Above Avalon Podcast Episode 143: Look at the Capex

For the first time in 16 years, Apple expects its capital expenditures (capex) to decline during the current fiscal year. Episode 143 is dedicated to discussing capex and how the financial metric provides a different look at how Apple is unique in comparison to its largest peers. Additional topics include defining capex, the theories behind Apple’s declining capex, the dramatic capex shift occurring among the Wall Street giants, and how capex shines light on a company’s cash-generating machine.

To listen to episode 143, go here

The complete Above Avalon podcast episode archive is available here

Apple's Declining Capex

The most surprising revelation found in Apple’s recent 10-Q and 10-K filings is related to capital expenditures (capex). For the first time in 16 years, Apple expects its capex to decline during the current fiscal year. Declining capex is made that much more intriguing for Apple considering how Amazon, Alphabet, Microsoft, and Facebook are each experiencing significant increases in capex. Analyzing Apple’s capex and the potential reasons for its decline provides a look at how the company is being managed and how Apple is unique when compared to other Wall Street giants.

Defining Capex

Capex refers to cash a company spends on buying or upgrading long-term assets in order to improve cash flow, productivity, and ultimately, value. These expenditures include both tangible and intangible items.

As depicted in financial filings, Apple’s capex includes money spent on:

  • Product tooling and manufacturing process equipment.

  • Data centers.

  • Corporate facilities and infrastructure, including information systems hardware, software and enhancements.

  • Retail stores.

Additional capex items include acquiring intellectual property such as patents.

One way of distinguishing capex from regular operating costs (opex) is that capex benefits a company beyond the current fiscal year that the expense occurs. While opex are deducted as they are incurred, capex are one-time costs capitalized on the balance sheet with the expense spread across the lifespan of the asset. Cash spent on assets that have not been proven commercially viable fall under R&D and is expensed as incurred.

Apple Capex: By the Numbers

At the end of each fiscal year, Apple provides an expectation for the amount of capex that it will report during the upcoming year. As shown in Exhibit 1, for the first time in 16 years, Apple expects a year-over-year decline capex in FY2019. Apple’s initial expectation called for $14B of capex in 2019, down from the $16B of capex originally expected in 2018.

Exhibit 1: Apple’s Initial Expectations for Capex (Annual)

For a variety of reasons, including the difficulty associated with estimating capex, Apple’s final capex total will often differ from its initial expectations. Exhibit 2 includes Apple’s final capex reported at the end of each fiscal year. Excluding how capex came in above Apple’s initial expectations in FY2018, the trend had been for capex to come in less than initial expectations. This is why it wasn’t too surprising to see in Apple’s most recent 10-Q that management had reduced its capex expectations for 2019 even further. Apple now expects $12B of capex in 2019. Based on this revised estimate, Apple may end up reporting a nearly 30% year-over-year decline in capex.

Exhibit 2: Apple’s Reported Capex (Annual)

The amount of cash Apple spends on capex during any given fiscal year will likely differ from reported totals. Companies disclose the amount of cash spent on capex via the cash flow statement using the line item property, plant, and equipment (PP&E). Exhibit 3 reflects the amount of cash Apple spent on PP&E over the past 10 years. It is not unprecedented for Apple to report a modest year-over-year decline in PP&E. However, this doesn’t take anything away from Apple expecting a rare drop in reported capex in 2019.

Exhibit 3: Apple Payments for Property, Plant, and Equipment (PP&E)

Theories

What may be behind Apple’s expectation for capex to decline by nearly 30% in FY2019? There are a number of plausible theories.

  1. Apple is buying less tooling and manufacturing machinery. In the late 1990s, Apple began outsourcing product manufacturing to third-party contract manufacturers. The move was done in an attempt to improve the company’s balance sheet and create a leaner, nimbler, supply chain. Given Apple’s reliance on contract manufacturers, the company doesn’t own a complex web of factories around the world. However, Apple does own much of the specialized tooling and machinery found in these factories.

  2. Apple cut back the pace of retail store openings. Apple may be spending less on its brick-and-mortar retail apparatus. After an aggressive store opening strategy in China, Apple cut back on its retail footprint expansion and instead has been focusing on opening fewer, more high-profile stores.

  3. Capex headwind from elevated spend on facilities is winding down. The decline in capex may be due to Apple having already spent aggressively on various capital investments including new data centers, land purchases, and a new $5B headquarters.

  4. Apple’s initial expectations will end up being proven wrong. It is possible that Apple’s expectation that capex will decline in 2019 may simply end up proving conservative.

