Apple Found a Wall Street Narrative

After months of iPhone sales estimates being slashed by analysts, expectations have been reset. The iPhone mega upgrade cycle of 2018 that so many were calling for is not going to happen. One assumes such a reset would have been accompanied by a significant decline in Apple's stock price. Instead, Apple shares have outperformed the market and continue to trade near all-time highs. The resiliency in Apple's stock price reflects the company finally finding a narrative on Wall Street, and it's not centered on the iPhone. Apple has become a capital allocation story. 


Narratives matter on Wall Street. A compelling and easy to understand narrative allows companies to navigate rough waters such as a disappointing earnings report. Amazon and Netflix currently possess some of the strongest narratives on Wall Street. Amazon is all about coming up with the best retail experience for customers. Wall Street is OK with Amazon funneling a good portion of its operating cash flow back into the business with the intention of becoming a better retailer. Netflix is focused on delivering a superb entertainment experience in which subscriber dollars are used to fund additional video content. Profits are not as important as subscriber growth

Apple has long struggled with Wall Street narratives. A good argument can be made that Apple has never had a true Wall Street narrative. Instead, the company was judged merely by unit sales growth of whatever its best-selling product was at the time. This posed a challenge as unit sales growth will inevitably slow. In addition, a narrative revolving around unit sales growth ignores attributes that make Apple's business model unique. Apple is viewed merely as a hardware company. 

In early 2016, Apple management began disclosing new data points in an attempt to find a Wall Street narrative and in the process, get investors to think about the company differently.

  • Installed base related purchases. Instead of relying on the Services line item to denote the amount of revenue driven by Apple's installed base, management disclosed the amount of installed base related purchases. The much-higher total included revenue retained by third-party app developers and digital content owners.  
  • Number of paid subscriptions. In an effort to demonstrate Apple's ability to monetize the iOS base beyond hardware sales, management began disclosing the number of paid subscriptions across Apple's various services. The data point also reinforced the idea of Apple possessing a stream of consistent revenue. 
  • Number of devices in use. Apple disclosed the total number of devices in use to highlight the strength of its ecosystem.

While a narrative revolving around services or ecosystem strength seems attractive for Apple, the stories contain major holes. A significant portion of Apple's Services revenue is tied to growth in the iPhone installed base. According to my estimates, Apple has grown the iPhone installed base by more than 100 million users per year since 2013. Once this new user growth slows, which has already begun to occur, Apple's Services revenue growth will likely face a headwind. 

A narrative involving the Apple ecosystem and the number of devices in use addresses some of the downsides found with a services narrative. Even in an environment of slowing product sales, the number of active devices in use could still increase. However, an ecosystem narrative lends itself to Apple being judged by growth rates in terms of the number of devices in the wild. Both narratives lack sustainability. In addition, neither is able to capture the attributes that make Apple unique. 

Stock Price Outperformance

Evidence is building that Wall Street has begun looking at Apple differently. As shown in Exhibit 1, Apple's stock price began to outperform the market in 2017. Apple shares were up 48% in 2017, more than double that of the S&P 500. Apple has continued to outperform the broader market in 2018 despite a sharp increase in market volatility.

Exhibit 1: AAPL vs. S&P 500

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Many look at Apple's recent stock price outperformance as a sign that Apple management's efforts to weave a new narrative are working. Wall Street must be paying more attention to Apple Services or the broader Apple ecosystem. In addition, lofty iPhone sales expectations leading up to the iPhone X launch were repeatedly cited in the press as driving Apple's stock price increase in 2017. None of these explanations for Apple's stock outperformance sit well with me. Instead, there's likely something else at play. 

A New Narrative

In July 2017, two months before the iPhone 8, 8 Plus, and X were announced, I published "Wall Street Has Begun to Think About Apple In a New Way" with the following thesis: 

"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."

With no new evidence disproving my theory, it is time to expand on my thinking. Apple has found a narrative revolving around capital allocation. Instead of iPhone sales or Apple Services revenue gaining importance, Apple's balance sheet strategy is driving the company's new Wall Street narrative. 

There are three core tenets to Apple's capital allocation narrative:

  1. Superb cash flow generation. Apple's business model predisposes the company to superior cash flow generation. Apple is able to monetize premium experiences more effectively and efficiently than anyone else. Instead of chasing scale, Apple sells tools that management think people will want and are willing to pay for. Scale ends up being merely a byproduct of a successful strategy. Apple is generating more than $60 billion of operating cash flow per year. 
  2. Capital efficiency. Apple's business model is remarkably efficient in terms of the amount of capital required to generate these cash flows. Instead of owning a complex web of factories, Apple has built a network of third-party suppliers and assemblers that are second to none. In addition, the company remains focused when it comes to funding capital expenditures for organic growth. As a result of these actions, Apple reports more free cash flow than Alphabet, Facebook, and Amazon combined
  3. Returning excess capital to shareholders. Given such strong free cash flow generation, Apple is kicking off more cash than management needs to fund growth opportunities. Instead of sitting on the excess cash or spending the cash on unattractive projects, management has shown the willingness to return excess cash to shareholders via share repurchases and quarterly cash dividends. 

Apple is a capital utilization machine spitting out more than $50 billion of free cash flow every year, nearly all of which will be used to fund the company's capital return program. This capital allocation narrative is not driven by any one product. Weaker iPhone sales won't derail the narrative. In addition, new revenue streams such as Apple Watch, AirPods, or growth in Apple Services don't represent holes in the narrative. Apple's new narrative is all about management's unique philosophy regarding how shareholder capital is used to generate future cash flows. Stronger product sales will lead to additional cash flows and consequently more cash for buyback and cash dividends. The opposite will be true as well with weaker product sales leading to a reduction in cash flow and less cash for share repurchases and cash dividends.

At its core, Apple's capital allocation narrative describes the company as a design-led organization tasked with developing tools for people. Apple doesn't develop products to drive revenue. Instead, many ideas are passed over to focus on a few really great ideas. Maintaining a focused product line and working closely with contract manufacturers on new processes to build products are key attributes of Apple's design culture. A narrative involving Apple's capital strategy rather than any story based on one particular product like iPhone or iPad ends up doing a better job of describing the company's design story.


