Apple Has the Best Business Model for Generating Cash

Apple is generating obscene amounts of cash. The company recently reported nearly $6 billion of free cash flow during what is typically its weakest quarter of the year. Over the last 12 months, Apple earned $51B of free cash flow. This is more than any other company earned. It is easy to chalk up Apple's financial success to the iPhone and call it a day. However, upon closer examination, Apple's business model predisposes the company to cash generation unlike any other firm in Silicon Valley. In fact, Apple currently possesses the best business model in the world when it comes to generating cash. 

The Numbers

Apple is in a financial league of its own. As seen in Exhibit 1, Apple's $224B of trailing twelve month (TTM) revenue was nearly as much as that of Amazon ($143B), Alphabet ($95B), and Facebook ($33B) put together. 

Exhibit 1: Revenue (TTM)

The numbers become more daunting when moving down the income statement. As seen in Exhibit 2, Apple's $60B of TTM operating income was nearly 50% more than the combined operating income of Alphabet ($24B), Facebook ($15), and Amazon ($3B).

Exhibit 2: Operating Income (TTM)

Turning to the cash flow statement, Apple's numbers are just as remarkable. Apple's $64B of operating cash flow was nearly as much as that of Alphabet ($36B), Facebook ($19B), and Amazon ($17B) combined. In essence, Amazon is doing as well financially as Facebook. Google is generating as much cash as Amazon and Facebook put together. Apple is generating nearly as much cash as Amazon, Facebook, and Google combined. 

Not only is Apple generating significant operating cash flow, but the company is also kicking off free cash flow at rates not seen elsewhere in Silicon Valley - or the world for that matter. Free cash flow is a measure of how much cash is generated after taking into account capital expenditures and other costs associated with running the business. Apple's $51B of TTM free cash flow is $3B more than the free cash flow produced by Alphabet, Facebook, and Amazon combined. In what may come as a surprise, Apple is bringing in 70% more free cash flow than Microsoft, who is still considered to possess one for the more lucrative business models in existence. 

Exhibit 3: Free Cash Flow (TTM)

Superior free cash flow generation has played a major role in Apple's ballooning cash hoard, which now stands at $154B of net cash (excludes $108B of debt). Despite spending $216B on share buyback and dividends since 2012, Apple's net cash level has increased by $33B over the same time period. The company is generating so much cash, management can't spend it fast enough. 

Exhibit 4: Net Cash

Profit Extraction

Most of the discussions involving Apple's finances position the iPhone as being responsible for the company's good fortune. While the iPhone accounts for approximately 60 percent of Apple's revenue, the device doesn't tell the full story. 

Consider Apple's current product line: 

  • The most profitable smartphone
  • The most profitable tablet
  • The most profitable laptop
  • The most profitable desktop
  • The most profitable smartwatch
  • The most profitable pair of wireless headphones
  • The most profitable streaming TV box

Few hardware manufacturers make money selling smartphones and tablets. The money found in the components business doesn't come close to Apple-like profitability. The best-selling laptop and desktop manufacturers can only dream of Mac margins. Apple is the most profitable wearables company. Even minor Apple products from a sales perspective, like Apple TV, are grabbing profit in an otherwise profitless industry.  

It may be easy to look at these products and conclude that Apple must be overcharging its customers. How else can Apple sell so many profit leaders? However:

Apple's product line shows that there is more than just pricing behind management's ability to extract profit from an industry. Apple's entire business model predisposes the company to superior free cash flow generation.

Core Tenets

The best way to begin dissecting the Apple cash machine is to take a closer look at Apple's business model. There are three tenets, or beliefs, underpinning Apple's business model.

  1. Placing the product above all else. Apple's superior cash generation begins all the way back in the R&D labs. Management is motivated by coming up with great products, not making massive profits. While Apple executives use every opportunity to reiterate this point, most outside observers think it's just talk or PR. However, Apple's financial performance backs up management's claim. Apple doesn't design and sell products to drive revenue. If Apple is able to make great products, management is confident that consumers will like the product and profit will follow. This motivation results in a much more unique product strategy than that of other companies. 
  2. Staying focused. Apple values the art of focusing, saying no to great ideas in order to concentrate the entire company on a few really great ideas. This intense level of focus extends all the way down to Apple's R&D efforts. The amount of money Apple spends on R&D as a percent of revenue is well below that of its peers. In addition, Apple's M&A strategy follows a similar protocol as management is very deliberate in its purchases, focusing on technology and people purchases capable of plugging holes in the asset base. 
  3. Relying on contract manufacturers. Apple is a product company that relies on others to assemble its products. While Apple brings in significant amounts of cash from hardware sales, the company's free cash flow generation receives a big boost from using contract manufacturers. Instead of owning an extensive web of factories around the world, Apple invests in equipment and machinery located in other companies' factories. This results in Apple spending much less on capital expenditures as a percent of revenue. Apple is on track to spend $15B on capital expenditures this year. Alphabet and Amazon spend nearly as much on expenditures despite having a much smaller revenue base. This means that a significant portion of Apple's operating cash flow ends up as free cash flow and can be considered truly "excess" cash. 

These three factors play a big role in Apple selling highly profitable hardware that stands out from the competition. 

Apple Is Different

The next item to investigate when dissecting the Apple cash machine is to see how the preceding core tenets come together to make the company's business model stand out from that of its peers. 

In some cases, Apple hardware has gone on to hold monopoly-like market share in its respective product category (iPod, iPad, Apple Watch). For other products, Apple hardware remains the small player in town in terms of sales share (iPhone, Mac, Apple TV). However, in nearly every example, Apple ends up being the profit leader because management looks at scale differently than other companies view it. Apple doesn't view scale as a requirement to achieve success. This has major implications on Apple's pricing strategy in addition to how the company thinks about monetization. 

Facebook and Google approach scale very differently. For both companies, scale is needed in order to reach as many people (and their data) as possible. The additional data enhances and improves their free services. Amazon's business model is also dependent on scale, albeit a different kind. Much of the company's ongoing investments (transportation, logistics, cloud, and artificial intelligence) are designed to get you to buy more and more goods through Amazon. This significant level of investment will likely be needed for the foreseeable future.

In summary:  

  • Apple is a design company focused on selling tools capable of fostering superior experiences. Scale is considered a byproduct of a properly functioning business model.
  • Facebook and Google are service companies focused on offering free, data-capturing services to as many people as possible. The business models are dependent on achieving scale in order to access as much data as possible. 
  • Amazon is a retail platform company focused on getting you to buy more stuff over time. Scale in terms of purchase volume is needed in order for the cash flow/reinvestment cycle to continue.

There are exceptions to these underlying themes such as Apple Music needing scale in order to become a better music streaming service. In addition, Apple Pay needs widespread retailer adoption to make sense for consumers. However, these examples only reinforce the uniqueness found with Apple's primary business model. Instead of being key revenue or profit drivers, Apple Music and Apple Pay are services meant to increase the value found with Apple hardware.

