Connecting the Apple Dots

Apple is following a clear and defined product strategy. Last week, Apple provided the latest look at this strategy by unveiling new iPhones and a redesigned Apple Watch. These products represent clues that help paint a picture of where Apple is headed.

Mission Statement

Tim Cook kicked off Apple’s most recent product event at Steve Jobs Theater with an overview of the company’s mission statement. Here’s Cook:

“Apple was founded to make the computer more personal. Of course first with the Apple II, and then later with the Mac. Over the years, we’ve taken this mission further than anyone could have imagined. We’ve created several categories of technology that have had a profound impact on people’s lives - from the iPod to the iPhone to the iPad to the Apple Watch…

Of course we aim to put the customer at the center of everything that we do. That’s why iOS is not just the world’s most advanced mobile operating system. It’s the most personal. We’re about to hit a major milestone. We are about to ship our two billionth iOS device. This is astonishing. iOS has changed the way we live - from the way we learn, to the way we work. To how we’re entertained, to how we shop, order our food, get our transportation, and stay in touch with one another. And of course, how we capture the moments of our lives and share them with those we love. It’s amazing how our mission started with personalizing technology for the desktop to now seeing the many ways that we’ve made it more personal in so many aspects of our lives.

So it’s only fitting that today, we’re going to tell you about two of our most personal products - the ones that are with you everywhere that you go - and how we are going to take them even further.”

Along with announcing three iPhone X successors, Apple unveiled the most significant year-over-year change to Apple Watch since its unveiling in 2014.

My full review of Apple’s event is available for members here (major themes and takeaways) and here (full notes).

iPhone XS / XR

In order to push the iPhone X experience forward, Apple focused on three items:

  1. Larger screens (A 6.5-inch screen with the iPhone XS Max and s 6.1-inch screen with the XR.)

  2. Smarter brains (The A12 Bionic gives Apple an even larger lead over the competition.)

  3. Better eyes (The dual-camera system is giving iPhone the ability to see the surrounding world with a more intelligent perspective.)

The following image does the best job at describing the current state of the iPhone business:

 
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There is a reason Apple spent nearly 10% of the presentation talking about the A12 Bionic chip. Apple has spent the past decade working to control the core technologies powering its devices. The end result is an Apple chip that is providing the company a significant competitive advantage in the marketplace. With each new iPhone release, Apple’s custom silicon is responsible for an increasing portion of the iPhone experience. Apple didn’t just announce three new iPhones last week. Instead, thanks to the A12 Bionic and increasingly capable cameras, Apple announced three AR navigators serving as laptop and desktop alternatives.

Apple Watch Series 4

While the new iPhones were impressive, Apple Watch Series 4 stole the show. Two slides from the Apple Watch portion of the presentation stood out. The first of these covers improved optical heart sensor on the back of Apple Watch. The second shows Jeff Williams demonstrating some findings from Apple's multi-year research into falls.

 
 

Both slides depict Apple Watch as a proactive digital assistant. The device is capable of monitoring everything from our heart rhythm to whether we have fallen and need help. By being worn on the body, Apple Watch is able to handle tasks that will never be given to iPhone. When combined with the independence found with cellular, Apple Watch contains an incredibly powerful value proposition.

Apple Product Theory

The iPhone and Apple Watch represent the two most personal devices in Apple’s product line. While it may seem like these products lack any obvious connection with their larger siblings, there is a single philosophy connecting each of Apple’s major product categories. Introduced in 2015, my Grand Unified Theory of Apple Products is worth revisiting given the significant changes that have taken place within Apple’s product line.

 
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Apple’s major product categories are interconnected by the roles they play in making technology more personal. Each product is given a goal that ends up describing its design attributes.

  • Mac desktops. Designed to be powerful and capable enough to push the boundaries of a computer.

  • Mac portables. Designed to handle tasks that may have traditionally went to a desktop.

  • iPad. Designed to serve as an alternative to laptops and desktops.