There are a number of implications found with Apple possessing a capital allocation narrative on Wall Street. 

  1. Quarterly iPhone sales won't matter as much. While there will continue to be value in monitoring iPhone sales trends, Wall Street will increasingly not care about the quarterly gyrations in iPhone unit sales growth. This is my theory for why negative iPhone reports have simply been tossed aside by the market. 
  2. The level of free cash flow will gain influence. The emphasis won't be on any one particular product but rather on the collective result of new products such as Apple Watch, AirPods, HomePod, and new services contributing to Apple's overall cash flow picture. It is certainly possible that wearables and Services revenue growth will offset any weakness in the iPhone business. 
  3. Apple's capital return program will continue to matter. New disclosures related to Apple's share buyback and cash dividends have the potential to move the share price higher or lower depending on how new revelations compare to expectations. 
  4. New initiatives may be judged more strictly. Traditionally, Wall Street hasn't cared much about new Apple products and initiatives since they were financial rounding errors next to iPhone. However, with a capital allocation narrative, increased attention may be given to new strategies that have the potential to change Apple's thought process regarding capital and the balance sheet. 

Apple's capital allocation narrative has also led to changes in the way the market is valuing Apple shares. As shown in Exhibit 2, Apple's stock price is up more than the percentage increase in market cap. This is likely due to two factors: The market is valuing Apple's future cash flows at a higher multiple, and Apple's cash on the balance sheet is being priced differently since the share buyback program was launched. Both developments are likely a result of Apple's capital allocation strategy taking hold. 

Exhibit 2: AAPL vs. Apple Market Cap vs. Apple Enterprise Value

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Nearly all of the increase in Apple's enterprise value over the past five years has come from the market attaching a higher valuation to Apple's future cash flows (i.e. a higher market capitalization). Apple shares are currently trading at a 13.5x forward price to earnings multiple. Two years ago, this multiple was closer to 10.5x. Apple has experienced a nearly 30% increase in valuation multiple.

As shown in Exhibit 3, Apple's market capitalization and enterprise value are up by approximately $330 billion since the beginning of 2016. These are significant moves that are indicative of a major shakeup in Apple's shareholder base and the market's view of the company. Investors are focused on Apple's ability to generate significant free cash flows and then return excess cash to shareholders via share repurchases and cash dividends.

Exhibit 3: Apple Market Cap vs. Apple Enterprise Value

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Offsetting Pessimism

Despite the sharp increase in share price and valuation, Apple shares are still trading at a 20% discount to the S&P 500 when comparing forward price-to-earnings multiples. Some of this valuation discount may be due to Apple's capital allocation narrative not being as simple as other stories on Wall Street. However, the more likely reason is that the narrative is polarizing. Not every investor or market participant is behind Apple's story. Some investors may not have confidence in Apple's ability to continue generating robust levels of free cash flow. Various theories involving greater competition or Apple's inability to innovate can lead to more pessimistic cash flow projections. This is where the impact from Apple's share repurchase program enters the discussion. 

Apple has likely seen massive turnover in its investor base since launching its share buyback program. Over the past four years, Apple has used share repurchases to reduce the number of shares outstanding by 23%. Stories are everything on Wall Street, and Apple is using its share repurchase program to buy back shares from existing shareholders not buying into Apple's capital allocation story. Apple has been the largest buyer of Apple stock in recent years thanks to the share buyback. There is no question that this dynamic has likely played some role in Apple's stock price outperformance. 

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An Apple R&D Bonanza

After a brief lull, Apple's R&D expenditures are once again exploding higher. Apple's 2Q18 financial guidance implies the company will soon report the largest year-over-year increase in quarterly R&D expense in its history. Management is on track to spend $14 billion on R&D in FY2018, nearly double the amount spent on R&D just four years ago. The dramatic rise in Apple R&D expenditures raises questions regarding the company's product pipeline and whether management's overall approach to R&D is changing.

The Numbers

Apple's pace of R&D expenditures is nothing like the company has ever seen. The $14 billion of R&D expense that Apple will spend in FY2018 will be more than the amount Apple spent on R&D from 1998 to 2011. The CAGR for Apple's R&D expenditures has been a remarkable 32% since 1998. As seen in Exhibit 1, the ramp in Apple R&D expense spanning more than two decades has been breathtaking. 

Exhibit 1: Apple R&D Expense (Annual)

Another way to demonstrate the dramatic rise in Apple R&D is to look at the year-over-year increase in expenditures on a quarterly basis. As seen in Exhibit 2, beginning in FY2Q17, Apple R&D expense growth has been on an uptrend. The expected $725 million increase year-over-year in Apple R&D expenditures in FY2Q18 will be nearly 25% higher than the previous R&D expense growth record. This $725 million figure is obtained by using Apple's guidance for operating expenses and backing into estimates for SG&A and R&D expenses. The recent ramp in R&D expenditures suggests Apple is definitely up to something.  

Exhibit 2:  Year-Over-Year Increase in Apple R&D Expense (Quarterly)

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R&D Growth Drivers

It's easy to assume that the increase in Apple R&D expenditures over the years simply reflects Apple's expanding product line. However, there is more behind Apple's R&D expenditures. Three items are responsible for the growth in Apple R&D expenditures:

  1. Existing products. Apple is doing more these days given a broader product portfolio.  
  2. In-house tech development. Apple has positioned controlling the core technologies powering its devices as a main goal. 
  3. New products. Apple is developing products for which it has no guarantee of future commercial viability. 

Once a project's commercial viability has been established, it becomes that much more difficult for Apple to classify subsequent manufacturing or evolutionary product updates as R&D. This means that cash spent on developing new versions of existing products may not necessarily qualify as R&D. Instead, such expenses may have to be marked as a capital expenditure and amortized or depreciated over the life of the asset. 

Another item that isn't contributing to Apple R&D expense is Apple Park construction. Real estate construction costs related to general corporate usage, or even design labs where some R&D may take place, cannot be categorized as R&D expense. Instead, for real estate to be classified as R&D, there has to be uncertainty regarding future commercial viability. As an example, the numerous buildings Apple bought, or began leasing, in the mid-2010s specifically for Project Titan likely boosted R&D at the time. (A map of Project Titan buildings is available to Above Avalon subscribers.)

