Finding Apple Strategy Clues in Apple Watch's Human Interface Guidelines

With over 40 tech blogs reporting on Apple's WatchKit release yesterday, there has been no shortage of designer and developer tidbits to digest including screen resolutions and fully native Apple Watch apps arriving in late 2015. I read the Apple Watch Human Interface Guidelines (HIG) with a different goal; to find clues as to how Apple will market Apple Watch.

During Apple's September Apple Watch keynote some observers thought Apple failed to demonstrate why someone should buy an Apple Watch. Instead of picking a few key selling points, Apple had VP of Technology Kevin Lynch go on stage and play with various apps and a confusing beehive-like layout of tiny icons. I disagreed as I thought Apple touched upon a few selling points that normal users might be interested in (maps, photos, communication) and the overall messaging was that the Apple Watch's full potential will be realized with third-party iOS apps. 

From my piece "Apple Keynote Notes":

"Apple didn't go into much detail about why someone should use an Apple Watch, instead demoing a few features that seemed cool or at least interesting. I think most of this is taken from the iPad playbook  - show users various things you can do with the device and then step back and see what sticks. At one point Apple even mentioned there is much more to say about the device, but there wasn't enough time."

Apple laid out three overarching design themes for Apple Watch in the HIG released yesterday: personal, holistic, and lightweight. Each not only helps describe Apple Watch, from its size to functionality, but also sheds some light on how Apple will market the device in relation to the iPhone. 

Personal - Apple goes out of its way to remind developers that the Apple Watch is something that is worn and therefore requires a level of personalization that has yet to be seen in the tech space.  The device's personal communication aspect (Digital Touch and the Taptic Engine) stands out as something that an iPhone just isn't able to accomplish. 

Holistic - A few days after purchasing my iPad, I knew the device was going to be a hit as the hardware seemingly melted away whenever I touched the screen. 

From my piece "iOS App Innovation and iPad 2 Design Lead to Magic":

"Remove the intermediary and let users interact directly with innovation." 

Apple is following a similar path with Apple Watch by stressing that the software must make the hardware disappear during usage. Such a requirement is made even more important due to the device being worn all day. 

Lightweight - The Apple Watch is meant to display small snippets of information and data. Instead of thinking of the device as a mini-iPhone, Apple wants developers to rethink how an Apple Watch user can consume data in a completely new way. Apple stressed key words that contained descriptive imagery, such as "briefly", "frequently", and "small display". 

I think these three Apple Watch design tenets go a long way in describing how Apple could market an Apple Watch. Apple will walk a thin line because if too much focus is put on the need to connect Apple Watch to an iPhone, consumers may look at the Apple Watch as an overpriced iPhone accessory, but overhype Apple Watch's capabilities and users may think they don't need the latest and greatest iPhone. 

How can Apple sell Apple Watch? Position the device as a way of improving one's iPhone. A device that can take iPhone's drawbacks and repackage the problem into new solutions. A few real-world examples of this strategy:

1. Communication. One of iPhone's communication problems is that the device needs to be both within the user's line-of-sight and reach to initiate or continue communication with someone. With Apple Watch, the user will be able to communicate only by touch (Taptic Engine) while the iPhone is tucked away in a pocket or purse, or lying on the passenger car seat. Granted, that type of communication is rudimentary when compared to iPhone's capabilities, but in certain contexts it is both efficient and effective. Users now have two distinct forms of communication: iPhone and Apple Watch.
2. Maps. The iPhone can be used to get turn-by-turn navigation to reach a parking lot or destination, but once the user is near that location on foot, the iPhone's utility diminishes as the need to actively look for real-world visual clues, as well as weaving in-and-out of pedestrian foot traffic, makes it difficult to have an iPhone in hand. An Apple Watch can be used via quick glances to determine if the destination is one block ahead or on the other side of the street while the iPhone is kept in a back pocket or backpack. Users now have two devices to use directions to reach a destination: iPhone for the sheer grunt work, Apple Watch for the nuance details at the end of the trip. 
3. Apple Pay. While Apple Pay and iPhone seem to work flawlessly, having to take your iPhone out of pocket and then hold it up to a POS terminal is not the most efficient process. Instead if users can rely on iPhone to manage payment information as well as retailer loyalty programs, but use Apple Watch to complete the retail transaction at POS. The iPhone remains safely in pocket or purse throughout the transaction, simplifying the process. 