  • iPhone. Designed to be powerful enough to reduce the need for iPad and Mac.

  • Apple Watch. Designed to handle an increasing number of tasks so that less time has to be given to iPhone and iPad.

Apple’s product strategy is based not on coming up with replacements for existing products, but on using personal technology to come up with alternatives to more powerful computers. By relying on new form factors in addition to new user inputs and outputs, Apple has seen much success in coming up with products that contain less in the way of barriers between the user and technology. Intuitiveness is used to harness technology’s potential. Apple’s goal with iPhone has been to give the product enough functionality to serve as a Mac and iPad alternative. Meanwhile, Apple’s goal with Apple Watch is to give the product enough functionality to reduce the need for an iPhone.

The Grand Theory also does a good job of explaining why Apple uses a hands-off approach when it comes to telling consumers which product(s) fit best in their lives. While some think this has been a strategic error on Apple’s part, ultimately management wants customers to determine the degree of personal technology that makes sense for their needs. For some customers, a Mac may be required. For others, an iPhone is the only computer needed. Based on the most recent Mac and iPad Pro ad campaigns, Apple management has become comfortable in allowing each product category to stand on its own and not necessarily lift up one category at the expense of the other.

Connecting the Dots

Based on the most recent iPhone and Apple Watch updates, Apple’s longer-term ambition has become crystal clear. This is a company that believes Apple Watch will serve as a viable alternative to iPhone. As a result, the environment will become more hospitable for new form factors capable of making technology even more personal than is possible with Watch. As shown below, the Grand Unified Theory will likely expand to include a new product category beneath Apple Watch: Apple Glasses.

 
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Apple Glasses fit perfectly within the theory as a product category given the job of handling tasks currently given to Apple Watch and iPhone. This would be accomplished by new user inputs (such as glances and voice) and outputs. The work Apple is doing with its custom silicon, along with miniaturization techniques it is using on Apple Watch will come together to make a pair of lightweight smart glasses possible. With the iPhone continuing to gain new capabilities as an AR navigator and the Watch becoming a new kind of proactive digital assistant, there will be room for a simpler device. This device will be designed to break down technology even further to provide an enhanced view of the world around us. There won’t be too many things as intuitive as a pair of smart glasses.

Consequences

One of the major consequences of the Grand Theory is shown below. Apple’s various product categories have dramatically different user base sizes based on the amount of personal technology found with each product. While the Mac has a combined user base of around 100M users, the iPad has almost three times as large of a user base. Meanwhile, the iPhone will soon exceed a user base that is nine times as large as that of Mac.

Screen Shot 2018-09-19 at 5.30.39 PM.png

For more information on the methodology and calculations used to derive these estimates, visit here (iPhone), here (iPad), and here (Apple Watch).

Apple Watch’s user base has grown to 40M in just three years. For context, the iPhone user base stood at 55M after three years. Considering that an Apple Watch still requires an iPhone, the 40M user base figure is that much more remarkable.

As shown below, my expectation is that Apple Watch and Apple Glasses will one day be used by more people than will the iPhone. Such a radical idea may seem like fantasy, especially given how pivotal of a role the iPhone is playing in our lives. However, the appeal found with intuitive devices capable of making technology more personal will prove too powerful.

Screen Shot 2018-09-19 at 3.57.50 PM.png

As new form factors allow Apple to harness technology’s potential, the scope to which those products are able to connect with humans intensifies. Multi-touch was a leading factor in iPhone having a user base that is nine times larger than that of Mac. A proactive digital assistant on the wrist will give Apple Watch a user base that eventually exceeds that of iPhone. The key to my projection is the eventual decoupling of Apple Watch from iPhone. This is an inevitable development. The only question is found with timing.

When it comes to glasses, a product that will be tasked with making technology more personal than iPhone or Watch, providing enhanced vision will be one of the more attractive value propositions in existence. While a user base of 900M people may seem impossible for Apple Watch or Apple Glasses to surpass, there are 7.5B people on Earth. Everyone can benefit from a device that delivers an enhanced view of the world around us.

