Apple Watch Isn't a Luxury Watch

Many people are trying to analyze Apple Watch with the assumption that the device is just another luxury watch only with additional customization and features. I think this type of thinking misses the big picture. An Apple Watch will be just as much a watch as an iPhone is a phone.

Last week, I discussed how I thought Apple will sell Apple Watch by positioning it as a watch with customizable faces and bands. By keeping the message simple, anxiety and uneasiness will be removed from the buying decision. Most consumers, even if they don't wear a watch, understand what a watch is and what it does. However, the comparsion of Apple Watch to a luxury watch needs to stop there as once a user begins to rely on Apple Watch for communication, health and fitness tracking, and mobile payments, the idea that it is just another luxury watch will no longer apply. 

The Apple Watch and its strengths shouldn't be compared to luxury watches, and more importantly, luxury watch strengths. Timelessness, or lack thereof, seems to be at the top of the list of lingering questions about Apple Watch. If a luxury watch can last the test of time and be passed down from generation to generation, how would Apple Watch compete? Who would pay thousands of dollars for a device that won't stand the test of time? Timelessness won't matter for Apple Watch since the Apple Watch isn't a luxury watch. Instead, Apple Watch is a mobile computing facilitator worn on the wrist. The users will have just as much motive and desire to pass the device down to children or family as they would with an iPhone or iPad. By discussing price in context of luxury watches, I suspect many are jumping to the conclusion that the only reason someone will pay thousands of dollars for an Apple Watch is to wear it forever as a status symbol. Instead, people will pay thousands of dollars in order to have the opportunity to buy an Apple product that can be worn. The desire to upgrade to a newer, more advanced version in the future will likely be just as strong as it is with iPhone. 

Apple understands its user base very well and correctly sees that there is a market for very high-end tech gadgets. This buyer takes an iPhone and its lack of personalization, puts thousands of dollars into the device to truly make it his or her own, and then will eventually upgrade to a newer iPhone just like everyone else. The Apple Watch Edition collection is Apple's first attempt at addressing this segment of the market. 

Just as with fashion, technology evolves. The Apple Watch isn't a luxury watch, but rather a fashionable communication facilitator worn on the wrist. 

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

iPad Observations Heading into Apple Earnings

In connection with establishing iPad sales, margin, and average selling price (ASP) expectations for 2015, I complied a few observations, including thoughts on the iPad mini, upgrade cycles, and the iPad's placement within the Apple ecosystem. 

iPad Mini 

I'm increasingly becoming confident in my theory that the iPad mini was a product released with a mission: serve as a hedge against low-end Android tablets in the beginning years of the tablet market.  With Apple still selling the original iPad mini for $249, a quick comparsion between iPad mini prices and the rest of the iOS lineup (Exhibit 1) would suggest that the iPad mini exists for more than just to sell more iPads, but instead serve as a defense for the iOS ecosystem. Steve Jobs infamous "price umbrella" quote, which was initially said with the iPhone in mind, can be used to describe the iPad mini. Apple is relying on the iPad mini as one of the lower-cost entry points into iOS (let's not ignore the iPod touch just yet) in order to prevent Android from establishing a position under Apple's prices. By not selling an inexpensive iPad, Apple risked mediocre Android tablets grabbing enough share of the market to squeeze Apple out. While Android tablets are selling for under $100, their use cases have proven to be more rudimentary than true table computing. Exhibit 1 depicts iOS device price levels in the U.S. as of January 2015. Note that the iPhone 4s (not included in table) is still being sold in select emerging markets, like India.

Exhibit 1: iOS Device Prices (Unsubsidized) - January 2015

With the iPad mini positioned at the low-end (grey columns in Exhibit 1), the lack of a significant update this past October shouldn't stand out as too meaningful given that the expected iPad mini buyer has different value priorities than an iPad Air buyer. There have been a few scattered rumors of a mid-cycle iPad mini 3 refresh. I am beginning to question my initial hypothesis from last year that the iPad mini would be discontinued in the near-term, unless Apple is planning to launch a new product that would fill the price layer that the mini currently occupies. While a revamped iPod touch with a 5.5-inch screen would surely sell, the price would suggest it wouldn't be an iPad mini replacement. 