Putting It Together

Apple possesses the best business model for generating cash because the company is capable of monetizing premium experiences much more effectively and efficiently than anyone else. 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. 

While Apple doesn't look at scale as a requirement for success, the company undoubtedly benefits from scale in a few ways. Greater economics of scale help drive down product costs over time, which both improves both product accessibility and Apple profitability. Scale also allows Apple to place larger component orders. There are a number of examples over the past decade involving Apple competitors being unable to ship competitive products due to Apple buying up all of the available component supply. These elements don't define Apple's cash machine but rather represent the lubricant that makes it run more smoothly. 

Stationary Speaker Market

Apple's unique approach to the burgeoning stationary speaker market highlights how the company plans on using its business model to set the company up for cash generation. Amazon and Google currently have products in the marketplace. Apple's HomePod is scheduled to go on sale in December. Facebook is rumored to be entering the market next year with some kind of stationary screen/camera/speaker.

Amazon. The company's goal with selling Echo hardware is to get its digital voice assistant, Alexa, in as many homes as possible. Greater Alexa usage leads to more data being collected which then helps Amazon become a better, and smarter, retailer. In order to accomplish this goal, the company is willing to give away Echo hardware at cost, or even a loss. When it comes to monetization, instead of making money from Echo hardware, Amazon positions Prime subscriptions as the cash generator. While this strategy has been wildly successful for the company, it has been difficult to miss Amazon's lack of free cash flow. Unlike Apple, Amazon piles most of its operating cash flow right back into the business. Market observers have made the mistake of looking at this behavior as purely optional on Amazon's part. In reality, Amazon will likely need to maintain this high level of investment indefinitely to ward off competitors and keep people buying products from Amazon. This means that Amazon's business model, while successful in delivering valuable customer experiences, may just end up being contained when it comes to excess cash generation.

Google and Facebook. Both companies are interested in capturing customer data in order to power their free services. This will lead to the companies selling hardware at cost or even at a loss, similar to the way Amazon does. Instead of making money on hardware, Google and Facebook will look to monetize the data obtained via microphones and cameras through advertising. We have seen this model's profitability over time. Facebook and Google serve more customers than Apple, but the companies generate cash on a much smaller scale than Apple. Their business models just don't throw off the same kind of free cash flow as Apple. While the home will present different dynamics than mobile and there is room for each to grow the advertising pie, there is little reason to think the overall profitability picture will be much different in the near term. 

Apple. Apple is positioning HomePod, its new stationary speaker, as the best sounding speaker people have ever owned. Apple is betting that controlling both the hardware and software while having the product work closely with Apple services such as Apple Music will lead people to want to own and use HomePod. Apple plans on making money from HomePod through hardware sales. Priced at $349, the device very likely contains a profit margin equivalent to that of other Apple hardware. It is worth pointing out how the device is aggressively priced compared to speakers with equivalent speaker quality. Over time, HomePod usage will help drive Apple services such as Apple Music and Siri. These services will then go on to add greater value to future Apple hardware. Apple's strategy will be to use HomePod to extract most of the profit from the standalone stationary speaker market. Additional profit will come from Apple expanding the speaker pie (i.e. bringing more people into the stationary speaker fold).

Even though it may seem counterintuitive, Apple stands to earn more cash through hardware sales at a smaller scale than companies giving away hardware at cost but looking to monetization in other ways. This is why the initial exhibits up above comparing Apple's financial picture to the leading consumer-oriented tech companies are so surprising. 

The Big Question

Apple has built a spectacular cash machine kicking off remarkable amounts of free cash flow. There does not seem to be any other company that is close to copying this machine. Amazon, Google, and Facebook look at hardware as a way of improving data capturing services. Microsoft's hardware success in consumer markets is fading. This leaves companies such as Samsung, Huawei, Oppo, Vivo, and Xiaomi as the only large companies trying to make money from consumer hardware. Each is seeing various levels of mediocre success.

There is no question that the smartphone wave has been a good one for Apple to ride. As iPhone sales have stabilized, Apple's revenue, operating income, and free cash flow growth has also stabilized. Meanwhile, Facebook, Amazon, and Alphabet are seeing stronger growth trends.

The big question going forward isn't if Apple will find another product as profitable as iPhone to drive growth, but rather if Apple will need to find another business model in order to enter new industries. Will there come a time when Apple's business model will need to evolve into something else? 

Growing Pessimism

It's been hard to miss the growing amount of pessimism surrounding Apple's cash machine. There is a large chorus in Silicon Valley that views Apple's business model as a liability given how artificial intelligence (AI) will infiltrate literally all aspects of our lives. Do Amazon, Facebook, Google, Microsoft, Tencent (WeChat), and Baidu actually possess early versions of the business models of tomorrow? Is Amazon's Echo strategy the more attractive way to handle hardware? Many people now think companies chasing scale and collecting as much data as possible are much better positioned for the future than Apple.

In some ways, concerns regarding Apple's cash machine are genuine. For example, it's not clear if Apple's current business model would do well in tomorrow's transportation industry without some modifications. Is the future of transportation based on people buying or leasing cars? A good case can be made that the future is found with ridesharing. The answer would likely impact the way Apple monetizes transportation tools.

However, there is also evidence that fears of Apple's cash machine imploding are overblown. Unlike the unknown found with the transportation question, the idea that AI will make Apple's business model irrelevant looks to be based on faulty logic. The entire thesis assumes the world is headed in a different direction that it actually is. 

Over the past decade, one of the biggest revelations in technology has been design's increased role in how we consume and value technology. The mass market has bought into Apple's view of personal technology. There is nothing about AI that changes this reality. Instead, we have non-hardware companies pontificate how hardware won't matter in the future. In reality, the opposite will likely occur. Hardware will matter more going forward. The wearables industry represents a good example of this in practice. Meanwhile, the way smartphone and tablet components are mattering more now than ever to AR and AI is another hole in the "hardware won't matter" thesis. 

Some Things Won't Change

As it stands today, Apple's business model is producing more excess cash flow than every other business model. Even assuming competitors see stronger growth than Apple over the next few years, it's not clear how any company will match Apple in terms of cash generation. There is also evidence to suggest Apple will continue to rely on its current cash machine in the wearables industry (Apple Glasses, Apple Watch, AirPods) as these products fit within Apple's current business model extremely well. In fact, the way Apple Glasses seems to match perfectly with Apple's current business model may end up elevating that product to likely be the next product category Apple enters.

However, even in a world that requires Apple to modify its cash machine, some things won't change. The core tenets that underpin Apple's business model will remain, and those are the key ingredients that make the cash machine tick. 