The Current Era

With smarter brains and better eyes, the iPhone XS and XR will continue the trend of iPhones gaining functionality. It is not a surprise that we see iPhone pricing begin to move higher as a result. However, despite these advancements, the Apple Watch Series 4 was the star of the show at Apple’s recent product event. While this may have come as a surprise to some observers, there have been signs that this day would come. The Watch’s ability to proactively monitor our life is game changing.

When we look back at the late 2010s for Apple, we will likely refer to this as the early stages of the Apple Watch and Apple Glasses era. Apple’s multi-decade quest to make technology more personal is based on using intuitiveness to knock down the barriers that exist between humans and technology. One way of accomplishing this is push the boundaries found with today’s most personal products. The faster Apple runs with iPhone and Apple Watch, the closer the company will get to announcing its most personal product yet: glasses.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on memberships, visit the membership page.

Above Avalon Podcast Episode 132: Titan vs. Tesla

In episode 132, we take a closer look at Apple's Project Titan. The discussion begins by going over the signs pointing to Apple expanding Titan initiatives in recent months. We then turn to Apple's goal with Titan and the automobile's changing value proposition. Tesla enters the discussion as we look at why the company isn't a realistic acquisition target for Apple. Additional topics include Tesla's struggles, poaching, Doug Field's move from Tesla to Titan, and the most interesting things to watch for in the auto space.

To listen to episode 132, go here

The complete Above Avalon podcast episode archive is available here

Poaching Tesla

Apple and Tesla share some similarities. Both companies possess remarkably strong brands, loyal customer bases, and products capable of maintaining that loyalty. Each also has a visionary product leader. Apple has Jony Ive while Tesla has Elon Musk. Accordingly, some have concluded that Apple should acquire Tesla as a way of quickly jumping into the transportation industry.

A Tesla acquisition doesn't make sense for Apple. However, Tesla does have something that Apple has a use for: talent.

Project Titan

Apple's ambition with Project Titan, a catch basin for the company's transportation R&D endeavors, continues to be underestimated. The number of signs pointing to Apple expanding Project Titan initiatives in recent months is on the rise. 

One word to describe Apple's Project Titan strategy is "methodical." Apple appears to be gradually doing everything one would expect of a company establishing a large test fleet of autonomous vehicles on public roads. All the while, Apple's hardware ambitions remain intact. The company appears to still own a web of buildings across the Sunnyvale / Santa Clara / San Jose area that are dedicated to heavy manufacturing and have open space for future growth. (A map of the various locations is available for Above Avalon members here.) This is a company that wants to come up with new transportation solutions consisting of hardware, software, and services. 

When news of Project Titan's existence broke in early 2015, many people were skeptical because Apple had no expertise in the auto industry. Apple would be starting from scratch. 

In what was a departure from the iPhone development playbook, Apple looked outwardly for Titan talent. Specifically, Apple turned to the auto industry for hardware expertise. As shown below, a list of select Titan members (as of mid-2015) served as a wakeup call to skeptics. Apple was indeed working on a vehicle.

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In late 2015, Project Titan began to hit speed bumps as friction between designers and engineers intensified. In order to come up with a truly new user experience, Apple designers wanted to skip human-driven vehicles and instead go straight to an autonomous vehicle. Others argued the better strategy was to begin with an electric car and then position autonomy as a future feature. Not surprisingly, the designers won. 

Bob Mansfield, a hardware engineering guru who is arguably one of Apple's most successful liaisons between the design and engineering teams, was brought in to right the Titan ship. The initiative was refocused on developing the core technologies that would power a variety of transportation hardware options. The refocus on autonomous driving led to a culling of hardware talent.

At least 40% of the outside hires listed in the table above are no longer at Apple (based on LinkedIn updates). Most of the departures took place between August 2016 and early 2017, which fits with the reported timeline of Mansfield overseeing Titan changes. In addition to turning to outside auto hires, Apple ended up poaching itself by taking veteran Apple product design managers off of other teams. There doesn't appear to be much turnover with those Titan additions. Recent reports peg the number of people working on some aspect of Project Titan to be between 2,000 and 2,500.  