Data from mobile ad analytics company Fiksu suggest the iPad mini still represents approximately 30% of iPad sales. Reported ASP and margins will help confirm if the iPad mini is indeed selling as Fiksu would suggest. 

Upgrade Cycle

One of the bigger questions plaguing iPad is whether the replacement cycle is to blame for slowing sales momentum, or if the tablet market is saturated. Tim Cook addressed the question on Apple's last earnings call:

“[I]if you look at our top six revenue countries, in the country that’s sold the lowest percentage of iPads to people who have never bought an iPad before that number is 50%. And the range goes from 50 to over 70. And so when I look at that number, our first time buyer rates in that area, that’s not a saturated market. You never have first time buyer rates at 50% and 70%. What you do see is that people hold on to iPad longer than they do a phone. And because we’ve only been in this business four years, we don’t really know what the upgrade cycle will be for people.”

Cook sounds confident that given roughly 50-70% of iPads are sold to new customers, the lack of unit growth is due to the dearth of repeat buyers. As a frame of reference, according to Apple, 25% of customers that bought iPhone 5s in the U.S. were buying their first iPhone. In that context, one can understand why Apple thinks slowing iPad sales momentum is more like a speed bump. What is iPad's average upgrade cycle? Using data from Fiksu, Exhibit 2 highlights the breakout of iPad devices currently in use, which leads to a 2.4-year rudimentary estimate as to the average life of an iPad. It is important to note one can not distinguish between new and used iPads using Fiksu data and with the iPad Air and iPad mini on the market for only 1.25 years, average life figures remain skewed. Another way to look at the data is approximately 1 out of 4 iPad users have owned their iPad for nearly four years (iPad 2).

Exhibit 2: Current Breakout of iPad Devices in Use as of January 5, 2015

Exhibit 3 charts the iPad's initial sales success compared to iPhone's more gradual sales levels. The iPad is now facing a leveling off of sales, while the iPhone is seeing accelerating sales growth. Based off of Tim Cook's comments on iPad upgrade cycle and new customers to iPad, Exhibit 3 depicts the big question for iPad: What is causing sales growth to slow? 

Exhibit 3: iPhone vs. iPad Sales

Where do iPad sales go from here? Exhibit 4 highlights three possibilities: 1) increase and start to  track iPhone adoption, 2) remain relatively steady to slightly down until a more sustainable sales level has been reached, 3) decline due to other reasons. My 2015 iPad estimates run with a scenario that falls somewhere between options 2 and 3.

Exhibit 4: Possible iPad Sale Trajectories 

If iPad sales (red line in Exhibit 4) continue to trend down gradually, and do not fall precipitously, than there would be a higher likelihood that the extended upgrade cycle is the primary culprit impacting iPad. If sales decline momentum worsens rather quickly in 2015, than I would position iPhone 6 and 6 Plus popularity, including the Mac, as primary culprits for iPad's weakness.  

Finding iPad's Niche Within Apple's Ecosystem

I continue to think we are in a period where the iPad is finding its niche markets, as well as its place within Apple's ecosystem. Recently, iPad has been included in Apple marketing campaigns like "Start Something New" alongside the iPhone and Mac, suggesting that management may have recalibrate iPad expectations over recent months and now position iPad as being able to fill certain demand holes that the iPhone and Mac are not able to fill on their own, such as an inexpensive video player and email machine (iPad mini) to high-end mac-like devices for creation (iPad Air and eventually iPad Pro). No longer is the iPad destined to the space between the iPhone and Mac.

In such a scenario, a larger iPad Pro continues to make sense for being able to stand out from an iPhone 6 Plus, while also setting itself apart from the Mac, especially the rumored new MacBook Air, due to a touch interface.  While the device wouldn't seem to have characteristics of being a mass-market hit like iPhone due to a high price and large-screen form factor, the iPad Pro may help keep some customers interested in the iPad, and more importantly, iOS. On the low-end, iPad mini may in some ways represent the "cheap" iPhone for consumers that position price as the determining factor for a purchase.

 Expectations for 2015

With Apple's upcoming earnings report in two weeks, and given the greater level of uncertainty when establishing iPad expectations for 2015, I asked myself two basic questions:

1) Will there be any catalysts that would change iPad's sales decline momentum from 2014? 

2) What are Apple's goals with iPad?

