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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iPhone Warning Signs

Apple has spent years proving iPhone doubters wrong. Those who made a habit of calling for the iPhone's demise have watched the product go on to bring Apple over $600 billion of revenue and close to $250 billion of gross profit over the years. Ironically, just when it seemed like iPhone skeptics had thrown in the towel and accepted the iPhone's supremacy, warning signs are beginning to appear in the iPhone business.

Apple's 2Q16 earnings report was not pretty. (I reviewed the full report and management's conference call here and here.) Not only did iPhone sales decline year-over-year for the first time, but management issued alarming guidance for 3Q16, suggesting another very difficult quarter for iPhone sales. In addition, Apple expects iPhone average selling price (ASP) and margin to deteriorate due to the recently introduced $400 iPhone SE. On top of it all, Apple will take a historically large $2 billion inventory adjustment related to the iPhone 6s due to sales coming in below expectations. While some are optimistic that the iPhone 7 and 7 Plus will turn things around in a few months, it's time to become skeptical. The iPhone growth story is breaking apart, and management does not seem to be in control of the situation.

Slowing iPhone Growth

The iPhone business is slowing. When looking at iPhone sales on a quarterly basis (Exhibit 1), it is difficult to see the true extent of the slowdown. 

Exhibit 1: Quarterly iPhone Unit Sales

Graphing sales on a trailing twelve months (TTM) removes the cyclical nature associated with annual iPhone launches and enables us to reach a clearer view of the iPhone's growth profile. As seen in Exhibit 2, the recent iPhone sales slowdown becomes quite visible. Apple's 3Q16 guidance implies Apple will report its first quarterly iPhone sales decline when looking at sales on a TTM basis. This is a noteworthy development. 

Exhibit 2: Quarterly iPhone Unit Sales Growth (TTM) 

Some have argued that recent iPhone sales weakness is due to the iPhone being on a two-year cycle. Accordingly, if the very popular iPhone 6 and 6 Plus are excluded from sales trends, the iPhone's long-term growth trajectory would still be in tact. The numbers tell a different story. When looking at iPhone sales on a trailing 24 months, which helps diffuse some of the outsized impact from the iPhone 6 and 6 Plus, the iPhone business is about to experience its slowest growth yet. As seen in Exhibit 3, while sales growth remains positive, recent trends are cause for concern with the iPhone business quickly approaching no growth territory on a trailing 24 months basis. 

Exhibit 3: Quarterly iPhone Unit Sales Growth (Trailing 24 Months Basis) 

Caught by Surprise

The most alarming aspect of the iPhone's recent growth troubles has been that Apple management appears to have been caught off guard. The company thought the iPhone 6s and 6s Plus would build off of the sales level associated with the very successful iPhone 6 and 6 Plus. Instead, Apple is seeing iPhone sales fall 15% to 20% in 2016.

Rumors from Apple's supply chain had indicated iPhone component orders were cut soon after the iPhone 6s and 6s Plus launch. This was soon followed by additional rumors that Apple had cut iPhone production by 30%. While it is difficult to position these reports as concrete evidence that Apple overestimated iPhone demand, there are clearer signs that suggest management has not been able to completely get ahead of a deteriorating iPhone demand environment.

On October 27th, 2015, Tim Cook mentioned on Apple's 4Q15 earnings conference call that he expected iPhone unit sales to grow year-over-year in 1Q16. Cook based this assessment on the percentage of iPhone sales attributed to Android switchers and the iPhone upgrade rate, or the percentage of the iPhone installed base upgrading to a new iPhone. Three months later, Apple reported total iPhone sales of 74.8 million units, only 311,000 more than the previous year. To make matters worse, the only reason Apple was able to report any growth in iPhone sales was due to 3.3 million iPhones being added to channel inventory. Apple also just barely met its own revenue guidance for the quarter.

Cook has also given recent comments regarding iPhone sales that proved to be too optimistic. On Apple's 1Q16 earnings conference call, Cook said that he did not think iPhone unit sales would decline more than 15% in 2Q16 (in reality sales fell 16%). Cook then said that iPhone declines would trough in 2Q16 with better results during the back half of FY2016 given an easier sales comparison to prior year results. Apple's weak 3Q16 guidance proved that comment to be grossly optimistic. These types of miscalculations are not common for Apple and demonstrate that management has been unable to completely grasp the full extent of slowing iPhone demand. 

