iPhone Courage

iPhone pricing has garnered more attention in recent months than any other Apple topic. However, pricing is not the most important variable impacting the iPhone business. With iPhone X, Apple is taking what previously worked with iPhone and throwing it away in an effort to create a better user experience. For Apple to take this much risk with the product responsible for the vast majority of its cash generation and new user growth is noteworthy. 

iPhone X

During its inaugural event at Steve Jobs Theater last month, Apple unveiled three flagship iPhones. Management dedicated 20 minutes of stage time to iPhone 8 and 8 Plus, models clearly positioned within the existing iPhone paradigm. Attention then turned to iPhone X, which garnered nearly twice as much stage time. While the "X" stands for ten, it could have very well stood for extreme. iPhone X will be the most radical iPhone Apple has sold to date. The home button has been removed to fit a larger screen in a smaller form factor. This change, which was years in the making, ushers in a completely new iPhone experience. Users will have to retrain their finger reflex to not press the bottom of the screen and instead, get used to swipes. In addition, the removal of fingerprint recognition in favor of facial recognition represents a very big change in how we will use iPhone. A strong argument can be made that removing the home button is the single-biggest change Apple has made to iPhone. The sheer amount of risk found in the move is being grossly underestimated. 

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iPhone Strategy

Apple is launching iPhone X at a critical juncture for the iPhone business. A slowing upgrade rate among existing iPhone users has led to overall unit sales plateauing, as highlighted in Exhibit 1. 

Exhibit 1: iPhone Unit Sales (Trailing Twelve Months)

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Despite weakening sales growth trends, Apple is still selling more than 200M iPhones per year, bringing in $140B of revenue and $60B of gross profit. In addition, the iPhone installed base grew by approximately 110 million users in 2017. iPhone remains Apple's most effective tool for grabbing new users. 

Apple's iPhone strategy can be broken into three parts:

  1. Pricing
  2. Product marketing
  3. Design

While much of the attention has been focused on Apple's move at the high-end of the iPhone pricing spectrum, the company is making just as interesting of a change at the low-end. Apple is following a consumer segmentation strategy. Management is cutting iPhone pricing at the low-end to improve accessibility. The $399 iPhone price floor that had been in existence for years was shattered last month. A $350 iPhone SE is the lowest-priced "new" iPhone Apple has sold to date. Management's decision to continue selling iPhone 6s and 6s Plus, and even iPhone 6 in select markets, positions additional SKUs for customers focused on value and price. Meanwhile, at the other end of the pricing spectrum, Apple is running with higher-priced models targeting consumers who value the latest and greatest technology. 

Underlying this pricing dynamic is a product marketing strategy focused on positioning the iPhone as the best camera people have ever owned. The dual-camera system found in iPhone 7 Plus is one of the more noteworthy iPhone features in years. With iPhone 8 Plus and iPhone X, Apple introduced Portrait Lighting, which adds a new element to Portrait mode. Apple then went further to include Portrait mode and Portrait Lighting on the iPhone X front-facing camera.

Apple saw how cameras are becoming much more than memory capture tools. Cameras are turning into smart eyes powering the dawn of the augmented reality era. Apple spent years dedicating resources to the effort and is now at the point where iPhone cameras are being powered by Apple silicon. This provides Apple's cameras additional differentiation and the ability to stand out from peers. 

Apple has seen quite a bit of success with its iPhone pricing and product marketing strategy over the years. However, these two variables are not the most important items impacting iPhone's evolution. Design, or the way consumers use the product, has a much larger impact on iPhone's future, and Apple is making big changes to how we will use iPhone going forward. 

The Headphone Jack

iPhone X demonstrates how Apple is willing to move beyond legacy design constraints and thinking. The home button has come to represent safety for hundreds of millions of people. In just a few years, Touch ID and fingerprint recognition became universally accepted because of their connection with the convenient iPhone home button. Apple is taking this familiar design and throwing it out the window in an attempt to push the iPhone experience forward. Although Apple is confident consumers will embrace the changes, the confidence sure isn't a result of consumers demanding or wishing for these changes. Instead, Apple designers and engineers are throwing away legacy thinking in order come up with something new. Upon closer examination, Apple has previously demonstrated this willingness to let go of legacy design. 

In September 2016, Apple unveiled iPhone 7 and 7 Plus. The two flagship models contained the typical assortment of new features and upgrades. However, one change stood out from the others. Apple removed the dedicated headphone jack despite no one having asked for such a move. Instead of including the traditional pair of EarPods in the box, Apple unveiled a new pair of EarPods that used the Lightning connector. In addition, Apple included a small adapter so that older headphones would connect with Lightning. 

When explaining Apple's decision, Phil Schiller, Apple SVP worldwide marketing, said "it really comes down to one word: courage. The courage to move on, do something new that betters all of us."

To say that removing the headphone jack was a controversial decision would be an understatement. The mere thought of removing the dedicated headphone jack from smartphones drove the tech community up a wall with some declaring the move as "user hostile" and "stupid." Schiller's explanation for the removal did not sit well with many. Some referred to it as tone-deaf, and others used arrogance and greed to describe the situation. There were then some who thought Schiller should have said "courage of convictions" in order to better encapsulate his meaning. 

In reality, Schiller was right in calling Apple's decision to remove the dedicated headphone jack courage. As it turns out, Apple displayed additional courage last month by removing the home button from iPhone X.

