Apple's Cheaper Stock Buyback

It is becoming cheaper for Apple to buy back its shares. Since Apple reported 3Q15 earnings, AAPL shares have been down by as much as 30%. Looking ahead, AAPL volatility will continue as the market continues to worry about slowing revenue growth in China. With $50 billion of share repurchase authorization remaining, Apple is in prime position to take advantage of stock market volatility and buy back its stock at a 15% discount to all-time highs resulting in up to $4 billion of "savings" over the next six months.

Apple Valuation

Stock valuation is a complicated subject. While finance textbooks explain how to take a series of numbers and assumptions and arrive at a stock's intrinsic value, the truth is market participants determine a stock's true worth. A stock price is merely the point at which a buyer and seller agree to exchange shares. Emotion and psychology play just as important of a role in determining a stock price as sales, earnings, and growth potential. 

Apple is currently trading at a 11x forward earnings multiple (20% EPS growth), a 40% discount to the overall market's 18x forward earnings multiple. If excluding $35 of cash per share, Apple is trading at a 7x forward earnings multiple, a 60% discount to the overall market. If Apple traded with a 18x forward earnings multiple ex-cash, shares would trade at $225, a 100% premium to the current market price. 

Growth Concerns

Many look at the valuation discrepancy as evidence that Apple is being penalized by Wall Street due to the lack of confidence in its ability to grow. However, nearly every sell-side Apple analyst is relying on higher earnings multiples, despite slowing operating income growth, to arrive at target prices that are well above the current market price. This doesn't strike me as overly pessimistic.

Instead, Apple continues to suffer from a lack of confidence and conviction on the part of current and prospective shareholders. Since growth concerns are a bit generic, more specific issues plaguing Apple continue to include doubt that strong Apple customer loyalty will continue and a business model that makes it difficult to forecast earnings. 

Apple Customer Loyalty Doubt. It is no secret that Apple is the iPhone company. With the product representing 60% of revenue and 80% of operating income, the iPhone deserves the attention it is receiving on Wall Street. However, there continues to be a general lack of understanding over the dynamics underlying iPhones sales, including the impact that Apple customer loyalty has on sales. 

Approximately 75%-80% of iPhones sold each year are to previous iPhone owners. Many on Wall Street look at the fact that Apple is relying on its existing user base to drive sales as a negative. Not only do repeat customers make up a significant amount of iPhone sales, but this actually describes Apple's business model. A company that sells not just products, but experiences, relies on repeat customers to offset any negative implications from the decision to not chase market share. This is one reason why Apple management has a tendency to focus on customer satisfaction rates whenever possible. High satisfaction is suspected to eventually turn into loyalty and repeat customers.  

When thinking about iPhone sales growth in 2016, having approximately 75-80% of unit sales come from the 525 million iPhone user base is an indication that the Apple machine is functioning properly. The iPhone upgrade cycle is dependent on evolutionary features that do not over serve the customer base but instead entice upgrades. A high percentage of repeat iPhone customers is actually a strength for Apple, not a weakness. Apple would then need to focus on bringing in approximately 40 million new users to the iOS ecosystem annually in order to report ongoing iPhone growth. When considering the large market opportunity in China and ongoing troubles with Samsung, this 40 million new user target is achievable.

One of the concerns Wall Street has with Apple's customer loyalty is questions about how long the trend can continue. The ongoing debate over smartphone "subsidies" going away (they aren't), not to mention cheaper smartphone alternatives from China, are continuously positioned as factors that may cause iPhone owners to look elsewhere for their next smartphone. 

A few Apple analysts have attempted to tackle this customer loyalty issue indirectly by coming at it from an ecosystem angle. By attaching a certain amount of revenue (and profit) to each iOS user over time, one can start to look at the iOS user base as a large annuity that will kick off profits each year. While the idea doesn't exactly rely on the most politically-correct analogy, the general idea is a fair one to make. The problem is that it does little to drive increased confidence that Apple's high customer loyalty will continue in the future. 

Difficult Business Model to Forecast Trends. Apple has a business model that makes it very difficult to forecast financial trends 3-5 years out. While some of this is born from the company's thoughts on secrecy and surprise, the reasoning actually goes much deeper. Apple's business model is built on the belief that things will not remain steady over the long-run. Management is constantly looking to break itself, only enjoying key sales milestones for a short while before looking to do something else. In recent years that may have meant cannibalizing existing products, while in the future, it may be moving from its comfort zone into new industries. Compare this to something like Google's search business which had never been thought of to be in trouble by many on Wall Street until only recently or Facebook's recent announcement that 1 billion people went to Facebook in a single day. These businesses, while inherently more complex and confusing than Apple, are thought of as more sustainable over the long-run, while Apple's business comes across as more susceptible to market forces. 