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Apple Glasses Are Inevitable

All of the pieces are coming together for Apple to sell glasses. Using fashion and luxury lessons learned from selling Apple Watch, Apple will enter the glasses industry and in the process launch its first product category designed specifically for the augmented reality (AR) era. While ARKit has taken the world by storm, the development platform is already making it clear that new form factors are needed to take full advantage of AR. It is no longer a question of if, but when, Apple will use AR to rethink glasses. 

ARKit

ARKit is Apple's new framework for developing AR apps on iOS. Apple defines AR as the illusion of virtual objects placed in a physical world. There are three ARKit layers:

  1. Tracking. Using Visual Inertial Odometry (VIO), camera sensor data is combined with CoreMotion data to get the device's location and orientation.
  2. Scene Understanding. Using the camera view, the device can find horizontal planes in a room in addition to estimating the amount of available light in a scene. 
  3. Rendering. A constant stream of camera images, tracking information, and scene understanding can be inputted into any renderer. 

ARKit transforms iPhone and iPad cameras into smart eyes. Developers then use those eyes, and the technology already found with iPhones and iPads, to enhance our reality. Of course, that enhanced reality is constrained to what appears on our iPhone and iPad screens. Despite this limitation, the possibilities seem limitless. 

While some of the earliest examples are interesting, it is difficult to ignore how many of these examples make more sense for a pair of AR glasses. Any AR app involving holding up an iPhone or iPad while not requiring much user manipulation directly on screen makes more sense for glasses. For example, virtual turn-by-turn directions are destined for AR glasses as it’s just not ideal to have to hold up a smartphone in front of our face as we are walking down the street. 

This isn’t meant to discredit iPhones and iPads as powerful AR tools. In fact, the iPhone’s future will be one as an AR navigator. However, wearable form factors will likely outpace iPhone and iPad over the long arc of time in terms of their ability to extract utility from AR.

Inevitability

AR glasses check off all of the boxes for a product in Apple's wheelhouse and are deserving of a rare green light to market. 

  1. Hardware and software integration. There is room for Apple to create value by controlling both the hardware and software comprising AR glasses. The sum will be greater than its parts.
  2. Wearables manufacturing. Apple is learning quite a bit about manufacturing techniques and materials from Apple Watch and AirPods. These lessons can be transferred over to glasses, an item that will need to include a plethora of technology yet remain light.
  3. AR technology. Apple's big bet on AR will represent the catalyst for turning glasses and sunglasses into something more. An engaged base of iOS developers experimenting with ARKit will give Apple Glasses a hospitable app environment. 
  4. Personal technology evolution. AR glasses represent the evolution of Apple's decades-long quest to make technology more personal - allowing people to get more out of technology without having it take over their lives.  
  5. Fashion and luxury themes. Apple Watch has taught Apple much about how to get people to wear personal technology. 
  6. Health/Medical. The ability to improve one's vision fits within Apple's expanding interest in health and medical.
  7. Retail demoes. Nearly 500 Apple Retail stores offer prime demo areas for customers to try on various glasses. 

In terms of selecting the next big industry and product category to enter, AR glasses are high on Apple's list. 

Glasses are Misunderstood

Glasses have gotten a bad rap. The item hasn't been able to shake the connotation of being a medical device used grudgingly by those in need of clearer vision. It is still commonplace for people to say something along the lines of "I wouldn't wear glasses if I didn't need to." Such a description undersells glasses, ignoring the device’s purpose and potential.

People wear glasses because they provide utility. For many, that utility comes in the form of improved vision. This is another way of saying corrective lenses (glasses and contact lenses) provide a clearer sense of reality to the wearer. Recent statistics show that nearly 75% of the population has vision that can be improved with corrective lenses. For certain age demographics, the percentage is even higher. 

It cannot be overstated how clearer vision is one of the most value-add items a product can provide to its user. There aren’t too many gadgets or devices that would be selected over a smartphone in terms of its importance in our lives. However, corrective lenses would certainly be at the top of the list for many people. Corrective lenses are even required for certain tasks, such as operating heavy machinery like cars. In these situations, clearer vision isn’t just a luxury, but it's a requirement to ensure one's safety. 

Glasses also provide a different kind of utility than clearer vision. A growing number of people are wearing glasses despite having perfect vision. Glasses are increasingly becoming accessories for the face, a fashion item complimenting a particular outfit, haircut, or even social occasion. Sunglasses have become a universal fashion accessory. A quick stop by the local shopping mall will reveal a number of stores focused on selling one accessory: sunglasses. Consumers have thousands of frames to choose from in order to find that one pair of glasses that best matches their personality. The glasses/sunglasses industry, led by Luxottica, has played a major role in pushing this new fashion narrative.

Evolution

Apple’s attitude toward face wearables has evolved. In 2013, Tim Cook was interviewed at the D11 conference, and the topic of wearable computing came up. Cook was very clear in his messaging: The wrist made more sense for computing than the face.

Here’s Cook:

"I wear glasses because I have to. I can't see without them. So I kind of have that problem. I don't know a lot of people that wear them that don't have to. People that do wear them generally want them to be light, they want them to be unobtrusive. They probably want them to reflect their fashion, their style, and so forth. And so from a mainstream point of view, [glasses] are difficult...I think the wrist is interesting."

It's noteworthy how Cook undersold glasses, positioning them as merely something he was forced to wear. In early 2015, Jony Ive, overseer of Apple's product strategy, referred to the wrist as "the obvious and right place" for a wearable device while saying the face "was the wrong place." Cook once again dismissed glasses: 

"We always thought that glasses were not a smart move, from a point of view that people would not really want to wear them. They were intrusive, instead of pushing technology to the background, as we’ve always believed."

It is easy to dismiss Cook's and Jony’s comments as simple posturing. In the case of Cook, Apple was well on its way to developing Apple Watch in 2013. It had become clear that the wrist would represent Apple’s entry into wearable computing. Regarding Jony's and Tim's later comments, Apple was just a few months away from the Apple Watch launch, arguably the largest product launch for the company since iPad. For them to talk up anything other than Apple Watch and wrist utility would have been surprising. 

However, this current Apple management team is not big into misdirection. Apple rarely shoots down product categories only to enter the same space shortly thereafter. Instead, there is a good probability that management was actually not completely sold on the idea of face wearables (i.e. glasses) when Cook and Jony provided their comments. Cook’s initial comments took place well before Apple began acquiring AR companies, which likely play a crucial role in justifying Apple selling glasses. In addition, prior to Apple Watch, Apple had little experience in selling an item as personal as glasses or sunglasses.

Hesitation

I have held much hesitation over the years regarding the idea of wearing computers on the face. Much of this skepticism originated out of questions regarding design (how the device would be used). Computers on the face can very easily become a barrier to getting the most out of technology. Taking a look at the current lineup of computers designed to be worn on the face, it is not difficult to see why such hesitation has been warranted.