Apple's Goal

The best way to understand Apple's goal with Project Titan is to think about the company's design-led culture. Apple's strength lies in taking existing product categories and using design to rethink our assumptions about that category. By rethinking how we use products, Apple is able to come up with products that can change the world. 

Apple wants to rethink the automobile. While electric powertrains, autonomy, and ridesharing will help in Apple's efforts, something more is needed. Our fundamental assumption of what a car is (and isn't) is still in need of being reimagined. Without fresh thinking when it comes to design, we are still left with most of our prevailing assumptions about cars. 

This lack of fresh perspective in automobile design is one factor likely fueling the growing interest in bikes and scooters in high density areas. However, the problem with automobile design goes beyond city centers. People are increasingly tired, frustrated, and bored with cars. The dramatic shift to SUVs in the U.S. is driven by consumers caring less about traditional car value metrics such as performance. Instead, consumers are craving personalization in any form possible. Unfortunately, personalization options, especially when it comes to driver and passenger compartments, remain limited in the auto industry. 

Screen Shot 2018-09-07 at 4.54.30 PM.png

Tesla did something extremely well: It developed electric cars that people actually wanted to drive. Talk of other luxury car makers competing with Tesla is likely more fantasy than reality. However, it's not clear if Tesla is actually on the right path given the car's changing value proposition. 

One way Tesla has been able to do so well in the luxury segment is by competing on old-school value metrics like performance and style. The problem for Tesla is that these values won't matter in the future. Instead, the focus will shift to convenience and personalization. While iPhone relies on software to become a personalized computer for 900 million people, we will demand a similar personalized experience from automobiles. As it stands now, personalization when it comes to the automobile amounts to CarPlay, moving the driver seat back and forth a few inches, and folding down a row of back seats.

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Why Not Acquire Tesla?

Given Apple's interest in transportation and Tesla having the most popular, highest-rated car on the road, many have positioned Tesla as an Apple acquisition target. Apple's strong balance sheet adds fuel to the fire. With $129B of net cash, Apple could pay $70B+ to acquire Tesla and instantly become a player in the auto space. 

However, Tesla isn't a realistic acquisition target for Apple. More importantly, Apple doesn't need to acquire Tesla in order to meet its goals. The best way to understand why is to look at the key components of Apple's M&A philosophy: 

  • A strong brand and product aren't enough for an Apple acquisition. There has to be more to an Apple acquisition target besides strong branding and a popular product in the marketplace. 
  • Apple doesn't use M&A to acquire revenue. Apple doesn't use M&A as a tool to grow revenue.
  • Apple doesn't use M&A to acquire users. Apple doesn't acquire companies simply to grow its user base. This tenet has become that much stronger in recent years as Apple's user base has grown. Apple currently has one billion users. When considering how the vast majority of those users comprise the premium segments of the smartphone and tablet markets, Apple has no need to acquire what ends up being its own users. 

In essence, Apple isn't interested in buying its way into new product categories. Instead, Apple positions M&A as a tool to either enhance its existing product line or plug holes in the product development process. M&A is used to a tool to supplement, not replace, Apple's design-led product development process. Accordingly, there are two things Apple looks for when acquiring companies: 

  • Apple uses M&A to acquire technology. Apple looks at M&A as a tool for plugging holes in its asset base. Given how Apple is constantly working on new products, one hole is often the need for new technology. 
  • Apple uses M&A to acquire talent. One area in which Apple is resource constrained is talent. As Apple moves from one industry to another, the company is always on the lookout for teams of talent that help boost knowledge and expertise. 

A look at Apple's acquisition history demonstrates these core M&A tenets. Acquisitions such as P.A. Semi, AuthenTec, LinX, and Metaio were about technology and talent. Even acquisitions that included consumer-facing products like Beats, Beddit, and Shazam (pending approval) were ultimately about the technology behind the products.    