This lack of business model visibility boils all the way down to granular features found in Apple products. When Apple introduces a new user interface for iPhones next week, it will be difficult for many to envision such a feature becoming a crucial feature across the iPhone line one day, opening the door to significant design changes. Apple is well aware of the 3-5 year plan with features and products, often introducing certain features just to serve as a stepping stone to future revisions. Extend this exercise to nearly every Apple action, and the end result is Wall Street placing heavy reliance on short-term actions with little to no value attached to the long-term. It is tough to value something that will happen in the future when it is not obvious it will occur. 

Even though this model of constantly looking to change the equation plays a key role in Apple's goal of remaining relevant over the long-term (what if Apple never moved past the iPod?), from Wall Street's perspective, such never-ending change is difficult to measure and value. Moving from counting iPod profits to iPhone margins, and soon financials behind monthly automobile leases, is not easy and results in low conviction. The end result is lower valuation multiples to compensate for this unknown. I suspect this has been one of the primary reasons over the years for Apple's valuation discount to the market. 

Google and Amazon continue to stand out to investors as both companies share some similarities with Apple in terms of unknown futures. The difference is that while Apple is reporting strong profits on very disciplined expense management, Google and Amazon are considered founder-led companies that keep profits artificially low due to excess expenses and investment. As a result, Google and Amazon are rewarded with higher valuation multiples on what appear to be more mediocre profit and growth trends compared to Apple. Some may disagree with this treatment, but the thing to keep in mind is Wall Street will continue to think a certain way until it no longer wants to. It is impossible to predict when that moment will arrive.  

Apple's Share Buyback Program

I continue to view Apple buying back its shares as the most appropriate use of excess cash that is not needed for organic growth and M&A. 

As of June 27, 2015, Apple had $50 billion of share buyback authorization remaining out of a total of $140 billion of authorization. Theoretically, Apple could repurchase 8% of itself without any additional authorization from the board of directors.  However, when looking at cash available for buyback, it becomes clear that Apple is not in a position to buy back that many shares at this time.

Apple is only able to use U.S. cash on hand to repurchase shares and as of June 27, 2015, Apple had $22 billion of domestic cash ($181 billion is held offshore).  When forecasting earnings through the second half of CY2015 and taking into consideration debt issuance and U.S. free cash flow generation, Apple will have approximately $50 billion of domestic cash available by year-end. After adjusting for routine cash needs, including cash dividends, as well as the need for a cash buffer, Apple will likely be in a position to spend $20-$25 billion on buyback over the next six months (July to December 2015).

Apple management can make a dollar worth of share buyback go much further when Apple's stock price is depressed. With shares down 15% from all-time highs, Apple could theoretically buy back 15% additional Apple shares with the same amount of cash resulting in a "savings" of close to $4 billion over the next six months. 

There are three likely strategies Apple can take in regards to its buyback: 

1) Scheduled Share Repurchases. Apple could follow a very strict schedule as to when excess cash is spent on buyback. It would be equivalent to an investor buying an index fund the same day each month to gain market exposure, regardless of whether the market was up or down. As each quarter comes and goes, Apple will spend the same amount on buyback, resulting in additional shares being bought if the share price decreases. There is evidence of Apple following this type of repurchase schedule with $5 billion spend on share buyback in 4Q13, 1Q14, 3Q14, and 1Q15. 

2) Opportunistic Share Repurchases. Instead of simply following a schedule, Tim Cook and Luca Maestri could take stock valuation and timing into greater consideration, resulting in an ebb and flow to the pace of buyback. Apple has shown the tendency of being opportunistic, such as in February 2014, when Tim Cook announced Apple had repurchased close $14 billion of shares over the span of two weeks (shares were trading around $70 at the time). 

Beginning in 3Q15, Apple initiated a new accelerated share repurchase arrangement (ASR). The mechanics of such a program may at first seem a bit opaque, but they are actually relatively straightforward. The investment bank(s) handling the ASR borrow AAPL shares in order to deliver a large number of shares to Apple up-front. The banks then proceed to buy back shares over the span of weeks and months to cover their borrow. With AAPL shares having been weak since 3Q15 earnings, Apple will actually be able to take full advantage of its lower stock price by receiving cash back from the investment bank(s) in charge of the ASR. 

3) Hybrid Strategy. Apple can combine the two strategies, and have both a scheduled buyback plan in place in addition to buying more shares during times of market weakness. Judging from historical trends, Apple management is following this strategy, suggesting there may be increased motivation to increase the pace of buyback during times of market weakness. 