In each case, both the Apple Watch and iPhone are required to accomplish a task, but the process of working through the "problem" is broken down into more granular tasks, with the more complicated and power-hungry steps kept on iPhone, while Apple Watch tackles the small finishing touches. Over time, it's not hard to see Apple Watch gaining more capabilities, but in the near-term the Apple Watch and iPhone can work together to improve one's efficiency. Apple's job in marketing Apple Watch will be to demonstrate how the iPhone's sheer power and capabilities produces some annoyances and then explain how Apple Watch can help solve those inconveniences.

Apple Watch Sales and Earnings Projections

Apple will start selling Apple Watch in early 2015 and based off of my analyses, I estimate Apple will sell 20-30 million Apple Watches bringing in $11 billion to $17 billion of revenue and $0.70-$1.00 of EPS over the first 12 months on the market. 

Apple Watch Addressable Market

Analysts are relying on various methods to arrive at Apple Watch's addressable market including surveys, prior Apple product launch sales trends, and current watch market data. I disagree with those methods since they contain significant issues or error-prone variables.

1. Surveys. Customer intention patterns do not correspond well with actual behavior. 
2. Previous Apple Product Launches as a Proxy. My biggest issue with this method is that it ignores the passage of time and ecosystem changes.
3. Current Watch Industry Data. As Apple has shown over the years it is pointless to use existing pre-Apple industry market data as a proxy for future Apple sales.

I extrapolate Apple's addressable market for Apple Watch from iOS adoption rates. I use the share of iOS devices that upgraded to the latest iOS release by the end of the first full day after release as a proxy for Apple's most loyal customer base. I classify these users as a fair approximation of Apple's initial addressable market for an Apple Watch. Using a 2.4-year iPhone replacement cycle, I estimate there are approximately 400 million iPhones in use today. Since there are older devices resold or passed down to children and relatives, I would label the 400M data point as a base case estimate.

I consider a user that upgrades to the latest iOS release within the first full day after release as someone who is more interested in their phone and consequentially Apple. Why? These users are actively seeking out, and then upgrading, their iOS software which demonstrates an interest in their device or a willingness to try the latest software product. The steep adoption rate drop-off from iOS7 to iOS8 suggest there wasn’t much of an impact from Apple automatically sending a download notification to devices on the first day of a major software release this year. Exhibit 1 displays adoption rate estimates for the previous three iOS version launches. 

Exhibit 1: Apple iOS Adoption Rates 

Using the average between Mixpanel and Fiksu, I arrive at 13%, however Mixpanel has historically tracked closer to Apple's reported adoption rates, therefore I increased the 13% average to 15% to reflect a greater weighting for Mixpanel. I then multiplied that percentage by the 400 million iPhones out in the wild to arrive at approximately 60M core iPhone users that serve as a prime target to sell Apple Watch (which requires an iPhone 5, 5c, 5s, 6, or 6 Plus). It is important to note, as Apple VP Greg Joswiak said recently at the Code/Mobile conference, the Apple Watch is geared for everyone and not just those interested in technology. However, due to the requirement of owning an iPhone, I think 60 million is a fair estimate of the number of people interested in buying an Apple Watch from Day 1. Another variable is since adoption rates reflect iOS devices, there may be an impact from the same user upgrading all of his or her iOS devices at the same time. Considering the steep adoption rate drop off from iOS 7 to iOS 8, this impact doesn't worry me too much as I consider my 15% estimate to be a base case as there were many users who could not upgrade to iOS 8 on the first day because of a lack of storage. 

Apple Watch Sales Projections 

With my 60M estimate for the addressable Apple Watch market, I assume everyone in this group buys an Apple Watch over the first 12-18 months. Taking into consideration Apple Watch prices, a certain amount of time may be needed before a purchase is made therefore I backloaded sales into the second year to arrive at 20-30M units sold in Year 1 and 30-40 million units sold in Year 2. 