Courageous

The reason these iPhone design choices can be called courageous is that Apple is not afraid to risk sales in order to make technology more personal. It is not easy to take a product that is bringing in more than $140B of revenue per year and change the way people fundamentally use the device. While this situation may seem too self-centered to deserve being called courageous, iPhone is used by 800 million people. (The math behind my iPhone user base estimate is available for Above Avalon members here.) A design decision capable of improving or advancing the iPhone experience will have a tangible impact on many lives. It's not an exaggeration to say that society as a whole can benefit from these iPhone design choices. We are empowered by having a mobile computer in our pockets, and additional power will flow to users as smartphones evolve into augmented reality devices.

The headphone jack is one of a handful of examples of Apple displaying courage by taking what seemed to be working fine and throwing it away to improve the iPhone user experience.

  • 30-pin dock connector removal
  • Headphone jack removal
  • Home button removal

These design choices share a few common traits: 

  1. Deliberate. Apple doesn't make changes for the sake of making changes. Instead, the company is deliberate with its choices. A headphone jack is not removed in order to merely have iPhone 7 stand out from iPhone 6s. Instead, the move is an early step in Apple's long-term mission to remove wires from our lives. Schiller's inability to discuss the long-term goal found in removing the dedicated headphone jack is one reason his courageous comments came off as tone-deaf. A number of years and iPhone versions often have to pass before the motivation behind some of Apple's design decisions becomes clear. 
  2. Decisive. Apple doesn't sit on the fence when it comes to design. One should not bet on a dedicated headphone jack returning to iPhone. In what is still a raw and polarizing topic for some, dedicated home buttons with fingerprint readers are on their way out over the coming years. Dedicated home buttons don't have a future at Apple. 
  3. Design. All of these significant iPhone changes are made with design in mind. By removing the dedicated headphone jack and home button, Apple is changing the way we interact with iPhone. While some of these changes occur through a new user interface, other changes involve how we use iPhone in relation to other products. While the user experience change is less clear with some changes, such as Apple swapping the 30-pin dock connector with Lightning, other examples, like the home button removal, are much more apparent. 

It's All About Design

Avoiding change out of fear of angering users or customers can cripple an otherwise successful product and company. Fear of throwing away design artifacts and legacy tendencies represents one of the biggest risks facing iPhone today. This is why design, and not pricing or product marketing, is the most important variable when thinking about iPhone's future. 

Fear of embracing change would make it impossible for Apple to accomplish its long-term goal of making technology more personal. When it comes to iPhone, this goal manifests itself in a design that blends hardware and software. Apple's willingness to take big design bets allows iPhone to evolve over time. As buttons and ports are removed to make room for the latest camera, battery, and screen technology, iPhone morphs from a multi-touch computer into an augmented reality navigator controlled by glances and looks. 

This behavior of killing off features, components, ports, and technology in an effort to push the user experience forward is a carryover of Apple's approach with the Mac. The difference this time around is that Apple is making these changes to a product that is used by 8x more users. 

Samsung vs. Apple

Apple is not alone in pushing smartphone changes like removing a front-facing home button or dedicated headphone jack. In fact, making changes for the sake of change is relatively easy in the smartphone industry. The difficult part is leveraging these changes to push the user experience forward.

Samsung was able to beat Apple to market with an OLED smartphone lacking a front-facing home button. However, the difference in how Samsung and Apple leveraged these design changes is noteworthy. By removing the home button, both companies had to come up with an alternative to having a fingerprint reader positioned in a convenient location. Samsung chose to place the reader in a much more awkward location on the back of the device. Meanwhile, the company's facial recognition alternative ended up being a bust as it quickly became apparent it just wasn't as good as fingerprint recognition. It is tough to argue that the Samsung Galaxy user experience was improved with such changes. Instead, Samsung serves as an example of making changes for the sake of change

Meanwhile, Apple is positioning Face ID as the alternative to having Touch ID and the home button. If done correctly, Apple will be the company to bring facial recognition as a form of biometric authentication to the masses. Based on the company's success with Touch ID, Apple deserves the benefit of the doubt that Face ID can follow suit and see massive customer acceptance. In fact, Apple's removal of the home button and embrace of Face ID will likely kick off a new era at the company involving facial recognition. It is only a matter of time before every Apple product with a camera has the TrueDepth camera system. Such a development may seem trivial, but it will lead to a new era of health monitoring to which we haven't even contemplated the implications yet.

TrueDepth camera system in iPhone X.

TrueDepth camera system in iPhone X.

The other implication found with Apple taking design risks is that unlike every other smartphone manufacturer, Apple sells very few smartphone models. The company does not have the benefit of taking risks with a much less popular model and only then bringing new features to the mass market once market adoption has been proven. Instead, Apple spends years and multiple iPhone versions systemically preparing for a major design change included in a flagship model.

Putting Fear Aside

The amount of risk Apple is taking with iPhone X should not be underestimated. There is a reason why management is positioning iPhone X as a glimpse of the next 10 years of iPhone. The model is dramatically different to iPhone 8 and 8 Plus. While Apple is confident that consumers will embrace these changes, it sure isn't due to consumers demanding or wishing for these changes. Instead, Apple designers, engineers, and marketers are showing a willingness to break down legacy thinking in order to come up with something new. By not letting fear of change and customer rejection dictate iPhone design decisions, Apple is displaying courage. While Apple stands to benefit financially from these design changes, iPhone users also stand to benefit. iPhone is empowering hundreds of millions of people in ways that were never before imagined. Courage is putting fear aside and taking bold risks in order to empower others.

