Above Avalon Podcast Episode 128: Figuring Out What's Next

One of the major takeaways from this year's WWDC keynote was found with something not announced on stage. Apple finds itself announcing new technologies that make more sense on form factors that don't yet exist. Episode 128 includes a discussion of this year's WWDC, which demonstrated how Apple is figuring out what comes next. After quickly recapping the major WWDC 2018 announcements, Neil discusses how Apple is setting the stage for smart glasses. The second half of the episode goes over Apple's motivation for looking beyond current success to figure out what's next.

To listen to Episode 128, go here

Apple Is Figuring Out What's Next

"If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next." - Steve Jobs

Apple used this year's WWDC to demonstrate a number of areas in which it is playing offense. This isn't a company content with letting others control the user experience found with its devices. However, one of the major takeaways from the WWDC keynote was found with something not announced on stage. Apple finds itself announcing new technologies that make more sense on form factors that don't yet exist. Management is increasingly focused on what comes next, and the answer is smart glasses. 

WWDC 2018

The features and software unveiled at WWDC 2018 could be split into two categories. The first group included items targeting the way we use and consume content on Apple devices. This included everything from empowering users with information regarding how devices are used to improving the way we consume content via:

  • An updated Apple News app.
  • Apple Podcasts on Apple Watch.
  • A completely redesigned Stocks app.
  • A revamped (and rebranded) Apple Books.

Apple knows it holds a lot of power when it comes to content distribution given a user base of a billion people and 1.4 billion devices. 

The other group of announcements was related to new technologies designed to make the cameras and screens in our life smarter.

  • ARKit 2 introduces new ways of transforming smartphone and tablet cameras into smart eyes.
  • Siri Shortcuts continue Apple's efforts to customize Siri to better suit a user's lifestyle.
  • New machine learning (ML) capabilities are powering Memoji and various other applications made possible by smarter cameras. 

There is a drawback found with most of the cameras and screens that stand to benefit from these new technologies: We still have to hold them. While AR makes for a cool on-stage demo, having to hold an iPhone or iPad up as an AR viewfinder for long periods of time isn't ideal. Items like Siri Shortcuts and Siri Suggestions are interesting on iPhone and iPad although they are incredibly more appealing on mobile displays worn on our bodies. ML applications on iPhone and iPad are useful, but the predictive and proactive nature of the technology can work wonders when combined with mobile cameras and screens that we don't have to hold. Apple is announcing new technologies that make more sense on form factors that currently don't exist.

My full WWDC 2018 review is available for subscribers here (major themes) and here (full notes). 

What's Next? 

While Apple management will never admit it, the company has been thinking and looking beyond iPhone for years. The Apple Watch's ongoing march to iPhone independency is clear evidence of this post-iPhone thinking. This isn't to say that the iPhone will lose its spot as the most valuable computer in hundreds of millions of lives anytime soon. In addition, the iPhone will likely remain Apple's top revenue-generating product for some time. However, those realities don't determine Apple's post-iPhone product strategy. Management isn't driven by the goal to come up with something that is more profitable than iPhone. Instead, the focus is on coming up with something that makes technology more personal and handling new workflows that were never able to be handled by iPhone.

Last month, Mary Meeker presented the latest edition of her Internet Trends presentation. Narrowing 294 slides into one major takeaway isn't easy, but such a task was possible this year - the smartphone industry is mature, and it's time to figure out what's next. Smartphone sales are flat as the average consumer is OK with holding on to his or her smartphone for longer before upgrading. 

As seen in the chart below, Apple hasn't been immune to this trend as iPhone sales have plateaued. Apple is currently selling approximately 215 million iPhones per year, and sales are likely to remain in that ballpark in the near term.

Screen Shot 2018-06-20 at 2.35.00 PM.png

When thinking about what comes next, it's difficult to miss the rising yellow line in the preceding chart. Apple is seeing significant sales momentum in its battle for our wrists with Apple Watch and our ears with AirPods. These new form factors are successful in making technology more personal for tens of millions of people. When combining Apple Watch and AirPods sales, Apple's wearables segment will soon outsell iPad in terms of unit sales.

