Apple's Initial Watch Ad in Vogue is Nearly Perfect

With Apple Watch Keynote 2.0 scheduled for March 9th, the Apple Watch will once again become the talk of the town in tech, fashion, and design circles. In anticipation of an April launch, Apple officially kicked off its Apple Watch marketing campaign with a 12-page spread in the important March issue of Vogue, valued at $2.2 million. I thought the ad was effective in highlighting the Apple Watch as a fashion piece that values design and luxury.  

There are only so many brands that can get away with just simply having Watch on a blank page. That one page is estimated to have cost Apple close to $200,000.

Watch Sport

Interestingly, the green fluoroelastomer band made the cut. Apple included a screenshot of the Activity app.

Watch

The milanese loop provides great imagery (this same shot is on Apple's website), while the profile shot is able to show the band's clean and minimal nature. Notice the lack of technology in these shots. 

Watch Edition

The rose gray modern buckle could be mistaken as a band from any luxury watch. Meanwhile, a sophisticated and sleek black watch face is used to highlight the Edition collection.

I think this ad is nearly perfect because it effectively gets the message across that this luxury item is much more than just any old watch without actually showing much, if any, of the technology that makes Apple Watch revolutionary. Apple is delicately positioning design and fashion ahead of the device's primary selling point: bringing utility back to the wrist.  

Apple is walking a thin line when marketing Apple Watch as the device has to be positioned for everyone, from students to fashion-minded executives. The ad takes many cues from other fashion-oriented ads with minimal text and no prices as the brand is the primary product being sold. I would be very surprised if Jony Ive did not play a major role in creating every page of this ad.

This Apple Watch print ad reminded me of iMac ads from the early 2000s, in which the product also did the talking. In what may be a sign of Apple's increased brand power, and also the difference in target markets (Vogue versus tech publications), notice how much text is included in these iMac ads. 

While having a large ad within Vogue is important, in theory anyone with money (and a good ad agency) can get a 12-page spread. The goal is to be on the front cover, which can't be bought in reputable magazines. In one chapter of Adam Lashinsky's "Inside Apple", the story of Steve Jobs lecturing an ad buyer included Steve's often-repeated response: "You worry about the back covers. I'll take care of the front covers." The key test will be if Vogue puts Apple Watch on the front cover. Google Glass got a 12-page editorial spread in 2013 and Apple Watch was featured on the cover of Vogue China, so maybe there is a chance we see Apple Watch on the coveted September issue of Vogue. Regardless, Apple is off to a good start with its Apple Watch marketing campaign. 

Apple's Strategy for Growing iPhone Sales by 50% in Three Years

The iPhone is a juggernaut with unit sales up 25% in 2014, representing close to 70% of Apple's operating income. Many market observers are wondering if Apple is approaching a limit to iPhone sales growth. With the iPhone 6 and 6 Plus representing possible inflection points in the phone market, the ingredients are in place for Apple to sell 300 million iPhone units annually within three years, which would represent 50% growth from the 193 million iPhones sold in 2014. By executing on a number of achievable tasks, including taking advantage of weaker smartphone competition, building a wider sales distribution network, broadening the iPhone lineup, and increasing the iPhone's value proposition, Apple would be in a position to increase its phone market share by more than 400 basis points from 11% to 15% within three years. 

The iPhone Growth Strategy

I continue to view doubling down on iPhone is in management's best interest as the iPhone 6 and 6 Plus serve as possible inflection points, reinvigorating the iPhone line. Apple can market the larger-screen iPhones to the hundreds of millions of smartphone users who did not buy an iPhone as their first smartphone over the past few years.

There are a number of pieces that need to come together for Apple to sell more than 300 million iPhones annually within three years.

Maintaining the iPhone Upgrade Cycle. With approximately 80-85% of iPhone unit sales coming from previous iPhone owners, it is crucial that Apple maintains a healthy iPhone upgrade cycle. Assuming a 2-3 year life cycle and relying on a few data points from Apple's recent earnings call, I estimate that approximately 185 million iPhone users are likely to buy a new iPhone in 2015, up from 165 million users in 2014 and 130 million users in 2013. Exhibit 1 highlights how crucial iPhone upgrades are to total iPhone sales. 