New Products

Whereas Project Titan was a leading R&D driver a few years ago, there are likely two new items now driving the recent surge in R&D expenditures: 

  1. Smart glasses. We know Apple is working on smart glasses given the company's M&A track record (Vrvana, SensoMotoric Instruments, patents, and subtle clues found in Apple management commentary. The team dedicated to the effort is likely massive.
  2. Content distribution efforts. Apple appears to have settled on a broader strategy for content, and it involves doubling down as a content distributor. Apple is investing big when it comes to delivering music, video, apps, news, and written content to more than 850 million users (of which 500 million visit the App Store on a weekly basis). Apple's effort to launch a video streaming service from scratch is likely being classified as R&D. For example, Apple has no guarantee that money spent on script development will lead to a commercially viable video streaming product. We also know Apple is reportedly spending $1 billion on original video content. 

Apple is also continuing to work on doubling down on hardware to control the brains powering its products. As long as the byproduct of such efforts leads to products that are significantly different from existing products, Apple is likely able to qualify such efforts as R&D. Ongoing costs associated with Project Titan are also likely substantial, especially relative to smaller product-specific projects found throughout Apple. 


Although Apple remains an incredibly focused company when it comes to products, the amount of money spent on R&D would seem to suggest that management may be relaxing its focus mantra a bit when it comes to researching new ideas. As seen in Exhibit 3, Apple R&D expenditures as a percent of revenue now stand at a 14-year high. This tells us that Apple is spending more on R&D for every dollar of sales earned despite the dramatic rise in sales over the years. For some companies this may not mean much, but for Apple it can't be ignored. 

Exhibit 3: Apple R&D Expense as a Percent of Revenue

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There are a few possible explanations for the growth in Apple R&D expenditures in recent years:

  1. Greater ambition. Apple finds itself in a position of being able to do a whole lot more. It is estimated that Apple spent $150 million to build the first iPhone in the mid-2000s. At the time, it was a significant amount of cash for Apple. Nearly ten years later, Apple finds itself spending that much money developing one show for its upcoming video streaming service. To a certain degree, Apple management may feel it has an obligation of having to do more given its size. As Tim Cook recently put it, "We can do more things than we used to do because we’re a bit bigger." 
  2. Competition. One factor driving Apple's ambition to do more is competition. It is no longer enough just to control hardware and software. Apple now finds itself needing to control the technologies powering its devices. Bringing development of fundamental technologies in-house doesn't come cheap. Apple has opened a series of R&D centers around the world (China, Japan, India, Indonesia, New Zealand, Canada, France, Italy, Israel, Sweden, and the U.K.), many of which are tasked with developing hardware. Some of these R&D outposts are a result of Apple acquiring teams of talent. 
  3. More experimentation. Apple is likely experimenting much more when it comes to new ideas and processes. While there is no evidence of Apple allowing more of these ideas to actually proceed to market, it sure looks like Apple management wants to be in a position where it can afford to say "no" to more ideas than in the past. 

The third point involving additional experimentation ends up being the most interesting. For a company that positions its ability to focus on a few things at any one time as a core competency, increased experimentation seems to be at odds with this value.

Apple R&D Theory

My theory on the dramatic rise in Apple R&D expenditures is that management is becoming more ambitious. Apple's future is found in new industries. Just as Apple moved from desktops/laptops to personal music players, smartphones, and watches, the company will need to enter new industries to remain relevant. This is not a company that is holding onto the iPhone as tight as possible for fear of change. Apple management is investigating new ideas and processes in order to support future moves into new industries.

This explains Apple's ongoing interest in transportation and Project Titan, an area that Apple has pretty much no expertise in. We have Apple building an entertainment arm from scratch despite having no experience developing scripted content. In each case, Apple has had to rely on outside hires and significant cash outlays to build core competencies. 

It's not that Apple has thrown its focus mantra out the window. Apple remains very selective in terms of both its M&A activity and deciding which products make it to market. Instead of funding significant R&D endeavors with no intention of them one day leading to a product, Apple's R&D remains focused on ideas that at least have the potential to see the light of day. The years of development behind making Face ID a reality would be a recent example. 

Much of this focus mantra is driven by the fact that Jony Ive and his Industrial Design group oversee Apple's product vision and the user experience found with Apple products. With only 20 or so members, Jony and team can only do so much at any given moment. In a way, Apple's organizational and leadership structure serve as safeguards preventing Apple from spreading itself too thin and doing too much. Instead of trying to expand the design team in order to work on more products, Apple's strategy appears to be to do the opposite and place bigger bets on a few products.

These bigger bets come in the form of owning the core technologies powering Apple devices. Apple wants to reduce dependency on others. We are quickly moving to the point at which every Apple product will be powered by core technologies developed in-house. Such a reality would have been a pipe dream just a few years ago. Apple believes this strategy will give them an advantage in the marketplace. It's a new twist to the Alan Kay line about "people who are really serious about software should make their own hardware." We are moving to the point at which companies serious about software should design their own silicon. Having $285 billion of cash on the balance sheet gives Apple the freedom to pursue this ambitious goal. It is this motivation to control more of the user experience while pursuing new industries to enter that is driving the remarkable increase in Apple R&D expenditures. 

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Apple's Strategy for Controlling Sound

September 2016 marked the start of Apple's latest battle in what has been a multi-decade war. This newest battle was going to look and sound different. Apple had unveiled new iPhones lacking dedicated headphone jacks. The controversial move was criticized by many as a sign of Apple going too far in flexing its power and killing off legacy technologies for the sake of change. However, Apple's move wasn't about headphone jacks or even iPhones. Apple had made a big bet regarding the future of "sound on the go," and headphone wires were the enemy. We now see Apple unveiling its revised strategy for controlling sound in the home. The best way to analyze products like AirPods and HomePod is to look at them as the latest weapons in Apple's battle for controlling sound in our lives. 