Netflix

Netflix represents a great example of how Apple doesn't use M&A. In a Netflix acquisition, the two primary things Apple would have bought are a strong brand and lots of users, neither of which is enough to justify an acquisition. In addition, Apple users already had full access to Netflix. It's unclear how Apple owning Netflix would lead to an improvement in Apple products. Positioning Netflix's technology as justification for an acquisition is quite the stretch. Netflix is a media company, and the company's content library is grossly overrated when moving beyond the 15 to 20 marquee series. 

Instead of spending $100 billion to acquire Netflix, Apple opted to poach talent from the entertainment industry and build something on its own. The result is a new "Apple Studios" division overseen by former Sony Pictures Television executives. Apple is reportedly planning to launch its new Apple Video streaming subscription service sometime next year. 

Arguing that Apple should acquire Tesla because it has a great brand and popular product in the marketplace is faulty thinking. Instead, Tesla would need to provide resources that can either strengthen Apple's existing product line or plug holes in Apple's design-led product development process. Some will say that Tesla's fleet of human-driven cars ends up being the company's secret weapon when thinking about the race to autonomy. I'm not so sure about that claim. Others think Tesla's charging network or factories represent the company's crown jewels. Both claims are questionable. Instead, those items could end up being viewed as liabilities, which is one reason Apple embraced contract manufacturing nearly two decades ago. 

Poaching

A Tesla asset that Apple may have an interest in is talent. Given Apple's ambition, Project Titan can benefit from having employees with experience developing cars that people love. However, instead of acquiring Tesla to bring on tens of thousands of employees, which would raise many red flags, a better strategy would include Apple selectively seeking out talent that would be the best fit for Titan. 

When selling prospective hires on the Titan message, Apple is ultimately selling two things: vision and process.

  • Vision. Explaining Apple's mission to come up with products that can change the world. Even though new hires aren't likely given the full lay of the land when joining Titan, the Apple mission can still be telegraphed. 
  • Process. Explaining the process in place for turning vision into reality.

It's not that Apple has necessarily struggled appealing to new hires for Titan. Instead, Tesla likely had the stronger message up to now. In the early 2010s, Tesla was successful at picking off members of the Mac, iPod, iPhone, and iPad teams looking for the next big challenge. At the time, Apple's focus was on Apple Watch, a product that ultimately had a relatively small development team. Project Titan was still a few years away. Doug Field was one of these employees who always had an interest in the transportation space and jumped at the Tesla opportunity.

Around the time Apple began ramping up Project Titan hiring in 2014 and 2015, the Apple versus Tesla talent wars began in earnest. Tesla was much farther along than Titan, with cars already on the road.

However, the environment has changed. The past few months have been a tough stretch for Tesla. The company's long-term goal is to usher in the era of sustainable transport. To reach such a goal, Tesla needed to take a luxury detour and sell cars to those most willing to pay top dollar for a high-performance electric sports car (which happens to have more than two seats). The problem is that Tesla finds itself having trouble getting back on track. A truly mass-market Model 3 remains missing in action. Tesla has become a case study of a company led by a product visionary struggling to turn vision into reality.

Elon Musk has consolidated power, and it's not clear that this is for the better. It's one thing for a product visionary to focus on details. It's a completely different story when a product visionary is being stretched too thin. Recent comments Musk gave to The New York Times regarding him being the only person that can solve Tesla's manufacturing problems is worrying. 

These challenges may give Apple a potential opening for poaching Tesla for talent. Meanwhile, after leadership changes and some shaky times, Project Titan is now in a much more orderly state. Apple would make the case that it has a better process in place than Tesla. It's relatively easy to design a great car. The challenge is to build tens of millions of that car and to then be able to develop new versions over time. 

Tesla's problem is ultimately its desire to do everything on its own. While such a decision was made given the lack of alternatives, Tesla faces less flexibility and financial capacity as a result. This has opened the door for Apple in terms of appealing to Tesla employees. Other factors may include being attracted by Apple ideals such as protecting data privacy and security, which will become a crucial topic in the auto space. 