Warning Signs

On Apple's 2Q16 earnings call, management positioned pent-up demand for the iPhone 6 and 6 Plus and the weak global economy as the two primary reasons for slowing iPhone sales. While there is tangible evidence to support a portion of that claim, I'm skeptical that the iPhone's slowing growth is strictly related to two iPhone models, currency fluctuations and weaker economic conditions. 

Instead, there are a number of warning signs beginning to appear in the iPhone business indicating underlying deterioration:

Longer iPhone Upgrade Cycle. Much of the iPhone's current success has been a result of iPhone users regularly upgrading their devices every two years. However, there are signs that this upgrade rate is actually much longer than two years. Over the course of the past year, Cook has provided updates as to the percent of the iPhone installed base as of September 2014 that had upgraded to a larger iPhone (6, 6 Plus, 6s, or 6s Plus). At the end of 2015, 60% of the iPhone installed based as of September 2014 had not upgraded to a larger iPhone. That data point is not representative of an iPhone business on a two-year upgrade cycle. Instead, the iPhone installed base is, at a minimum, on a three-year cycle.

Much more concerning for Apple is that the longer the remaining 60% of the installed base delays an iPhone upgrade, the longer the upgrade cycle is extending. It is not unreasonable for the iPhone installed base to extend out to four or even five years. Not surprisingly, these trends were never accurately captured in consumer survey research reports. This is unchartered territory for Apple.

iPhone Growth Catalysts Are Disappearing. While there are legitimate reasons for explaining some of the iPhone's recent sales declines, much more concerning is how the largest multi-year growth catalysts for the iPhone business are either disappearing or turning out to be much less attractive than first thought. 

  1. Mobile carrier expansion is slowing. A significant contributor to iPhone sales growth over the years has been mobile carrier expansion. As Apple brought the iPhone to new mobile carriers, the device's addressable market continued to expand. In early 2014, China Mobile began selling the iPhone for the first time, opening up the iPhone to hundreds of millions of new consumers of which tens of millions were in a position to buy an iPhone right out of the gate. There are no additional carriers like China Mobile waiting in the wings where Apple can expand the iPhone's addressable market. Most of the world's population is now on a mobile carrier that sells iPhone. 
  2. India is not the next China. India has recently been positioned as the next big growth engine for iPhone. However, it is becoming clear that this optimism has been grossly misplaced. Cook even admitted on Apple's 2Q16 earnings call that India's smartphone market is where China was seven to ten years ago. That comment is not too reassuring for anyone thinking India would pick up the sales slack from a slowing China market. The country is just not in a position to represent a significant driver for iPhone unit sales given Apple's current pricing strategy. 
  3. High smartphone saturation rates. High smartphone saturation rates in the U.S. and other developed countries have removed feature phone users as an iPhone growth catalyst.
  4. Declining number of premium Android switchers. Apple has been very successful over the past year and a half appealing to high-end Android switchers craving larger iPhones. However, there are signs that the easy growth in terms of Android switchers is ending. There are only so many premium Android users in the marketplace, and Apple will need to begin appealing to Android users in lower price brackets to achieve the same kind of user growth. During 2015, there were approximately 1.2 billion people that bought a non-iPhone smartphone, up from a little more than 1 billion in 2014. Of that total, approximately 100 million were likely in a position to even buy a flagship iPhone. This does not exactly leave much room for Apple to grow the number of Android switchers year after year.    

ASP and Margin Pressure. During Apple's 2Q16 conference call, management attributed a portion of its weak guidance to the iPhone SE impacting iPhone ASP and margins. Over the past two years, both of those metrics had held up remarkably well despite Apple peers facing increasingly deteriorating conditions. The combination of a higher priced "Plus" iPhone model and iPhone storage configurations provided a significant tailwind for maintaining attractive iPhone ASP and margin trends. The iPhone SE introduces a new headwind into the mix as the more successful the iPhone SE sells, the more pressure overall iPhone ASP and margin will face. 

Apple Has an iPhone Growth Problem

When looking at all of these iPhone warning signs, it is becoming clear that Apple has a significant iPhone growth problem on its hands. The combination of a slowing iPhone upgrade rate and declining number of growth catalysts for expanding the iPhone's addressable market will make it very difficult for management to report unit sales growth going forward given its current strategy. In addition, the iPhone SE highlights how any strategy to fix some of these issues will likely end up jeopardizing iPhone ASP and margin trends. 