While there may be some logic found with each of the preceding theories, a few theories end up having more holes than others. Consider the following:

  • Retail store remodels. The declining number of store openings ignore what has been a substantial amount of resources being dedicated to store remodels around the world.

  • Lower expectations. After three months, management has already lowered its 2019 capex expectations from $14B to $12B. It is not likely that Apple is simply running with conservative capex expectations and will somehow end up reporting more than the $16.7B of capex in FY2018.

Most Logical Explanation

When taking the preceding theories into consideration, two stand out as being the most logical. As shown in Exhibit 4, despite the surge in wearables sales, the overall number of devices manufactured has remained roughly the same due to the decline in iPhone sales. This would suggest no major growth in capex due to additional tooling and machinery. In addition, Apple is coming off of a massive investment cycle for iPhone related to OLED and Face ID. Management was not exaggerating when saying the iPhone X marked a turning point for the iPhone business. This dynamic likely resulted in elevated capex in recent years which is now cooling down a bit in 2019.

At the same time, Apple management’s capex expectation for 2019 likely reflects little growth in tooling and manufacturing machinery related to a major new product category. Apple’s fiscal year ends in September, and the latest rumors claim that high volume production for Apple Glasses will be more of a FY2020 event.

Exhibit 4: Apple Device Unit Sales

Note: "Other" includes Apple Pencil, Apple TV, HomePod, and select Beats headphones. Wearables include Apple Watch, AirPods, and select Beats headphones.

Another contributing factor behind declining capex is that Apple likely finds itself facing less of a capex headwind from years of significant growth in infrastructure. As disclosed in Apple’s most recent 10-K, the company had amassed a significant amount of office space and land in recent years. As of September 29th, 2018, Apple owned 16.5M square feet and leased 24.3M square feet of building space, up 12% from the previous year. In addition, Apple acquired 2,448 acres of land in 2018 to have a total of 7,376 owned primarily in the U.S. As Apple grows into its expanded footprint, the company is likely taking a temporary breather in terms of capex on corporate facilities.

Peers

Apple’s declining capex highlights the remarkable capex shift among the Wall Street giants (Microsoft, Apple, Amazon, Alphabet, and Facebook). Exhibit 5 highlights the change in PP&E from FY2016 to FY2018 for the five giants. In 2016, Apple led the pack with nearly $13B of PP&E. The closest peer was Alphabet at $10B. Jump ahead two years, and the landscape has completely changed.

Exhibit 5: Payments for Property, Plant, and Equipment (PP&E)

Alphabet spent $25B on PP&E in 2018, nearly double the second-highest total reported by Facebook ($14B). Based on Apple management’s capex expectation, it is likely that Apple will also be surpassed by Microsoft and Amazon when it comes to PP&E in 2019. This means that in just two years, Apple would have gone from being the highest to lowest spender in terms of PP&E.

On a combined basis, the $32B increase in PP&E reported by Alphabet, Facebook, Amazon, and Microsoft between 2016 and 2018 exceeded Apple’s PP&E growth by 56x.

Change in PP&E (2016 to 2018)

  • Alphabet: $15B

  • Facebook: $9B

  • Amazon: $5B

  • Microsoft: $3B

  • Apple: $1B (rounded up)

Business Models

Business models dependent on collecting as much of our data as possible require increasing investment at unprecedented rates. This would explain the massive increases in PP&E reported by Alphabet (Google) and Facebook. Each is a services company focused on offering free, data-capturing services to as many people as possible. The business models are dependent on achieving scale in order to grab as much data as possible. 

Amazon is a retail platform company focused on getting you to buy and consume more products over time. Scale in terms of purchase volume is needed in order for the cash flow/reinvestment cycle to continue. Amazon’s data capturing investments are a bit more difficult to observe via PP&E growth given the company’s need to make other long-term investments to support its cloud business.

Apple is a design company focused on selling tools capable of fostering premium experiences. Instead of chasing scale with the goal of monetizing data or usage, Apple sells tools that management thinks people will want and are willing to pay for. For Apple, scale is considered a byproduct of a properly functioning business model.

Declining capex in any given year does not necessarily reflect Apple management underinvesting in its business. Instead, as discussed above, such declines result from Apple leveraging its existing fixed assets to generate robust free cash flow. In essence, Apple’s business model is capex light.