The Strategy

Apple's motivation in controlling sound is based on delivering impactful and memorable user experiences. Accordingly, music has played a fundamental role in Apple's sound strategy for the past two decades. Listening to a particular song can mentally remove someone from his or her surroundings. Music is one of the few things capable of fostering such strong emotional connections and experiences. It's a safe bet to assume music will be around for a very long time while music consumption will remain a key task handled by our computing devices. 

There are two parts to Apple's strategy for controlling sound:

  1. Sound on the Go
  2. Sound in the Home

Sound on the Go

Apple is no stranger to selling devices designed to deliver sound. However, the iPod marked the beginning of Apple's quest to control sound on the go. Positioned as a "breakthrough digital device," the iPod changed the way we consumed music on the go, offering a much better experience than existing mobile listening options at the time. In what is now difficult to comprehend, the iPod effectively put an end to not being able to have your entire music library in your pocket. 

The first iPod commercial highlighted the device's mobility as the user danced around his house while listening to music via iPod and white earbuds. The kicker was found at the end as he stepped outside the four confined walls of his home and into the outside world without missing a beat. The iPod was about consuming sound not just around the home, but more importantly, outside the home. 

Over the subsequent years, Apple went on to unveil a number of different iPods, some of which turned out to be more popular than others. However, Apple was just getting started when it came to controlling sound on the go. Sensing that the iPod's long-term threat was found with people listening to music on smartphones, Apple began work on a much more ambitious product: iPhone.

As seen in Exhibit 1, the iPhone changed the course of Apple's sound on the go strategy. While the iPod was thought to be Apple's first mass-market product, the iPhone went on to redefine what it meant to be truly mass market. When Apple unveiled iPhone, the company was selling 50M iPods per year. Apple is currently selling 215M iPhones per year. Even though iPhone was much more than a dedicated music player, Apple never let go of its deep interest in music. 

Exhibit 1: Apple "Sound on the Go" Devices Unit Sales (iPod and iPhone) 

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AirPods mark the latest step in Apple's sound on the go strategy. The device is born out of the belief that there isn't a place for wires in a wearables world. AirPods were initially criticized for their unusual looks, but those concerns have quickly disappeared. Whereas wireless AirPods may have looked odd to some, having wires hanging out of people's ears will eventually look out of place. 

Based on sales, AirPods have been a resounding success. According to my estimate, Apple sold approximately 11M pairs of AirPods in 2017. This positions the device as the third best-selling Apple product out of the gate, behind iPad and Apple Watch. 

Exhibit 2: AirPods Unit Sales

AirPods sales momentum is poised to continue over the next few years. As Apple Watch achieves greater independency from iPhone, AirPods will play a crucial role in delivering sound to tens of millions of Apple Watch users. Apple will reportedly unveil updated AirPods later this year. The runway for AirPods is long with a list of potential features that could include everything from health tracking to noise cancelling and augmented hearing. The big question found with future AirPods is, which features will get the green light? Apple is also rumored to unveil new noise-cancelling, over-ear headphones in a move suggestive of Apple expanding its line of wireless headphones.

Sound in the Home

It's easy to look at HomePod as Apple's foray into controlling sound in the home. In reality, the company's sound in the home strategy started with a whimper in 2006 with the iPod Hi-Fi speaker. The speaker was tasked with reinventing the home stereo for the iPod age by being positioned as a companion product to iPod. Apple ended up pulling the plug on the device after just 19 months of sales. 

Twelve years later, Apple is giving sound in the home another try with HomePod. There are key differences in strategy this time around. Whereas iPod Hi-Fi was meant to enhance the iPod and iTunes ecosystem, HomePod and its A8 chip are being given a more ambitious goal of reinventing sound in the home by bringing computational audio to the masses. HomePod scans the room it's located in and then tailors sound output to that room. However, Apple isn't using computational audio to underpin its initial HomePod marketing campaign. Instead, Apple is relying on emotion, a page taken directly from the iPod, iPhone, and even AirPods playbooks. The latest HomePod "ad," a 4-minute film directed by Spike Jonze, is striking in theatrics. However, the thing that instantly jumped out to me about the video is how similar it is to the original iPod ad.

In both, we see people enjoying music using Apple devices.  While one is listening to an iPod to get him pumped up to leave the house and experience the outside world, the other is listening to HomePod after coming home following a tough day. In both examples, the people lose themselves in the music experience produced by an Apple device. 

Apple Music and Beats

Instead of being a revenue or profit driver, Apple Music serves as the glue in Apple's quest to control sound. While Apple's Beats acquisition was driven by music streaming and buying into Jimmy Iovine's overall music vision, Apple probably didn't mind getting a popular headphones brand in Beats. It's not as if Apple was unfamiliar with the power found with headphones (not to mention the branding opportunity). 

The fact that Apple kept the Beats brand for headphones speaks to how Beats headphones are likely serving a different target market. In fact, Apple has positioned Beats headphones as a compliment to AirPods. This has likely gone a long way in removing the oxygen from the wireless headphone category market and preventing competitors from establishing any kind of beachhead.

Elephant in the Room

Apple's strategy for controlling sound in the home seems to have met its match in the form of Amazon Echo Dot and Google Home Mini. Whereas iPod, iPhone, AirPods, and Beats are personal devices delivering sound to individual users, cheap stationary smart speakers powered by digital voice assistants are shaping up to be more about communal experiences. In addition, the value found with an Echo or Google Home isn't derived from sound quality but rather from the intelligence of the digital voice assistant that lives in the cloud. This has led the tech community to think Apple misfired by positioning HomePod as a high-quality music speaker. 

I see things differently.

The rise of digital voice assistants like Alexa and Google Assistant have seemingly redefined a stationary speaker's purpose so it's now about delivering intelligence rather than sound. The implication here is that the stationary speaker part of the equation is temporary in nature. If the same intelligence can be delivered to the user via another way, say via smart glasses, a smartwatch, or a pair of wireless headphones, low-end stationary speakers lose value. This idea serves as the basis for why I think the current stationary speaker narrative is off the mark. Apple looks at a stationary speaker as a tool capable of delivering intelligent sound. This use case likely won't change any time soon.