It is important to note that the iPhone business is not imploding. Satisfaction rates and loyalty trends remain industry-leading. Apple has a very attractive iPhone installed base numbering close to 550 million users with additional users purchasing an iPhone in the grey market. Each quarter, Apple is still bringing new people to the iOS ecosystem. Instead, it is becoming much more difficult for Apple to grow iPhone unit sales each year. 

How Did This Happen? 

All of this seems a bit surreal. Apple just recorded its best quarter for iPhone sales in 1Q16. How can there now be so many iPhone warning signs only a few months after this milestone to the point that even Apple management was caught off guard?

The iPhone 6 and 6 Plus masked deteriorating iPhone trends. While those two iPhone models ushered in a wave of sales from both existing iPhone users and consumers new to iOS, upon closer examination the iPhone installed base had become much more diverse than first thought when it comes to thoughts on upgrading. In addition, the sheer success associated with launching iPhone on China Mobile made it that much more difficult to see an even greater amount of success in subsequent years. When dealing with unit sales growth, Apple needs to bring in many new consumers just to break even each year. At a certain point, it is just not sustainable. 

Finding the Path Forward

Apple needs to get ahead of this deteriorating iPhone demand environment. There are a few key elements to such a strategy: 

1) Throw out all existing conventions about upgrade cycles. Management cannot assume that iPhone users will upgrade to new iPhones like they have in the past. This will have an impact on how Apple approaches iPhone development schedules. It was clear that the iPhone "S" cycle ended last year, and current iPhone trends all but confirm that to be the case. It is now time to get rid of the "S" iPhone nomenclature as well. A case can even be made that it is time for Apple to change its entire iPhone numbering nomenclature given changing device upgrade behavior. 

2) Keep a pulse on the iPhone user base. It is becoming more critical than ever for Apple to understand the average iPhone customer. There is much change going on within the iPhone user base with a more diverse collection of thoughts towards technology and smartphone features. With Apple rumored to push ahead at the premium end with a differentiated iPhone Plus model later this year, Apple can no longer assume that iPhone users will follow the company in a similar direction. Greater focus needs to be placed on the risk that Apple ends up over serving the market by introducing certain features. It may sound odd, but Apple may end up slowing the introduction of certain new iPhone features and instead focus on other items that consumers are truly craving. 

3) Recognize the iPhone SE's power. The iPhone SE has the power to impact Apple ASP and margins much more than Apple management initially thought. There is an increasing level of risk that there may be unintended consequences associated with the iPhone SE including greater cannibalization of higher-end iPhone models.    

At a certain level, none of this should surprise Apple. The company's long-standing iPhone strategy involved it beginning at the high end of the market and slowly making its way down market, capturing as much profit share as possible at each subsequently lower price tier. At a certain point, this strategy enters a phase where growth slows and the business enters a much more mature product trajectory. The various warnings signs flashing in the iPhone business indicate that point has arrived.  

The good news for Apple is that the company is organized in such a way as to handle these iPhone warning signs better than most other companies. There are signs that Apple has been working to move beyond the iPhone for well over a year with Project Titan and other wearable devices representing the company's future. The one thing management needs to work on is moving the Apple narrative away from iPhone unit sales growth

One Steve Jobs quote displayed at Apple HQ will end up doing a great job of describing Apple's path forward for iPhone: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next." 

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Above Avalon members received my complete AAPL 2Q16 earnings review including new iPhone unit sales projections for FY2016 and FY2017 (available here).

AAPL 2Q16 Earnings Expectation Meters

During Apple's 2Q16 earnings conference call, management will continue to sow a new narrative around the company. With hardware unit sales slowing across the board, management is focusing on recurring revenue streams and iOS customer transaction values. 

Exhibit 1: Above Avalon's AAPL 2Q16 Estimates

The details and rationale/methodology behind all of my estimates are available in my 2Q16 Earnings Preview available here for Above Avalon members. (Click here for more information on membership.)

Given management's revenue guidance, Apple will report its first quarterly iPhone unit sales decline. The only question remaining is, just how bad was the drop? As seen in Exhibit 2, an iPhone unit sales decline of 10% to 17% would fall within my expectation range with the center point being a 13% drop from last year. It is important to note that the iPhone SE will be a 3Q16 earnings event given the device's launch timing. 