Ultimately, Apple's business model predisposes the company to superior free cash flow generation. The company is capable of monetizing premium experiences much more effectively and efficiently than anyone else. Free cash flow is a measure of how much cash is generated after taking into account capex and other costs associated with running the business. Apple's $62B of trailing twelve month free cash flow is $6B more than the combined free cash flow produced by Alphabet, Facebook, and Amazon during the same time period. Given how those data capturing companies find themselves needing to spend increasing amounts on capex, Apple will likely be able to maintain its significant free cash flow advantage for the foreseeable future.

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Above Avalon Podcast Episode 142: Rethinking the Smart Home

In one word, the smart home has been disappointing. Episode 142 is focused on why the way we think about digital homes is in need of a major reset. After going over my thoughts on the current state of the smart home, we take a closer look at Apple’s vision for the home and why the company is likely looking to revamp its broader home strategy. Additional topics include how Amazon and Google have used voice to hijack the smart home in order to push alternative visions and Apple hiring Sam Jadallah to lead its various home initiatives. We also discuss how Apple can revamp its home strategy and why the smart home path is going to be bumpy going forward.

To listen to episode 142, go here

The complete Above Avalon podcast episode archive is available here

Revamping Apple's Home Strategy

Last week, news broke that Apple had hired Sam Jadallah, a former Microsoft executive and most recently founder of a smart lock company, to lead its various home initiatives. The announcement raised a number of questions, including the most obvious: What is Apple’s home strategy? Consensus in the press is that Apple is far behind Amazon and Google in the race to control the home. I’m not so sure about that. Instead, the entire smart home genre appears to be floundering. Jadallah’s hiring points to Apple reassessing how to best get the idea of an intelligent home off the ground.

The Smart Home

Starting a few years ago, the tech industry became desperate to position the smart home as the next big thing. Much of this was due to a strong desire to find growth after smartphones and tablets. Other companies were focused on moving past Apple’s and Google’s control over the smartphone and tablet paradigm. With wearables, success has been contained to a select few companies. Meanwhile, the smart home umbrella ended up covering multiple times the number of companies, including a long list of hardware-focused start-ups.

In one word, the smart home has been disappointing. The premise underpinning smart home adoption was that one smart device purchase would lead to another and then another. In reality, that kind of behavior has not become the norm. Despite there being plenty of products available, smart home adoption remains sporadic and disjointed.

While a few product categories, like stationary speakers, have gained traction in the home, such products end up being tangential to the idea of the smart home.

Amazon is considered to be the leader in the home, at least when going by the media’s perception. The company’s acquisitions in the space certainly help push the narrative of Amazon being aggressive and forward thinking. Similarly, for Google, considered a distant second in the smart home race, its Nest acquisition provided the company a decent amount of positive coverage when it came to smart home ambitions. However, that positivity is beginning to disappear based on increasingly questionable decisions like not disclosing microphones in products. Regardless, both Alexa and Google Assistant, Amazon’s and Google’s voice assistants, respectively, have never been short of praise in the press.

Problems

A number of issues are at the root of mediocre smart home adoption. The largest issue is that the vast majority of smart home devices lack an attractive value proposition.

  • Smart doorbells with cameras have become more about providing entertainment than anything else, serving as a way to see who stole packages off the front porch.

  • Smart power plugs end up being nothing more than a way to avoid changing timers a few times during the year.

  • Smart kitchen appliances controlled by voice still make more sense in cartoons than in real-world settings.

While a handful of interesting product stories exist in the smart home realm, they are few and far between. Instead, the way smart home gadgets have embraced voice assistants has ended up being more of a distraction than anything else. In the rush to add microphones and speakers to anything and everything, the smart home’s grand vision has been muddled.

Amazon and Google have used voice to hijack the smart home in order to push alternative visions, one around e-commerce and the other around delivering information, respectively.

  • Amazon is focused on becoming the go-to place for buying stuff in the home. For Amazon, the home is an e-commerce hub. Every one of Amazon’s actions within the home has been done in pursuit of this focus.

  • Google is focused on positioning its services as front-and-center in the home. For Google, the home is an information hub. Every one of Google’s actions within the home has been done in pursuit of this focus.

While there are some value-add propositions found with improving at-home shopping and delivery and having easy access to information-rich services, both home strategies amount to collecting as much user data as possible. In addition, neither strategy takes full advantage of the most powerful and valuable screens in our lives to push the smart home forward.

Amazon Echo and Google Home marketing are notorious for never showing other computing gadgets being used in home. There are zero smartphones, tablets, or wearables to be seen. It’s as if people leave their devices by the door when entering the home, only to pick them up on the way out. Amazon and Google both want people to think stationary smart speakers controlled by voice are adequate replacements for the various screens in their lives. The reality is that the best devices for consuming and transferring information in the home have screens and are either worn on us (wearables) or always near us (smartphones). It is far more useful and practical to get the day’s weather with a quick glance and tap at the wrist than by asking a digital assistant contained in a stationary speaker.