In reality, few companies take aggressive, bold moves with buyback programs during periods of market turmoil. Instead, capital management strategies tend to become more conservative as companies prepare for adverse capital market conditions. There had been a noticeable decline in the pace of Apple buyback recently, but it's difficult to know if it was due to a rising stock price, depleted U.S. cash reserves, or a combination of the two factors. Year-to-date, Apple spent $17 billion on buyback, 26% less than the $23 billion spent during the same time period in 2014. It will be important to see if this pace changes in the face of market volatility and lower share prices.  

Volatility Will Continue

There is no evidence to suggest that AAPL volatility will decline anytime soon. The market will focus on slowing EPS growth in 2016 while in reality, there will be much deeper issues at play. Customer loyalty and Apple's eventual embrace of new product categories will likely continue to be ignored by Wall Street. One of the primary ways for a $640 billion market cap company to grow in terms of valuation multiples is for current shareholders to become more comfortable owning a greater share of the company. As long as there are still basic misunderstandings about how Apple thinks about the future, valuation multiples will remain range bound, and management will rely on the share buyback program to take advantage of any perceived market dislocation. 

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Members have access to the Above Avalon stock buyback primer which can be used to become familiar with Apple's share buyback.

Apple's Plan to Destroy the Large Cable Bundle

The cable bundle is misunderstood. While analysts and pundits focus on when the cable bundle will finally succumb to Netflix, HBO, and Hulu, the reality is the future of television will be built on the video bundle's back. Due to attractive economics, video bundles are one of the best values in the media space and will remain the dominant way we receive premium video content. We are quickly approaching the point where Apple can capitalize on market dislocation to destroy the modern-day big cable bundle with a leaner bundle that is built to thrive in a mobile world. 

Video Bundle Economics

The cable bundle has been one of the best consumer deals in the modern era. By subsidizing content's true cost, the bundle makes it possible for consumers to receive a vast amount of video content for an artificially low monthly price. The bundle works marvelously well as long as everyone pays into the system, and this has been the case for the last 20 years. Nielsen estimated there were 116 million homes with televisions in the U.S., of which approximately 100 million had some form of pay TV for the 2014-2015 TV season. ESPN is one of the most widely distributed cable networks, reaching 95 million homes. ESPN has a farther reach than Facebook, a testament to how much power the cable bundle holds.  

While the video bundle will remain relevant for many years, the content associated with the bundle will change. New companies have relied on the old bundle parameter, namely, selling a wide range of content to as many people as possible to carve out a piece of the subscription video streaming market. Companies like Netflix, HBO, and Hulu sell video bundles. Instead of charging viewers by individual shows and series, these companies charge for access to a wide selection of content appealing to a range of consumers.

Most cable networks are in existence today because of the large cable bundle. Without the bundle, these networks would not be able to fund their current slate of programming. The mistake many people make when analyzing the bundle is to ignore the value of access. Having a window to nearly 100 million households is in many ways more lucrative than the pennies or nickels that the average channel receives from each household each month. This is a cable distributor's key selling point, and we often see fighting between content owners and distributors over access.

The Trickiness in Going Direct to Consumer

When contemplating the future of television, many have thought the strongest cable networks can one day bypass the large cable bundle and sell their programming direct to consumer. For simplicity's sake, I position ESPN and AMC as the poster children of this theory. In the current system, ESPN receives approximately $6 per month from every household subscribing to cable. AMC receives quite a bit less, approximately $0.50, although it is still well above the average $0.15 received. If ESPN and AMC were to leave the bundle and embrace the direct to consumer model, they would need not only to make up lost subscriber fee revenue, but also contemplate losing access to 100 million households. AMC relies on that access to sell new series, like "Fear the Walking Dead," to viewers. "Fear the Walking Dead" just became the highest-rated series premiere in cable TV history thanks to AMC's reach.  ESPN also benefits from grouping sports programming into one channel, appealing to a much wider fan base, including those who may only watch a game or two each month. 

There is no question that the best networks will have loyal fans ready to pay top dollar for a direct to consumer option. However, that won't be enough since these networks are simply not built to support such a model. It will be very difficult for ESPN and AMC to stop subscribers from signing up for their content only to watch their favorite series or sports season and then cancel their membership afterwards. With the cable bundle, such month-to-month volatility does not exist. 

I am very skeptical that a cable network will be able to go 100 percent direct to consumer. The economics are just not in their favor. Instead, a hybrid approach may work although in many instances, the best case scenario would be to just get to a point that matches the current large cable bundle. There is much incentive on the part of cable networks to make the bundle work. 