None of the preceding devices represent the future of face wearables for the mass market. The best case scenarios for such devices are found with niche applications such as gaming and certain enterprise settings. For AR glasses to go mainstream, the product will have to shed the “computers for the face” image portrayed by Google Glass, HoloLens, and every VR headset. This will involve innovative software and technology as well as a breakthrough user interface. 

Something Changed

Apple's success with Apple Watch has done much to calm some of my fears and hesitation regarding face wearables. With 29 million Apple Watches sold to date, Apple has turned the dynamic of tech meeting fashion on its head. Apple has been able to get people to wear an item that was increasingly losing its place in a smartphone world.  

Before Apple unveiled Apple Watch, smartwatches were bulky computers on the wrist with mediocre user experiences and questionable value. The product did not play in the fashion and luxury realms. Instead, smartwatches were judged by the degree to which their functionality could replace a smartphone.

Apple was able to completely change the connotation found with smartwatches and make them a mass-market item. The Apple Watch is now just as much of a fashion item as it is a computer. That is a good, not bad, thing. Watch bands and the ability to easily swap bands allow Apple Watch to be worn all day, every day, for various occasions and activities. Much of this dynamic can be recreated for glasses. Apple has the potential to change the narrative surrounding glasses, including our perception of the device. 

M&A

In the clearest sign to date of Apple's growing interest in AR glasses, the company recently acquired SensoMotoric Instruments, an eye-tracking company. While the company's technology can improve various Apple products, my suspicion is the deal was all about Apple developing a pair of AR glasses that can be controlled by our eye movement. The idea of controlling technology using just our eyes is very intriguing.

Apple also acquired a number of AR-related entities in 2015 and 2016 including MetaioEmotient, Polar Rose, Faceshift, PrimeSense, Flyby Media, and Perceptio. All of these companies in one way or another can play a role in Apple Glasses. In fact, all of the work Apple is doing with iPhone and iPad cameras can ultimately play a role in glasses.

Apple Glasses

When it comes to envisioning what a pair of Apple Glasses would look like, there is value in not overthinking the topic. Marc Newson, the most recent addition to Apple’s Industrial Design group, has experience designing face wear. In 2014, Newson designed various glasses (seen below) for Safilo as part of a special collection marking the company's 80th anniversary. 

My suspicion is that Apple Glasses would look similar to Newson’s previous designs. Certain attributes such as being lightweight while having lenses with a large surface area will likely be carried over to Apple Glasses. There is precedent in Apple Industrial Design relying heavily on Newson's prior designs. A number of Apple Watch bands were clearly inspired by Newson.

Strategy

Apple Glasses would be a mass-market item with a target market measured in the hundreds of millions of users – similar to Apple Watch and AirPods. The go-to market strategy for a pair of Apple Glasses is relatively straightforward. Consumers would purchase hardware via Apple (online and in store) and through third-party retailers including retailers focused on selling corrective lenses, such as LensCrafters.

Apple Glasses would be a continuation of Apple's wearables strategy. The product would initially be positioned as an iPhone accessory, similar to other Apple wearables including Apple Watch and AirPods. Apple would also likely launch glassOS in an attempt to create an ecosystem of third-party AR apps destined specifically for glasses.

 
 

Instead of selling just one version, Apple would likely sell an entire line of Apple Glasses including various lenses (prescription, light-responsive, polarized, and clear). There would also be different sizes for men and women. The prescription lenses carry the important implication of Apple Glasses following Apple Watch in potentially qualifying as an item covered by insurance plans. In addition, prescription glasses can be bought using flexible spending or health spending account dollars.

In terms of pricing, Apple Glasses would likely continue Apple's current strategy of underpricing their wearables relative to the competition

Marketing

It is crucial to not miss the forest for the trees when it comes to Apple Glasses. The device's purpose will be to enhance, not replace, reality for the wearer. As of today, glasses enhance reality by making things appear clearer. In the future, this utility will be transformed. Glasses will not just make our surroundings appear clearer, but also use AR to provide additional context related to our surroundings. The implications related to such a feature are far and wide. 

This raises a few questions:

  • What would be the "killer app" for Apple Glasses?
  • Will Apple Glasses replace iPhones? 

The idea of a product having a "killer app" has been misconstrued over the years. The iPhone really doesn't have a killer app. Instead, the device itself has turned into the killer app - the most valuable computer in our lives. In addition, the iPhone's role in our lives has evolved over time - a true sign of value. Apple Glasses would provide an improved view of the world to its user. For some, this will come in the form of clearer vision plus additional context. Others will gain value just from receiving additional context. 

Apple Glasses won't "replace” an iPhone. However, it's not likely any product will replace the iPhone. Thinking about new products in the sense of their ability to replace existing products is faulty. iPhones and iPads didn't replace PCs and Macs. Instead, they became viable alternatives to PCs and Macs for hundreds of millions of people. Similarly, Apple Glasses will one day serve as a viable alternative to the iPhone, handling a new set of tasks never given to iPhone. 

Timing

Historically, Apple has launched a major new product category every few years. While consensus thinks the gap between when Apple enters new product categories is something like three years, it is more likely five to seven years. However, there isn't a large sample size to allow us to place much confidence in any particular pattern. Since the Apple Watch was unveiled in 2015, Apple still has some time before the inevitable pressure arises for the company to launch a new product category. It is certainly plausible that Apple Glasses have become Apple's most likely new major product category, even ahead of any Apple transportation initiative. It is no longer a question of if Apple will sell its own AR glasses, but when. 

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Wall Street Has Begun to Think About Apple In a New Way

For the past few years, Apple shares have been judged by one metric on Wall Street: iPhone unit sales. As iPhone growth has fluctuated, so has the stock price. Analysts have been infatuated with quarterly iPhone sales gyrations and the impact they may have on Apple earnings and the stock. However, things are changing. The iPhone’s influence over Apple’s stock is subsiding on Wall Street. 

Wild Ride

Over the past five years, Apple shares have been volatile. As seen in Exhibit 1, Apple's stock has experienced distinct stretches of severe underperformance and outperformance. For a company valued at more than $700B, a 70% move in a year is surprising, if not downright shocking. 

Exhibit 1: Apple Stock Price Performance

Screen Shot 2017-07-19 at 12.57.07 PM.png

Five years of Apple stock price performance can be broken into four distinct eras:

  1. Samsung competitive fears. The 2012 to 2013 period was symbolized by Samsung commercials mocking Apple users waiting in line to buy small screen iPhones. The market was beginning to demand larger smartphone screens, and Samsung was running fast to fill the need. There were growing fears of iPhone losing to smartphones running Android, resulting in lower iPhone ASP and margins. Apple shares dropped nearly 45% over this stretch.
  2. iPhone 6 and 6 Plus excitement. The iPhone launch at China Mobile, along with Apple's entry into large screen phones, drove a two-year stretch that saw Apple shares more than double in price. iPhone sales growth returned with a vengeance, with quarterly shipment growth up as high as 46% in late 2014.
  3. iPhone's first sales decline. Once the excitement surrounding the iPhone 6 and 6 Plus launch subsided, the new reality set in for the iPhone business. iPhone warning signs were appearing. The era of significant unit sales growth was coming to an end. The iPhone business registered its first quarterly sales decline in early 2016. During this period, Apple shares fell 30% from the previous high. 
  4. Something new. Apple shares are now up nearly 70% from the low experienced in mid-2016. 