The next wearables battle will be for our eyes. This battle will revolve around a product that benefits from technologies currently found with ARKit, Siri, and Apple's ML efforts. Apple is setting the stage for smart glasses. A pair of smart glasses will essentially boil down to an ML playground cool looking and light enough to wear throughout the day. There's one problem for Apple: The world isn't quite ready for such a product. As Jony Ive put it a few months ago, "there are certain ideas that we have, and we're waiting for the technology to catch up."

Biding Time?

It's easy to think that Apple may simply be biding its time until the world is ready for AR glasses. However, WWDC gave us a glimpse of how Apple is busy behind the scenes, preparing for what comes next. With ARKit, Apple is using hundreds of millions of iPhone and iPads to inspire 20 million developers with the potentials found with AR. A similar dynamic is at play in getting customers comfortable with items like Animoji and Memoji - items that will likely one day be available via a pair of smart glasses. 

In many ways, Apple is doing more than any other company to prepare the world for AR. Startups like Magic Leap have positioned themselves as being ambitious for wanting to control everything needed to develop a pair of mass-market AR glasses. However, Magic Leap is missing a few crucial ingredients needed for success. Unlike Apple, Magic Leap doesn't have a few hundred million devices for seeding early technologies that will eventually power a pair of smart glasses. Instead, Magic Leap is forced to conduct a portion of its R&D in public, releasing early prototype versions of AR goggles in an attempt to capture AR mind share that is increasingly flowing to Apple. 

Another item that Magic Leap doesn't have, but which will prove to be incredibly useful for AR glasses, is Apple Watch. Apple has learned a significant amount about how personal technology can be worn on the body by having nearly 40 million people wear an Apple Watch on any given day. In addition, Apple Watch serves as a test bed for learning about proactive digital assistants. However, the most important aspect of Apple Watch is how the device will likely end up playing a key role in serving as a place to put tech on the body that will help power smart glasses. In fact, an argument can be made that Apple Watch will become more instrumental to Apple Glasses' success than any other Apple product. 

Apple's Game to Lose

We see Apple pulling away from the competition when it comes to grabbing real estate on our wrists and ears. The company has a good shot at doing the same in the battle for our eyes. Consider the various ways Apple is well-positioned for AR glasses:

  1. Hardware and software integration. Apple has a few decades worth of experience while competitors have only recently realized that hardware/software integration is essential when it comes wearables. 
  2. Controlling core technology. Apple's silicon efforts and broader ambition to control the core technologies powering its devices are giving the company a head start that will likely be measured in decades. 
  3. Wearables manufacturing. Apple is learning a great deal about miniaturization with Apple Watch and AirPods. No other company is close to Apple in this area.
  4. AR technology. In just over a year, Apple has announced two major versions of its AR platform with hundreds of millions of supported devices. Years of extensive M&A activity in the AR arena is beginning to pay dividends.  
  5. Developers. Apple has 20 million iOS developers focused on coming up with new experiences for a billion people. Companies like Magic Leap and Microsoft lack this critical piece of the equation. 
  6. Fashion and luxury. Apple has learned a great deal about selling fashion with Apple Watch. 
  7. Health/Medical. What may have started as an interest for Apple is turning into a strategic mission. A pair of smart glasses stand to improve the well-being of hundreds of millions of people as one of the key use cases for such a device is enhanced vision.
  8. Retail demoes. Apple has 502 retail stores around the world with plenty of space for glasses demoes. 

There's an elephant in the AR room. This is Apple's game to lose. 

Creating Tools

Five years ago, Apple management was facing growing pressure to announce something new. Wall Street and Silicon Valley were eager to see Apple unveil a new product category in the post-Steve Jobs era. To this group, the lack of a new product category from Apple meant that management was either struggling with innovation, or worse, suffering from a lack of imagination. The intense pressure to come up with something new likely played a role in Apple giving Apple Watch a huge product unveiling in September 2014. 

Fast forward a few years, and Apple faces a dramatically different environment. There aren't as many calls for Apple to come up with something new following Apple Watch. Instead, Apple's ability to monetize the iPhone experience beyond hardware sales has made people think Apple is a different kind of company - one that is more focused on monetizing existing users instead of dreaming about what's next. In a way, many market observers are the ones now suffering from a lack of imagination when it comes to Apple. 