Time for Action

The mobile revolution has weakened the large cable bundle's fundamental underpinning. Mobile hasn't changed just the way we communicate, but also the way we create and consume content. Having new types of video content in our pocket has led us to no longer sit in a particular room at a particular time to watch a particular show. As smartphones continue to grow in screen size, all other pieces of smart glass in our lives, including our television sets, will lose value and importance.

The old definition of TV doesn't do justice to the much wider array of available content that we now have at our fingertips. As smartphone adoption grew, the idea that anyone could be a content creator became reality. While YouTube may still lead in terms of mindshare when thinking of user-generated content, we also have plenty of interesting content found on video-sharing networks like Vine, Snapchat, and Periscope, not to mention premium content from the likes of Netflix, HBO Now, Hulu, and Amazon.

One example of an entirely new form of content that people are increasingly turning to is vlogs, which is short for video blogs. The following Google Trends chart highlights vlogging's expanding popularity. The vlogging industry, notorious with young people chronicling their daily activities, is still in its infancy. Vlogging combines elements of reality TV with scripted television as many vloggers record real-life situations although the heavy use of editing and some pre-planning suggest there are also elements of a regular sitcom.

Exhibit 1: Google Trends for Vlogging

All of this new and entertaining content made available due to mobile and new video bundles suggest that the large cable bundle is a house of cards held together by cable distributors. We have evidence that the large cable bundle is fraying a bit at the edges although collapse is not imminent. Disney CEO Bob Iger started a panic on Wall Street a few weeks ago when he disclosed on Disney's earnings conference call that ESPN had continued to see modest subscriber losses. Anyone following ESPN's recent cost cutting initiatives, including a move away from expensive on-air talent, would have seen this news coming. Assuming Iger's comments about ESPN subscriber loss trends remain unchanged for the rest of the year, ESPN will likely report a 2-3 million decline in subscribers in 2015, which may actually represent a slight improvement in the rate of decline compared to last year. 

Exhibit 2: Change in ESPN Subscribers

Although ESPN is experiencing recent weakness, there is no evidence to suggest an exodus from the bundle is taking place.

I suspect cable subscriber trends are being impacted by cable distributors. As anyone trying to cancel his or her cable can attest to, it is not the easiest process, and very often consumers receive discounts or other promotions from their cable company to keep the bundle instead of completely canceling cable. The problem for many cable content owners is that if things remain status quo, we will enter a vicious cycle where weaker cable viewer ratings will result in less ad revenue, leading to inferior programming, which will only drive weaker ratings over time. Instead of there being a quick implosion, the cable bundle would deteriorate over time. The cable industry needs that one factor that will not only cause the house of cards to fall, but also address fundamental issues plaguing the large cable bundle.

Apple's Plan

The modern-day cable bundle is now vulnerable. Apple's strategy to destroy the large cable bundle would entail taking the best parts of the current bundle and creating an improved bundle. Essentially, Apple would be using a slimmer cable bundle to kill the large cable bundle. This may not seem too innovative. However, it is one way of addressing the biggest issue people have with their large cable bundle: finding and watching content at a time of their choosing. 

As has been previously reported by the WSJ and Re/code, Apple's slimmed down cable bundle would include 20-30 channels and be delivered over the internet to iOS devices. These channels could be considered as home to the best content found within the current large cable bundle. Similar to the modern cable paradigm, the combination of monthly subscriber fees and advertising revenue would represent the primary funding sources for networks included in the bundle. Add in live programming like sports, which come with a hefty price tag, and local news, which depend heavily on advertising revenue, and a new kind of bundle begins to take shape. 

Why would networks work with Apple? Having a customer base of nearly 90 million iPhone users and rising in the U.S. is very appealing to content owners. In an era where content bundles obtain their economics by having the widest access, 90 million users represent great opportunity. Similar to how Apple Music will be available on Android, it would be in Apple's best interest to make this new video streaming bundle available to Android as well. 

With a rethought cable bundle, Apple would be appealing to the 95 million households that still subscribe to cable, not those who stopped paying for cable. To destroy the large cable bundle, Apple will need to have current cable subscribers be willing to go through the hoops of canceling their current cable with their distributor. The house of cards would then collapse. 