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The Significance Behind Steve Jobs Theater

On paper, Steve Jobs Theater doesn’t make complete sense. The price tag would lead many to question the rationale in building a massive underground theater for unveiling products. It’s difficult to envision any other company wanting to undertake such a project. However, after I attended Apple’s inaugural event at Steve Jobs Theater, Apple’s motivation behind the building became crystal clear. Steve Jobs Theater is an Apple product, and a closer look at the building uncovers a side to Apple that few have seen before.

Initial Visit

Steve Jobs Theater is located in Cupertino and positioned in the southeast corner of Apple's new $5 billion Apple Park headquarters. The 167,000-square-foot building consists of a 921-seat underground theater and accompanying product demo room. Apple plans on utilizing Steve Jobs Theater for product unveilings and the periodic corporate event. Apple hired Norman Foster and his firm Foster + Partners as the project's architect although Apple Chief Design Officer Jony Ive and other Apple designers played a pivotal role.  

Steve Jobs Theater. Photo credit: Apple

Steve Jobs Theater. Photo credit: Apple

Most visitors arriving at Steve Jobs Theater for the first time will be impressed by its seclusion and allure. Unlike the 2.8-million-square-foot ring building, Steve Jobs Theater cannot be seen from nearby streets surrounding Apple Park. Instead, visitors must walk along a path that winds its way through a series of carefully landscaped hills. It soon becomes clear that this short walk is actually part of the broader experience Apple was trying to achieve.

The path empties out into a basin containing Steve Jobs Theater’s lobby. The 22-foot curved panes of glass create a strong first impression. To the right is an unobstructed view of the giant, circular ring building. The entire experience is reminiscent of Disney World as it becomes clear that someone has created this specific experience to be consumed at this particular location. The lobby, the only part of Steve Jobs Theater that is above ground, is massive, intriguing, and even magical. It doesn’t take long to notice the lack of walls or support structure. This leads to the inevitable question of how the 155-foot roof is being held up. (Spoiler: the glass supports the carbon fiber roof.) Additional questions are raised regarding how plumbing for the water sprinklers and electricity for the lights and speakers are piped to the roof. As it turns out, a little magic is indeed at work. As reported by Lance Ulanoff over at Mashable, all of the necessary plumbing and wiring is found in 20 of the narrow gaps between the large panes of glass. 

 
Steve Jobs Theater floor plans.

Steve Jobs Theater floor plans.

 

The other item that stood out about Steve Jobs Theater was the two sets of stairs on either side of the lobby that are used by visitors to walk down to the theater. The intriguing use of Castagna stone and handrails hand-carved into the stone walls reminded me of a mix between an Egyptian structure and something from space. Photos and videos don't do them justice. 

(My complete review of Apple's inaugural event at Steve Jobs Theater is available for Above Avalon members here.)

Not Perfect

Steve Jobs Theater is far from perfect. A strong argument can be made that Apple outgrew the theater before it even opened. Apple's prior two iPhone launches took place in a venue that fit 50% more people, which allowed Apple to invite many more Apple employees than they did to the inaugural event at Steve Jobs Theater.

Despite the building's large footprint, the exhibit space felt incredibly cramped. While Apple may like the visual of hundreds of people bumping into each other to get their hands on the latest products, it's not exactly the best experience to go through. My suspicion is that the exhibit space needs a few modifications to reflect the new era of reporters wanting to live stream. 

 
The Steve Jobs Theater exhibit space was still packed after an hour of hands-on time. 

The Steve Jobs Theater exhibit space was still packed after an hour of hands-on time. 

 

In addition, there were a number of odd design decisions found at Steve Jobs Theater. These range from the awkward paper towel dispensers in the restroom to uneven temperature control in the lobby and doors that are unusually difficult to open. There was also a decent probability of getting a little wet from water dripping off the carbon fiber roof in the morning. However, the building's accomplishments end up vastly outweighing these minor oddities.

Observations

Much of the discussion regarding Steve Jobs Theater up to now has been superficial. Most people agree that the building is impressive and fits within Apple's broader design focus. However, upon closer examination, Steve Jobs Theater provides a fascinating look at today's Apple. A number of items stood out to me. 

An Apple Product. Apple is no longer a company that just ships consumer hardware powered by differentiated software. The unveiling of Steve Jobs Theater is the latest sign of this reality. The theater is an Apple product, in the same vein as Apple's redesigned Retail stores. Apple approached Steve Jobs Theater and the broader Apple Park headquarters in the same way that it would any other product. Significant time and resources were spent on modeling and prototyping before construction. An identical process occurs for Apple products that eventually end up on our desks, in our pockets, and on our wrists. 

One of the most significant takeaways from Steve Jobs Theater is that Apple is no longer a company content in just focusing on making well-designed electronics. Apple is moving into bigger and bolder initiatives. Jony Ive has hinted in various interviews about his never-ending drive to make technology more personal and create tools for people. While this goal will inevitably lead Apple further into wearables, including glasses, there is a very high likelihood that Apple will focus on bigger tools like self-driving cars. These bigger tools will require Apple to move much further into construction and architecture. Apple reportedly owns and leases a collection of heavy manufacturing facilities close to Apple Park that includes some of the last remaining open space in the San Jose vicinity. (A listing and map of these Apple buildings are available for Above Avalon members here). The day when Apple designers build their very own state-of-the-art transportation R&D center minutes away from Apple Park is no longer a fantasy. All of this puts the PR photos with Tim Cook and Jony wearing Apple hardhats into a new light. 