Exhibit 1: iPhone Unit Sales Breakdown (iPhone Upgrade vs. New to iPhone)

The significant increase in iPhone upgrading in 2014 was driven by the iPhone 6 and 6 Plus and that trend will continue in 2015. As the iPhone user base expands, it is not hard to fathom that close to 250 million iPhone users will be upgrading their iPhones on any given year by 2017. Apple would likely position the screen, battery, and camera as some of the more marketable upgrades each year, as well as upgraded components including the fingerprint sensor, speakers, headphone jack (or lack thereof). In addition, Apple will continue to update the iPhone's form factor, including cosmetic chances, as well as altering width and weight. 

Appealing to Android Users. Android represented approximately 80% of global smartphone sales in 2014, depicted in Exhibit 2. In order for Apple to achieve 50% iPhone unit sales growth within three years, Apple needs approximately 40-45 million iPhone unit sales annually to come from new users who currently don't own an iPhone.  Android would be positioned as the most likely target for these platform switchers given Windows' low market share and Blackberry's lack of sales.  

Exhibit 2: Smartphone Shipments and Market Share

Tim Cook mentioned on Apple's most recent earnings call that iPhone 6 and 6 Plus saw a higher Android switcher rate than the previous three iPhone launches. Exhibit 3 highlights this increasing trend of non-iPhone users making up a larger share of total iPhone sales. Given market dynamics, it will be difficult to have non-iPhone users make up more than 20-25% of iPhone sales, unless the iPhone upgrade cycle slows or Apple is more successful in getting new users to the platform.

Exhibit 3: Percent of iPhone Sales to Non-iPhone Users

Considering that Apple sold 20-30 million iPhones to new users annually since 2012, it is achievable to grow this to 40-45 million new users a year (the range required to grow iPhone shipments 50% by 2017). China Mobile alone may represent 15-20 million new iPhone users a year. 

With a target of acquiring 40-45 million new iPhone users each year, Apple would be aiming for the top 4% of the Android base, which is a plausible goal. In terms of the most appropriate Android competition, 40-45 million represents less than 15% of Samsung's annual smartphone shipments. The high-end Android phone environment is quite different in 2015 as Samsung has lost momentum and Apple has a more competitive phone in terms of screen size. Samsung still has 20-30% share of the smartphone market in many developed countries, and those users will eventually be ready to upgrade their phone. Samsung has loyalty rates close to 60% in its strongest market (U.S.). Apple has a 90% loyalty rate. While 60% loyalty may seem high, the other way to look at it is 40% of Samsung's base will likely look at what else is in the market when it is time to upgrade phones. This trend may represent Apple's best opportunity to convert Android users to iPhone in developed markets. For the first time, premium Android users will walk into a mobile carrier store and compare similar-sized iPhones and Samsung Galaxy phones. 

Appealing to Feature Phone Users.  If Apple picked off 40-45 million premium Android users each year, within three to four years, much of the high-end Android market would have switched to iPhone, which may not be the most realistic assumption. In that case, Apple will also likely need to rely on feature phone users looking to buy their first smartphone. With smartphone penetration around 75% in the U.S., according to comScore, and lower penetration rates else where in the world, there is still opportunity for Apple to appeal to customers looking to buy their first smartphone. Gartner estimated there were around 900 million feature phones sold in 2013. While some may think late adopters in developed markets will gravitate towards low-end smartphones, I actually think the opposite may occur as late adopters (especially the top 5-10%) may look at a smartphone as a laptop/desktop replacement and be willing to spend more money on an smartphone.

Exhibit 4 displays overall phone shipments, including the roughly 600-700 million feature phones likely shipped in 2014. Samsung's market share decline (22% from 25%) was likely a result of Apple's stronger iPhone lineup and more competitive offerings from Chinese smartphone vendors. 