Apple is a design company focused on creating tools for people. While some of those new tools may be positioned as accessories to existing products, other tools will be capable of ushering in paradigm shifts. The only way for Apple to remain relevant in the future is to disrupt itself by coming up with new tools consisting of a combination of hardware, software, and services. Such groundbreaking tools won't likely be released every two or three years. In fact, Apple may go more like five, six, or even seven years between announcing major new product categories. The point is that such paradigm shifts are needed.

Screen Shot 2018-06-10 at 5.44.17 PM.png

Steve Jobs' quote calling for figuring out what's next and not dwelling on current success for too long was from a 2006 interview in which Jobs was asked where he sees himself within history's famous thinkers and inventors. Jobs was describing where the motivation for coming up with so many new products originated. For Apple, Jobs' quote serves as inspiration for not resting on its laurels and instead coming up with the next "pretty good" thing.  

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Above Avalon Subscriptions Turn Three

Last week, I celebrated the third anniversary of launching Above Avalon subscriptions. Those who signed up on May 13th, 2015 began their fourth year as Above Avalon subscribers. In an environment where online publishing is being questioned and doubted like never before, Above Avalon subscriptions are working. Above Avalon is an independent source of Apple analysis, 100% supported by subscriptions. The lack of dependency on ads, sponsors, or other revenue streams has played a large role in what Above Avalon has become over the past few years. In addition, Above Avalon has given me a front-row seat for watching the changing Apple news industry. 


Above Avalon embraces a subscription model in which subscribers pay for access to my full analysis and perspective on Apple. Two subscription options are available: $20 per month or $200 per year. Along with publishing weekly articles and podcast episodes, which are available to everyone, I publish a daily email available exclusively to subscribers. These emails go over everything that I think matters in the world of Apple. On any given week, I will cover 10 to 12 topics, one of which is discussed in the weekly article and podcast. The remaining topics are covered in email.

Subscribers receive other benefits that include receiving the weekly Above Avalon article via email, accessing the subscriber forum in Slack (more on this down below), and utilizing an archive consisting of approximately 600 emails previously sent to subscribers

Above Avalon is unique as a paid subscription site that focuses on analyzing one company. I am unable to name another paid subscription site that has the same objective. Most subscription sites focus on broader topics such as certain genres or entire industries. In an interesting development, the other paid subscription niche popping up has been in the sports world as writers and analysts launch sites focused on specific sports teams. 

The paid subscription model for analysis is not new. Its pioneers can be traced back to the financial world in which publications sent monthly and quarterly correspondence to paid subscribers via postal mail. However, the major change that has taken place more recently is a diversification in the way we consume news and analysis. A number of independent sites, often run by one person or a small team of people, have been able to grab an increasing amount of mind share from larger, more traditional news publications and multinational research firms. This market dislocation was one reason that led me to leave Wall Street and launch Above Avalon in 2014. The harsh economics of online publishing, combined with social media and tools for accepting online payments, sending emails, etc., have made it possible for one-person operations to find their audience (i.e. sustainability) in a sea of giants.  

Paid subscriptions afford me the ability to focus on quality, not quantity, when it comes to readership. There is no financial incentive for me to publish sensational articles as the primary byproduct is a temporary jump in page views. Instead, my incentive is aligned with my desire to write articles that inform, enlighten, and provide an alternate view of Apple and the world. This ends up producing trust and credibility with readers, which are important drivers for attracting new subscribers. 

Over the years, I've received different versions of the same question: Why don't I expand my coverage to include companies other than Apple? There is a simple answer: As Above Avalon subscribers can attest, my coverage area is already large. Since Apple doesn't operate in a vacuum, there is a need to monitor and analyze Apple's various competitors and the industries in which the company plays. However, the difference between Above Avalon and other sites is that all of my analysis is positioned from the perspective of Apple. In my view, having it any other way tends to breed Apple cynicism given the company's unique attributes. This cynicism often leads to the conclusion that Apple's different way of approaching the world will lead to failure. In fact, unwarranted cynicism is one of the main characteristics that lead to faulty Apple analysis. 

