out his 10-year plan for Facebook. It is easy and natural for people to then label Facebook as innovative and focused on the future. The same principle applies to Larry Page reorganizing Google to make it easier for investors to see how much is being spent on various moonshot projects. Jeff Bezos is famous for his attitude towards failing often and in public view, giving Amazon an aura of being a place of curiosity and boldness when it comes to future projects and risk taking. 

Meanwhile, Tim Cook has remained very tight-lipped about Apple's future, which gives the impression that Apple isn't working on ground-breaking ideas or products that can move the company beyond the iPhone. Instead of labeling this as a mistake or misstep, Apple's product secrecy is a key ingredient of its success. People like to be surprised. Another reason Apple takes a much different approach to product secrecy and R&D is its business model. Being open about future product plans will likely have a negative impact on near-term Apple hardware sales. Companies like Facebook and Google don't suffer from a similar risk. The end result is that there is a legitimate disconnect between Apple's R&D trends and the consensus view of the company's product pipeline. Apple is telling us that they are working on something very big, and yet no one seems to notice or care. I find that intriguing.

Logical Explanations for Apple R&D

Even though Apple remains tight-lipped about its dramatic increase in R&D expense, there are three logical explanations for what may be happening.

1) Apple's expanded product line requires additional R&D. This theory represents the most straightforward explanation. Essentially, because Apple has grown significantly over the years, the company needs to spend more on R&D just to keep up with its more expansive product line and greater competition. The company is now invested in four hardware categories (iPhone, iPad, Mac and Apple Watch), not to mention various software and services initiatives. 

2) Apple plans on doing more. Keeping with another simple explanation, Apple's increased R&D spend could signal that the company is willing to try its hand at more things. The expectation would be that Apple will begin releasing a greater number of products in terms of hardware, software and services. 

3) Apple is looking to pivot. Apple is ramping up R&D because they have a few big bets that require a massive increase in investment. The two most logical areas for these bets are wearables and personal transport initiatives. In both cases, Apple is moving well beyond its comfort zone of selling pieces of glass that can be held in one's hand. Instead, Apple is literally building a new company with additional capabilities and strengths.

The Most Likely Explanation

After analyzing the three preceding possible explanations for Apple's R&D increase, we can conclude the only one that actually makes sense is the third choice: Apple is looking to pivot. The first two theories fail to hold much water since they do not mesh with Apple's functional organizational structure. Since each senior Apple executive is in charge of his or her domain across Apple's product line, it is not possible for Apple to simply keep expanding the product line without negative consequences. At a certain point, Apple's resources are just stretched too thin to be effective. Some have argued that Apple had experienced some of this resource strain towards the end of Apple Watch development. In reality, Apple is constantly suffering from this resource strain despite having $233 billion of cash and cash equivalents on the balance sheet. 

It is this functional organizational structure that explains why Apple management talks about the need to remain focused and saying no to certain products and industries even though Apple could conceivably see much success. This rules out the explanation that Apple is spending more on R&D with the intent of doing a greater number of things. Apple's R&D follows a similarly focused mantra. While there are always scattered teams of people focused on far-fetched ideas and products, these activities do not amount to much of Apple's $10 billion budgeted for R&D in 2016. Instead, sudden and dramatic increases in Apple R&D are a result of new product initiatives.

One way of validating the claim that R&D is very much product focused is to graph the year-over-year change in R&D in absolute terms. As shown in Exhibit 3, a step pattern becomes apparent over the past 10 years. There have been two discernible increases in R&D expenses followed by periods of flat growth. When taking this step pattern and then overlaying it with Apple product launches, three product development stages become apparent: iPhone and iPad in the mid-to-late 2000s, Apple Watch beginning in 2012, and something new beginning around the Spring 2014. I suspect this latest item is primarily related to Apple working on its own electric car (Project Titan).

Exhibit 3: Apple R&D Expense Growth (Quarterly)

Apple Will Pivot

Apple is not spending $10 billion on R&D just to come up with new Watch bands, larger iPads, or a video streaming service. Instead, Apple is planning on something much bigger: a pivot into the automobile industry. 

The word "pivot" has become a buzzword lately, often misused to simply mean change. In reality, pivoting is actually a sign of strength as a company takes what it learns from one business model in one market and applies it a new one with a different business model. Apple would be taking lessons learned from its long-standing view on the world based on the Mac, iPod, and broader iOS lineup to begin selling an electric car.

This sounds incredibly ambitious and bold, and that is the point. Apple wants to move beyond the iPhone. In this regard, pivot seems like the wrong word to use since the iPhone is a very successful product generating more cash flows than the rest of Apple's product line put together times two. However, it is this success that ultimately serves as the greatest motivation for Apple management to figure out the next big thing.

In terms of how Apple can physically pivot, Apple's functional organizational structure needs to once again enter the conversation. An ability to pivot is the primary reason Apple has a rare functional organizational structure in the first place. By allowing management to put all of its attention on the product, and not internal politics, Apple's organizational structure is a major strength, not weakness. Apple is designed to move from product to product, industry to industry. We see the company do just that by entering the smartphone market, followed by the wearables market and soon, the auto market. 

Project Titan: A Finished Product is Likely

It seemed like many in Silicon Valley and on Wall Street spent most of 2015 debating if Apple even wanted to design its own car. (The answer was obvious: yes.) The discussion has now turned to whether Apple will actually end up selling a car or if management will conclude there isn't enough there to actually lead to a finished product. While Apple does indeed say no to most products and projects, Project Titan is not just any R&D project. 

In reality, people are grossly underestimating the odds that Project Titan will lead to Apple actually shipping an electric car. At this point, I peg odds of Apple selling its own electric car to be at least 80 percent. There is one very simple reason for my high degree of confidence: Project Titan is a long-term pivot. I don't consider Titan to be just another project that Apple has been tinkering around with in the lab for years like an Apple television set or Apple Pencil. Instead, Project Titan is much more about building a foundation for Apple that will literally represent the company's future.

It was recently revealed that Apple has set up a web of Project Titan buildings and infrastructure spread across Santa Clara, Sunnyvale and San Jose. This means that it is incorrect to think of Project Titan as just being about one product or one feature. Instead, Apple is building an entire start-up focused on the electric car industry, giving me a high level of confidence that Apple's efforts will lead to products. When diving deeper into Project Titan, this is where there is greater unknown as to whether a certain technology will ever ship, such as various autonomous driving features, different features for new internal passenger compartments, unique car materials, and the list goes on. Each one of those items should be thought of as an individual project that may not see the light of day. 

Apple has likely spent upwards of a few billion dollars on Project Titan so far when including real estate and stock-based compensation. When considering that Apple will likely be spending upwards of $14 billion per year on R&D by 2017 or 2018, Project Titan could easily end up being a $10-$15 billion project before Apple even ships a product. This is uncharted territory not just for Apple, but for the entire auto industry.

There is much to be discovered from tracking just one line item on Apple's income statement. R&D expense tells me that Apple is planning its most significant pivot yet. 

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