Recent Outperformance

Over the past year, AAPL shares have outperformed the overall market. There are now questions regarding what has driven a 53% increase in Apple's stock price from the bottom experienced in May 2016. 

  • Is Apple's services narrative finally catching on Wall Street?
  • Are investors becoming increasingly optimistic about iPhone sales prospects?

Apple has become much more vocal in telling its services story. Management went so far as to provide a rare financial projection of doubling the Services business over the next four years. While Apple analysts have certainly been talking more about Apple services, it's not clear if new investors have actually bought into Apple's new messaging. At the same time, greater attention is being placed on the upcoming OLED iPhone, which may be the most significant iPhone update to date. Not only is Apple expected to announce a completely redesigned iPhone, but the device will likely include significant changes to the user experience. Some analysts have been adamant that the device will kick off a "mega upgrade cycle." 

It may be easy to assume Apple services or new iPhones may have been responsible for much of Apple's latest stock outperformance. However, I don't think those factors alone were able to drive a 50% increase in Apple's share price.

Services represents less than 15% of Apple's overall revenue. Truly recurring services revenue in the form of subscription revenue occupies an even smaller portion of that total. It is a stretch to argue that such a small piece of the business can drive what amounts to nearly $250 billion of market capitalization gains in a little over a year. There would need to be a widespread change across Wall Street when it comes to investor attitude towards Apple services, and there just isn't any evidence of that occurring.

In terms of a new iPhone driving a mega upgrade cycle, consensus EPS estimates have barely budged for FY2018. This tells us there isn't widespread optimism flooding into the market. In fact, the trend has actually been for Apple EPS estimate cuts as talk of iPhone supply issues and potential delays grow louder.

Exhibit 2 takes Apple's stock price data from Exhibit 1 and superimposes iPhone unit sales growth (set on a three-month forward basis to account for investors' forward-looking tendencies). As clearly seen in Exhibit 2, Apple shares have skyrocketed over the past year despite a lack of iPhone sales growth. This represents a significant change from previous years. Something just doesn't add up. 

Exhibit 2: iPhone Unit Sales Growth vs. Apple Stock Price Performance

Note: iPhone unit sales growth is on a three-month forward basis (3Q17 and 4Q17 growth metrics are estimates).

Note: iPhone unit sales growth is on a three-month forward basis (3Q17 and 4Q17 growth metrics are estimates).

One may look at Exhibit 2 and argue that Wall Street is taking a longer view of the iPhone business. Instead of just looking at the next quarter of iPhone sales, the focus is on 2018 and even 2019 sales. That could very well be true. However, it may not be that investors are necessarily expecting the iPhone business to return to some kind of sustainable growth. In what is the most telling sign that something unusual is occurring, rumors of iPhone supply issues and delays that would typically send Apple shares sliding now seemingly have no impact on the stock. Something major has changed regarding how Wall Street is thinking about Apple. 

Balance Sheet Optimization

My theory is that the iPhone no longer has the same kind of influence over Apple shares as it once did. Instead, Apple has turned into a balance sheet optimization story on Wall Street. Apple's growing net cash balance (now standing at an all-time high of $158 billion) has taken the place of iPhone unit sales growth as the most influential variable impacting Apple shares. 

The best way to lay out this theory is to compare Apple's stock price performance to the change in market capitalization. As seen in Exhibit 3, over the past five years, the two data points have increasingly been on a divergent path. Apple's stock price is up 74% while its market capitalization has increased just 35%. Apple's enterprise value (market cap + debt - cash) is up just 36%. Why is Apple's share price significantly outperforming the company's overall change in valuation on Wall Street? The share buyback program is impacting Apple's share price.  

Exhibit 3: Apple Stock Price vs. Market Cap Performance

Apple management is using share repurchases to funnel excess cash from the balance sheet to shareholders selling their Apple shares. This not only reduced the number of Apple shares outstanding, but also gave each remaining share a larger ownership claim to Apple's future cash flows and earnings. It's not that share buyback is creating shareholder value with excess cash simply moving from the balance sheet to those selling their shares. Instead, investors are now willing to pay more for Apple's future cash flows and earnings.

There are a few reasons likely driving this higher valuation of future Apple cash flows.

  1. Higher ownership stake. As Apple uses excess cash to reduce the number of shares outstanding, each remaining Apple share has a higher ownership stake in a more optimized balance sheet and cash flows. This has led to a significant increase in EPS. Over the past five years, Apple's operating income has increased just 15%. However, Apple's EPS has increased 45%. As long as Apple continues to use excess cash and low-cost debt to buy back shares, this trend will continue indefinitely.
  2. Apple cash discount. While it may seem counterintuitive, it's actually not wise for a company to hold a significant amount of excess cash on the balance sheet. Apple was likely being penalized for holding so much cash. Another way of saying this is that investors were not fully valuing the $150B of net cash sitting on the balance sheet. This would materialize via below-average price-to-earnings (P/E) multiples. Investors just weren't interested in paying up for the full amount of cash on the balance sheet (technically, the amount of cash left over once Apple brought its foreign cash back to the U.S. at a lower tax rate). There is plenty of financial theory behind investors pricing excess cash at a discount, including fear of management misusing the cash on bad M&A or other improper uses. 
  3. Expectations for additional capital management. Wall Street is forward-looking and with $240B of foreign cash and cash equivalents sitting on Apple's balance sheet, investors are increasingly contemplating various use cases for the cash if it is returned to the U.S. The most likely outcome would be a significant increase in the share buyback pace. At that point, a Dutch auction tender offer would even be a possibility. This would reduce the number of Apple shares outstanding by up to another 25% (which would boost EPS even higher). 
  4. Shareholder base. Share repurchases are systemically shrinking Apple's shareholder base. Apple has reduced the number of outstanding shares by 20% since kicking off its buyback program. Apple investors who have done nothing but hold on to their shares over the past five years would have seen their ownership stake in Apple grow by 20%. As a result, long-term shareholders who have bought into the Apple story are gradually becoming larger Apple owners over time. While some of these holders may not be comfortable with their Apple stakes continuing to grow and represent an outsized portion of their portfolios, in theory, Apple is relying on fewer investors to buy into its narrative. 