Highlights and Challenges

Highlights from the first three years of Above Avalon subscriptions include: 

  1. Reaching sustainability. While there was a specific subscriber threshold that marked Above Avalon sustainability (reached in 2015), subsequent events over the years have served as milestones. For example, seeing the first wave of annual Above Avalon subscriptions renew back in May 2016 further validated the business model. 
  2. Online community. One thing that I didn't necessarily expect to happen was an online community to develop around Above Avalon. The Above Avalon subscriber forum in Slack continues to see an increasing amount of interaction and discussion. Subscribers currently reside in 55 countries and hold a diverse range of backgrounds and occupations. They include Silicon Valley executives and investors, the largest Apple shareholders, and the leading Apple journalists and writers in the business.
  3. Member meet-ups. There have been three member-meets (two in San Francisco and one in San Jose). The fourth is scheduled for next month during WWDC. Each has been memorable as I've been able to meet subscribers and put faces to what were previously just names in email, on Twitter, or in the forum.
  4. Subscriber support. Since launching Above Avalon subscriptions, I've experienced quite a few life changes. My wife and I welcomed two boys into this world. Each time, the outpouring of well-wishes from subscribers has been great. However, there have also been difficult times, such as my mother's recent passing. Subscribers were there with condolences. I even received condolences via postal mail from subscribers. It may seem like a small thing, but it's something I will never forget. 

The biggest challenges have been:

  1. New things. I'm self-taught when it comes to the world of online publishing, podcasting and videography. In my prior career, I was a Wall Street analyst. While it hasn't been easy, YouTube and Twitter have been great tools for finding answers to questions. 
  2. Hesitancy to publish. As Above Avalon has grown in terms of readers, listeners, and subscribers, I've become more hesitant to publish on topics when my views on them are still in their fragile state. This hesitation has resulted in certain articles and podcast episodes taking a shockingly long amount of time to write and produce.   


Above Avalon is an example of a paid subscription site working. However, when it comes to the model being replicated, I don't think there is a particular recipe or path for success with paid subscriptions. While some will find success literally overnight, others may find success only after a number of years.  

There are three requirements needed for paid subscription sites to work: 

  1. A strong voice. The recurring theme found in every successful independent site, email, or podcast is that it contains a strong voice. Wishy-washy stances on positions won't go far. The strongest voices have an ability to support their opinions with facts. 
  2. Perspective. Above Avalon subscribers aren't interested in simply reading about news events and topics that matter to Apple. Instead, subscribers want to know my perspective on those news events and topics. By having perspective, one possesses a certain kind of philosophy that transcends any particular topic or news event.
  3. Be the best. While "best" is subjective, in my view, being the best entails having a deep understanding of the subject matter at hand. In nearly every example of a successful subscription-based site, the founders / writers are experts in their coverage areas.

The Apple News World

Above Avalon has given me a front-row seat to the changing Apple rumors and news world, also known as the Apple blogosphere. There are three buckets: 

  • News / Rumor Aggregators. MacRumors, iMore, 9to5Mac, and AppleInsider are the most well-known. Others such as Cult of Mac, MacDailyNews, and MacSurfer have also been around for some time. The largest sites are characterized by having a team of writers and a business model consisting of various revenue streams (ads, sponsors, affiliate links, different forms of memberships). Many have moved into video, podcasts, and email newsletters. A vibrant online community in the form of active message boards and forums play a big role in these sites' sustainability. 
  • News Publications. These include Financial Times, The Wall Street Journal, The New York Times, Fast Company, CNBC, Recode, Bloomberg, Wired, The Independent, BuzzFeed, The Verge, and *insert your favorite news publication that covers Apple news here*. Most of these sites have one or two correspondents who write about Apple. However, it is becoming rare for news publications to have Apple-exclusive writers. Business models vary in this group but have increasingly been moving towards paid subscriptions. Only a select number of these sites have vibrant online communities.
  • Curators / Analysis / Research. Above Avalon, Daring Fireball, Asymco, Stratechery, MacStories, Tech.pinions, Six Colors, The Loop, Apple 3.0, TidBITS, Wall Street sell-side firms, podcast-only ventures, YouTubers, industry research firms, VC firms, and popular Twitter personalities are included in this category. There is much diversity in this group. Some write exclusively about Apple while others write and talk about Apple from time to time. Meanwhile, others use Apple as a way to analyze broader business and disruption theories. Business models run the gamut and include everything from ads and sponsors to paid subscriptions, donations, and affiliate links. Other sites and accounts are run strictly for marketing purposes. Communities tend to play a major role in these sites. 