Exhibit 2: 2Q16 iPhone Expectation Meter

The unit sales declines are expected to extend to both iPad and Mac. Given my analysis regarding recent iPad sales mix, my 9M iPad unit sales estimate implies a dramatic 27% drop in sales from last year. This is made that much more worse considering the 12.9-inch iPad Pro was released a few months ago, not to mention the iPad category had already fallen 23% last year. The iPad business has essentially been cut in half. Similar to the iPhone SE, the 9.7-inch iPad Pro will be a 3Q16 earnings event given its launch timing. As for the Mac, it is still possible Apple may just barely squeak out unit sales growth. 

Exhibit 3: 2Q16 iPad and Mac Expectation Meters

Regarding Apple Watch, Apple's pattern has been to not disclose any actual revenue or unit sales data. Instead, management has chosen to provide subtle clues or hints as to how Apple Watch has performed. It is possible we may get a broad comment as to how Watch sales have done in the new year. As shown in Exhibit 4, Apple's "Other Products" revenue line item can be converted into Apple Watch unit sales. The usual caveat is that this table assumes an Apple Watch ASP of $425 (lower than previous quarters) and that accessories revenue amounted to $1.6 billion.

Exhibit 4: 2Q16 Other Products and Apple Watch Expectation Meters

As is the case with every Apple earnings report, most investor attention and focus will be put on management's guidance for 3Q16. Expectations over the past few months had Apple's 2Q16 showing the weakest year-over-year revenue performance from an optics perspective. However, in recent weeks, there has been growing concern that Apple's 3Q16 would also show a substantial revenue decline. My expectation is for Apple to guide revenue to -5% and -11%.

Exhibit 5: 3Q16 Revenue and Gross Margin Guidance Expectation Meters

As seen by my 2Q16 AAPL earnings expectation meters, Wall Street is expecting an all-around weak earnings report from Apple. Accordingly, investors will be looking for any surprises that help shed light on how current iPhone sales have been trending following the iPhone SE launch. The $400 iPhone 5s successor may end up representing the one bright spot in an otherwise difficult stretch for Apple regarding hardware unit sales growth.

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Above Avalon members received my detailed earnings preview (available here) and will receive my exclusive earnings reaction note containing all of my thoughts and observations on Apple's results this Wednesday following Apple's earnings release. 

The Car's "iPhone" Moment

The iPhone has never stood out for its voice calling capabilities. A feature phone from 2005 is able to make just as clear of a voice call as an iPhone 6s. Instead, the iPhone went on to do something much more profound than just improve the voice call. The iPhone showed the world that there was another way to think about the phone. Fast-forward nine years, and there are questions about whether the auto industry will experience its own "iPhone" moment. Will a new product or service come along that changes our perception of a car? Is autonomous driving the technology that will ultimately change how we think about cars? Will Uber and other ridesharing companies be able to rethink personal mobility? Does Apple think it has an answer for rethinking the car? Did Elon Musk already change the car's definition with Tesla? The journey to find all of these answers begins by looking at how Apple rethought the phone with iPhone.

Rethinking the Phone

The iPhone was born from a different kind of inspiration. Instead of looking at Blackberries and Motorola RAZR, the most popular phones at the time, Apple used the iPod as an example for what it wanted to achieve with its own phone.

While Blackberry, formerly called Research in Motion, was seeing remarkable success in enterprise by selling a smartphone with a keyboard that gave each letter its own dedicated hardware key, Apple looked at such a feature as a drawback. A smartphone's dedicated hardware keyboard ended up holding back the smartphone's potential. By taking multi-touch technology originally targeted at a large screen and seeing if it could work on a smaller screen, Apple ended up changing the smartphone's trajectory by not just removing the hardware keyboard but replacing it with an alternative that helped to rethink our perception of a phone. 

Of course, the iPhone didn't just add chaos to the smartphone industry because of its hardware design. Apple's existing capabilities when it came to software turned what was a phone in our pocket into a computer. In addition, working exclusively with AT&T gave Apple the flexibility to think outside the box. Even though the strategy was not looked at as a strength in 2007, Apple's control over phone hardware and software made it possible to rethink the phone.