The iPad's sale trajectory is not clear (Exhibit 4). In my Apple Questions for 2015 post, I mentioned looking at iPad average selling price (ASP) as a way of figuring out how the iPad mini is selling. I continue to think that data point will give hints as to what Apple will ultimately do with the mini. I'm also assuming that the iPad Pro will help maintain the current iPad trajectory, rather than improve it. 

I estimate Apple sold 19.5M iPads for the three months ending December 2014 (FY1Q15), down 25% from 2014.  As shown in Exhibit 5, my unit sales growth estimate improves through 2015 due to easier year-over-year sales growth comparisons (iPad sales were weaker in the back half of 2014), and a slight pick-up in demand related to an iPad Pro (reflected mostly in 3Q15). Obviously, if the iPad Pro does not materialize, my estimates would need to be adjusted a tad downward. 

Exhibit 5: Above Avalon iPad Sales Expectations

My estimates were reached by a combination of analyzing Fiksu iPad model share trends from September to December, in addition to taking Apple's comments about expanding the supply chain (1.5M channel build estimate). Given the high degree of uncertainly, I would position Pad unit sales of 17-21 million units as my wider expectation range. If sales come in weaker than 17 million than it is likely that other iOS devices are being bought in place of iPad. If sales are stronger than 21M than the iPad is likely suffering more from a longer replacement cycle with core sales trends holding up well. 

Another way to put my estimates in context would be comparing my growth expectations with iPad's historical growth rates, highlighted in Exhibit 6. After two years of strong growth, the iPad is now bouncing around double-digit unit sales percentage declines. 

Exhibit 6: iPad Quarterly Growth Rates

As my 1Q15 quarterly sales decline estimate shows, the iPad is still in flux. Apple's upcoming earnings release on January 27 represents the next event that may provide additional clues and data points as to how to think about iPad.

This report was produced by Neil Cybart on January 12, 2015 and is not meant to be used as investment advice. Risks to my estimates primarily include customer demand. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

Selling Apple Watch

Many people are overthinking Apple Watch. For Apple, the hardest part won’t be telling people why they should use the device, but rather getting people to use the device. There is a subtle difference.

One of Apple’s secret weapons for selling Apple Watch will be its retail stores and the ability to see and touch the device. Trying to appeal to a potential customer’s wants and desires begins by positioning the product so that they simply want to use it. While Apple certainly will rely on a more complicated marketing message that positions certain use cases over others, I don’t think that message will be the thing that sells Apple Watch. Apple’s goal is merely to get a potential customer to want to use the device.  Only after the Apple Watch purchase does a revolutionary user interface and a few well thought-out features, shown through marketing, help nurture a user's relationship with Apple Watch. 

Why people will buy an Apple Watch:

1. It’s a cool watch. The Apple Watch is a watch with a customizable digital face and a selection of interchangeable bands.
2. It looks nice. The Apple Watch has a clean, fresh, design that strikes a balance between luxury and technology.
3. It’s made by Apple. The Apple Watch is designed in California by the same company that is responsible for the iPhone, iPad, and Mac.

Over the past few months, I’ve learned to change the way I explain Apple Watch to friends and family. Instead of starting out with a list of reasons why they may enjoy an Apple Watch, I now begin with a pretty simply explanation: Apple is making a watch with customizable faces and bands. I then let that person respond, and depending on their answer, I mention how Apple Watch can serve as a communication device, a health and fitness tracker, or a mobile payment facilitator.  As a result, I now get a much more open response from people that want to see and learn more about Apple Watch. That is how Apple will sell Apple Watch. 

We recently saw this play out with iPad and competing tablets, where Apple’s strength was having iPads available to play with in its retail stores. Meanwhile, competitors used advertisements to push all of the features their product had that the iPad lacked. In the end, people picked iPad.

There has been a tendency to mock people that want to buy products simply because a certain company makes them. Some will say this type of buyer is being guided by marketing, or is just a follower, but in reality it comes down to trust. Many people trust Apple. It is this very important connection with users that will likely get people to at least try the Apple Watch, and for Apple that is the best outcome they can wish for.  

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

Larger iPhones May Be a Game Changer

The latest phone sales share data from Kantar Worldpanel paints a bright picture for Apple with iOS gains in most countries, but diving deeper into a few countries would lead to some interesting questions. Are the iPhone 6 and 6 Plus game changers, propelling Apple past its "niche" smartphone status in developed markets such as U.S. and Great Britain? The answer may have far-reaching consequences for services like Apple Pay, Beats Music streaming, app developer innovation, wearables, smart home, and connected cars, not to mention other tech companies like Google and Amazon. 

