Tackling the AAPL Unknown

Humans hate the unknown. Some look towards charts and tables, while others simply create stories to turn the unknown into easy to understand answers. 

Apple is currently facing the following questions (I suppose you can say its my attempt at tackling the unknown): 

1) Is iPhone growth slowing?  Maybe. We don’t know. iPhone 5 supply/demand is not in equilibrium. Apple is currently selling every iPhone 5 it can produce. After reporting 81% annual iPhone unit sales growth in 2011, Apple is tracking towards 70% growth in 2012. Will growth continue to decline or can the iPhone 5 stem the inevitable for a few more quarters? 

2) How should we think about iPad? I’m left somewhat confused following Apple’s iPad event. Heading into today, my gut was telling me the iPad (3) was not selling too well compared to the iPad 2 - a sign that consumers’ needs were being met with a cheaper, lower quality iPad. I also assumed an iPad mini would be positioned as a content consumption device to the iPad 2 and 3.  

Instead, Apple revised the iPad (4), kept the iPad 2 alive (seemingly to float in no man’s land), and unveiled an iPad mini that by all measures is as capable as a full-size iPad and just as worthy as its larger, and more expensive, siblings.  Will iPad’s ASP continue to decline? Where are margins heading? Are consumers’ technology needs being met by iPad? Questions are certainly outnumbering answers. 

3) Will Apple introduce new product categories?  Maybe. We don’t know. We can assume that Apple has plenty of new stuff cooking in the labs, but we have few concrete details on anything.  Will 2013 be the year of the next “big thing”? 

4) Is the economy impacting Apple?  Maybe. We don’t know. Apple was able to survive the financial crisis of 2008-2009 without much damage, however Apple was a much smaller company at that time appealing to a more niche audience. Are consumers delaying technology purchases due to economic pressures?  Apple continues to have supply issues, but once demand/supply equilibrium is met, sales are increasingly disappointing as product cycles appear to be accelerating. 

Now compare today’s unknown with the “AAPL story” of early 2012:

1) The iPad (3) was widely expected to be introduced and replace the iPad 2 as the top-selling iPad.

2) The iPhone 4S was selling well and the iPhone 5 was widely believed to be in the works.

3) Overall product margins were making new highs and expected to continue.

4) Management announced a dividend initiation (which may have included some front-running by AAPL shareholders). 

AAPL observers had a much easier time turning the unknown facing Apple from January to April into a convenient and easy to understand story. AAPL stock also went up 50% during the same time period. Are the two related?  Does a stock go up or down due to a specific reason or is that another example of humans trying to cope with the unknown?

Apple’s unknown will eventually be packaged into a clean story. It may take a day, week, month, or year, but it will happen because humans hate the unknown. 

AAPL 4Q12 Estimate

Revenue: $36.2 billion (AAPL guidance: $34.0 billion/Consensus: $36.2 billion) 

• I expect iPad and iPhone to represent approximately 69% of Apple’s quarterly revenue.  

GM: 40.8% (AAPL guidance: 38.5%/Consensus: 40.4%)

• Apple’s margin will likely decline sequentially from 3Q12 due to the iPhone 5 and continued iPad 2 sales. A key question facing AAPL in the near-term is the margin run rate. In 2011, Apple reported a 40.5% gross margin, which increased to approximately 44% in 2012. Looking at 2013, I expect margins to decline a few hundred basis points to 42% related to the iPad mini and ongoing costs related to the iPhone’s new form factor.

EPS: $8.95 (AAPL guidance: $7.65/Consensus: $8.85) 

• I expect Apple to report 27% yoy EPS growth.  Interestingly, my $8.95 estimate is close to the Street’s $8.85 average, with 17 analysts projecting EPS higher than my $8.95. I attribute my low estimate to weaker iPhone sales, a lower iPhone average selling price (ASP), and a lower overall margin.