Doug Field

Tesla critics have been quick to point out the growing list of executive departures as a sign of major issues within Tesla. While the turnover does raise an eyebrow, Doug Field's departure stands out.

Field was Tesla's second-highest ranked engineer, behind CTO JB Straubel. Field was responsible for vehicle engineering and Model 3 production. Back in 2013, his hire from Apple was positioned as a huge win for Tesla. With experience that included Segway's CTO and Mac product design, Field had experience in both personal transport and shipping consumer products at scale. 

Field's job at Tesla was to turn Musk's vision into reality. As recently as this past April, Musk viewed Field as one of the most talented engineering executives in the industry. Accordingly, it's telling that Field ended up quitting Tesla to join Titan. It will be interesting to see if any of Field's deputies at Tesla make the same move. Such a defection would end up being a major coup for Titan. 

Elon vs. Jony

There will be a role for cars in the new transportation paradigm. Two visionaries to keep an eye on are Elon Musk and Jony Ive. Each is taking lessons learned from other industries with the goal of rethinking transportation. It is no surprise that Musk has thrown a few snide comments and jokes Jony's way in recent years. 

Two of the more interesting things to watch in the auto space remain design and manufacturing. Instead of asking questions about legacy auto's software expertise, the more valuable question to ask is, Who is that company's Jony Ive? While auto manufacturers have teams of talented designers, such talent ends up being wasted as upper management and boards mitigate design risk out of fear of losing sales.

Over at Tesla, a company more geared towards engineering than design, Musk and company are learning the harsh realities of auto manufacturing. Many of Tesla's decisions won't be repeated by others.

Meanwhile, Apple's Project Titan is becoming a testbed of new technology that can be used to power new vehicle concepts from Apple's industrial design group.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on memberships, visit the membership page.

Above Avalon Podcast Episode 131: Growth Drivers

Apple's latest growth story is driven by three drivers: iPhone, Services, and Wearables. In episode 131, we discuss these three growth drivers to see how they are not created equal. After going over the factors fueling Apple's growth drivers, we spend time discussing how Apple's growth story may change in the near term. The episode concludes with a big picture overview of why Apple's long-term growth story won't just be about Services.

To listen to episode 131, go here

The complete Above Avalon podcast episode archive is available here

Apple's Growth Story

Apple is on a roll. The company is seeing record high iPhone ASPs, strong momentum with Services, and a wearables platform connecting with the mass market. Revenue growth has accelerated for the past seven quarters. Apple's growth story has returned with a vengeance. Upon closer examination, it becomes evident that Apple's three primary growth levers are not created equal. While some growth levers are at risk of slowing, others are still just getting started. 

Growth Has Returned

In early 2016, Apple hit a rough patch. The company reported its first year-over-year decline in iPhone unit sales as the iPhone 6s and 6s Plus sales cycle proved quite different from that of iPhone 6 and 6 Plus. Overall revenue trends also turned negative with Apple reporting a double-digit revenue decline in 2Q16 and 3Q16. 

Just as consensus began to throw in the towel on Apple as a growth story, iPhone unit sales stabilized. As shown in Exhibit 1, revenue bottomed in early 2017 and then once again began to increase. The most recent quarter marked a record high for Apple revenue on a trailing-twelve-month (TTM) basis and the seventh consecutive quarter of sequential growth in revenue. 

Exhibit 1: Apple Revenue (TTM)

There are three drivers behind Apple's return to revenue growth:

  1. iPhone. The average selling price (ASP) of iPhone is up $100 year-over-year.
  2. Services. Apple is seeing strong revenue growth from the App Store, licensing, and AppleCare. 
  3. Wearables. Apple's wearables platform is gaining sales momentum as Apple Watch and AirPods go mainstream. 