Apple and the Home

Apple’s approach to the home is quite different than the approaches of Amazon and Google. Apple is a design company tasked with coming up with tools that enrich people’s lives. Accordingly, the home is looked at as a place to use those valuable tools.

When it comes to the smart home, Apple has been following a three-pronged strategy:

  1. Rely on HomeKit and third-party hardware to establish an ecosystem of smart home devices. These devices can be controlled and configured using the most valuable tools in our lives including iPhones, iPads, and Apple Watches.

  2. Use select third-party hardware, such as stationary speakers and television sets, as Trojan horses for Apple’s content distribution services.

  3. Remain selective when deciding to ship first-party hardware solutions for the smart home. Apple TV and HomePod are the rare smart home exceptions for Apple. Both end up being accessories for Apple users looking for the best content consumption experiences in the home. Other Apple devices for the home like the Beddit sleep monitor end up being tangential to the smart home idea.

After a slow start, Apple has seen a pickup in HomeKit adoption among third-party smart home products. However, the way expanded AirPlay 2 support has been generating greater buzz says something. With AirPlay 2, Apple uses third-party hardware as a way to spread its content distribution services.

The fact that Apple doesn’t sell its own television set implies that there are going to be many large, non-Apple pieces of glass being used to consume video content in the home. This explains Apple’s decision to bring AirPlay 2 support to most of the premium television sets available in the market. A similar story is found with cheap stationary speakers in the home. Apple knows people are tempted by $30 speakers in a can. A significant portion of stationary smart speaker sales can be attributed to two products during the holidays: Echo Dot and Google Home Mini. The primary use case for such speakers is music consumption. At the same time, a good portion of Echo Dot users are iPhone users. This explains Apple’s decision to make Apple Music available on Echo devices. Apple ends up leveraging its existing user relationships to push Apple Music.

Benefits and Drawbacks

One benefit found with Apple’s strategy is that the company remains focused on offering a few great experiences in the home. When it comes to delivering sound in the home, HomePod, especially when multiple HomePods are paired together, offers intelligent sound at a fraction of the cost of a high-end speaker system. Apple TV is the best way for iOS users to consume various video bundles on a large piece of glass.

However, there are also drawbacks to Apple’s home strategy. Apple is ultimately dependent on others for its smart home vision. This reality may result in lackluster device support in addition to questionable experiences in the home. Further, Apple has been facing a growing amount of backlash for saying no to certain products in the home. Some people want Apple to provide everything from the internet wired into homes and Wi-Fi routers connecting our devices to smart light bulbs controlled by digital voice assistants. This just isn’t realistic given Apple’s functional organizational structure and design-led culture.

New Hire

Apple recently hired Sam Jadallah, CEO/founder of Otto, a smart door lock company that went under before getting its $700 lock to market. According to CNBC, and apparently confirmed by Jadallah himself via Twitter, he will oversee Apple’s various home initiatives.

It would be a mistake to look at Jadallah's hire as a sign that Apple will open the floodgates and develop a wide range of smart home devices. Apple simply isn’t structured for such a scenario. Instead, Apple’s culture positions the industrial design group as the ultimate gatekeeper of the experience found with Apple devices. The implication is that Apple will remain very selective in terms of developing its own home products.

Instead, Jadallah will likely focus on coordinating Apple’s various home plays and more importantly, revamping Apple’s broader strategy for the home. This task includes coming up with tangible ways Apple’s teams can turn vision into reality. Based on Jadallah’s previous public comments regarding smart home devices and given Apple’s product philosophy, we have some clues as to what such a vision may look like. Here’s Jadallah in 2017 in a post titled “The End of the Connected Home:

“Creating a product for the home is different than a wearable or a device that is easily replaced. Connected Home products are often installed. That installation dictates that they are reliable, durable and follow many of the rules of the products they replace. In our case, that requires a digital lock to be durable and to have design, and design options, that support the diversity of homes. Homeowners, beyond the early adopters, aren’t willing to sacrifice design, security or performance — they demand it all.

I’ll refer to Connected Home products that meet this bar as ‘Digital Home’ products. The Connected Home is far simpler — basic gadgets, obvious products with a primary value focus on connectivity. The Digital Home is the next wave of the Connected Home. Obvious products need not apply to the Digital Home, as they need to be very focused on the digital experience (connected, open, upgradeable) but also fit well into the home (designed as the home wants, not out of context design) and most importantly, be reliable, durable and classic as they are installed.”