Sling TV

On paper, Sling TV, an over-the-top video service owned by Dish Network, sounds similar to the bundle Apple would be looking to put together: a collection of 22 channels, including ESPN, for $20 per month. The problem is Sling TV is designed for those who aren't subscribed to cable, the exact opposite target market for an Apple streaming video service. Sling TV has limitations that cable payers would simply not be able to put up with such as only being accessible on a single device at a time and not including broadcast networks or stations. There are also valid questions over the quality of Sling TV's streaming with many reports of inferior viewing experience during popular shows. 

Video Bundles on a Smartphone are the New TV

Mobile will determine not just television's future, but also video's future. Any company or producer that thinks otherwise will likely be left behind to fight over legacy remnants of a bygone era. Instead of some truly revolutionary video streaming service that leaves all prior ideas about cable and TV in the dust, we are headed towards a future that has distinct similarities to the past, namely a handful of companies subsidizing a vast amount of content by offering video bundles to tens of millions of people. The large cable bundle's demise will occur when the 95 million U.S. households that still pay for cable each month are presented with an attractive alternative that takes the best parts of the bundle, adds better discovery and curation, and finally embraces mobile. 

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Apple Scouting a Self-Driving Car Testing Area - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on August 17th. 

Apple Scouting a Self-Driving Car Testing Area

In an article with quite the intriguing title of "Documents confirm Apple is building self-driving car," the Guardian became the latest publication to add their take to the ever-growing Apple Car debate.  

Here's the Guardian:

"Apple is building a self-driving car in Silicon Valley, and is scouting for secure locations in the San Francisco Bay area to test it, the Guardian has learned. Documents show the oft-rumored Apple car project appears to be further along than many suspected.  

In May, engineers from Apple's secretive Special Project group met with officials from GoMentum Station, a 2,100-acre former naval base near San Francisco that is being turned into a high-security testing ground for autonomous vehicles."  

The Guardian published certain parts of correspondence between Apple and GoMentum Station, obtained under a public records act request. The language would seem to show that Apple was interested in doing something at the testing location.

Frank Fearon, an Apple engineer wrote: "We are hoping to see a presentation on the...testing grounds with a layout, photos, and description of how the various areas of the grounds could be used." Additional correspondence from Apple included: "We would...like to get an understanding of timing and availability for the space, and how we would need to coordinate around other parties who would be using [it]." Meanwhile, Jack Hall, a program manager at GoMentum Station responded saying a tour of the facility needed to be postponed along with saying: "We would still like to meet in order to keep everything moving and to meet your testing schedule." In reference to Apple showing interest in the site, Hall told the AP, "We don't know. [Apple hasn't] said what they want to test. It could be an iPhone." 

In a rather comical confirmation that Apple did in fact reach out to GoMentum, an executive director at the Contra Costa Transportation Authority, owner of GoMentum Station, told the Guardian: "we had to sign a non-disclosure agreement with Apple...We can't tell you anything other than they've come in and they're interested." So much for that non-disclosure agreement.

The first thing that stood out to me about this report is that it was indeed a great find by the Guardian. It would seem that the GoMentum Station project was thrown back in the public spotlight a few weeks ago when the town of Concord and the Contra Costa Transportation Authority reached an agreement for how the space will be governed. GoMentum Station won't just be a testing site for self-driving cars, but also vehicles with self-driving technology and "smart" traffic signals and other technologies. Up to five automakers and 15 other companies may use the base with Honda and Mercedes-Benz having already agreed to test autonomous vehicles there.

Before then, the only confirmation that this site was going to be used to test self-driving cars seemed to come from a press release from this past October saying Mercedes signed up as a test partner. Considering that Apple communicated with GoMentum Station officials from this location only a few months ago, it's likely that the Guardian may have been the first outlet to find this scoop, or certainly unveil the details of correspondence between Apple and GoMentum.

The other aspect of the article relates to the seemingly definite title and byline in which the Guardian said: "Correspondence obtained by the Guardian shows Project Titan is further along than many suspected and company is scouting for test locations." There was nothing found in the correspondence published in the article that showed Apple was looking to test an actual Apple-branded self-driving car. Instead, we have information indicating Apple showed interest in using the testing area.

Instead of Apple looking to test a complete self-driving car in the near-term, it is much more likely that Apple is interested in using GoMentum Station to further advance its self-driving technologies. Think more along the lines of the cameras, sensors, and software that would make up the navigational brain of the car rather than a full car with carbon fiber and battery. Being able to test a self-driving rig in a real-world scenario with weathered roads, railroad track crossings, and tunnels would be an essential stage for Apple to take before getting to the point of testing the "Apple Car." 

With nearly all evidence pointing to Apple giving the Apple Car project the green light approximately a year ago, I'm skeptical that Apple has a fully functional prototype ready to hit the road. The timing for something like that so soon after a team had been assembled (and is still being put together judging by recent hires) just doesn't sound right.