Exhibit 4: Overall Phone Shipments and Market Share

In China, 20% of iPhone sales last quarter were to first-time smartphone users. Add these first-time smartphone buyers to premium Android switchers, and the goal of getting 40-45 million unit sales annually from the 1.7 billion of non-iPhone phone shipments seems a bit more attainable. 

Expand Distribution.  Apple now has 72% of the world's mobile phone subscriber base covered with 375 carriers supporting iPhone. In recent years, Apple has benefited greatly by adding carrier distribution partners, such as NTT DOCOMO and China Mobile. Apple is still seeing a positive impact from China Mobile despite it being a full year after launch as Apple continues to work on expanding distribution points in China, both in terms of brick-and-mortar retail as well as online. The easy growth phase may be over in terms of carrier expansion, which is why appealing to Android and feature phone users may represent most of the iPhone's near-term growth potential. Nevertheless, countries such as India and Brazil represent untapped sales potential. While such markets are not as established compared to China, there is room to expand iPhone's reach. 

Expand iPhone Product Line and Price Points. While a "cheap" iPhone may not fit in Apple's strategy, I would expect management to continue debating the merits of releasing a new 4-inch screen iPhone that is sold at a slightly lower price than the iPhone 6. A smaller iPhone wouldn't be a top seller when compared to the bigger screens counterparts, but I don't think management will consider that as a factor for whether or not to release a smaller iPhone.  The fundamental question comes down to whether the experience produced by using a 4-inch iPhone can be better for some users than using a larger iPhone.

In regards to overall iPhone pricing, I would expect Apple to continue bringing down the entry-level price of older iPhone models. I previously laid out how Apple is able to successfully maintain user experiences by selling older models at a lower price. Such a pricing strategy will help maintain iPhone momentum as Apple focuses on grabbing as much profit share as possible at each price level before moving further down market.

Increase iPhone's Value Proposition. Apple is positioning iPhone into critical aspects of our lives (home, health, car, finance) using HomeKit, HealthKit, CarPlay, and Apple Pay. Such efforts are not only to prevent Android from establishing insurmountable positions in key parts of our daily lives, but also to increase the iPhone's value proposition. The Apple Watch may also come into play as an ancillary device meant to break complex tasks into simpler, more manageable ones, may prove to increase iPhone loyalty and serve as a catalyst for driving news users to iOS. 

Financial Impact

Selling approximately 300 million iPhones annually (up from 193 million units sold in 2014) would boost Apple's annual revenue by $60 billion. Assuming Apple is able to maintain iPhone margins, boosting iPhone's share of the phone market from 11% to 15% would equate to an additional $25 billion of operating income, or close to $20 billion on an after-tax basis (roughly $4.00/share). Considering that Apple reported $7.42/share EPS in CY2014, it becomes clear that the iPhone is one of the more important drivers for Apple EPS going forward in the near-term, especially with the Apple Watch accounting for a relatively small share of the revenue pie in the first 1-2 years on the market. Exhibit 5 includes Above Avalon's iPhone units sales and growth estimates. 

Exhibit 5: Above Avalon's iPhone Unit Sales and Growth Estimates (Calendar Year)

The Big Picture

In 2014, the iPhone represented approximately 11% of phone market sales. While some question if there is much growth left in iPhone, I think there is an attainable strategy that can lead Apple to grow annual iPhone sales by 50% from 193 million units in 2014 to approximately 300 million units in 2017. In such a scenario, the iPhone would represent 15% of the phone market. For some perspective, even after growing iPhone sales by 50%, five out of six people buying a phone in 2017 would still be choose something other than an iPhone.

Obviously, execution remains key, and I continue to think maintaining the iPhone upgrade cycle is Apple's most difficult task. If users stop seeing the need to upgrade their iPhones every 2-3 years, it will be difficult for Apple to achieve 300 million unit sales within three years as there won't be enough new users coming from Android and feature phones to offset the decline. In terms of appealing to Android and feature phone users, the current iPhone lineup has never been stronger. For the first time, Apple will have iPhone models that display very well next to big Android phones in mobile carrier stores. Many consumers go to carrier stores not knowing which phone they will end up purchasing, so having a competitive product with a large screen may be a big factor in explaining how Apple can grow market share. In emerging markets, Apple continues to improve iPhone's distribution infrastructure in order to sell less expensive, older models at additional points of sale. It is in Apple's best interest to double down on the iPhone given current market dynamics and the 2-5 year outlook.