Declining Influence

One unintended consequence of Apple's cash hoard gaining influence over Apple shares is that the iPhone no longer has the same kind influence it once did. This isn't to say that Wall Street ignores iPhone trends. The vast majority of free cash flow used for share buyback is coming from iPhone sales. The key difference is that Wall Street has grown less concerned about the quarterly gyration in iPhone sales. In the grand scheme of things, there is little difference between Apple selling 200M iPhones per year and 300M iPhones per year. It also doesn't matter if a new iPhone is delayed by a few months. These are relatively minor details that just don't matter in terms of the big picture. I suspect this is why ongoing iPhone delay rumors are having little impact on the stock. In addition, Apple's ongoing iPhone sales pressure and troubles in China and India are no longer viewed as significant hiccups that could derail the stock. Both countries combined represent approximately 20% of overall iPhone sales. U.S. and European sales strength would likely be enough to maintain the iPhone's current sales level.

Warren Buffett Symbolism

Warren Buffett's recent purchases of Apple shares over the span of less than a year (the stake is now worth $20 billion) symbolize how Wall Street is thinking differently about Apple. While Buffett is on record talking about how the iPhone is such a compelling consumer product, his comments regarding share buyback are quite telling.

Here's Buffett back in May on his Apple investment:

"Well the shares when we bought 'em, at least, were much more reasonable in relation to current earnings. Apple didn't have to do a lot better in the future than they were doing at the current time." 

It's not that Buffett expects any significant change in Apple's business going forward. Instead, he viewed Apple's valuation as compelling given Apple's current performance. This begs the question, why now? Why didn't Buffett buy Apple years ago when the valuation was lower? Buffett claims he now understands the competitive landscape facing Apple. However, my suspicion is that Apple's balance sheet optimization story had simply become too hard for Buffett to ignore. Here's Buffett back in February responding to questions about Apple's market cap being too large to grow from here in any significant way:

"[Y]ou could have a lot fewer [Apple] shares outstanding at some time and still do very well on a per share basis. [Apple management] bought about 4 percent of the company last year. And they've been pretty, pretty aggressive on that. So my guess is they've got about 5.25 billion shares outstanding now, but my guess is that ten years from now they'll have substantially fewer."

Buffett is buying Apple because he has confidence that the iPhone business is a good cash generating machine that can fund aggressive share buyback. The Apple story on Wall Street now revolves just as much around the company's balance sheet and significant cash balances as it does around the iPhone business.

Future Implications

There are a number of implications related to Wall Street thinking differently about Apple. 

1) Apple earnings will take on a different meaning. While quarterly earnings will still matter from the perspective of providing a window into Apple's current business trends, the way Wall Street responds to earnings will change. There will be less focus on weak/strong guidance or a beat/miss to iPhone or iPad sales. Instead, the focus will be on whether the overall Apple story has changed. This new reality will actually make it more important than ever for market observers to possess a longer view of Apple. Fresh and unique perspective will be needed to assess just how Apple's long-term competitive positioning is holding up. 

2) Share buyback will continue to gain importance. The single biggest factor impacting Apple shares isn't the upcoming new iPhone or competition with Amazon or WeChat. Instead, it's the probability of Washington passing U.S. corporate tax reform, including a lower tax rate for bringing offshore cash back to the U.S. Apple is poised to spend a significant portion of its $240B of excess cash currently sitting in foreign subsidiaries on buyback, assuming it can be bought back at a lower tax rate.

3) A potential new long-term Apple story. Apple still lacks a compelling business narrative on Wall Street. For analysts and investors focused on modeling Apple's forward cash flows, a company that sells customer experiences comprised of hardware, software, and services isn't exactly the easiest company to forecast. Of course, there is also unknown found with companies like Amazon, Facebook, and Alphabet. However, those companies have easier (and simpler) narratives revolving around non-hardware revenue. There is no evidence to suggest that Apple is now viewed as a design company focused on something much larger than just selling hardware. Apple's R&D pipeline, an item that plays a critical part in the company's mission statement of coming up with future product that can improve people's lives, is still not valued on Wall Street.

This dynamic presents an interesting theory as to Apple's future as a public company. The notion of Apple being considered some kind of annuity with recurring hardware and software revenue may never catch on Wall Street. At the end of the day, Apple's future will always be focused on coming up with new products. This makes it incredibly difficult for investors to model Apple cash flows going forward. What if Apple were instead viewed as a balance sheet stock? The company would go through cycles based on a varying degree of share repurchases. These repurchases would be based on the company's ability to generate strong cash flows. For example, we are currently in the cycle in which iPhone is funding share repurchases. In the future, we may see Apple AR glasses or transportation initiatives fund share repurchases. Simply put, regardless of Apple's product line at any particular moment, investors will likely remain more focused on Apple's balance sheet and cash levels. As a result, Apple's future as a public company would be one of a cash generating machine supporting the largest share repurchase program in the world. 

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iPhone Turns Ten

Today marks the tenth anniversary of Apple launching the iPhone. It would be an understatement to say that the iPhone has changed Apple and the broader mobile industry. The iPhone fundamentally altered the way Apple views the world and measures ambition when contemplating new industries to enter. At the same time, Apple's steadfast approach to controlling both iPhone hardware and software ended up being a bet that is still giving mobile competitors headaches a decade later. 

The Numbers

There are three sets of numbers that stand out when thinking about ten years of iPhone. 

Unit Sales

On a cumulative basis, Apple has sold 1.2 billion iPhones to date. The magnitude of this number is difficult to grasp and put into context. Prior to launching the iPhone in 2007, Apple had sold approximately 180M devices since being founded in 1976 (70M Macs and 110M iPods). Assuming Apple is able to ship at least 200M iPhones per year for the next few years, Apple is on track to sell its two billionth iPhone at some point in 2020.  

Exhibit 1: iPhone Unit Sales (cumulative)

Revenue

With an average selling price (ASP) exceeding $600, more than one billion iPhone sales translates to $743 billion of cumulative revenue. Apple is on track to report one trillion dollars of revenue from iPhone sales by the end of 2018. Even more remarkable, the iPhone's evolving role in our life has led to iPhone ASP increasing as time goes on. The probability of Apple unveiling the first $1,000 iPhone SKU in the U.S. this coming September is quite high.

Exhibit 2: iPhone Revenue (cumulative)

Profit

Apple has a monopoly on smartphone profits. Assuming an average gross margin of approximately 45%, Apple has earned approximately $330 billion of profit from iPhone over the past ten years. On a net income basis, the iPhone has brought in 1.5x more profit than the combined profits of Amazon, Facebook, and Google during the same time period.

Exhibit 3: iPhone Gross Profit (cumulative)

iPhone Lessons

The more intriguing impact from ten years of iPhone cannot be measured or quantified by sales, revenue, or any chart for that matter. Instead, the iPhone contributed quite a bit to preparing Apple for future pivots into new industries. Along those lines, there are three specific items that stand out when it comes to lessons Apple learned from the iPhone over the past 10 years: 

  • Ambition
  • Control
  • Platform

Ambition. Prior to the iPhone, Apple was primarily a computer company selling Macs and Mac accessories. The company had only recently begun to see broader consumer appeal with iPod. Apple had no expertise in mobile telephony prior to developing the iPhone. On paper, Apple shouldn't have been able to come up with something like iPhone. The company just didn't have the required core competencies for selling a great phone.