While some sites have tried to play in more than one bucket, few have found success. News and rumor sites have made few inroads in terms of analysis and research while analysis sites have generally stayed away from the tough business of breaking news and scoops. 

Over the years, there have been a number of major changes in the Apple blogosphere:

News / rumor aggregators have grown up and gained legitimacy. After years of rocky relations, Apple basically treats the leading Apple news and rumor aggregators like any other news organization. Aggregators have achieved sustainability by broadening coverage to include pretty much everything that is in some way connected to Apple or the large iOS ecosystem. In addition, each runs with super lean operating budgets. The stories themselves likely don't pay the bills. Instead, it's the repeat visitors that are interested in the comment sections and forums. Each publication relies on podcasts and video as ways to maintain mindshare in each respective news medium. 

Apple rumor / scoop industry has dried up and consolidated. Ten years ago, there were a number of news publications that were in a legitimate position to break the next Apple scoop (some of which were likely controlled leaks from Apple). Today, there are only two or three sites that even publish Apple scoops. The consolidation in Apple scoops has been driven by Apple ramping up the amount of secrecy regarding unannounced projects. In addition, Apple "scoops" have increasingly come from research firms paying for confidential information coming out of Apple's supply chain. One byproduct of this rumor consolidation has been a relatively high degree of turnover among Apple reporters. 

Ad-supported business models are struggling. It is becoming more difficult to find ad-supported business models on the web. While there are likely a few reasons for this change, one includes ad dollars being funneled away from blogs and into podcasts and videos. This explains what appears to be an exodus of resources away from written blogs and into podcasts and video-focused efforts. Unfortunately, my suspicion is this won't end well for many as increased competition in the podcast and video space will tend to push sponsors to those with the largest followings. Such an environment would make it increasingly difficult for independent ventures to find sustainability by chasing scale. 

Paid news sites boost independents. Most news publications have embraced paid subscriptions as another way of boosting revenues. While a paid subscription to a multinational news organization may make sense for many readers, the value / price tradeoff becomes murky for readers interested in specific topics and niches. For example, the average news publications will only write about Apple once a week (if that much). This environment provides an even greater amount of oxygen to independent sites that can give the time and attention to niche subjects. 

Donation / support route isn't promising. The transition from ad-supported business models to subscription-based models hasn't been easy for many independent sites. Going from a scenario in which all content was public to one in which only a fraction of content is public can be jarring. Most sites have handled this transition by keeping content free and instead giving paid subscribers a very marginal amount of exclusive content. In essence, sites are treating subscriptions and memberships like donations. This is not sustainable for or attractive to subscription-based models.

Exciting Times

It's never been easier to start a paid subscription site. This reality has made it harder than ever to get a paid subscription site off the ground. While barriers to entry have been lowered in many content-focused genres, including blogs, YouTube, and podcasting, discovering your audience is becoming more challenging. At the same time, competition is intensifying. It's not realistic to assume the average consumer will subscribe to dozens of paid sites. However, there is no such thing as an "average" consumer. Instead, every consumer will subscribe to a different portfolio of paid sites. As an independent, the job is to earn a spot in some of those portfolios.

As I enter the fourth year of paid subscriptions, a big thank you goes out to Above Avalon subscribers. The past three years have been great and I'm looking forward to many more. I don't think there has been a better time to examine Apple. 

To become an Above Avalon subscriber, visit the subscription page

The Apple Services Machine

Apple's services business is remarkably strong yet surprisingly mysterious. A closer look at Apple Services reveals an apparatus, which can easily qualify as a Fortune 100 company, that isn't what it seems from the outside. Apple isn't becoming a services company focused on coming up with a myriad of ways to milk existing users. Instead, Apple's services strategy primarily reflects the company's long-held ambition of becoming a leading content distribution platform. 


Services represent Apple's second-largest revenue source behind iPhone. In 2017, Apple reported $31 billion of Services revenue, which represented 13% of overall revenue. As seen in Exhibit 1, Apple Services revenue has experienced steady growth for years.