Apple is unable to test its self-driving technology on public roads in California without going through the permitting process which would serve as confirmation that Apple was indeed testing self-driving car technology. While Apple wouldn't need to disclose much information as part of the permitting process in California, aside from any information related to accidents, the mere confirmation that the company was looking to test self-driving car technology wouldn't exactly fit with Apple's model of placing an incredible amount of value in secrecy and surprise. If public roads are out of the question, that would mean that the only other option is GoMentum Station, another privately owned plot of land, or an Apple-owned location. There are plans to have other fake towns built around the U.S. to test self-driving cars, like Mcity, which is a 32-acre fake town in Michigan that opened last month. Ford, GM, Delphi and Toyota have all shown interest in using Mcity for testing. Considering GoMentum Station's proximity to Apple's resources and staff, this particular location in Concord would seem to be too good to be true.

Recall the WSJ article from this past February which explicitly made the claim that Apple's Titan project did not include a self-driving car. I think that was a head-fake, purposely passed down the grapevine to throw off competitors. There is increasing evidence that self-driving capabilities may in fact be positioned as an eventual selling point for an Apple-branded car. Self-driving technology, or even just the beginning stages of it, would go a long way in positioning such things as safety and convenience as attractive value propositions to consumers.

If you're Apple, a 2,100-acre former naval base lined with barbed wire would certainly seem to be a testing site worth checking out. 

Along with the preceding story, the full list of stories sent to Above Avalon members last week included: 

Become a member to receive these stories (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

U.S. Watch Sales Collapsed in June - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on August 11th. 

This story flew under the radar late last week. Watch sales in the U.S. seem to be collapsing. Here's Bloomberg:

"U.S. watch sales fell the most in seven years in June, one of the first signs Apple Inc.'s watch is eroding demand for traditional timepieces. Retailers sold $375 million of watches during the month, 11 percent less than in June 2014, according to data from NPD Group. The 14 percent decline in unit sales was the largest since 2008, according to Fred Levin, head of the market researcher's luxury division."

A 14% year-over-year drop in unit sales is a pretty significant drop. According to NPD, timepieces priced from $50 to $999 saw declines in June, with the $100 to $149.99 range seeing the biggest drop, registering a 24% decline in unit sales. Just a few notes about NPD's data: they rely on consumer surveys along with point-of-sale data collected at individual retailers. NPD doesn't include sales from boutiques owned by watch brands, supermarket chains like Walmart, and online retailers. Think of it as if you are willing to share your sales data with NPD, you will then get much more comprehensive data from NPD in return.

Let's get the obvious out of the way first: we don't know if the Apple Watch is the reason for this watch implosion. Consider that Fitbit's earnings implied that the company sold at least 1 to 2 million devices in June, most of which were in the U.S. I think it is much safer to say that something is going on in the "wrist wearable" market because this watch sales decline is just too significant. 

Apple could very well have been the top watch manufacturer in the U.S. during the month of June when looking at revenue. While NPD pegged U.S. watch revenue in June at $375 million, it is likely Apple sold around 1.5M Apple Watches in the U.S. during the same period bringing in somewhere around $700 million of Watch revenue. This estimate comes from the fact that Apple sold between 2 and 3 million Watches last quarter at an average selling price (ASP) of around $475. My theory is that the U.S. represented an outsized portion of Watch sales because of the number of U.S. Apple retail stores, which were important locations for showcasing the Watch to consumers. In addition, Watch sales were backloaded in June due to supply/demand imbalance.

There is evidence to suggest that much of the collapse in U.S. Watch sales was segmented to the low-end of the market. Swiss watch export trends did not show a similar level of collapse in June with U.S watch revenue actually up 5% in June. 

When you add Apple Watch U.S. sales to those of other wearables like Fitbit, you likely had 2-3 million "smart wrist devices" being sold in June, which would come very close to outpacing the number of watches sold in the U.S. 

It is an understatement to say we are still the early days of wearables (I have only seen one Apple Watch in the wild, although I am seeing more Fitbits these days), but I would look at NPD's watch sales data as one of very first pieces of evidence that there could indeed be deterioration in the traditional watch market caused by smart devices in the form of watches and fitness trackers with Apple and Fitbit being the market leaders. 

Since owning Apple Watch, I'm more confident in saying the device may be a bit much to get used to at first if you are a luxury watch owner. It's not due to any particular inferior aspect of Apple Watch, but instead just the fundamental difference between wearing a computer on your wrist that tells time and so much more and a luxury watch that is worn for other reasons besides just giving you the time.