With HomePod, Apple isn't selling a high-quality music speaker. Instead, Apple is selling a new kind of music experience - one that isn't able to be produced with mobile devices, low-end speakers used for digital voice assistants, or even high-end speaker systems that may exceed $1,000. This music experience consists of a music streaming service, a digital voice assistant, and a combination of hardware and software that allows HomePod to map its surroundings and adjust sound output accordingly. 

iPod did not become popular because it offered vastly superior sound quality on the go. Instead, it became a hit because it offered a better all-around music listening experience versus the competition. In addition, fashion began to matter with iPod and the accompanying white earbuds. We see a similar dynamic take place with AirPods. Millions of people aren't buying AirPods because of their superior sound quality. Instead, AirPods just work and offer a great user experience. Similar to iPod, AirPods are also seeing building momentum in fashion. AirPods are becoming the new cool, fashionable item that people want to be seen wearing on the street. 


Apple is running away with its controlling sound on the go strategy. The company has no legitimate competition in the wireless headphone market. While this may change, it's not clear where that competition will come from. Meanwhile, Apple's positioning with controlling sound in the home appears to be much more precarious. Many think such a dramatic juxtaposition is due to Alexa and Google Assistant having already established a beachhead in the home. I'm not so sure about that. My suspicion is that HomePod is facing three different issues that make a challenging environment: 

  1. Communal experiences. Voice-controlled smart speakers positioned in a common area aren't personal gadgets like iPhones and AirPods. It's not realistic to assume a family of four will have four different smart speakers catering to each member of the family. Apple's approach to this situation with HomePod appears to be to initially assume the device is for one user and then give that user the option to turn the device into more of a family music speaker that anyone can use to consume music. However, there are questions as to whether that can truly provide a superior music listening experience. 
  2. Not just about music. While music has underpinned Apple's sound on the go strategy, iPhone and AirPods are used for more than music consumption. It's a stretch to say the same thing applies to the first iteration of HomePod with which music consumption is the primary use case. This may change down the road as Apple brings additional features to HomePod, but it's not clear if anything would replace music consumption as the speaker's primary use case. 
  3. Competing against nonconsumption. With HomePod, Apple's most intense competitor ends up being nonconsumption, or the lack of high-quality speakers in the home. Up to now, most people haven't seen the need for or appeal of high-quality sound in the home. The high-end speaker market is niche. Apple is trying to change that and thinks a broader focus on the music listening experience is the answer.

While there are differences between Apple's sound on the go and sound in the home strategies for controlling sound, both share a common trait. Ultimately, each is about delivering experiences. In terms of sound on the go, Apple will likely look to deeply integrate Apple Music into its growing wearables lineup. In addition to delivering music, these wearables products will also serve as a conduit for delivering a digital voice assistant to the user. For sound in the home, Apple believes a use case for a stationary speaker that will likely still be around 5, 10, and even 15 years from now is music consumption. There is a long runway found with HomePod and the ability to reimagine sound to deliver a better music experience. 

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The iPhone's Turning Point

Later this year, Apple will unveil a 6.5-inch screen that runs iOS. Five years ago, such a product would have been introduced as the newest member of the iPad family. However, Apple finds itself on the verge of releasing its largest iPhone to date. In fact, the device will likely be one of the largest smartphones in the market. Upon closer examination, such a dramatic change in product strategy was ultimately driven by Apple's realization that iPad mini was the wrong bet. It marked a turning point for iPhone. 

An iPad World

The iPad was a rocket ship like nothing Apple had ever seen. It's difficult envisioning a future Apple product that will outsell iPad out of the gate. Three million iPads were sold in the first 80 days. During the first year on the market, 22 million iPads were sold. 

As seen in Exhibit 1, iPad sales outpaced iPhone sales by nearly 3x after three years of sales. The iPad made the iPhone look mediocre. Some people even thought the iPad would become a bigger deal than iPhone. One has to wonder if at least a few Apple executives viewed iPad, not iPhone, as the product most capable of changing the world. We were truly living in an iPad world in the early 2010s. 

Exhibit 1: iPad and iPhone Sales Out of the Gate

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There were a number of factors behind the iPad's astronomical rise overnight. One of the more obvious was Apple's success in making the case that a device like iPad was needed. Apple positioned iPad as a device that sat between an iPhone and Mac. The juxtaposition elevated iPad at the expense of iPhone and Mac. The iPhone was positioned as a small, mobile device that wasn't great for things like web browsing, email, and consuming photos and video. Meanwhile, the Mac was positioned as a heavy beast blown out of the water by iPad for certain tasks. 

iPad Mini Rationale

Despite strong iPad sales out of the gate, the early iPad years were also a period of immense anxiety and worry for Apple. Much of this fear was born from Apple's paranoia around competition. A $499 9.7-inch iPad left a price umbrella, so manufacturers can potentially undercut Apple with cheaper and smaller tablets running Android.

In late 2010, Apple was so worried about these 7-inch Android tablets that Steve Jobs made a rare appearance on Apple's earnings conference call to downplay the threat. This is when he gave the now infamous comment about having to sandpaper your fingers to one quarter of their present size in order to use a 7-inch touchscreen. Much of this was posturing as other Apple executives were making the case to Steve that Apple should do a smaller iPad. 

Ultimately, it was this fear of cheap Android tablets that pushed Apple to launch iPad mini two years later in 2012. While the product was a rare defensive move from Apple, management also saw something intriguing about the 6-inch to 7-inch screen form factor. Instead of pursuing that interest with a larger iPhone, Apple saw the iPad as the better-suited product. It was increasingly looking like an iPad world after all, and smartphones were all about mobility. This turned out to be a mistake. 


Just as Apple launched iPad mini, something was brewing over in smartphone land. Samsung was grabbing buzz by shipping smartphones with larger screens. It caught Apple's attention. 

In March 2013, on the eve of Samsung's Galaxy S4 unveiling in NYC, Apple SVP Worldwide Marketing Phil Schiller sat down for an exclusive interview with The Wall Street Journal to throw punches at Samsung and downplay the momentum found with larger smartphones. Here's Schiller: 

"Given the iPhone 5 is so thin and light, the reason that people are making their devices bigger is to get up to the battery life the iPhone 5 offers."