Exhibit 1: Apple Services Revenue (TTM)

Screen Shot 2018-05-15 at 3.05.48 PM.png

In recent quarters, Apple's services business has seen renewed momentum. As shown in Exhibit 2, Services revenue growth began accelerating in late 2015 and is now at multi-year highs. The growth likely coincided with very strong new user trends for the iPhone business. An acceleration in growth despite Apple's already large Services revenue base is that much more impressive. 

Exhibit 2: Apple Services Revenue (TTM) Growth

Screen Shot 2018-05-15 at 4.17.11 PM.png

The Services Machine

Services is a financial catch basin for Apple's non-hardware revenue. As disclosed in Apple's financial filings, Services consists of five categories: digital content, iCloud, AppleCare, Apple Pay, and licensing. 

Exhibit 3: The Apple Services Machine

Screen Shot 2018-05-12 at 3.14.38 PM.png

Digital content. This includes revenue from Apple's various content stores, including the App Store and iTunes. Apple Music is also included in this category. While Apple doesn't disclose the total amount of revenue associated with selling digital content, the company has provided the amount paid to app developers on an annual basis. This data point makes it possible to derive the total amount of App Store revenue. In addition, Apple regularly discloses the number of paid Apple Music subscribers, which can be used to derive Apple Music revenue.  

iCloud. Apple offers three tiers of additional iCloud storage (50GB, 200GB, and 2TB). Prices vary depending on the geography. The 200GB and 2TB storage tiers are eligible for family sharing. While Apple has not disclosed the number of users on a paid iCloud storage plan, management recently disclosed that iCloud revenue was up over 50% year-over-year to a record high, which implies good new user growth. 

AppleCare. Apple sells a number of service and support options for its products. 

Apple Pay. Apple earns a small percentage of every amount transacted through Apple Pay. Initial reports pegged this percentage at 0.15% for U.S. transactions. For every $100 of Apple Pay purchases in the U.S., Apple earns 15 cents. However, in the UK, Apple reportedly receives a smaller fee. Given Apple Pay's prominence outside the U.S., a safe assumption is that Apple earns on average less than 0.15% of every Apple Pay transaction.

Licensing and other services. Apple earns revenue from third parties for offering their services as default options on Apple devices. One of the more well-known examples is Apple's contract to have Google be the default search provider for Safari on Mac and iOS. Apple recently expanded its Google relationship to include Google for web searches via Siri and YouTube for video searches. Microsoft Bing remains the option for Siri image searches.

Estimating Services Revenue

Apple doesn't disclose the amount of revenue generated by each Services category. However, after sifting through years of earnings call transcripts as well as recent news releases involving the App Store and Apple Music, it is possible to put together a few pieces of the Apple Services puzzle. 

According to my estimates, Apple earns a majority of its Services revenue from delivering content to nearly a billion people using more than 1.3 billion Apple devices. In 2017, Apple earned an estimated $21 billion from selling digital content ranging from apps (especially games) to music and movies. 

Back in January, Apple disclosed that it paid $26.5 billion to app developers in 2017. Apple keeps either 15% or 30% of app revenue, depending on the app and whether it is a subscription. This suggests that overall App Store revenue was approximately $37 billion. Since Apple reports App Store revenue on a net basis, recognizing only the commission it retains, the full $37 billion of App Store revenue is not reflected under Services. Instead, Apple reports just its $11 billion share of the revenue.

The remaining portion of Apple's digital content revenue came from iTunes and Apple Music. Apple reports Apple Music revenue and some digital content sold through iTunes on a gross basis. This results in iTunes and Apple Music representing a large portion of Services revenue despite bringing in significantly less revenue than the App Store. In fact, iTunes and Apple Music likely contribute close to the same amount of Services revenue as the App Store. 

Exhibit 4: Apple Services Revenue Mix (2017)

Screen Shot 2018-05-15 at 3.03.53 PM.png

To put the preceding revenue totals in context, Apple Watch generated $6.5B of revenue in 2017. 

The primary reason Apple has experienced accelerating Services revenue growth since late 2015 is that the company has seen a dramatic increase in the number of people accessing its various content stores. The iPhone installed base grew by more than 100 million people each year from 2013 through 2017. These new users are spending an increasing amount of money buying various forms of content through Apple's stores. 