Former Palm CEO Ed Calligan's now infamous words regarding Apple's entrance into the phone industry were based on the belief that Apple would never be able to learn as much as established phone players:

We've learned and struggled for a few years here figuring out how to make a decent phone. PC guys are not going to just figure this out. They're not going to just walk in.

There was one glaring hole found in Calligan's logic. Phones were going to become computers. Instead of Apple worrying about becoming a good phone maker, phone makers should have been worrying about becoming good computer makers. 

The innate desire to rethink a gadget that many people had trouble using drove Apple into smartphones. Of course, the fear of smartphones one day impacting iPod sales also pushed Apple management. This led to a more than two year process during which Apple learned quite a bit about phones, mobile carriers, and itself. The learning didn't stop after launching the iPhone in 2007. In subsequent years, Apple learned, at times the hard way, about the ins and outs of mobile telephony. Over time, Apple's long-standing strengths in building computer hardware and software gave the company its advantage over the Blackberries and Nokias of the world. 

Today, Apple's ambition continues to be underestimated. Apple is approaching new industries in a way that is similar to how it looked at the mobile phone arena in the mid-2000s. The Apple Watch was tasked with rethinking wrist watches. Apple had to learn quite a bit when it came to fashion and luxury in order to get people to want to wear Apple gadgets. Management now has its sights set on the transportation industry, a sector that hasn't seen much change in 100 years. In addition, Apple is moving into the health and medical arena at an incredible pace.

Just a few years ago, this kind of product pipeline would have been labeled an ambitious pipe dream for Apple. Something changed over the past 10 years. The iPhone showed Apple how a single product with a rethought user experience can change an entire industry to make it much more hospitable for the company. At this point, it is fair to say that Apple is willing to compete in any industry as long as there is room for someone to rethink the user experience. The same couldn't be said prior to iPhone. 

Control. The iPhone taught Apple quite a bit about the power found in controlling one's destiny. While the iPhone did not introduce the company to the idea of controlling both software and hardware, the iPhone played a major role in showing Apple benefits associated with owning the core technologies powering a device. Some of the early bets Apple placed in this regard, such as the P.A. Semi acquisition in 2008, are still paying dividends.

Here's Tim Cook talking to Businessweek following the WWDC keynote earlier this month:

Steve’s DNA will always be the base for Apple. It’s the case now. I want it to be the case in 50 years, whoever’s the CEO. I want it to be the case in 100 years, whoever’s CEO. Because that is what this company is about. His ethos should drive that—the attention to detail, the care, the ­simplicity, the focus on the user and the user experience, the focus on building the best, the focus that good isn’t good enough, that it has to be great, or in his words, “insanely great,” that we should own the proprietary technology that we work with because that’s the only way you can control your future and control your quality and user experience.

It says a lot that Cook looks at owning core technologies as an inherent aspect of Apple's culture. The iPhone contributed quite a bit to that reality. There is now an increasing amount of evidence pointing to Apple working on its own GPU solution in addition to LTE modem chips. We are moving to the point at which it will no longer be enough for Apple to just own the most important components powering a device. Rather Apple will need to come up with its own solutions that combine the most important components to power increasingly smaller, wearable gadgets. 

What were once hardware and software bets that gave Apple a five-to ten-year head start on the competition are now turning into technological bets that will give the company advantages measured in decades. 

Platform. While Wall Street remains infatuated with iPhone sales, Apple continues to see a strengthening iOS platform thanks to robust new iPhone user growth and an engaged developer community. The iOS platform has afforded Apple a new way to think about the world. There are signs of Apple management being well aware of the power and influence found with iOS.  

Here's Eddy Cue in August 2016

[Apple] can’t be everything. One of the reasons we’ve been highly successful is that we focus. We can’t be great at everything; nobody’s great at everything. I mean, come on. So, if you want to be great at something, you have to focus and do a few things. We’ve been lucky. We’ve had a few, and not just one. That’s the only way we know how to work. So we don’t want to be Amazon and be Facebook and be Instagram and so on. Why? Or Uber. Why? I think it’s awesome that Travis [Kalanick, Uber’s CEO] and his team have done Uber on our platform. It would not exist without our platform, let’s be clear. But great for them for thinking of that problem, and solving it. We would never have ever solved that problem. We weren’t looking that way. We would have never seen it.

It's easy to read Cue's response as Apple taking responsibility for Uber's success in rethinking personal transport. However, Cue is correctly pointing out that the iOS platform served as the breeding ground for innovative ideas and business models. With the iOS platform, Apple has played a major role in creating a number of new industries. In the coming years, management will determine which parts of the iOS platform are worth Apple playing in themselves. Management has already determined a need to play in music and video streaming in addition to messaging and mobile payments. It's not yet clear if ridesharing or another larger industry will one day make sense for Apple. Even more importantly, the iOS platform has given Apple a fighting chance to create the most attractive platforms for third-party developers around a new suite of products including Apple TV (tvOS) and Apple Watch (watchOS).

Defining Legacy

A great deal of iPhone's success can be traced back to the fact that Apple bet on a very big product category at just the right time. The smartphone redefined a computer for billions of people in just a few years. 

While some people are convinced that nothing will match the smartphone in terms of its influence on our lives, such prognostications end up selling future innovations short. Odds are very good that a new device, or series of devices, will one day serve as a viable smartphone alternative. It's likely that these new devices will achieve even greater market penetration than smartphones.

Regardless of where technology is headed, we are already starting to get an early glimpse of the iPhone's legacy. The iPhone spawned an industry that redefined a computer, transforming it from a niche tool into a mass-market phenomenon. For Apple, the iPhone went further than any other Apple product before it in terms of making technology more personal. The iPhone was Apple's first genuine mass-market product. All of this occurred in just ten years, which ends up being the most remarkable part of the story. 

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WWDC Clues Hint at Mac's Future

Apple used this year's WWDC keynote to let the world know it has every intention of supporting the Mac for the long haul. When reading between the lines, it becomes evident that the Mac's future is one of a niche product within Apple's portfolio. Meanwhile, Apple's messaging around the iPad during the same keynote couldn't be any different. As the Mac is going in the direction of niche, the iPad is being groomed to be the Mac/PC alternative for the masses.

Turning Point

The past few years have been an odd stretch for the Mac. Hardware updates have been unusually sporadic although the few updates that did ship were noteworthy. The MacBook Pro with Touch Bar, unveiled in October 2016, represented a prime example of Apple's strategy to use aspects of mobile to push the Mac forward. Apple silicon, Touch ID, and multi-touch displays bring a different kind of experience to the Mac. Throughout this awkward stretch for the Mac, the Apple Industrial Design team's influence on the Mac remained quite obvious, which only increased the level of uneasiness felt by many pro Mac users.