 
Tim Cook and Jony Ive at Apple Park. Photo credit: The Telegraph

Tim Cook and Jony Ive at Apple Park. Photo credit: The Telegraph

 

We have arrived at a weird point in time. Silicon Valley giants are gaining unfathomable amounts of power yet remaining remarkable aloof when it comes to manufacturing and construction. Apple is the notable exception. Apple is the company most eager to step outside its comfort zone and experiment in construction and architecture realms. Apple sees the gap between architecture and design starting to shrink. According to Jony, architecture is "a sort of product design; you can talk about it in terms of scale and function and materials, material types. I think the delineation is a much, much softer set of boundaries that mark our expertise."

Experience. There's a reason why Steve Jobs Theater and the overall Apple Park campus is reminiscent of Disney World. Both locations provide an unmatched experience to the visitor. When walking around the grounds surrounding Steve Jobs Theater, it truly felt as if the building is meant to represent Earth while the large circular ring building off in the distance is the Sun. 

Steve Jobs Theater symbolizes how Apple is doubling down on extending the Apple experience beyond just iPhones in our pockets and Apple Watches on our wrists. As Apple's Retail store strategy shows, the idea of using architecture and physical spaces to explain the Apple story isn't new. However, Apple has taken the idea further to include its headquarters and even the theater at which it plans to unveil many of its future products.  

Focus. It's easy to look at Steve Jobs Theater and forget the amount of work and resources that went into the building. Jony and Apple's Industrial Design team reportedly worked alongside Foster + Partners on nearly every aspect of the theater and the entire Apple Park campus. Apple management likes to use every opportunity to reiterate its goal of remaining focused and saying no to a lot of great ideas. The company's product line demonstrates such focus. Accordingly, there is logic in considering how much attention went into Apple Park over the past few years and where that attention is now being placed. This brings us to the most crucial takeaway regarding Steve Jobs Theater: Jony Ive.

Jony Ive

In May 2015, Jony was promoted to Chief Design Officer. The transition kicked off a debate regarding the underlying motivation behind the move. Many argued that the promotion marked the beginning of the end for Jony's time at Apple. Some observers argued Apple is setting the stage for Jony's eventual retirement by shifting day-to-day responsibilities to Richard Howarth and Alan Dye. The degree to which Jony then took a less visible presence in subsequent months (which was clearly telegraphed by Apple in announcing his promotion) added oxygen to the fire.

Others said Jony's Chief Design Officer title is mostly ceremonial with little-to-no responsibility and compared it to Steve Jobs giving the Chief Software Technology Officer title to Avie Tevanian in 2003. Tevanian ended up leaving Apple a few years later. In reality, such a comparison is so off base it could classify as intellectual dishonestly. 

I've held a completely different view of Jony's promotion. The day after Jony's promotion was announced (via a Stephen Fry article), I wrote

"With Howarth and Dye serving as Jony's two lieutenants in terms of managing day-to-day aspects of Apple design, what would such a dynamic look like and where would Jony fit into the picture? I consider Jony's new role to be much more about leadership while Howarth and Dye handle the more corporate side of things - the actual management of teams. The amount of additional time and attention that Jony can spend on entirely new projects, while leaning on his two right hands to make sure that schedules are being met and projects are receiving all of the resources they need, goes a long way in describing Apple's strategy over the next few years.

I see an environment in which Jony's potential can be unleashed even more now than the world has already seen. Similar to how Steve Jobs was known to head down to Jony's design lab to hang out, I suspect in some ways, Jony wants to do the same - check out of the day-to-day executive grind and lose himself in research and design elements on whatever topic or subject he choses. By being positioned in more of a leadership role than a managerial role, Jony could maybe be more like Jony."  

Two years later, and with Steve Jobs Theater officially open, it is clear Jony holds the role closest to the one held by Steve Jobs. The promotion to Chief Design Officer represented sustainability for Jony. It has been reported that Apple Watch development, in addition to overtaking leadership of human interface, took its toll on Jony. The entire Apple Park project represents much of Jony's focus in recent years. Jony reportedly was the one who carried Apple Park on his shoulders. Its completion now gives Jony the freedom to focus on new initiatives and projects at Apple. 

A Design Company

"[O]ne of the ways that I believe people express their appreciation to the rest of humanity is to make something wonderful and put it out there." - Steve Jobs

It's difficult to envision any other company building something like Steve Jobs Theater. Based on the reported $14 million price of the theater seating, my estimate for the overall cost of the building exceeds $100 million. Most management teams will struggle to find how such an initiative would ever come back to boost sales or benefit the company. The fact is that Apple is unlike any other Silicon Valley firm. Steve Jobs Theater symbolizes how Apple isn't a tech company but rather a design company. Apple believes that how we experience and interact with a product is more important than a single focus on the technology powering that product. Apple is now bringing that philosophy to the way we experience architecture. As for the why behind it all, Apple's answer would probably be to make something wonderful. 

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Major Tech Trends Ahead of Apple's Big Event

With Apple about to host its largest product event in years, much of the attention continues to be focused on the details. Plenty of questions remain regarding the various changes Apple will announce across its iPhone, Apple Watch, and Apple TV lines. A closer look at the broader trends taking place in these product segments go a long way in adding much-needed context to Apple’s inaugural event at Steve Jobs Theater.

Smartphones

On the surface, the smartphone battle seems to be largely settled. Predictions calling for iPhone’s demise at the hands of Google and Android have subsided although some are now eager to replace Google with WeChat as Apple’s arch nemesis.

Behind this facade of relative calm, the smartphone market continues to evolve at a rapid pace. Three major trends are unfolding regarding how consumers view smartphones:

  1. Larger screens continue to gain momentum.
  2. Form factor size is hitting a ceiling.
  3. The pricing gap is widening.