Exhibit 2: Apple Watch Sales Projections

Apple Watch Average Selling Price Estimate 

I estimate the Apple Watch average selling price (ASP) to be $563, as shown in Exhibit 3. While the $349 price for Apple Watch Sport has been announced, I included estimated selling prices for the other two watch collections. My estimates do not include additional Apple Watch band revenue. I am estimating a $7,500 estimate for a supply constrained Apple Watch Edition. I wouldn't expect much of a difference in demand moving from $3,000 to  $7,500, so in order to maintain its exclusivity, I expect Apple to set a high price.  The obvious risk to my logic is if Apple prices the Edition collection closer to $1500 and includes a viable replacement program, driving much more in the way of sales, but even then the ASP would only change by approximately 15%.  I expect China to be a big variable when estimating Apple Watch Edition sales, but for now I am including a limited production schedule at least in the first few quarters of release.

Exhibit 3: Apple Watch Collection Breakdown and ASP Estimate

Apple Watch Sales and EPS Estimates 

Exhibit 4 includes my estimates for a few Apple income statement line items. I estimate Apple Watch margins will come in less than iPhone, but higher than iPad with economics of scale adding a few hundred basis points of margin over time. Obviously this is an inexact science and watch accessories can help boost margin. Estimates reflect continued share buyback through 2016.

Exhibit 4: Apple Watch Revenue and EPS Estimates

Conclusions

I suspect Apple may have a hit on their hands with Apple Watch. Running with a 15% iPhone base penetration rate, I estimate Apple will be able to sell upwards of 60 million Apple Watches over the first 24 months on the market with more risk to the upside given Apple's strong iPhone guidance for this quarter.  From an EPS perspective, Apple Watch can add between $0.70-$1.00 in the first 12 months after launch. 

 

This report should be used to understand where I stand on Apple Watch especially when I discuss the product in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. Downside risks to my estimates include: Apple Watch supply issues and weaker-than-expected customer demand. Upside risks to my estimates include: Stronger-than-expected customer demand, especially in China.  This report was produced by Neil Cybart on November 18, 2014. 

I publish a daily email called AAPL Orchard containing interesting Apple-related links and analyses. Click here to subscribe. 

UnionPay Received an Apple Press Release

Event: Customers in China can now use UnionPay for App Store purchases.  

1) Apple has issued 48 press releases YTD in 2014, all of which have a certain level of importance and noteworthiness, which stands at contrast to many other companies of Apple's size. 

2) I judge an Apple press release's importance by its Apple executive quote. Apple SVP Eddy Cue in announcing UnionPay support: "The ability to buy apps and make purchases using UnionPay cards has been one of the most requested features from our customers in China" and "China is already [Apple's] second largest market for app downloads, and now we're providing users with an incredibly convenient way to purchase their favorite apps with just one-tap." I really wouldn't read much more into the announcement. Apple expects this deal will boost app purchases in China, simultaneously boosting the iOS ecosystem. 

3) China is an interesting topic when analyzing Apple. Many assume that China represents untapped potential where Apple will win simply by opening retail stores and selling new product. In reality, Apple has been working extremely hard and has faced numerous challenges in China.  Greater China (Hong Kong, Taiwan, and the mainland) currently represents approximately 15% of Apple's revenue. This UnionPay press release embodies one small victory that when combined with years of work will likely lead to China being Apple's largest market. 

Samsung's White Flag

Event: With its smartphone business prospects looking darker by the day, Samsung is now turning to the Internet of things for growth.  

Samsung's battle with Apple in the high-end consumer tech space is likely over.  This past February I wrote a piece titled, "Samsung's Crisis of Design 2.0" referencing Samsung's utter lack of direction and focus with half-baked smartwatch ideas and subpar smartphone industrial design. The first "crisis" occurred when Samsung was unsure how to compete with the iPhone's user experience back in 2010. Now in an effort to find growth Samsung is focused on the Internet of things despite software being the company's weak point. Engineers are being shuffled around,  management tension is building, and the company is still trying to find something that will stick against the wall.  Two months ago Tim Cook was on Charlie Rose and when the question about Apple's competitors came up, Tim Cook quickly responded "Google" and then mentioned how Google enables other hardware companies, like Samsung.  The message was clear: Samsung was already placed in Apple's irrelevant bucket.  I suspect Samsung will give the low-end smartwatch space another try once the Apple Watch is released, but with design and software being Samsung's weak points, my expectations are set pretty low. 