Product Unit Sales and Commentary

Macs: 5.5 million (12% yoy growth)

• Mac growth is slowing as tablets and smartphones satisfy many consumers’ computing needs. I expect double-digit growth in portables, driven by back-to-school purchases, to be partially offset by a modest decline in desktop sales due to stale models.

iPad: 18.4 million (65% yoy growth)

• I expect Apple to report record iPad sales for 4Q12. My iPad estimate assumes approximately 1.5 million iPads sold per week (including iPad 2 sales), which compares to the approximate 1.4 million weekly run rate last quarter. Supply/demand is in balance. Anecdotally, iPad 2 sales in education and business appear robust following the price cut, while lower component and manufacturing pricing should help limit drastic margin compression.

iPod: 6.1 million (8% yoy decline)

iPhone: 24.8 million (45% yoy growth)

• My estimate reflects 7 million iPhone 5 units and approximately 18 million iPhone 4S units (and to a lesser extent iPhone 4 and 3GS). Apple is currently suffering from a supply/demand imbalance for iPhone 5, which will limit sales in the near-term (including 1Q13). Other unknowns include the iPhone 4S sales run-rate prior to the iPhone 5 introduction and iPhone 4S popularity following the price drop. My 18 million iPhone 4S estimate reflects the impact from consumers delaying iPhone purchases ahead of the iPhone 5 release.  I am including a declining ASP due to robust iPhone 4S sales following the price drop (an observation partially derived from Verizon’s earnings which showed strong non-iPhone 5 sales, which I attribute to the price drop).  

When Apple releases earnings on October 25, investors will focus on product ASPs and margin. Publicized iPhone 5 supply shortages and iPad mini rumors should go a long way in explaining any moderate misses in iPhone and iPad unit sales, respectively. Nevertheless, any evidence of continued margin weakness and declining ASP in iPad and iPhone may push observers to reduce forward earnings, which have a high sensitivity to margins. A 100 basis point change in margin corresponds to a 3% change in Apple quarterly EPS.

iPad Invading Enterprise. Re: Urban Outfitters

Urban Outfitters, a clothing retailer with $2.5 billion in annual sales, held an analyst/investor day on September 27 and to say that iPad and Apple played a minor role would be an understatement. Management outlined how iPad is increasing customer satisfaction, in addition to improving Urban Outfitters’ efficiency and financial performance. I found the presentation quite revealing and helpful in trying to understand, straight from the source, one example of how iPad is invading enterprise.

All quotes are attributed to Calvin Hollinger (Chief Information Officer), unless noted otherwise.

Two years ago, we deployed iPad point-of-sale into all the stores. An iPad point-of-sale is pretty much — it looks like your iPhone. It has a little case around it. You can scan bar codes. You can swipe the credit card, and it does everything that a normal point-of-sale system does, except you can’t take cash obviously. We don’t have a debit device. You can’t take debit transactions, and you can’t take checks. But it does everything else that a point-of-sale device can do.

When we deployed it, again, two years ago, it was very well received by our customers. There’s a very personal interaction between a sales associate and the customer. It was well received by sales associates. They had fun having a customer sign their signature with their thumb. And it was especially well received by Frank Conforti, our CFO, because this device, fully loaded, fully installed, is about $500 and register is about $5,000. So it also made financial sense. 

Not only are iPads improving customer satisfaction (which is an important piece of brick and mortar retailing), but Urban Outfitters is saving money by moving to mobile point of sale. What is a drawback? An iPad can’t physically hold cash. As more customers move away from cash and towards other forms of payments, this “drawback” will become less relevant and judging from how cash is handled in Apple stores (hidden cash drawers), a cash-paying customer can still have a carefree transaction with mobile point of sale. 

And in fact, we told the stores, “Give us back your fixed register that we can refurbish and use somewhere else. Give us back one register, we’ll give you five of these devices.” I don’t have the exact numbers. John [ph], you can correct me. Between the brands, I think we’ll be sending about 1,100 of these devices for peak of this year.

Compared to the millions of iPads Apple sells each quarter, 1,100 iPads are drop in the bucket. However, more importantly, Urban Outfitters is planning on replacing every cash register with five iPads, expanding iPad’s usage and relevancy within each store. 

Richard Hayne - Co-Founder, Chairman of the Board of Directors, CEO, and President:

Right now our store associates can better service our customers by selling merchandise from the web inventory using an iPad in stores. This is a very impactful thing that we have rolled out this year, and it’s been incredible for us. And vice versa, the web can now sell merchandise that’s from our stores, so customers can be shipped items from their local store, which is resulting in fewer broken sales in the web, better use of slow turn merchandise in the stores and faster delivery times for the customer. So all in all, a happier customer.