I do think it is more likely that Apple Watch will initially impact the low-end watch industry, which I will call "casual watch owners," those who may buy a $99-$299 watch just to have something on the wrist. This may explain why, according to NPD, the $100 to $150 space saw the biggest drop even though the Apple Watch retails for a good 3-4x the cost. In addition, watch loyalty at the low end is likely to be weak, and these consumers would be continuously on the lookout for new things to wear. Said another way, buyers in the $100 to $150 Watch range are more likely to experiment.

Given June's awful U.S. watch sales data, it is important to monitor if this is the start of a trend throughout the summer. If there are continued sales declines, then we are in a much stronger position to make more solid declarations about smart wrist wearables. 

Along with the preceding story, the full list of stories sent to Above Avalon members this week included: 

Become a member to receive these stories (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

Finding iPad's Future

The iPad raises interesting questions in terms of Apple strategy. A product that carries so much brand relevancy that it still represents the entire tablet market now finds itself the leader of a category that has lost all momentum as other product categories marginalize the tablet form factor. Although Apple is still selling more than 10 million iPads per quarter, there is something about the iPad that just doesn't sit right with me. We have gotten to the point that the status quo will likely lead to the iPad and the modern-day tablet becoming irrelevant over time. A new direction for iPad is needed based on a fundamental rethink of tablet computing.

The Current Tablet Market

The tablet market is in complete disarray. Only five short years ago, the iPad helped jumpstart the category, ushering in multi-touch computing and the modern-day app revolution to large-screen devices. Today, there has never been a time when the tablet market faces so much unknown.

A quick look at iPad and tablet shipment data would show that things have gotten bad in recent quarters. However, in reality, things are much worse than quarterly shipment data would suggest. The seasonality found in the tablet segment makes it difficult to see these long-term problems. A much better way at understanding what has been taking place is to look at the year-over-year change in shipments on a trailing 12-month (TTM) basis, highlighted in Exhibit 1. This smoothing effect highlights that the iPad and tablet have been on the decline for years and things continue to worsen with the overall tablet market hitting negative territory for the first time. All momentum has been lost.  

Exhibit 1: Change in Trailing 12-Month (TTM) Tablet Market and iPad Shipments 

After kicking off the tablet market in 2010, Apple went on to sell a cumulative 84 million iPads in just two years. The iPad's initial success was simply unprecedented, with unit sales outpacing the iPhone's relatively "slow" start by 2.5x. I suspect Apple wasn't just caught off guard by the iPad's success, but was led to believe that the iPad represented the future of computing. Many thought the iPad would outshine the iPhone. 

In relatively short order after launching the category, Apple uncharacteristically expanded the iPad line to include a completely different form factor known as the iPad mini. The motive was primarily based on price, making sure there wasn't a repeat of the Windows vs. Mac battle from the 1990s in the tablet market due to Apple letting competitors underprice iPad. The iPad mini was soon called the best tablet ever, evidence that the larger form factor was losing a bit of its luster in just two years. Many didn't see it, but tablets were quickly turning into content consumption devices where price was a leading purchase decision. 

We now find ourselves with a tablet market where Apple and Samsung are losing share to "Others," which is represented by dozens of firms selling mostly generic tablets used to consume media, depicted in Exhibit 2.

Exhibit 2: Global Tablet Market Sales Share 

On a profit and mindshare perspective, Apple continues to lead the way. Instead of wishing for smart television sets, the future of TV watching is taking place with $99 tablets. 

When looking at iPad's declining ASP trends, consumers continue to choose older, less costly iPads, another indicator that tablet computing is shaping up to be something different than we have been led to believe. A product category with a use case summed up by Netflix watching is quite problematic since it is that much harder to sell a differentiated product, leading to a rush to the bottom in terms of pricing, quality, and features. 

Momentum is not on the side of iPad. Larger screen iPhones have been in the market for only 10 months. The latest Macbook, which effectively gave us a look at where the MacBook is headed, has been out for only a few months. These two products are game changers not just in their categories, but for tablet computing. It is becoming that much easier to recommend an iPhone or Macbook over an iPad.

Tablets Are Being Used for Consumption

When the iPad first started to show signs of trouble, many market observers were shocked, thinking Apple must be losing to low end Android tablets. In reality, one reason sales momentum was slowing was iPad owners weren't upgrading their device. Using Fiksu data and my own estimates, consumers have held onto their iPad, on average, for three years, which is longer than the iPhone's 2.6-year upgrade cycle. Since the tablet category is still young, the iPad's three year upgrade cycle is still extending and will likely go out as far as 5-6 years. The theory that a longer upgrade cycle was impacting iPad sales began to be used in the press and conference calls. 