According to Schiller, large smartphones were being sold simply because manufacturers were able to use the additional size to fit a bigger battery. The devices were not being launched because they provided a better experience, according to Schiller. In reality, Apple was worried. They had just placed a big bet on iPad mini as a way to prevent Android from gaining share in the tablet space. However, the competition wasn't found with smaller Android tablets. Instead, it was found with 5-inch and 6-inch smartphones running Android. Having just launched the 4-inch iPhone 5, Schiller knew that Apple wouldn't have an adequate answer to these larger smartphones for at least another year and a half. Apple was caught flat-footed due to betting on iPad mini.

Turning Point

At some point in 2013, Apple likely made the decision that iPhones had to become larger in a big way. Giving the next major iPhone a small step up in screen size wasn't going to cut it. While Apple was likely pushed in that direction by market forces, the realization that such a move was needed was still a crucial one for management to make. In particular, Apple had to accept the fact that the iPad mini may not have too bright of a future despite just being launched and seeing remarkable strong sales out of the gate. There wasn't going to be a compelling use case for a 7.9-inch iPad in a world with larger smartphones. 

What Happened?

My theory as to how all of this came together is that Apple executives were initially mesmerized by iPad's rocket sales out of the gate. It seemed like consumers would own and use both a smartphone and an iPad. Even if iPhone's market share remained on the low side, Apple would be able to sell iPads to feature phone, Blackberry, Windows, and Android users. This outcome would materialize as long as two factors were true: 

  1. iOS was the tablet platform of choice for developers. This is why Apple was so concerned about 7-inch Android tablets. 
  2. Smartphone screens were small. Larger smartphones would throw a wrench in Apple's strategy as the iPad would lose quite a bit of its value proposition.

Apple had an incentive to keep a sizable screen size differentiation between iPhone and iPad. As a result, Apple downplayed the phablet threat while dragging its feet in terms of shipping larger iPhone screens.

Based on Jony Ive's recollection of events, Apple tested larger iPhone prototypes with screens ranging from 4 inches to 6 inches as early as 2011. Apple designers thought a 5.7-inch screen felt good for iPhone, but the size was later deemed too large. It would end up taking another three years for Apple to launch iPhone 6 and 6 Plus with 4.7-inch and 5.5-inch screens, respectively. 

Annual iPad sales peaked at 74M units at the end of 2013. According to my estimates, strong iPad mini sales played a big role in establishing that sales peak. In fact, iPad mini sales likely exceeded 35M units on an annual basis at their high point. However, the realization that the most formidable competition was found with larger smartphones rather than smaller tablets pushed Apple. The company was no longer hesitant to run with larger iPhones even if it meant weaker iPad fundamentals weren't too far behind.

As seen in Exhibit 2, which breaks out 7.9-inch iPad sales, iPad mini sales were decimated following Apple's move into larger iPhones.

Exhibit 2: iPad Unit Sales (TTM)

We now see Apple becoming extremely aggressive with larger iPhones. A 6.5-inch screen iPhone will launch less than a year after a 5.8-inch screen. A 6.5-inch iPhone would have been unfathomable during the early iPad years. Such a device would have decimated Apple's iPad strategy. Today, Apple is comfortable ceding a much larger portion of the market to iPhone at the expense of iPad. This has led to a much stronger iPhone franchise. 

Earlier this week, Samsung unveiled its latest flagship smartphones, the Galaxy S9 and S9+. Unlike five years ago, when Schiller nervously tried to upstage Samsung's keynote, it is doubtful Apple even blinked an eye this time around. Apple removed Samsung's key advantage when it began to ship larger iPhones in 2014. The iPhone versus Samsung dynamic has never been the same since. 


There are a few lessons to be taken from this situation. 

  1. Cannibalization is OK. Cannibalizing a product is OK as long as you are the one doing the cannibalizing. For Apple, the thought of severely damaging iPad mini, which looks to be the best-selling iPad size out of the gate, wasn't easy. It would be the equivalent of Apple deciding to give AirPods health and fitness monitoring even if it meant Apple Watch would be permanently impacted as a result. However, Apple found itself with a much stronger iPhone business as a result of cannibalizing a portion of the iPad line. A 6.5-inch iPhone will likely sell for $1,199 while the original 7.9-inch iPad mini retailed for just $329. 
  2. Admit Mistakes and Embrace Change. There is this attitude that Apple doesn't make mistakes and instead the company needs to possess the right strategy out of the gate to be a winner. Reality is quite different. Apple is willing to admit to mistakes and then make needed changes to get back on course. Apple's decision to set aside iPad cannibalization fears and launch larger smartphones fundamentally changed both the iPhone and iPad businesses. 
  3. Get Rid of Dogma. Throwing away the dogma that smartphones derived value from small screens was crucial in uncapping iPhone's potential. In what may be hard to believe, we are likely still underestimating the trend found with larger smartphones. Apple has seen growing momentum with its 5.5-inch iPhone Plus models over the years. In fact, the iPhone 8 Plus is the best-selling 5.5-inch iPhone relative to its 4.7-inch sibling. Meanwhile, Apple will sell tens of millions of the 5.8-inch iPhone X in 2018. A 6.5-inch iPhone may outsell an iPad mini despite selling for 4x more.

Ultimately, the iPad mini's demise at the hand of larger iPhones led Apple to view the iPhone and iPad as siblings on the same computing spectrum. In such a vision, smartphones are allowed to possess increasingly large screens (6+ inches) while iPad screens trend larger (10.5-inch and 12.9-inch) in an attempt to stand out from increasingly larger smartphones. 

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The Goldilocks Era for iPhone Has Begun

Not too hot. Not too cold. The iPhone is entering a new era that can best be characterized as status quo. The days of huge growth are over, and fundamentals aren't likely to improve significantly from current levels. However, underlying dynamics found with the iPhone business will likely prevent sales and revenue from dropping precipitously in the near term. We are in the iPhone's Goldilocks era.

iPhone Growth Era Over

iPhone sales have plateaued at a 215M units per year pace. As seen in Exhibit 1, Apple reached this sales plateau in mid-2016. The unit sales growth era that had defined iPhone for years is over.