With an increasing amount of content consumed on smartphones, consumers and manufacturers alike continue to get behind larger screens. Once deemed excessive and niche, large smartphones with 5-inch to 6-inch screens are seeing growing sales momentum. This large screen smartphone trend has materialized across the industry, indiscriminate of geography and even price.

While there is still evidence that a portion of the market is OK with smaller screens as seen by continued 4-inch iPhone SE sales, this segment is more likely to contract than expand over time. 

The newest and most intriguing development in the smartphone space is found with the relationship between screen size and form factor. Historically, smartphone screen size faced a ceiling in terms of its relationship to form factor. Mobility is greatly reduced if a smartphone is so large that it is unable to fit comfortably in pockets, purses, and pouches. The trend of removing front-facing bezel and dedicated home buttons is eliminating this form factor limitation. Smartphone manufacturers are able to ship larger screens without increasing form factors.

The OLED iPhone is rumored to include a 5.8-screen, which is larger than the 5.5-inch iPhone Plus screen, in roughly the same form factor as an iPhone 7. This will have a major impact on how consumers think about smartphone size preference. It is inevitable that all iPhones will eventually contain the same design language - no home buttons and little to no front bezel. Large swathes of the iPhone user base will likely want to upgrade to these new iPhone models over time. It is the type of multi-year upgrade cycle that PC makers hoped would occur in the laptop space but never materialized. 

As manufacturers increasingly bet on camera and screen innovation to stand out from the competition, smartphone pricing has been on the rise. While smartphone prices are increasing at the high-end, as seen with the $750 Samsung Galaxy S8 and $950 Galaxy Note 8, there continues to be a significant portion of the smartphone market desiring price accessibility. The key for smartphone manufacturers will be balancing higher-priced smartphone SKUs packed with the latest technology with increasingly lower-priced SKUs still offering a premium experience. 

Wearables

The wearables market has had a rocky start. Some of the initial wearables players have retreated out of the space while others have taken a more cautious view. Only a handful of companies are seeing wearables sales success. It is fair to say everyone, including Apple, has seen their fair share of strategy changes over the years. 

Three major trends are unfolding in the wearables space: 

  1. Sales momentum is flowing to smartwatches.
  2. Fashion and luxury continue to gain importance.
  3. The wearables battle is slowly expanding beyond the wrist.

Dedicated fitness trackers have lost momentum while Apple Watch continues to outperform sales expectations. Fitness and health tracking is moving from being a product to a feature. Nowhere is this seen more than in a comparison of Fitbit and Apple Watch sales over the past year. 

Exhibit 1: Fitbit vs. Apple Watch Unit Sales

Screen Shot 2017-09-07 at 1.55.12 PM.png

Meanwhile, Fitbit’s new Ionic smartwatch is a "bet the company" type of move in an attempt to capitalize on this new wearables landscape. Garmin has seen similar trends with sales momentum flowing from dedicated fitness and health trackers to its smartwatch offerings. We are only seeing the initial fallout from this development.

One of the items Apple got correct out of the gate with Apple Watch was interchangeable watch bands. This dynamic is now viewed as natural and almost inevitable when discussing smartwatches. Going forward, technology companies will continue to face pressure in the wearables space given how consumers are demanding luxury and fashion options.

As the battle for the wrist evolves, the ear is shaping up to be the second major wearables battleground. Apple, Samsung, Fitbit, and a slew of smaller hardware companies and start-ups will have wireless or cordless headphone offerings in the market for the upcoming holiday season. Apple is the clear leader in the space with its W1 chip-equipped AirPods and Beats. More importantly, given the company's sales success with Apple Watch, Apple has the most formidable wearables platform. We are moving to a point at which the wearables narrative will evolve. No longer will it only be about wrist devices. Rather, it will also include platforms consisting of hardware and software solutions for different parts of the body. 

Television

After years of unknown, we are starting to get a glimpse of TV's future. The large cable bundle's days are numbered. Netflix, Amazon, Facebook, Google (YouTube), and Apple are the new power brokers in the TV space. There is a long list of others including Disney (ESPN), HBO, and Hulu that would like to join that coveted list of influencers. Netflix and Amazon are the newest TV networks with massive budgets for funding scripted video content. YouTube and Facebook continue to reign supreme when it comes to offering ad-supported video content. Apple owns the most lucrative platform that involves consumers accessing paid video subscriptions. 

Major themes unfolding in the space include: 

  1. Price is playing a major role in the streaming set top box market.
  2. Momentum is found with smaller screens.
  3. New content players are holding optionality.

Roku is the current streaming video box leader with approximately 40% market share in the U.S. Amazon, Google, and Apple hold second, third, and fourth place, respectively. The market is unfolding largely based on price. Roku has been able to position itself as the cheapest way for people to access Netflix and YouTube on a large television screen. The company is going so far as to give away its Roku OS to TV manufacturers for free. Meanwhile, with Apple TV priced nearly five times higher than Roku, Apple's streaming TV box is bringing in nearly 6x more gross profit than Roku earns from its players.

While much attention continues to be placed on large screen televisions, such focus ends up being grossly misleading. Apple is actually selling more than 250M "TVs" per year called iPhones and iPads. These smaller screens are responsible for delivering an increasing amount of video content to consumers. 

In a battle for our time and attention, content creators with formidable content budgets are winning. There is a brain drain underway in Hollywood as talent in front and behind the camera is moving to the new players in town. There are still genuine questions as to just how sustainable some of these streaming video business models are as independent entities. However, there is no question that a company like Netflix has earned itself optionality from providing a superior entertainment experience to more than 100M people. 