Cars Are Like Phones

Given the iPhone's level of success, it is has become too easy to look at everything through an iPhone lens. Taking what worked with the iPhone and then applying it to other products and industries is a recipe for disaster. However, there are a few reasons that the automobile industry is much more similar to the smartphone industry than what first meets the eye. 

Using a smartphone and sitting in a car both revolve around a relationship between the user and product. For a smartphone, this relationship is straightforward: interacting with hardware in order to utilize software. The feel, look, and sound of a smartphone matter to the user. The car contains many of these same attributes. By simply sitting in an automobile, we are taken into a different environment in which a number of our senses are driven into overload including smell, touch, sight and sound. Both a smartphone and car are capable of containing and fostering unique experiences. Accordingly, it is possible to improve or alter the product in an attempt to create a better experience.

Tesla's success can be attributed to the relationship consumers have with their Model S and the broader experience of buying and driving an electric car direct from Tesla. Uber's success is a result of the experience created by easily getting from Point A to Point B in a safe and comfortable vehicle.

Similar to how hardware and software come together to contribute to a smartphone's experience, a similar dynamic is beginning to take over the auto industry. While it is difficult to call today's car dashboard experience pleasant, products such as CarPlay help to alleviate some of the friction points while autonomous features like Tesla's AutoPilot only exemplify the significant role software and hardware have to play in the car's future.

Rethinking the Car

Since cars and smartphones share a few important characteristics, the best way to discover the car's "iPhone" moment, or a new product or service that changes the long-standing perception of a car, is to look at our relationship with the automobile. What aspect of today's modern car has the potential to fundamentally change how we perceive and think about cars? 

Internal Combustion Engine? Replacing an internal combustion engine with an electric powertrain seems like a good way to improve various aspects of an automobile. Not only are we able to help the environment, but using battery power for propulsion leads to fewer moving parts to maintain on a regular basis. However, an electric powertrain by itself doesn't rethink the car. As the Model S and X have shown, while an electric car is capable of providing a much more enjoyable driving experience than many gas-powered cars, at the end of the day, it is still a car, albeit one of the better cars on the road. The primary reason electric powertrains are being positioned for a comeback is that the price of batteries continue to fall, making electric cars much more economical. 

Human Driver? Having software control a car will certainly change how we use cars. However, people have been sitting in the back seat of cars and having someone else drive them around for a very long time. Uber and the broader taxi industry serve as prime examples for why autonomous driving doesn't fundamentally alter a car's definition. Similar to electric powertrains, autonomous driving features may lead to a better car experience, but more is needed to actually rethink the car. 

Dashboard? Many have positioned a car's dashboard as the modern day version of a Blackberry keyboard - a collection of overly complicated buttons and switches that take away from the experience of driving or simply sitting in a car. Following this thought through, some have argued that allowing our smartphone to integrate with our car's dashboard will provide the familiarity that consumers demand. Unfortunately, improving a car's dashboard does not change our perception of a car.

At a fundamental level, the dashboard is an interface used to control a car. Simplify a car's propulsion system by replacing an internal combustion engine with an electric powertrain, and the need for a complicated dashboard is instantly reduced. Go further and add software that handles everything from autonomous driving features to cabin temperature, and the result is the Tesla Model 3. Replacing a complicated assortment of dashboard buttons with one large tablet screen marks a milestone for the car. However, a self-driving, electric car with a tablet as a dashboard does not fundamentally transform how we think about a car. It is still a box, albeit a much smarter box on wheels that gets us from Point A to Point B.  

The Car's Friction Point

If electric powertrains, autonomous driving, and software dashboards don't change how we perceive a car, it would appear that the auto industry may lack an iPhone moment in the traditional sense of the term. That is unless the answer has been literally sitting beneath our noses for decades. 

While it may seem like of one the most boring parts found in a car, the seat represents the biggest barrier to rethinking the car. If a company can rethink the car seat, our perception of a car will change, and ultimately, the entire auto industry will be impacted. The car seat is the car's version of the smartphone hardware keyboard. 

Seats play the largest role in our in-car experience. Everything from how we feel to where we are looking and what we are doing is determined by a car seat. Given these important roles, it is shocking that the car seat has seen very little change over the years, as depicted in the following pictures.

If cars are nothing more than boxes on wheels, the primary way to rethink the car is to change how we think about the "box." Similar to how the iPhone was inspired by the iPod and not the leading smartphones at the time, the best inspiration for rethinking a car's passenger compartment comes from the mobile products in our pockets and on our wrists, not the best-selling cars on the road.