Exhibit 1: iPhone Unit Sales (Trailing Twelve Months)

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One issue found with Exhibit 1 is that reported iPhone sales include channel inventory adjustments. This opens the door to Apple management having a greater level of discretion over reported sales, especially in an environment of slowing demand. In an effort to get the most accurate view of iPhone demand, channel inventory adjustments have to be excluded to reveal sales on a sell-through basis (i.e. customer demand).

As seen in Exhibit 2, strong iPhone 6 and 6 Plus sales in late 2014 and early 2015 marked a high point for iPhone unit sales growth on a sell-through basis. After a difficult 2016, growth in sell-through demand has been anemic for the past five quarters. Management's 2Q18 guidance points to only a slight improvement in iPhone sell-through demand. Analysts calling for the "OLED iPhone" to kick off an iPhone megaupgrade cycle in 2018 - something I've been skeptical about from the beginning given the number of growth headwinds found in the iPhone business - have given up on the thesis.

Exhibit 2: iPhone Unit Sales Growth (Sell-Through Basis)

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Red Flags

The lack of iPhone unit sales growth is not surprising. In May 2016, I published "iPhone Warning Signs" and the conclusion that "the iPhone growth story is breaking apart and management does not seem to be in control of the situation." Over the past two years, this is exactly what has happened as the four iPhone growth warnings signs highlighted in my article have fully materialized. 

  • Mobile carrier expansion is complete. Apple no longer has a sales tailwind from bringing iPhone to new carriers around the world. 
  • India isn't the next China. Any expectation of India becoming an iPhone sales growth engine in the near term is misplaced. 
  • Smartphone saturation. The era of iPhone sales growth coming from people buying their first smartphone has come to an end.  
  • Running out of Android switchers. There are only so many premium Android users in a position to switch to iPhone. 

Two additional red flags have now appeared:

  • Slowing iPhone upgrade rate. iPhone users are holding on to their devices for longer before upgrading. This trend has been unfolding for years, but the impact on iPhone sales is only now being felt. 
  • Overserving users. One reason iPhone users are holding on to their devices for longer is that their needs are being met with older models and less capable features. While new iPhones are still intriguing and enticing to a majority of iPhone users, a growing percentage of the iPhone installed base is content with their current device. 

Instead of there being one particular reason or cause for the lack of iPhone unit sales growth, the six preceding factors have come together to create a much less friendly growth environment. 

The Sky Isn't Falling

Given the presence of so many iPhone sales growth headwinds, it is logical to assume that iPhone sales will decline, potentially substantially, from current levels. In such a hypothetical situation, iPhone sales could even track similar to iPad sales which are now trending at 40% below peak levels. However, such a scenario isn't likely in the near term given the unique fundamentals underlying the iPhone business. A closer look at the dynamic between the two main iPhone sales drivers show a more resilient iPhone business. 

There are two iPhone sales drivers:

  1. New iPhone users (a.k.a. switchers). This group includes consumers buying their first iPhone from Apple or a third-party retailer. Once someone buys an iPhone from Apple or a third-party retailer, that person becomes part of the iPhone installed base. 
  2. Existing iPhone users (a.k.a. upgraders). This group includes current iPhone owners who purchase another iPhone from Apple or a third-party retailer. 

Over the past six years, Apple has seen very strong iPhone sales to new users. This has helped Apple grow the iPhone installed base from 100M people in 2011 to more than 700M in 2018. These new users have come from various sources over the years. In the beginning, feature phone users drove iPhone installed base growth. Eventually, Blackberry users became a growth driver. Today, former Android users and people using preowned or hand-me-down iPhones are driving Apple's iPhone installed base growth. 

As seen in Exhibit 3, I estimate Apple grew the iPhone installed base by more than 100 million people in 2017. While adding 100 million customers to the iPhone installed base is no small feat, my estimate reflects Apple's first year-over-year decline in the number of new users entering the installed base. The iPhone sales growth headwinds mentioned above are starting to take their toll. It is logical to assume iPhone sales to new users will continue to decline as time goes on.

Exhibit 3: iPhone Unit Sales to New Users

Screen Shot 2018-02-21 at 1.03.39 PM.png

One of the largest benefits found with years of strong growth in the iPhone installed base is that Apple now has hundreds of million of users in a position to upgrade to a new iPhone. Exhibit 4 highlights annual iPhone sales to upgraders. According to my estimate, Apple sold a record number of iPhones to existing users in 2017. This may seem counterintuitive given the slowing iPhone upgrade rate. However, following years of dramatic growth in the iPhone installed base, there are simply more iPhone users in a position to upgrade. The increase in the installed base has more than offset the sales headwind caused by a slowing iPhone upgrade rate. It is logical to assume iPhone sales to upgraders will remain robust as time goes on. 

Exhibit 4: iPhone Unit Sales to Upgraders

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Combining iPhone sales to new users with sales to upgraders provides a clearer view of the dynamic underlying the iPhone business. The number of iPhones sold to existing users is increasing at approximately the same rate as the number of iPhones sold to new users is declining. This dynamic resulted in Apple reporting roughly flat iPhone sales for the past two years. In essence, the iPhone business is operating at sales equilibrium. It took iPad years to find its sales equilibrium after putting in a sales peak in 2013. Products like iPod and Blackberry never found a sales equilibrium as outside forces reduced their long-term value in the marketplace. 

Exhibit 5 highlights the iPhone sales equilibrium dynamic. The blue portion of the bars (iPhone sales to existing users upgrading) made up a larger portion of overall iPhone sales in 2017 while the grey portion (iPhone sales to new users) shrunk. 

Exhibit 5: iPhone Unit Sales Mix (New Users vs. Upgraders)

Defining the Goldilocks Era

The iPhone business has entered a new era in which status quo is the new normal. Along with unit sales growth, this dynamic will encompass other iPhone fundamentals such as average selling price (ASP), revenue, and margin trends. 

Unit Sales. There is no clear path for Apple to grow iPhone sales substantially from current levels. While Apple may still report quarterly iPhone unit sales growth from time to time, especially if year-over-year compares are favorable, the growth would not represent some kind of step increase in sales. 