One of the more interesting revelations from my estimated Apple Services revenue mix is the degree to which licensing is a key revenue driver. My estimate has Apple earning $4 billion per year from licensing. While Apple doesn't discuss its licensing business, recent reports of Google paying much higher TAC (traffic acquisition costs) suggests Apple has seen strong growth in its licensing revenue. The growth is a result of iOS gaining power at the premium end of the smartphone market. Companies like Google increasingly need access to iPhone users in order to feed their free data capturing services. According to my estimates, the $4 billion of revenue associated with licensing is roughly the same amount of revenue generated by AppleCare.

While Apple has built new services revenue streams in the form of iCloud and Apple Pay, neither come close to matching the revenue associated with content distribution. Given the economics surrounding Apple Pay, it's not likely the service will be a significant revenue driver for Apple in the near term. For every $1 trillion transacted through Apple Pay, Apple would generate just $1.5 billion. As for iCloud, while management boasts about record revenue, the total likely pales in comparison to content distribution. 

Estimating Services Gross Margin

In addition to not breaking out Services revenue by category, Apple management has kept Services margins under wraps. We know from management commentary that Services end up boosting Apple's overall gross margins. This is a major clue suggesting Services gross margin exceeds 40%. One way of reaching a more specific Services margin estimate is to look at each revenue driver.

Exhibit 5: Apple Services Gross Margin Mix (2017)

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As shown in Exhibit 5, each Services category has a different gross margin. Licensing is likely the most profitable for Apple, followed by Apple Pay and iCloud. Extended warranties, such as AppleCare, are also highly profitable. The fact that Apple reports some iTunes revenue and Apple Music revenue on a gross basis weighs on digital content gross margins. Overall, my estimate is that Apple's services business has a 55% gross margin. 

The Services Strategy

Apple's services strategy is misunderstood. Many have looked at Apple's services momentum and concluded that Apple is turning into a services company. In addition, a growing number of people are positioning services as Apple's future. Neither viewpoint is true.

Apple has been pursuing two goals with services:

  1. Deliver Content. Apple has a long-standing ambition of leveraging its platforms in order to become a leading content distributor for apps, music, books, podcasts, and video. To claim that Apple has only recently begun to focus on earning revenue from delivering content is incorrect.  
  2. Increase Hardware Value and Functionality. Management looks at services as a key differentiator that increases the value found in using Apple hardware and software. Services like AppleCare, iCloud storage, and Apple Pay are designed to improve the experience found in using Apple hardware and software.

A recurring theme found with Apple Services is hardware dependency. Apple's ambition to be a content distributor is intertwined with its hardware capabilities. Without more than 1.3 billion devices in the wild, Apple's digital content revenue would be a fraction of its current size.

In addition, AppleCare, Apple Pay, iCloud, and licensing are also heavily dependent on the number of Apple devices in the wild. It is this hardware dependency that makes it impossible to look at Apple Services as a stand-alone business. The relationship between services and hardware is one reason why an Apple Services narrative on Wall Street hasn't been able to stick. The Services narrative isn't compelling if it excludes Apple hardware from the equation.

Apple's future isn't about selling services.  Rather, it's about developing tools for people. These tools will consist of a combination of hardware, software, and services. 

Looking Ahead

Apple management recently reiterated its goal of reaching approximately $50 billion of Services revenue by 2020. The most likely way Apple will reach this goal is by growing the amount of revenue associated with digital content distribution. App Store revenue has been growing by approximately 30% per year. Assuming Apple Music revenue growth more than offsets a decline in paid music downloads, Apple stands to grow its digital content revenue by at least $15 billion over the next two years. This will push Apple very close to its $50 billion Services revenue goal by 2020. These calculations don't take into consideration any new content subscription offerings from Apple.

Apple currently has more than 270 million paid subscriptions across its services, up over 100 million year-over-year. My suspicion is that a good portion of those subscriptions are content subscriptions. Apple is currently developing two new paid services for delivering content: Apple Video and a paid tier to Apple News. Each service will likely be given a long-term target of having at least 100 million paying users. In addition, Apple is in a good position to benefit from growing momentum for video streaming services including Netflix, HBO, and Hulu. It is not a stretch to claim that Apple will one day have 500 million paid subscriptions across its services. 

Apple isn't becoming a services company. Instead, Apple is building a leading paid content distribution platform. 