Home

The smart home ended up being the surprise tech topic of 2016. Much of this was due to sheer fascination in Amazon's Alexa digital voice assistant and accompanying Echo speakers. The narrative has shifted in 2017 as mindshare is now splintered due to additional companies entering the scene. Apple is expected to discuss HomePod in detail at its upcoming product event. Major themes in the smart home space include: 

  1. Voice is being positioned as an early user interface.
  2. Companies are basing their home strategy around core competencies. 
  3. It is still early to declare definitive leaders and laggards.

As the number of smart items for the home available for sale increases, questions have swirled as to the best way to control these devices. Voice continues to grab much of the attention although the automation capabilities found in Apple's HomeKit hold much intrigue. At the same time, we are seeing pretty dramatic differences in strategy for the home based on a company's core competency. While Google and Facebook will look to monetize the data obtained via microphones and cameras through advertising, Amazon is looking for Alexa to serve as a better shopping assistant in order to drive Prime memberships. The preceding strategies include giving away hardware at or below cost. Meanwhile, Apple's strategy to sell the best-sounding speaker people have ever owned gives the company a good shot at becoming the most profitable device in the smart home space.  

Even though Amazon has garnered much good press in the space, it is simply too early to declare winners and losers in the smart home. The way that Apple and pretty much every large consumer-facing technology company are running forward with stationary speakers and screens for the home brings back flashbacks to the early wearables rush. Many companies will end up being disappointed. At the same time, the attention given to stationary devices has taken the spotlight off the importance of mobile devices in our home. The smartphone remains the most valuable computer in our home and we should not underestimate it when contemplating the smart home's future. Of course, a home won't likely truly be a smart home until Silicon Valley firms begin building their own housing, but that topic is for another day. 

Apple's Big Event

Apple's upcoming event at Steve Jobs Theater has the ingredients to be the largest Apple product event since the Apple Watch unveiling at the Flint Center in 2014. Apple will unveil at least three new iPhones in addition to new Apple Watches and a refreshed Apple TV. In some areas, Apple's goal will be to improve upon existing themes unfolding in the smartphone and streaming video arenas. In other areas such as smartwatches, Apple will likely take a true leadership role in pushing the market forward. 

I will be attending Apple's inaugural event at Steve Jobs Theater. My full thoughts and observations on the event will be sent exclusively to Above Avalon members. To receive this analysis and perspective, visit the membership page. Members also receive my analysis and perspective on Apple throughout the week via exclusive daily emails (2-3 stories a day, 10-12 stories a week). 

Apple in China

The narrative of Apple's China problem boiling down to a brutal battle with Tencent (WeChat) or local smartphone manufacturers is inaccurate. Apple's business in China is not imploding. Rather, it is experiencing growing pains. After more than a year of sales declines, positive signs are beginning to reappear in Apple's China business. China continues to represent more of an opportunity than a risk for Apple. 

The Numbers

Greater China is Apple's third-largest operating segment and consists of Mainland China, Hong Kong, and Taiwan. As shown in Exhibit 1, the segment saw significant revenue growth in 2015 followed by a surprising decline in 2016. With Apple on track to report nearly $45B of Greater China revenue in FY2017, the segment will report its second consecutive annual decline.

Exhibit 1: Apple Revenue from Greater China

In 2013, Tim Cook looked at China as being well-positioned to eventually become Apple's top market. At the time, Greater China was Apple's third-largest operating segment, representing approximately 15% of overall revenue. Over the subsequent two years, it looked like Cook's prognostication would be proven correct. After a very strong 2015, Greater China bypassed Europe to become Apple's second largest operating segment, responsible for 25% of overall revenue. Observers soon began to forecast when Greater China would overtake the Americas to become Apple's largest operating segment.

As seen in Exhibit 2, the situation changed dramatically in 2016. Weakness in Greater China led to the segment falling back below Europe in terms of revenue. Meanwhile, the Americas firmly remains Apple's largest operating system with revenue nearly double that of Greater China.

Exhibit 2: Apple Revenue by Operating Segment

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What Happened?

Apple's declining revenue in Greater China over the past six quarters can be attributed to a slowdown in iPhone sales. As seen in Exhibit 3, iPhone sales share in Mainland China saw a notable tick down beginning in early 2016. The data is courtesy of Kantar Worldpanel, an analytics firm relying on longitudinal surveys to track the same individuals and their smartphone habits over time. Kantar data provides a decent snapshot of how the iPhone is selling relative to other manufacturers (sales share). The sales share peaks experienced in early 2015 and early 2016 corresponded to new iPhone launches. The most recent iPhone launch (iPhone 7 and 7 Plus) clearly underperformed the two previous iPhone launches. This weakness undoubtedly led to much discussion at Apple HQ as it came as a surprise to management.

Exhibit 3: iPhone Sales Share (Mainland China)

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A number of theories have been put forth in an attempt to explain iPhone sales weakness in China. Ben Thompson over at Stratechery made the case that WeChat's prominence in China has reduced the value and lock-in found with iOS, reducing Apple to "simply another smartphone vendor." According to Thompson, this situation has led to declining loyalty and retention rates among iPhone users. WeChat also seems to have become the consensus pick among western media when it comes to pinpointing Apple's problem in China. 