Smartphones, tablets, and wearables are all about personalization. We want our iPhones and Apple Watches to be specifically suited to our personalities. Both hardware and software help accomplish that goal. With cars, the same type of personalization is nowhere to be found. The average car buyer has a finite number of options available to create an experience specifically suited to them. Once a car is delivered, future modifications and changes are pretty much nonexistent. What if there was a way we could rethink what it means to personalize our car experience? 

It all begins with the seats. By no longer thinking of seats as stationary benches facing forward, we can begin to come up with a way of creating different experiences inside a car based on our mood or merely the time of day. Of course, we have seen examples of this in the real world when it comes to the family car, such as the 2008 Dodge Caravan (pictured below).

However, there is a reason why consumers never embraced this type of setup in numbers: It was clumsy and aggravating to set up, and it was far from personalized. What if there was a way to create a certain kind of car compartment layout for one situation but then be able to switch layouts with an iPhone or even Apple Watch? Or how about creating a seating arrangement on our iPhone for one car, saving it, and then loading that same arrangement in a different car? The way we perceive a car will change. Instead of being just a box on wheels, the car will become a room on wheels. 

By relying on software to create our own unique experience and then taking that experience from car to car, we would have essentially recreated an iPhone-like experience on wheels. 

Competitive Landscape

There are very few automobile companies in a position to combine hardware and software to rethink the car seat. Ironically, the cars that have historically been the closest to delivering this kind of vision have been either large boxes on wheels like Dodge Caravans or an ultra-luxury car like a Rolls-Royce. Even then, the offerings still pale in comparison to what can truly be accomplished with software. 

Despite very high customer satisfaction rates, Tesla doesn't seem close to moving in this direction as it continues to position performance as the primary reason to buy a Tesla Model 3. In fact, the inside of a Tesla is often regarded as the vehicle's weak point. Meanwhile, the Model X internal compartment design is very conservative. This leaves Apple and Project Titan.

Project Titan

It is no secret that Apple's strength is not just hardware and software integration but the design behind the experience created from combining the two. Along those lines, while very little has been said about Apple's rumored electric car project, there are a number of clues to suggest where Apple is likely looking. Marc Newson, the newest member of Apple's industrial design team, has tried his hand at seemingly everything at least once, but one of his most well-known designs was a concept car for Ford commissioned back in 1999 (seen below with orange seats). While the car has ended up being quite a polarizing object over the years, the takeaway from his design was the importance of rethinking conventional wisdom all the way down to how we would enter or exit the car. 

In addition, a company reportedly attached to Project Titan shipped a 1957 Fiat Multipla 600 (the yellow car below) to the U.S. in 2014. Don't focus on that exact car. Instead, consider how the internal compartment would certainly mesh well with the concept of rethinking car seats and turning a box on wheels into a room on wheels. 

In fact, Marc Newson has a pretty extensive history of turning boxes into rooms. He designed the internal compartment of a private jet interior as well as a Qantas A330. 

Add it all up, and it would look like Project Titan has the resources to spend much more time rethinking a car's interior than an electric powertrain or driving performance. 

The Car Seat Opens Doors

If a company can rethink the car seat and the kind of experience possible inside a car, our definition of a car wouldn't just change, but we would be able to fully utilize car features like electric powertrains and autonomous driving.

If a car becomes fully autonomous, what happens to the driver seat? Does it make sense for everyone to face forward when the car is moving? These types of questions don't have clear answers if the car seat isn't rethought. Instead, we are merely occupants in a box that drives itself. Bring in the topic of ridesharing and being able to "load" our individual car compartment settings for a car just about to pull up to our pickup zone, and the possibilities created by rethinking the car seat begin to materialize. While it may seem like safety regulations and state laws may curtail the possibilities in this area, rethinking the seat may actually end up improving safety inside moving cars. The main reason why car companies have not embraced new ideas for the seat is limited customer acceptance. However, instead of it being a roadblock, it should serve as an opportunity for new companies to approach the problem from a different angle. 

The car's "iPhone moment" will likely end up being an idea - thinking of cars as extensions of our homes - personalized rooms on wheels. While most think the way to build such a product is to simply add software to a car dashboard, the answer is actually found by rethinking the most important part of a car - the seat. 

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