Management used this year's WWDC keynote to officially put an end to this odd Mac stretch. The keynote couldn't have been any different from the previous, somewhat awkward Mac event that took place this past October. This time around, Apple unveiled item after item, clearly targeting pro Mac users.

 
 

The new $4,999 iMac Pro was announced to much surprise and with certain configurations that were unimaginable for a Mac all-in-one just a few months earlier. Apple's decision to sell an external graphics development kit was also unthinkable just a few months ago.

It is likely that all of these Mac announcements had been in the pipeline for a while. Nevertheless, Apple seemed eager to spin a fresh Mac narrative around pro users. Much of this change in narrative and attitude was a carryover from management's recent Mac intervention with journalists at Apple HQ this past April. At that meeting, SVP Phil Schiller, SVP Craig Federighi, and VP John Ternus clearly telegraphed a revised Mac strategy focused on placing more attention on the tail end of the business. While one would think the new iMac Pro marks Apple's extent into niche Mac territory, the company still plans on releasing a completely redesigned Mac Pro. Given iMac Pro pricing, it is not out of question the for a new Mac Pro configuration to surpass $10,000. Let that sink in for a minute. 

The iPad Juxtaposition

If this year's WWDC keynote doubled as a Mac event (Apple dedicated 23% of stage time to the Mac), the event could have also moonlighted as an iPad event (Apple dedicated 21% of stage time to iPad). My full WWDC review is available for members hereHowever, when the two products were viewed back-to-back, there couldn't have been a more stark difference between them. While the pro in iMac Pro and Mac Pro stood for professional, the pro in iPad Pro stood for productivity.

During the Mac portion of the keynote, management's focus was on addressing the tail end of a 100M Mac user base. A $4,999 iMac Pro is not about adding productivity for the masses. Instead, it is targeting a particular kind of professional. Apple will likely sell fewer iMac Pros than cylinder Mac Pros sold to date. In terms of a redesigned Mac Pro, it is difficult to picture the machine even qualifying as niche. Instead, it will be a niche of a niche.  

Meanwhile, the iPad portion of the WWDC keynote was all about Apple bringing additional productivity to the masses. The new $649 10.5-inch iPad Pro continued Apple's multi-year bet on larger iPad screens (a very sound strategy). Apple also unveiled iOS 11 refinements for iPad that some had been hoping to see for years. One key aspect found in every major iPad software refinement was optionality. For those users craving additional capability, the new software features will prove to be quite valuable. However, for many iPad users, items like multitasking or the new Files app may never be used. In those cases, the same, familiar iOS experience will still be available. Apple was able to add productivity options to the iPad without changing what had gotten the product to where it is today - simplicity and ease of use. The not-so-subtle implication made on stage at WWDC was that the iPad is becoming more of a genuine laptop alternative for hundreds of millions of people.

Change in the Air

This year's WWDC keynote provided a glimpse of the Mac's future. A large portion of the Mac user base are going to find their computing needs met with iPad Pro. According to Apple, approximately 70% to 85% of the current Mac user base does not rely on professional Mac software. This amounts to approximately 80M people. These users are not app developers, nor do they have the need for the kind of power found in a MacBook Pro, iMac Pro, or Mac Pro. Instead, these users are likely attracted to the Mac for keyboard computing. 

As Apple pushes the iPad Pro forward with hardware and software advancements, including various keyboard improvements, these 80M Mac users are going to discover that the iPad is getting better at handling their computing needs. It's not that the Mac will lose value, but rather that a large multi-touch display running iOS will gain value. The shift won't occur overnight for the simple fact that consumers hold on to Macs for years. In addition, it is important to point out that Apple management won't have any issue with this development as long as these Mac users remain within the Apple ecosystem.

Over time, the exodus of non-pro Mac users to iPad Pro will transform the Mac into a niche product category. There will still be millions of users, but the machines will increasingly be geared toward narrow use cases such as VR and AR content creation. In addition, the Mac will become the preferred tool for those in various academic, science, and engineering fields.

 
Screen Shot 2017-06-22 at 12.57.41 PM.png
 

One may ask, what will happen to consumer-grade Macs, including the MacBook Air and 12-inch MacBook? They will be cannibalized by the iPad Pro line, much as the iPad mini has been cannibalized by larger iPhones. In fact, the entire Mac portable form factor is at risk of cannibalization at the hands of iOS screens. While this won't stop Apple management from pushing the MacBook form factor forward, consumer purchasing habits will speak volumes. 

The Achilles' Heel

Two months ago, I published "The Mac Is Turning into Apple's Achilles' Heel." My thesis was that Apple's inability to move beyond the Mac represents a vulnerability in an otherwise strong product strategy geared toward the mass market. Reaction to the piece came in swift and spanned the spectrum.

The issue facing the Mac has never been Apple's ability to give the product category attention. We saw evidence of this first-hand at this year's WWDC. Apple is able to update the Mac, along with every other product category. In fact, it is not a stretch to say the Mac's outlook within Apple has never been brighter and stronger than it stands today. If one were to place a bet on which current Apple product category will remain within Apple's product line the longest, the Mac would certainly be high on the list. This ends up supporting my thesis that the Mac is Apple's Achilles' heel.

It is very difficult envisioning Apple being able to move beyond the Mac. The product is on track to become a permanent niche within a continuously changing product line.

Apple is moving to a point where the product line will look something like: 

This may not seem like a problem for Apple. The Mac has been responsible for a lot of beneficial things at the company, including inspiring the current generation of content creators. However, the problem for Apple is that having a long tail end of the business comprised of niche Macs may pose a new kind of challenge. Apple Industrial Designers will need to look after the user experience found within a portfolio of mass market product. At the same time, they will need to handle the dramatically different user needs found with a niche product category, the Mac. It's not clear how they will do this. Will Apple designers cede control over the user experience to their engineering peers when it comes to niche Mac hardware? 

Unchartered Territory

While some people look at Apple's big risk as management's inability or unwillingness to move beyond the iPhone, that fear is misplaced. Apple is already moving beyond the iPhone as seen with more personal gadgets worn on our body.

Instead, the genuine risk facing management is that Apple will be unable to move beyond the Mac. This is unchartered territory for Apple. The theory that Apple has to move beyond legacy products in order to completely focus on the future is going to be put to test. It is also possible that the Mac will end up being the first product category that represents genuine growing pains for Apple. In the past, the company would have been able to bring its entire nimble user base from one product category to the next. A niche Mac line will put an end to that era.

Despite gaining niche status, the Mac will still play a major role in creating content consumed on future Apple products including wearables and transportation products. This will give the Mac a level of influence that should not be underestimated. While it is difficult for some to believe, now has never been a better time to be a pro Mac user. This year's WWDC made it clear that the Mac has a future at Apple. However, the amount of change headed towards the Mac should not be underestimated. 

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