Wired's Jeremy Hsu took a slightly different angle, saying Apple was "a victim of its own failure of imagination." The company's failure to adapt services such as Apple Music and Apple Pay to local culture has contributed to fading consumer interest in Apple hardware. Hsu argued Apple Music should have a free tier while Apple Pay's reliance on near-field communication technology isn't appealing in China.

While the preceding arguments contain solid points, they ultimately end up being dubious for explaining iPhone sales weakness. Both arguments position weak Apple services adoption, either due to a strengthening WeChat or Apple's own doing, as a sign of shifting customer perceptions facing Apple in China. Poor Apple services adoption is then said to lead to less brand loyalty and greater odds of switching away from iPhone. Such a claim ends up giving way too much credit to the influence Apple services play. It's as if Apple is a services company that just happens to sell hardware. This isn't the case. There is something more at play in China regarding weaker iPhone sales besides greater WeChat competition or lackluster Apple services. 

The Smartphone Market in China

A closer look at the smartphone market in China provides the context needed to assess Apple's performance. There are three major smartphone trends:

1) Anemic smartphone sales growth. There continues to be a misperception that Mainland China is seeing 20% to 30% smartphone unit sales growth year-over-year. This just isn't the case.  In reality, smartphone sales growth is much harder to find. According to IDC, the smartphone market in China grew 3% in 2015, 8% in 2016, and has been struggling to grow in 2017. Apple management likely contributed to the false perception of there being massive smartphone sales growth in the country by constantly talking up the opportunity tied to China's expanding middle class. While this shift is occurring, its impact on overall smartphone growth is less clear. 

2) Massive consolidation. Given such anemic sales growth, there has been intense competition and consolidation, especially at the low-end of the smartphone market. In 2014, the "Other" category consisting of Samsung, Lenovo, and a number of smaller smartphone manufacturers, represented 238M smartphone shipments. Two years later, "Other" sales declined by 60M units to 178M smartphones. The big smartphone loser in China hasn't been Apple, but rather Samsung and smaller smartphone manufacturers. 

Meanwhile, Oppo has experienced the strongest increase in smartphone sales on an absolute basis in China with Vivo and Huawei coming in second and third, respectively. On a combined basis, Oppo, Vivo, and Huawei saw an increase of 130M smartphone unit sales from 2014 to 2016. While it may be easy to look at Oppo, Vivo, and Huawei as winning at the hands of Apple, in reality, their sales gains have likely come from Samsung, Lenovo, and new customers entering the smartphone market at the low-end. Despite a very difficult 2016, Apple was still able to grow annual iPhone shipments by 8M between 2014 and 2016. This goes to show just how strong the iPhone performed in 2015.

 
 

3) ASP Divergence. The smartphone pricing gap in China is expanding. While Apple sits at the premium end of the market with an iPhone average selling price (ASP) exceeding $700, every other major smartphone manufacturer is reporting ASP that is a fraction of iPhone's. Pricing data would support the theory that Apple and those smartphone manufacturers with the strongest sales momentum are appealing to completely different customers. While overall smartphone growth remains subdued, whatever growth there is can be found at the low-end of the market.

Issues

Taking into account the unique trends found in the China smartphone market, my theory is that there are actually four distinct issues impacting Apple in China. 

1) Lack of New Users. It is becoming that much harder for Apple to find pockets of premium users in China ready to buy their first iPhone. Apple's smartphone sales share in China peaked in 2015 right after China Mobile began selling the iPhone 6 and 6 Plus. While China Mobile had officially begun selling iPhone a year earlier, it was the iPhone 6 and 6 Plus that represented the first big iPhone launch for the carrier. 

Apple experienced a big iPhone sales boost from the iPhone 6 and 6 Plus launching into an untapped reservoir of premium China Mobile users. Once these users purchased iPhones, there weren't similarly-sized pockets of new users elsewhere in China. Instead, Apple had to turn to Android switchers for new users. This is one reason why new users as a percent of overall iPhone sales has been on the decline. 

2) Longer iPhone Upgrade Cycle. Considering how Apple saw a significant number of new iPhone users in China in 2015, these users were not ready for an upgrade in 2016 or even early 2017 for that matter. Instead, iPhone users in China are likely holding onto their iPhones for a longer period of time before upgrading. This trend is not unique to China but rather has occurred in various geographies. 

3) Pricing Pressure. The significant smartphone pricing gap in China has placed a ceiling on Apple's iPhone target market. It looks like the number of Android users switching to iPhone is on the decline. According to Apple, switching outside of China was up year-over-year. The implication is that switching in China was down year-over-year.  A similar dynamic does not exist in the U.S. where iPhone is actually priced at or below the Android competition. A better comparison for measuring iPhone sales share performance in China would be countries where the iPhone is similarly priced at a premium. As seen in Exhibit 4, in what may come as a surprise, iPhones sales share in these countries end up even worse than that of China. 

Exhibit 4: iPhone Sales Share (2017)

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4) Growing Pains. Although Apple has made much progress opening new Retail stores in China, the company still has an inadequate retail footprint in the country. There are only 40 Apple Retail stores in China, a country with 1.4 billion people. To put that number in context, Apple has seven retail stores in Connecticut, home to a little more than three million people.

Brick and mortar retail matters in China. According to Kantar, nearly 90% of Oppo smartphone sales took place through brick and mortar. Apple just doesn't have the retail penetration in Tier 1, 2, and 3 cities in China. For example, Apple has only three stores in Chongqing, one of the largest municipalities in China with a population of 30 million people.