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Apple 2Q18 Earnings Expectations

Wall Street has major jitters when it comes to Apple's upcoming earnings release. Sentiment has decidedly swung toward the negative as questions swirl around iPhone X demand. Despite the dramatic downturn in expectations, Apple's stock price has held up remarkably well. While many eyes will be on iPhone sales tomorrow, my suspicion is that the data point won't have as much influence as consensus assumes. Instead, Apple's capital return update has the potential to be the major takeaway from 2Q18 earnings.  

The following table contains my Apple 2Q18 estimates. The ingredients are in place for Apple to report a slight EPS beat to consensus although 3Q18 revenue guidance will likely come in below consensus. 

My full perspective and commentary behind these estimates are available to Above Avalon subscribers. (Become a subscriber to access my full 5,000-word Apple 2Q18 earnings preview available here. To sign up, visit the subscription page.)

Items Worth Watching

Here are the five variables worth watching when Apple releases earnings on Tuesday: 

iPhone Channel Inventory. Given prior management commentary, iPhone unit sell-through growth and iPhone average selling price don't represent the major wildcards for 2Q18 earnings. Instead, the big unknown is found with iPhone channel inventory. A significant channel inventory drawdown will result in Apple reporting iPhone unit sales closer to 50M units. Vice versa, a relatively minor decline in iPhone channel inventory may lead to Apple reporting iPhone sales slightly ahead of my 52M unit expectation. 

iPad ASP. The days of dramatic iPad unit sales declines are over. Accordingly, instead of unit sales, average selling price (ASP) stands to provide much more information regarding the latest iPad trends. A weaker-than-expected iPad ASP may support the view that the 9.7-inch iPad at the low end of the line is likely gaining momentum at the expense of the higher-end iPad Pro options.

Other Products. Apple's "Other Products" category has the sales momentum. The line item includes various products such as Apple Watch, AirPods, HomePod, Beats headphones, iPod touch, and Apple-branded and third-party accessories. 

3Q18 Guidance. Apple's 3Q18 revenue guidance will likely provide a few clues as to how iPhone demand has been trending. One complicating factor when it comes to revenue guidance is that Apple's non-iPhone part of the business is seeing major momentum. iPhone weakness will be partially offset by strength in Other Products and Services. 

Capital Return. Apple will announce changes to its capital return program. My expectations are for a $100 billion increase to share buyback authorization and a 20% increase to the quarterly cash dividend. Management commentary regarding timing associated with share repurchases will be closely monitored. 

2Q18 Expectation Meters

Each quarter, I publish expectation meters ahead of Apple's earnings release. Expectation meters turn single-point financial estimates into more useful ranges that aid in judging Apple's quarterly performance.

In each expectation meter, the grey shaded area is my expectation range. A result that falls within this range signifies that the product or variable being measured is performing as expected. A result in the green shaded area denotes strong performance and likely leads me to raise my assumptions and estimates going forward. Vice-versa, a result in the red shaded area has the opposite effect and leads me to reduce my assumptions. 

I am publishing three expectations meters this quarter: iPhone unit sales, Other Products, and 3Q18 guidance. 

My iPhone unit sales expectation range stretches from 50M to 54M iPhones. iPhone unit sales within this range would be labeled as expected. If Apple reports iPhone sales greater than 54M units, results would best be described as strong. A sub-50M iPhone result would lead me to reassess my sales expectations going forward. 

For "Other Products," revenue that exceeds $4 billion would support the view that Apple Watch and AirPods were strong sellers during the quarter. HomePod sales will also likely contribute to the year-over-year growth in revenue.  

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Revenue guidance that exceeds $50 billion would likely be viewed positively while revenue closer to $45B would be viewed negatively. It is likely that Apple's 3Q18 revenue guidance will reflect a year-over-year revenue increase. The increase is due to momentum in Services and Other Products.

Above Avalon subscribers have access to my full 5,000-word Apple 2Q18 earnings preview (four parts):

  1. Setting the Stage
  2. iPhone Estimates
  3. iPad, Apple Watch, Mac, Services Estimates
  4. Revenue, EPS, Capital Return, 3Q18 Guidance

Subscribers will also receive my exclusive earnings reaction emails containing all of my thoughts and observations on Apple's 2Q18 earnings report and conference call. To read my Apple earnings preview and receive my earnings reaction notes, sign up at the subscription page