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Apple Is on Track to Buy Back 20% of Itself by 2017 (Video)

An update on Apple's share buyback program. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017.

Don't Focus on Apple Watch Edition Pricing

The ongoing debate over Apple Watch pricing is causing many to miss the big picture: Apple wants the Apple Watch to be for everyone. By selling a device for the wrist, Apple is trying to appeal to a wide range of consumers, from high school students to senior executives. In such a scenario, price is only one piece of the puzzle as Apple positions Apple Watch as both a mass-market good and luxury item.

Tim Cook and Jony Ive have been quite clear from the start: Apple Watch is the most personalized device Apple has ever made. Apple's goal to make wearable products required taking a different page from the old product playbook. Personalization was crucial as different options based on color, material, and style were required. Apple priced the entry-level Apple Watch Sport collection to be a mass-market good, attainable for mostly anyone willing to spend money on an iPhone accessory for the wrist. Prices will likely rise to thousands of dollars for the Edition collection to appeal to the consumer who wants a well-crafted device serving as a luxury status symbol. It really doesn't matter what price the high-end models cost as Apple's strategy will be the same: segmenting the market between mass-market and luxury. 

Luxury denotes supply scarcity at higher prices, while mass-market denotes abundant supply at low prices. In an attempt to chase profits and market share, some companies with a traditional luxurious brand are trying to appeal to the mass-market. Such "mass-market luxury" brands can be seen in the automobile industry as Mercedes-Benz, BMW, and Audi continue to move down-market with entry-level vehicle options priced around the ultra-competitive $35,000-$40,000 range. After closer examination, one would see that these prices are artificially low as additional upgrades and options are required to truly get the "experience" of owning one of those high-end brands. By moving down-market, these brands are losing their luxury status and diluting their brands by removing features. Just as mass-market luxury is an oxymoron, many of these brands may be harming their long-term reputations.

Instead of following the automobile playbook when it comes to appealing to both mass market and luxury, Apple is taking a different strategy with Apple Watch. Rather than selling a cheaper Apple Watch model with fewer features, Apple is relying on different materials to establish distinct watch collections. The Apple Watch experience isn't dependent on price. Apple Watch Sport provides the same technological capabilities as Apple Watch Edition; both show notifications, monitor daily activity, and accept incoming tap messages. Instead, the three Apple Watch collections contain different materials, which help give the Edition a more luxurious status with precious metals and greater craftsmanship, compared to the Sport's anodized aluminum and Ion-X glass watch face. By focusing on materials variance instead of feature variance, Apple is hoping to be able to sell a product that appeals to the mass-market and luxury circles at the same time. To complete the sale, Apple will likely need to rethink its retail distribution as well. 

There may be Apple retail stores that go days or weeks without selling the most expensive Apple Watch Edition watch face and band combination if it's priced at $20,000. Meanwhile, a customer going into an ultra-luxury jeweler would likely be insulted seeing a $349 Apple Watch Sport being sold next to some of the world's most expensive watches. If Apple is interested in having such a wide variation in price for Apple Watch, a new retail distribution model would likely be utilized.  Apple can rely on segmentation for setting up kiosks or a store-within-a-store in high-end shops that sell only Apple Watch Edition or Watch collections. There are reports of Apple building a store-within-a-store in a high-end Paris department store (probably not that high-end as to exclude Sport collection though), but that general idea can be expanded into even more high-end retail locations. Meanwhile, there may not be much reason to stock Apple Watch Edition collection options at big-box retailers like Walmart and Best Buy. By using a more segmented retail distribution, Apple may avoid some of the backlash from appealing to wealthy and less wealthy customers at the same time, which apparently worried executives as reported in The New Yorker profile of Jony Ive. 