As long as Apple is bringing in new users, a scenario that is likely to continue for at least the next few years, the iPhone installed base will continue to expand. This expansion will help offset some of the pressure from a slowing upgrade rate. A good rule of thumb is that annual iPhone sales will remain around 215M units, give or take 10 percent, for the next two to three years. 

Once new user trends slow to the point of Apple barely bringing in any new users, all bets are off in terms of annual iPhone sales. From a unit sales perspective, the lack of new users will likely mark the top for iPhone sales given an upgrade cycle that continues to elongate. Apple likely has a few years before reaching this point. 

ASP. Similar to iPhone sales growth, iPhone ASP will likely follow this Goldilocks path of not being too hot or cold, but rather following a status quo. As seen in Exhibit 6, after years of remarkable consistency, iPhone ASP hit $796 in 1Q18. Not only was this a record high for iPhone ASP, but the $178 sequential jump in ASP was also a record. The strong results were driven by a perfect storm of the higher-priced iPhone 8 and 8 Plus as well having the iPhone X launch take place in 1Q18. 

Management commentary points to iPhone ASP falling in 2Q18. ASP will then decline further as we move away from the iPhone 8, 8 Plus, and X launches. 

Apple can only push so far with iPhone pricing in the near term before demand trails off due to accessibility concerns. While many thought that threshold was $999 for an iPhone, in reality it's probably closer to $1,500. In addition, Apple will likely continue to get aggressive at the low end of the iPhone pricing spectrum. Accordingly, a reversion to the ASP mean of $650 is likely. The addition of a higher-priced iPhone X with a larger screen should keep iPhone ASP from falling too far below $650 in the near term.

Exhibit 6: iPhone Average Selling Price

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Revenue. Apple saw robust iPhone revenue growth in 1Q18 due to the dramatic jump in iPhone ASP. Going forward, an ASP reverting back to the mean, combined with modest iPhone unit sales growth, will make it difficult for Apple to maintain robust iPhone revenue growth. 

Margins. Apple doesn't disclose iPhone margins. However, given the company's stable overall gross margin, there is no reason to believe iPhone margins have deteriorated significantly in recent years. While Services revenue growth has certainly contributed to Apple's stable overall gross margin, much of that positive impact has likely been offset by weaker wearable and iPad margins.

One reason iPhone margins won't likely change much in the near term is Apple's broader iPhone strategy of using higher-priced, high-margin SKUs to offset margin pressure from lower-priced SKUs.


There are two major implications from the iPhone business entering a Goldilocks era: 

  1. Time. A relatively stable iPhone business buys Apple management much needed time to come up with the next big thing(s). It's been a little more than three years since Apple unveiled Apple Watch, the company's most recent major new product category. New products like Apple Pencil, AirPods, and HomePod are accessories meant to work with Apple's major product categories. It's not realistic to expect Apple to launch new major product categories every three or four years. Instead, pressure for Apple to unveil a new product category will likely begin to grow in 2019 or 2020, five to six years after the Apple Watch was unveiled. 
  2. Money. The iPhone is kicking off approximately $60 billion of gross profit per year. Assuming iPhone fundamentals remain relatively unchanged from current levels, Apple stands to earn close to $200 billion of gross profit from iPhone over the next three years. This is enough cash to support Apple's organic growth, R&D, M&A, and still leave funds to handle the capital return program. 

Risks and Wildcards

In the mid-2000s, there was a school of thought that viewed the U.S as having a Goldilocks economy. Instead of strong growth, which would lead to inflation, or weak growth, which would lead to a recession, the economy was following a path somewhere in the middle. As it turned out, an asset bubble was forming in housing during this period. The bubble burst in 2007. A massive recession ensued, made much worse by toxic financial instruments based on an inflated asset.

Is there a variable that may do the same to the iPhone business? What may be developing or building in the background that has the potential to appear suddenly and quickly unravel the iPhone business overnight?

A few of the more popular items positioned as iPhone risks include:

  • Voice. The expansion of rudimentary digital voice assistants into new platforms where data is increasingly transferred via voice and value moves away from apps and touch screens. 
  • Post Device Era. All-powerful cloud services eventually reduce the value found with hardware. 
  • China. The iPhone business can experience a sizable contraction overnight due to new policies enacted in China targeting Apple.
  • Lack of Innovation. Mediocre features that are on par with competitors can lead to longer upgrade cycles, lower margins, and fewer sales.
  • New Product(s). A new kind of product reduces the value found with iPhone.

Out of those five items, China regulatory issues represent the only item capable of impacting a decent portion of iPhone sales overnight. China is responsible for approximately 30% of iPhone sales. The other risks don't pose as much of a near-term concern for the iPhone business. 

The largest wildcard that will jeopardize the iPhone business over the long run is a new kind of screen that is able to grab our time and attention away from iPhone. (I don't think voice by itself will be the answer.) This screen won't replace the iPhone, just as the iPhone didn't replace a laptop or desktop. Instead, this screen will initially appeal to those who felt overserved by iPhone. Eventually, this screen will begin to handle an increasing number of new tasks and workflows, some of which were never given to iPhone. Apple Watch and a pair of augmented reality (AR) glasses are best positioned to be those screens. 

The initial versions of AR glasses for the mass market will probably be more like head-up displays positioned as smartphone accessories. This leads me to think that it will be difficult for new products to unravel the iPhone business overnight. The iPhone is simply too multi-functional and multi-purpose. The artificial sense of safety found with such a statement does not escape me. The moment when it seems like there is nothing that can impact a business or product is usually the time when safety needs to be thrown out the window.

Big Picture

The iPhone's Goldilocks era is all about stable fundamentals for the next two to three years. During this period, Apple will continue to experiment with higher-priced and more capable SKUs at the high end while making iPhone more accessible with lower pricing at the low-end.  

As for what comes after the Goldilocks era, a good argument can be made that iPhone's future is one of a powerful AR navigator. In this environment, Apple Watch and Apple Glasses handle much of the low-hanging fruit in terms of mobile tasks and workflows while iPhone is a more powerful computer targeting increasingly niche applications. This would lead to less robust iPhone unit sales but improved ASP and margin trends. 

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