In essence, Jadallah’s “digital home” concept describes a scenario in which design plays a much larger role in the home than what has traditionally been found in the space. It is this lack of design that has played a role in smart home products having questionable value propositions and resulted in mediocre smart home devices. With Otto, a company that reportedly was staffed with many former Apple employees, Jadallah was focused on developing a smart lock that would play in this new “digital home” era. His experience as an entrepreneur and product manager certainly fits with the idea that he will end up working closely with Apple designers on new experiences for the home.

Revamping

There are a number of ways for Apple to revamp its home strategy:

  1. Leverage existing tools in our lives (smartphones, wearables) to push the idea of a digital home forward. Should a smart home require us to use our most valuable devices less frequently? This question is going to gain importance when people begin wearing smart glasses in the home. Since we are going to literally be wearing the most valuable and powerful tools in our lives, why not take advantage of those tools to improve the home experience?

  2. Further incorporate design into the vision for the digital home. This step will involve addressing some obvious but incredibly important questions. How should humans interact with homes? How can digital home products improve our lives? Voice can’t be the only interface choice. Simply being able to unlock the front door with our voice or Watch isn’t enough.

  3. Determine where the most important experiences are found in the home and come up with ways of interconnecting those experiences. There are various genres at play within the home (entertainment, utility, health monitoring, security, etc.) How should health monitoring devices in the home communicate with devices tasked with keeping our home safe? As it stands today, there is little to no relationship or connection between experiences. Instead, everything is either funneled into a voice assistant or a framework like HomeKit.

Apple is not opposed to the idea of moving into first-party solutions for smart home gadgets. The company sells Apple TV and HomePod, after all. Instead, Apple will continue to ask the following questions: Which smart home devices are capable of fostering experiences? Which devices have a long runway when it comes to adding features and capability over time? The answers to the preceding questions will be the devices most likely to be tackled by Apple designers and engineers.

Bumpy Road

In my view, the smart home path is going to be very bumpy going forward. We are trying to compensate for the lack of homes being built from the ground up with technology truly in mind. Having homebuilders simply add voice activated gadgets in new homes falls short. Instead, the only genuine answer is to have tech companies build homes themselves. However, that isn’t on the horizon at this point.

As highlighted in the following exhibit, the home represents a crucial part of the new tech landscape. The home is a treasure trove of data, and companies are looking to grab as much of our data as possible. This explains why monitoring within the home has been all the rage. However, the home has not been the recipient of a great amount of design attention when it comes to intelligence and personalization. Instead, we have a whole lot of questionable voice-controlled devices and not much else. Hardware start-ups have been focused on adding voice control to smart home devices without a clear reason or purpose. Do consumers really want to talk to or control dozens of smart appliances installed throughout the home? Are consumers going to be OK with installing microphones throughout the home? Based on the backlash to news of Google not telling customers about a microphone being included in Nest Guard, there is a good chance we are moving to a major backlash phase against the smart home.

In recent years, the topic of “controlling” or “winning” the home has been a popular talking point. Consensus has landed on the winner in the home being the company with the most capable voice assistant as measured by the number of skills or features. This type of thinking is off the mark. Few people are using these voice skills. This explains why tens of millions of smart speakers end up being used for little more than listening to music, a development that ends up helping push forward the music streaming industry more than the smart home genre.

Instead, the winner of the home is the company that ultimately is able to grab our time and attention. This is why Apple’s vision of the home being a place where we use tools to improve our lives makes sense. If someone is dedicating most of his or her time to an iPhone while in a room full of smart home devices, which company is actually winning in that room? If an Apple Watch is continuously worn and used in a home filled with smart devices, which company is actually winning in the home? The way we think about digital homes is in need of a major reset.

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 membership, visit the membership page.

Above Avalon Podcast Episode 141: Viral AirPods

There’s a remarkable story found with AirPods. Nearly two years after launch, AirPods began to go viral at the end of November 2018. In December, search interest was up 500%. This is unprecedented for an Apple product. In episode 141, we take a deep dive into the AirPods phenomenon and how the product became part of culture. Additional topics include AirPods unit sales, the size of the AirPods user base, the keys to success in wearables, and thinking of wearables as battles for real estate on our wrists, ears, eyes, and body.

To listen to episode 141, go here

The complete Above Avalon podcast episode archive is available here