Some industry analysts have been pushing the idea that phone market share questions are yesterday's news with iPhone destined to the top niche of the market and Android representing everything else. I'm becoming increasingly uncomfortable with that assertion, especially given some underlying trends occurring in the smartphone market following the iPhone 6 and 6 Plus launch. I have little confidence that the current phone market as it appears today will look the same for years to come.

In the U.S., the iPhone nearly outsold Android during the three months ending November 2014, as seen in Exhibit 1, which also includes Android and iOS share of sales in the U.S. going back to 2012. Obviously an iPhone launch helps boost share as loyal iPhone users upgrade their phones, but the current upgrade cycle is different. 

Exhibit 1: iOS and Android Smartphone Sales Share - U.S. 

According to recent Kantar data, iPhone 6/6 Plus sales share in the U.S has surpassed iPhone 5s/5c and is now tracking very close to the iPhone 5. Up to now, this would not suggest that larger iPhones are a game changer as the sales patterns are following the typical iPhone upgrade effect. However, today's smartphone market is indeed different with Apple now selling a 4.7-inch and 5.5-inch iPhone. Large screens were the key differentiator for Samsung, the leading hardware manufacturer for Android, for the better part of the past three years. Add what seems to be a lack of innovation with Samsung's latest Galaxy offerings, including the company's recent comments about 2015 being another troubling year for Samsung phones in face of Apple's latest offerings, and the iPhone 6 and 6 Plus may represent a game changer for the U.S. smartphone market with iOS outselling Android. 

In Exhibit 2, iPhone 6 and 6 Plus sales share can follow two primary routes: A or  B. Route A would reflect increased sales share approaching 60% at the expense of Android as the iPhone 6 and 6 Plus are true game changers. Route B would reflect the typical decline in share following an iPhone launch as the iPhone upgrade cycle slows and Android users do not switch to iPhone. Next month's Kantar sales report will be quite telling as any continued share gain (or even flat share) at the expense of Android will stand out versus the iPhone 5, 5s, and 5c reiterations, suggesting that the upgrade cycle is indeed continuing to be strong and users are switching from Android to iOS. 

Exhibit 2: iOS Smartphone Sales Share and Possible Share Trajectories - U.S. 

Why is this important? Isn't market share an old topic? The ramifications of iPhone representing close to 60% of smartphone sales in the U.S. has dramatic implications in terms of Apple Pay adoption, Beats Music subscription services, and other areas including app developer focus, smart devices, and wearables. I continue to think that owning the most lucrative 30-40% of the smartphone market is enough to warrant sustainability as developers remain invested in the ecosystem. However, if iPhone can capture 60%+ share, the argument changes rather dramatically for services with which adoption is more easily assured by the sheer number of users and not just the top portion. For example, with iPhone representing 60% of U.S. smartphone market, Apple Pay has a significant leg up on CurrentC, Beats Music (if pushed to all iOS devices) would gain more power over competing streaming services, and Apple Watch would be even that more compelling as a communication medium. Not to mention, iMessage, FaceTime, and Photo Stream would serve as lucrative communication channels. In addition, iOS and the connected home and car take on more meaning if iOS becomes the dominant mobile platform in the U.S. in terms of volume. 

Concerning U.S. mobile carrier pricing plans, in reality, as carriers move away from hidden built-in subsidy plans, and instead push $0 down, 24-month installment plans, the "iPhone subsidy boost" topic is losing relevancy as consumers are now more aware of how much their phone really cost. Despite this trend, iPhone sales share pre-iPhone 6 and 6 Plus has tracked very similarly to previous years, which would go against consensus that iPhone's strength was primarily dependent on full-blown subsidies masking the iPhone's high price. In retrospect, the ability to buy new iPhones sooner (which the new plans promote) may pose as another benefit to Apple as well. 

In Great Britain, the iPhone 6/6 Plus would appear to already be a game changer, clearly reaching all-time smartphone share levels. While the iPhone refresh cycle is certainly helping, approximately 20% of iPhone buyers during the three months ending November 2014 had switched from Android according to Kantar. 