Helping customers while improving business fundamentals, all the while saving cash - hard to say no to that proposition. The ability to seamlessly sell web inventory in a physical store is a big deal as the retailer is able to save in inventory costs, while not losing a potential sale. Anecdotally, I have heard the ability to order different clothing sizes, colors, and styles from the web (after first trying on in-store) is a big deal. 

The iPad is a very, very powerful device. So in addition to being a register, we can download a lot of content down to the stores, maybe training videos, maybe, Hey, this product sells or this product, the whole market buys it, all the reports, sales reports, a lot of information because it’s a very, very powerful device, and it’s very, very easy to use. A big screen, very, very intuitive. 

That’s a lot of verys.  Not only will Urban Outfitters use the iPad as a point of sale, but it will truly transform the way business is done at the brick and mortar retailer.

Now although this is a mobile device, iPad is a mobile device, we have to set up with the pilots to have it on a swivel arm, so it’s very clean. If it’s not in use, you can take the swivel arm and put the iPad away and you can use this as a packing space or maybe to display more items to sell, et cetera. And then from a customer’s point of view, here’s the customer, return the iPad to the customer, she’s confirming her shipping address. We could also use it to — well, and used to be, for example, a gift registry. A very, very powerful device.

Gift registry. Yet another use for iPad. 

2 or 3 weeks ago, we placed our very last register order. We’re out the register business. Going forward, we had placed the orders. We’ve got some new stores coming up. But once we successfully make sure this iPad works in all the stores, all stores will be designed and equipped with iPod Touches and iPads. And Frank is, again, happy, because the iPad is $1,000 fully installed versus $5,000. But all our stores going forward will have iPads and iTouches.

Regardless of a fully installed iPad’s cost - ranging from $500 to $1000, the price pales in comparison to a cash register’s $5,000 price tag. 

Similar stories and case studies of iPad being used in enterprise are occurring in a range of industries and companies as iPad’s disruptive capabilities are becoming more valuable. iPad’s invasion into enterprise is only getting started.  A full transcript of management’s presentation can be found here. 

Marketing a Smaller iPad

Marketing is an art, not a science. We were fortunate to see this art first-hand on January 27, 2010 as Apple unveiled the iPad. Technological and engineering marvels aside, Apple faced the daunting task of marketing a disruptive product that had to grow into its role of replacing the modern-day PC. Jump ahead 33 months and it appears Apple has had some initial success, selling 84 million iPads. Within weeks, the world will see Apple’s second test marketing iPad, but this time it will be a new form factor, a smaller iPad.
 
Marketing; Portraying the Product
 
The most important aspect of marketing is the product; the look, feel, and sound (fortunately iPad’s smell and taste aren’t a major factor in this discussion). Apple eloquently marketed the iPad as a sexy device that could do a few things extremely well, all the while feeling great in your hand. The consumer was left focusing on iPad’s strengths, and not its short-comings, or mysteries, such as if its weight becomes an issue after extended use. In subsequent years, Apple began the task of marketing the iPad as a device capable of content creation, in an effort to begin cementing its path to replacing the modern-day PC. When unveiling a smaller iPad (7.85-inch screen) in October, Apple will be given 60 minutes to tell a story; why a smaller iPad should exist.
 
Apple may take two paths:
 
1)      Positioning a smaller iPad as a replacement to the current 9.7-inch iPad. Apple’s presentation will include all of the features a smaller iPad could do well, such as web surfing, content consumption and creation, but in a smaller form factor and at a lower price point. Consumers will have to decide between a small or large iPad.
2)      Positioning a smaller iPad as a companion to the current 9.7-inch iPad. Apple’s story will include the few things a smaller iPad could do extremely well, such as content consumption, in a more convenient form factor for extended passive use, such as reading or watching movies. Consumers will understand the differences between a small and large iPad and come away from the event wanting both, not one or the other.
 
Apple will most likely choose the second path, positioning the smaller iPad as a companion device to the current iPad line-up, and in doing so will not only sell a lot of small iPads, but keep the large 9.7-inch iPad as the powerhouse in the tablet market.
 