While consumers have the option of buying Apple products through carriers or third-party retailers, there are drawbacks found with Apple relying on others to sell product. Despite selling the iPhone for years, iPhone sales share at Verizon remains lackluster compared to that at AT&T, Apple's initial partner in the country. Many have speculated that this lower sales share is due to the way smartphones are sold at Verizon where sales clerks have sway over consumer purchasing decisions.

Apple Retail stores represent one of the best ways for management to push the Apple experience. This is something not possible with third-party retailers. Considering it took management two years to open 20 stores in China, the lack of Apple Retail stores is an issue that will take Apple years to fix. 

WeChat

Apple's main issues in China are related to the underlying structure of the smartphone market, not greater WeChat competition. Why then is WeChat positioned as Apple's arch nemesis in China? If users spend all of their time and attention within the WeChat ecosystem, is Apple's ecosystem negatively impacted? Is WeChat cultivating a user base that views Apple as simply a premium-priced hardware provider, which will then result in less consistent hardware sales?

Unfortunately, quite a bit of the analysis regarding Apple and WeChat relies exclusively on anecdotal evidence. In an effort to move beyond this, we can use WeChat's most recent disclosures to gain a better perspective. The company disclosed that half of its 900M monthly active users spend 90 minutes a day on a WeChat property. That is a significant amount of time which likely makes Mark Zuckerberg and Evan Spiegel quite envious. WeChat is seeing success on a scale that simply isn't seen elsewhere by any other services company. However, we use our smartphones for more than 90 minutes a day. Current estimates peg average smartphone usage at five hours per day. This means the average WeChat user, while heavily invested in WeChat, is still relying on other services besides WeChat.

Meanwhile, App Annie recently pegged Chinese smartphone users as relying on ten apps on a daily basis. In terms of monthly usage, that number rises to 30 apps. Even if we assume these estimates are being generous, the narrative that WeChat users only use WeChat is exaggerated. 

The WeChat topic raises a broader question: What is Apple actually selling in China? iOS? Services? Hardware?

Apple is selling the same thing in China as it does in every other country. Apple is selling an experience. The simple act of buying an iPhone, even if it is used for WeChat, is part of that Apple experience. While Apple management would certainly like to see customers using Apple services, in reality, Apple service usage is not a requirement for Apple to succeed in a market. Instead, services are meant to add even more value to Apple hardware. At the same time, Apple service usage doesn't necessarily lead to increased loyalty and retention. Instead, the dynamic is much more complicated. For example, Apple loyalty is doing just fine in the U.S. even though Apple Pay usage remains surprisingly low.

Light at the End of the Tunnel

Signs of a bottoming process are appearing for Apple in Greater China.

  1. Revenue trends are stabilizing. During Apple's 3Q17 earnings conference call (my complete review of Apple's 3Q17 earnings is available for members here), management commented that although Hong Kong sales were still down, revenue trends in Mainland China were actually flat year-over-year. Revenue trends have now been improving for the past two quarters. While Apple is clearly not out of danger, the Greater China operating segment appears to have found some stabilization.
  2. iPhone sales share is improving. As seen in Exhibit 3, iPhone sales share has now seen two months of improvement in Mainland China. For this to occur in the period leading up to Apple's largest iPhone release in years is actually remarkable. There are two possible explanations for this improvement: the Product Red iPhone 7 and 7 Plus and a natural bottoming process in which existing iPhone users are ready for an upgrade. 
  3. Broader Apple ecosystem strength. Judging from Apple management commentary, Apple is seeing solid sales growth through its App Store in China. In addition, the iPad and Mac continue to sell well. Apple Retail store traffic and sales are up year-over-year as well. This sure doesn't look like a company seeing its opportunity in China slip away due to WeChat attacking the iOS ecosystem. 
  4. Apple made a notable leadership change. Apple recently promoted Isabel Ge Mahe to the newly created role of vice president and managing director of Greater China, reporting to Tim Cook and Jeff Williams. While the move was an acknowledgement of issues and trouble in Greater China, it is reasonable to expect greater operating efficiency, including additional effort to localize products. 

One question regarding Greater China is whether the operating segment still represents an opportunity for Apple or if it is more appropriate to look at the segment as a risk. Is the $45 billion of annual revenue from the region more likely to decline over time or can Apple be confident in looking at that total as a base for future growth? 

China still represents an opportunity for Apple although management will likely need to make additional strategy adjustments:

  1. Continue fine-tuning products to better fit local culture. There is pretty much no downside to spending additional resources on this effort. New iOS features targeting China (QR Code support, SMS fraud prevention, etc.) are a clear sign that management looks at this fine-tuning as crucial. 
  2. Embark on a massive Retail store expansion in Mainland China. A strong case can be made that Apple should have hundreds of retail stores located throughout China. 
  3. Continue strengthening relationships with key partners, including Foxconn and Tencent. With future China government regulations representing an unknown, Apple's best strategy for handling the geopolitical environment is to strengthen its relationship with local companies, including Foxconn. Contrary to popular belief, Tencent is more of a partner than enemy for Apple.
  4. Remain steadfast on taking a long-term view on China. Apple should focus not on turning around quarterly iPhone sales by releasing a cheap iPhone, but instead on forming a foundation for the Apple brand in the country. 

Apple ends up being graded on a curve in China. Apple is on track to report $45B of revenue in Greater China in 2017. Meanwhile, some of Apple's peers in the U.S. may never see much revenue at all from China. While Apple has its fair share of issues to overcome in China, fundamentals appear to be intact. Apple's ultimate goal in China is similar to its goal in every other country: Sell tools that are capable of improving people's lives. Apple is going to be just fine in China, even if customers use WeChat to enhance their Apple tools. 

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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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