Measuring Growth

The interesting thing about Apple's latest growth story is that few people were forecasting that Apple would grow revenue via hardware sales. Instead, many said that Services would be Apple's growth engine going forward. As it turns out, things are developing differently than consensus assumed.  

For the twelve months ending this past June, iPhone was responsible for 57% of Apple's year-over-year revenue growth. Services was the second-largest revenue driver, responsible for 23% of Apple's year-over-year revenue growth. Wearables was responsible for 11% of Apple's growth. As seen in Exhibit 2, iPhone has been responsible for an increasing portion of Apple's revenue growth.

Exhibit 2: Measuring Apple's Revenue Growth Drivers

Details

It is helpful to take a closer look at the factors underpinning Apple's three revenue growth drivers. 

iPhone. In 3Q18, iPhone revenue was up 20% year-over-year. The vast majority of this growth was due to Apple selling higher-priced iPhones. The iPhone 8 and 8 Plus are the highest-priced 4.7-inch and 5.5-inch iPhones, respectively, to date. Furthermore, the iPhone X is Apple's highest-priced iPhone yet. As seen in Exhibit 3, iPhone ASP experienced a step increase beginning in 1Q18, which marked the first full quarter of iPhone 8 and 8 Plus sales in addition to the iPhone X launch. Given strong flagship iPhone sales momentum, Apple has continued to report strong ASP trends. Apple reported a record high $119 year-over-year increase in iPhone ASP in 3Q18.

Exhibit 3: iPhone ASP

According to my estimates, Apple has sold approximately 120M higher-priced, flagship iPhones (8, 8 Plus, and X) since September 2017. Some of these devices were bought by former Android users switching to iPhone. However, there are only so many premium Android users out there. The majority of sales have likely gone to existing iPhone users upgrading their devices. With an iPhone installed base of approximately 750M users, less than 15% of the iPhone installed base bought a new flagship iPhone over the last nine months. 

A small percentage of the iPhone installed base is responsible for driving much of the year-over-year increase in iPhone ASP. While this doesn't necessarily mean that iPhone ASPs are more fragile than they appear, it does add clarity to the current state of the iPhone business. The iPhone upgrade cycle continues to get longer while growth in customer demand for iPhone remains mediocre. Despite these challenges, the sheer size of the iPhone installed base makes it possible for Apple to sell close to 150M higher-priced, flagship iPhones in any given year.

Services. Apple's second-largest revenue driver, Services, is comprised of five items:

  1. Digital content (App Store, iTunes, Apple Music, etc.) 
  2. Licensing
  3. AppleCare
  4. iCloud storage
  5. Apple Pay

A majority of Apple's Services revenue is associated with Apple distributing digital content to hundreds of millions of people via the App Store and iTunes. Accordingly, the increase in the number of people accessing Apple's content stores, combined with existing users spending more as time goes on, is a leading driver behind Apple's strong Services revenue growth.

Licensing revenue is another major contributor to Services revenue growth as third parties are paying Apple more to get their services in front of Apple's users. It helps that Apple's grip on premium users has gotten stronger over time. AppleCare revenue is also on the rise as the number of Apple devices in the wild increases and Apple expands its AppleCare distribution efforts. 

Wearables. Apple is seeing strong unit sales growth for both Apple Watch and AirPods. In just three years, Apple Watch sales have exceeded 20M units per year with a user base nearing 40M. Despite extended supply issues, Apple likely sold more than 10M AirPods during the first year on the market, and coming close to 20M unit sales is a distinct possibility in CY2018. Apple Watch and AirPods sales are benefiting from aggressive pricing, strong mindshare, growing word of mouth, and increased distribution, especially with the cellular Apple Watch Series 3. As shown in Exhibit 4, wearables unit sales (the orange portion of bar) are no longer a footnote on a Apple gadget sales chart. 