Another reason I'm not too focused on Apple Watch Edition pricing is that I suspect the device will display inelastic demand once the price exceeds $5,000-$7,500. Said another way, once Apple sells certain models over a certain price, raising the price may not necessarily correspond to a decline in demand, or at least not in a direct relationship. John Gruber at Daring Fireball thinks Apple Watch Edition may come in options approaching $20,000, while others think $10,000 is a given. 

There is a much bigger strategy at play here besides just selling expensive wrist gadgets. There is a battle for the wrist. For Apple Watch to be worn on some wrists, the luxury watch that is currently taking up real estate will need to be put back in its watch case. How will Apple be able to accomplish that difficult task? Selling a luxurious device that contains materials denoting high-end and craftsmanship, like precious metals and special watch bands. It's rather interesting that Apple has been able to go so long without customizing the iPhone. There are cottage industries focused on customizing mass-market consumer gadgets like phones into luxury items. With a wearable, this option had to be offered from the start. I'm not too concerned with where Apple Watch Edition pricing will end up because Apple will be utilizing the same strategy regardless of price: positioning Apple Watch as both a mass-market good and luxury item.

Apple Is on Track to Buy Back 20% of Itself by 2017

Apple is sitting on $178 billion of cash. What does Apple plan to do with its excess cash? It looks increasingly likely that Apple has already given us the answer: repurchase shares. Apple will most likely revise its capital return program in April, raising its share buyback authorization and quarterly cash dividend payout. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017. 

Apple raised a small amount of debt last quarter, bringing total long-term debt held on the balance sheet to $32 billion at the end of December. Apple has since raised another $8 billion of debt in 2015, bringing the total amount of debt issued to $40 billion. Net cash (gross cash minus debt) stood at $142 billion ($24/share) at the end of December, depicted in Exhibit 1. 

Exhibit 1: Apple's Cash, Cash Equivalents and Marketable Securities

From a foreign cash perspective, Apple now has a $158 billion war chest. Due to strong holiday iPhone sales, Apple's U.S. gross cash (cash and debt) increased last quarter to $20 billion, despite continued share repurchases. 

Exhibit 2: Apple Gross Cash - U.S. Versus Foreign

As a reminder, Apple can not use its foreign cash to buy back shares or pay dividends without incurring tax penalties. Instead, Apple must rely on U.S. cash. With only $20 billion of U.S. cash remaining, Apple needs to tap the debt markets and rely on U.S. free cash flow (FCF) generation to fund additional share buyback. In Exhibit 3, I estimate Apple's likely U.S. FCF generation over the next three years and possible debt issuance loads ($25 billion a year as yields remain low). 

Exhibit 3: Apple's Capital Sources for Capital Return Program

Apple will kick off approximately $45-$50B a year in U.S. excess capital (including debt) over the next few years which can be used to fund the capital return program. Running with $50B a year in share buyback, shown in Exhibit 4, Apple would be in a position to have bought back 18% of its outstanding shares by 2017. 

Exhibit 4: Potential Apple Buyback Scenario

Apple began buying back shares in 2013. If Apple continues the current pace of buyback through 2017, the company would have bought back approximately 30% of the company, meaning roughly one out of three AAPL shares that existed in 2012 would have been bought back by the company. Going forward, management will continue to judge the value of share buybacks by comparing P/E and P/CF metrics versus other uses for cash such as special dividends and organic growth opportunities.  As seen in Exhibit 5, assuming Apple maintains the pack of buyback around $50 billion a year, Apple will spend $150 billion in buyback over the next three years, versus $68 billion spent on buyback in 2013 and 2014 combined. Apple will likely be able to raise the quarterly cash dividend each year, but the lower share count will result in only a modest increase to divided expense. 

Exhibit 5: Expected Apple Capital Return Program Expenditures

The wild card in this discussion remains AAPL stock price. A higher stock price will make share buyback less attractive, resulting in Apple buying back fewer shares. Conversely, a lower stock price would represent an attractive opportunity for Apple to ramp up its share repurchases. Even after three years of aggressive share repurchase activity and paying quarterly cash dividends through 2017, Apple would have more than $225 billion of gross cash remaining on its balance sheet. 

This report was produced by Neil Cybart on February 20, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.