The Tablet Story
 
On January 27, 2010, Apple could have unveiled an iPad with a 7-inch screen, or 8 inches, or maybe even 12 inches, but settled on 9.7 inches. Apple knew there would be plenty of television commercials marketing iPad, but the biggest marketing ploy would be the product itself, a device capable of eventually replacing the modern-day PC as the primary form of computing. Apple wanted (or needed) consumers to begin thinking of an iPad as a possible laptop replacement from the start. The “iPad as your new laptop” thought didn’t need to be completely formed on Day 1, or even by Year 3, but Apple needed to plant the seed on Day 1 and a 9.7-inch device was an easier sell than a smaller 7-inch device.
 
Fast forward a few years, and the tablet market is now flooded with smaller 7-inch tablets. Besides not being given an adequate reason for their existence, consumers are confused by these 7-inch tablets labeled as a “full tablet” despite failing in comparison to a laptop’s immense feature list.  
 
So why should Apple introduce a smaller 7.85-inch tablet now? It is time because the 9.7-inch iPad is a success.
 
A Smaller iPad; Companion to the Current iPad
 
The iPad is now well established as a successful tablet and cornerstone to Apple’s product line-up. While many have fallen in love with iPad, the device does have some minor drawbacks, namely form factor for extended use and price. The device tends to feel heavy in hand after extended use, such as reading or movie watching, while the $499 entry price is still unattainable for a large swath of the population, including education and business, leaving wiggle room for competitors to try something at the bottom-end of the price ladder. Are these two factors (heavy form factor and price) enough for Apple to introduce a smaller iPad?
 
In October, Apple will address the space between an iPhone and a 9.7-inch iPad and most likely market a 7.85-inch iPad as a companion to the 9.7-inch iPad. Books, movies, TV shows, podcasts, and games will be shown as more enjoyable given a smaller iPad form factor. Apple will need to walk a delicate line though positioning a smaller iPad as the best way to consume content, as many will continue to enjoy content on their large iPads (as well as on their iPhones).

More importantly, Apple needs to portray a small iPad not as a 9.7-inch iPad replacement, but as an iPad companion. If consumers begin to think of a smaller 7 to 8 inch device-great at content consumption but not so great at other aspects-as an iPad replacement, the effort of positioning iPad as the disruptive force will be in jeopardy since wide-spread adoption would come under pressure and laptops would continue to appear superior to the average 7-inch tablet.
 
For those who would buy a smaller iPad due to price, proper marketing will position the smaller iPad as a gateway drug to a larger iPad. If a consumer enjoys content on a small iPad, the thought of not only consuming the same content, but also creating content on a larger iPad will only be enhanced.
 
Other Musings
 
Price. If given three $5 casino chips and told to guess the small iPad’s price, the $199, $249, and $299 squares would be occupied with a chip. If given one $15 casino chip, the $249 price point would be occupied. Not only is the product itself a form of marketing, but a device’s price can say a lot. Priced too low, a small iPad may have a hard time losing the “just a content consumption” tagline, while priced too high and the small iPad becomes an iPad competitor as consumers assume the two devices must be similar in compatibility. A $249 price point would be the best of both worlds; a device $150 less expensive than the entry-level iPad 2, but still more expensive than other 7-inch tablets.
 
Future iPads. One could replace any mention of “small iPad” in this piece with “larger iPad” and the same overall thesis would apply. A larger iPad (greater than 9.7 inches) for content creators (movie makers, artists, designers, etc.) would certainly make an interesting proposition.
 
iPod touch. The updated 5th generation iPod touch (and all of its amazing features) is sold for just $299, which could very well be more expensive than a 7.8-inch iPad. Apple is positioning the iPod touch as that powerful guard, awake all night, preventing any Trojan horse from causing havoc.
 
Product Quality. It says a lot that throughout this entire discussion, the idea of Apple selling a small iPad with superior quality and craftsmanship is simply assumed to occur.  Anything else would be a disappointment. High expectations can be both a blessing and curse.

Amazon Phone

One of Amazon CEO Jeff Bezos’ answers from his recent AllThingsD interview stood out to me: 

"[Amazon’s] approach is, if we have a good idea, and if it’s something we think customers would care about…then we don’t ask why do this, we ask why not do this? We have a high bar for doing those things. We don’t want to do me-too things. The people we’ve attracted over time to Amazon want to be pioneers. They want to be inventors. They want to do new things."

Sounds like Amazon will not only be entering the phone market, but also simultaneously inventing a new business model along the way.  I have a feeling Walmart and Target executives will be reading technology blogs a little more closely these days.