Exhibit 3:  iOS Smartphone Sales Share - Great Britain

Of course, China's smartphone growth potential cannot be ignored, and iOS sales share is indeed lower in China than other countries, including U.S. and Great Britain. As shown in Exhibit 4, iOS sales share has been on the rise recently and jumped 2.4 points from October to November, this despite the new iPhones launching in mid-October. China Mobile began offering iPhone in January 2014, but the delayed boost can be seen as iOS sales share started to pick up in June. I estimate customers are now buying 5-7 million iPhones a quarter through China Mobile. Tim Cook mentioned on Apple's earnings call that 80% of iPhone sales in China do not involve a subsidy. Despite the lack of subsidies, iPhone share is approaching 18-month highs and the iPhone 6 and 6 Plus will likely lead to continued share gains.   

Exhibit 4: iOS Smartphone Sales Share - China

As many tech and mobile analysts focus on China, India, and emerging markets to determine how the next billion users will join the mobile era, some have said that the major questions surrounding mobile in developed markets have been answered. I disagree. The iPhone 6 and 6 Plus introduction has the potential to be a game changer as iOS nears a majority of sales in a few countries, a marked step-up from previous iPhone reiterations. Implications on ecosystem services dealing with payments, music, apps, cars, and connected devices cannot be underestimated. The big question now is as the iPhone 6/6 Plus upgrade cycle slows (which has been the pattern going 3-4 months out from launch), will Android converts drive iOS share even further? Sales share data over the next few months will be very telling.  Samsung's smartphone troubles have been well publicized, but only now are we starting to see the impact, and Apple looks to be the primary beneficiary in many countries. Apple may be in a sweet spot here.  If iPhone 6/6 Plus don't bring many from Android, the iOS ecosystem is now vibrant enough to be self-sustaining. However, if Android switching becomes a theme, the iOS ecosystem value increases in terms of messaging, communications, and services.

While China, India, and developing markets represent the unknown in mobile, I think we need to keep an eye on developed markets in which Apple is gaining strength. 

This report was produced by Neil Cybart on January 7, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard.

The Next Marginal Customer

Being a niche player has led Apple to much success, as resources are funneled into the most profitable and lucrative segments of a market. However, this doesn't mean that Apple isn't focused on new customer acquisition. I suspect some of Apple's recent troubles with software quality over the past two years has been related to tradeoffs created by acquiring the next marginal customer.

Apple is a growth company. Accordingly, marketing takes on a more vital role at Apple than at a mature company where user acquisition is not a primary goal. Apple relies on marketing (and design) in an attempt to appeal to the marginal customer, the next user to buy into the Apple ecosystem. This drive leads to new and exciting software features shown in retail stores and in marketing campaigns. However, because of the tight schedule Apple has adhered to, as well as the sheer volume of change taking place, features are not receiving the needed attention. In this context, core users (the ones likely to use all of these new and exciting features) feel the downside, and become increasingly vocal with their complaints, while new users largely avoid much of the frustration. This dynamic may help explain how management is insulated a bit from some of the backsplash as financial trends depict no major issues. Former early Apple employee Bruce Tognazzini similarly discussed how Apple's user interface also suffers from management's focus on new users at the determent of power users.

What's the solution? Time. Apple's approach to new customer acquisition is correct. Apple knows its next marginal customer very well. Instead, I suspect as we move past the Apple Watch launch, and the first few quarters of sales, Apple will be in a better position to address some of the recent software shortcomings. Apple would then have marketable features that new customers would enjoy, while still appealing to core users with reliable functionality. How can the two groups be satisfied with the same product or feature? Design. This is where Jony Ive's leadership and vision will need to be utilized. I hear some say, "if it just worked, it would be great," referring to Apple software, which tells me Apple is on the right track in terms of design implementation. 

For Apple, the ability to shift directions and funnel resources into a new product is one of the most misunderstood and undervalued aspects of the company. In this context, Apple Watch, and all that remains untold and misunderstood about the device, and Apple's move into personalized hardware, may play a crucial role in understanding what Apple has been planning with its unrealistic pace of development in recent years. The game may have changed, but I suspect Apple wrote the new playbook, and has been away practicing. With the company nearly ready to return, with Apple Watch in tow, the question is will early adopters show up for the game? I suspect the answer may surprise some Apple critics.