Large M&A Is Not in Apple’s DNA: Case Study of Why Apple Won’t Buy Tesla

Apple’s Beats acquisition raised questions pertaining to Apple’s attitude towards acquisitions. The $3 billion price tag was approximately five times higher than that of its previous largest acquisition, NeXT in 1997, after adjusting for inflation. Was Beats the start of a new era in which Apple would follow other large tech companies and use some of its $150 billion cash pile to fund larger acquisitions? While Apple may alter its outward appearance in reaction to the environment, large M&A is not part of Apple’s DNA. With Apple’s product success built on collaboration and design and reinforced by Apple’s organizational structure, there is no room for large M&A. Using this theory to address a real case study, Apple will not buy Tesla because of the low probability of long-term value creation.

Acquiring Beats

Beats did not represent a change in Apple’s acquisition strategy. The $3 billion price, while large on paper, is a bit misleading because Apple acquired a significant amount of intangible assets, including brand and human capital, which I discussed in my piece titled “What the Beats is Going on? Thoughts on Apple Acquiring Beats” published soon after the rumor broke. With only 700 employees, Beats was not a large company. Approximately 200 employees were not given long-term Apple employment according to Bloomberg, leaving roughly a 500-person team, or a team the size of a small Apple division. If additional personnel are shifted to other departments over time, Apple is left with a 300-person team that can easily fit into Apple’s way of doing business. Beats ends up looking very similar to many other Apple acquisitions. I look at the Beats deal as Apple reacting to the changing music industry with no underlining change to its philosophy of avoiding large acquisitions, just as someone can change his or her physical appearance, despite having the same personality and DNA.

Apple’s Keys to Success

Apple SVP of Design Jony Ive isn’t one to shy away from describing how Apple has been so successful, and that trend continued last week with a talk he gave at Design Museum in London. To Jony, success is born from complete collaboration and focus, which at Apple means something more unique than at other companies.

Apple’s 18-person core industrial design team remains very loyal and tight-knit with no deflections over the years. The group’s small size and the benefits that arise from that make Jony hesitant to grow the group much more. It is that family-like bond that contributes to Apple’s success as products are created over a multi-year period with conversations in the earliest stages often determining where the next steps will lead. Jony told the audience at Design Museum, “[p]articularly at the beginning of ideas, we have to have incredible discipline to listen really hard. To realise we can end up somewhere very different if we make these decisions…[product design] always starts off as a conversation and a thought.”

Collaboration

Collaboration manifests itself elsewhere in Apple’s structure as major initiatives take resources from different departments.  An analogy I like to use associates an upcoming Apple product with a Macy’s Thanksgiving Day Parade balloon float.  The rope handlers (those who help guide the balloon) represent resources from different Apple departments.  If a few aren’t on the same page, the float may veer of course or become unsteady. Once the float has navigated the parade route safely, the rope handlers (employees) can move on to the next balloon (product). Bloomberg had reported that the Apple Watch had “hundreds of engineers, designers, and marketing people” working together over the span of two years. How can big M&A fit into this required collaboration to create additional value?

Design

Even if a company can find the secret to bottle collaboration, success is still not guaranteed as the keystone; intuitive design, is missing from the arch of success. Design and collaboration go hand-in-hand, not just for consumer tech hardware companies, but for any company selling a product. Jony explained this trend when he said, “I think it’s much harder for good design to come out of an organization and to come from that as a driving force. [Apple’s] goal is to desperately try to make the best products we can.” Adding in new teams, resources, and ideas to a very tightly controlled equation raises the risk of failure without adding much in the way of upside.  With Apple being a product-focused company, this delicate combination of intuitive design and collaboration makes it that much more difficult to add large M&A into the mix.