Exhibit 4: Apple Gadget Unit Sales

Future Growth

When it comes to thinking about how Apple's revenue growth drivers will perform in the coming quarters, it is important to assess the broader environment facing each driver. At the same time, a look at Apple's product strategy is required to the weigh the impact from new products and pricing decisions.  

iPhone. Among Apple's three revenue growth drivers, the iPhone faces the most headwinds. While Apple can still grow iPhone revenue with modest unit sales growth, the company will likely see less of a revenue boost from huge iPhone ASP gains. It will be difficult for Apple to increase iPhone ASP by another $100 in 2019. Instead, iPhone ASP increases will likely decline. 

Apple is expected to unveil three new flagship iPhones (6.5-inch OLED, 5.8-inch OLED, and 6.1-inch LCD) next month. Even if we assume the 6.5-inch OLED is priced higher than iPhone X, the model likely won't have as large of an impact on iPhone ASP as iPhone X, given a smaller share of overall iPhone sales. Instead, the majority of iPhone sales will be found with the 6.1-inch LCD and 5.8-inch OLED iPhones. These models will likely be priced similar to this year's flagship iPhones, making it that much harder for Apple to see another step increase in iPhone ASP. 

Services. There are a number of factors supporting continued robust Apple Services revenue trends into 2019. Apple Services will benefit from continued growth in the iPhone installed base. At the same time, larger industry themes such as video subscription services gaining popularity stand to benefit Apple Services revenue in a few ways. In addition to earning a share of revenue via third-party video subscriptions, Apple is widely expected to launch its own paid video streaming service in 2019. Additional Services growth levers are found with higher licensing fees from third parties, more AppleCare revenue, and a larger number of iCloud storage subscriptions. In a scenario in which iPhone revenue growth slows, it is reasonable to expect Services will represent a larger portion of Apple's revenue growth in 2019. 

Wearables. Apple's wearables segment will likely serve as an Apple revenue growth engine for years. The days of Apple wearables being considered a revenue footnote are over. Over the past 12 months, Apple sold over $10 billion of wearables (Apple Watch, AirPods, and Beats headphones). Assuming Apple is able to maintain at least 30% to 40% unit sales growth over the next few years, Apple's wearables platform will reach $20 billon of annual revenue within three years. Given the still relatively low adoption rates for Apple Watch and AirPods within the Apple user base, there are plenty of potential users left to fuel unit sales growth. Over the long run, Apple will likely expand the wearables platform to include new form factors and product categories. These developments will add even more growth potential to the segment. 

Big Picture

On the last two quarterly earnings conference calls, Tim Cook has talked about the smartphone market being one of the best for a company like Apple in the history of the world. There aren't too many markets capable of supporting 215M+ annual unit sales at an average selling price exceeding $750. Read between the lines, and Cook's confidence signaled Apple's belief that nothing will displace smartphones as the most valuable computer in our lives in the near term. For example, Cook's answer to an analyst's question about tech in the home didn't make it seem like Apple management was worried about stationary smart speakers. 

Much of Cook's optimism around smartphones is supported by recent Apple financial trends as revenue growth has been driven primarily by iPhone, with Services and wearables serving in more supporting roles. 

However, this doesn't mean that Apple is betting on iPhone over the long run. In fact, over the next few quarters, it is reasonable to expect that iPhone will become less of a growth driver for Apple, with the growth spotlight turning to digital content distribution and wearables as Apple's primary growth engines. 

Apple continues to place bets on new products that have the potential to gradually serve as iPhone alternatives (not replacements). In essence, Apple wants to be the one to disrupt the iPhone. These iPhone alternatives, having to be powered or supported by iPhone out of the gate, will initially be viewed as rudimentary or even as toys. However, these products will be placed on the path to independency from iPhone. The Apple Watch is a great example of such a product. Apple Glasses have the potential to be an even bigger catalyst for growth

At the same time, we are seeing Apple gain confidence in delivering services focused on distributing digital content and adding value to hardware used by a billion users. As the average number of Apple products per user increases, thanks to wearables, these services will prove essential in delivering personalized and proactive solutions to the Apple community. This strategy will provide Apple years of revenue growth opportunity and pave the way for Apple's eventual entrance into the transportation industry.

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