Apple’s Existing M&A Strategy

Apple has been quite active on the acquirer front, with approximately 35 acquisitions since the beginning of 2013, most of which were never made public. A few commonalities amongst these companies: small, focused, bolt-on type transactions.  Apple looks at acquisitions as a way to fill talent and resource holes that could only be addressed in a timely manner by acquisition. Tim Cook has often said while Apple has a significant amount of cash, Apple does not have unlimited resources in terms of human capital and will have holes that become apparent either in the areas of software deficiencies or hardware design.

Apple M&A Case Study: Tesla

BI Deputy Editor Jay Yarow published an article last week titled, “Apple Should Buy Tesla,” containing four reasons why Apple should acquire Tesla:

• Apple can afford to spend $60 billion on Tesla so it should spend the cash.
• Apple knows how to manufacture complex objects like phones and tablets, so a car shouldn’t be that much different.
• Elon Musk could focus on other ventures besides cars.
• Apple executives Eddy Cue, Phil Schiller, and Jony like cars.

While I assume some of these reasons are a bit tongue-in-cheek, and Yarow primarily is looking at Tesla’s popular Model S vehicle and the inability to meet demand due to manufacturing “troubles” as reasons for Apple to acquire the company, does Tesla pass the litmus test for representing a key Apple acquisition target? Three reasons lead me to conclude no; a Tesla acquisition would make little sense for Apple.

1) Tesla doesn’t bring enough value to the table. I struggle to see the value Tesla would provide Apple especially when compared to the value Tesla is creating on its own concerning energy generation, storage, and distribution.

• Does Tesla have design talent? Yes. Does Apple need a significant infusion of design talent? No.
• Does Tesla have a great product? Yes, the Model S. Does Apple need to have that product to offset a weaker product portfolio or missing hole in its ecosystem? No.
• Does Tesla provide any strategic benefits to current Apple products? No (excluding possibly some aspects of battery R&D).
• Does Tesla have headwinds or negatives that may continue after an acquisition? Yes. Regulatory roadblocks concerning vehicle sales as well as consumer limitations with electric cars.   

2) Tesla is too large and complex. With approximately 10,000 employees, a 5.5 million square foot assembly facility in Fremont, California, and now a $5 billion advanced battery factory being built in Nevada, Tesla would not be easy company to fold into Apple. Add in the financial complexity from building cars and owning such significant level of assets, and the financial impact on Apple quickly becomes just as ugly. Apple has traditionally outsourced manufacturing and assembly, and with Tesla that would be drastically altered as Tesla is known for its ability to turn raw materials into a finished product all in the same plant – one reason contributing to the vehicle’s high price.

3) Apple doesn’t need Elon Musk. Steve Jobs’ greatest product was Apple: a company built to allow complete collaboration and focus. At this point in Apple’s history, the company doesn’t need an Elon Musk figure, whose aspirational dreams concerning transportation and civilization may cause friction within Apple. That type of overarching reach and generalization could lead to significant issues for Apple and its product-led, design-focused goal where end products may end up having just as big impacts on society as some of Musk’s reaches, but without the fanfare during the development stage.

In a situation where Tesla did have value to bring to the table, such as incorporating CarPlay into its vehicles or battery technology, a partnership with Apple would make more sense, similar to Apple’s recent IBM enterprise partnership for getting more iOS devices into the corporate world.  In addition, even though Apple already has R&D dedicated to transport and vehicles, primarily on the side of energy production and efficiency, it’s not clear what the automotive industry will look like in 5-10 years and if there is a need for Apple to enter the space.  It may be more likely that Apple gets involved in automobiles at a point where the industry has shifted to a position where a new entrant with a different way of looking at the world and automobiles can enter the space to create a great product.

Apple’s M&A Going Forward

I wouldn’t expect any slowdown in Apple’s acquisition pace as the company continues to push the envelope with various products such as more powerful mobile devices, innovative industrial design, and new services for content (music, video, apps, and communication). By remaining “focused” on a few products, Apple does leave itself exposed to holes where outside talent may be needed, but with $150 billion of cash and a company DNA that doesn’t include large M&A, Apple has significant resources to accomplish the goal of making great products. 

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I publish a daily email called AAPL Orchard containing interesting Apple-related links and analysis. Click here to subscribe.

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