Exhibit 3: Current iPad Mix (model and model year)

While there is nothing inherently wrong with a long upgrade cycle, as seen with the Mac, which continues to report solid sales momentum, the reasoning behind holding on to tablets for years is much more troubling. There are currently approximately 3 million units of the original iPad still in use, or 20% of the devices Apple sold. For the iPad 2, it is possible that close to 60% of the units Apple sold are still being used. These two devices are not superior tablets. The initial iPad lacks a camera, while the iPad 2 has a mediocre camera. When compared to the latest iPads, these first two iPads are simply inferior tablets with slow processors, heavy form factors, and inferior screens. But none of that matters with owners. This is problematic and quite concerning, suggesting that many of these tablets are just being used for basic consumption tasks like video and web surfing and not for the productivity and content creation tools that Apple has been marketing. 

There are signs that Apple believes there may be some kind of iPad revival around the corner. Since the average iPad upgrade cycle is three years and counting, does this mean that Apple may benefit from some sort of upgrade cycle? I'm skeptical.  Why would someone upgrade an iPad that is just being used to watch video?

Potential Isn't Reality 

On the surface, the iPad's declining sales momentum is difficult to comprehend. There seem to be so many use cases for larger-screen multi-touch computing devices across a number of industries. We hear about "iPads in the classroom," new and interesting enterprise apps resulting from the Apple/IBM partnership, plenty of anecdotal evidence of children loving to play games on iPad, and of course, iPads replacing desktops, laptops, and televisions. Apple has consistently referred to superior iPad satisfaction rates on earnings calls which support the idea that people love their iPads. Yet in the face of all this potential, we are just using iPads for Netflix and YouTube. 

On closer examination, there are cracks in the iPad story. School districts have seen mixed results with iPad adoption programs. We have seen a few high-profile disasters where the combination of a lack of curriculum built for the iPad, along with high costs, made the iPad not the magical device in the classroom once thought. The idea of replacing student books with iPads never materialized due to poor incentives in the textbook industry, not to mention technological limitations found with the device.

The scope of iPad in enterprise still remains mostly a dream. We are seeing more stories about enterprise embracing Macs, not iPads. Meanwhile, consumer usage on iPad has moved away from content creation apps. Take a look at the iPad App Store to see the lack of compelling apps for larger screens for additional evidence of iPads being used much more for basic content consumption. 

Things are Getting Worse, not Better

Back in October 2014, I wrote a post titled "Thoughts on iPad," in which I explained the iPad's ultimate sales trajectory would be much more modest as Apple was selling large-screen iPhones and thinner Macs. While I received an incredible amount of pushback at the time, trends have largely materialized as I expected. The continued migration of smartphone manufacturers to 5+ inch screens was not just a game changer for the smartphone market, but will come to represent a watershed moment for the tablet market. Many of the use cases once destined for the iPad are permanently gone, now taken up by the iPhone and MacBook.

Another consequence of growing large-screen smartphone popularity is that it is becoming increasingly difficult for Apple to market the iPad Air and iPad mini.  Features such as cameras and even Touch ID simply don't make as much sense on a device that can't be comfortably held in one hand or carried in a pocket. Apple has tried to position the iPad as a mobile device, emphasizing its ability to take photos and video on the go, but it's not realistic to assume people will prefer an iPad to an iPhone in such settings.

Not only are tablets being used for more rudimentary purposes, but smartphones and laptops are crippling the odds of tablets being used for much more. The iPad market is in trouble and if there are no changes made to the lineup, Peak iPad is on the table. Peak iPad is a simple concept driven by the belief  that underlining structural changes to the tablet market would result in the iPad losing most of its value propositions, leading to a permeant decline in sales. For example, Peak iPod is alive and well as even though Apple is still selling iPods, the product category will never reach record quarterly sales. Meanwhile, while some argued that we had seen Peak Mac, we instead were just in a sales slump that quickly reversed itself with a revamped product line. The Mac's value propositions were still alive and well. In a world where smartphones are getting larger and laptops are getting smaller, the Peak iPad theory is starting to look more likely as time goes on. Something needs to be done to create new tablet value propositions, redefining its role in the mobile revolution.

Apple's Plan for iPad

It is time to fundamentally address the problems with multi-tech tablet computing. The answer is to introduce a new product subcategory at the high-end of the tablet market. With video consumption taking over at the low-end, it becomes that much harder to sell a differentiated product at a low price. Apple has better chances of pushing the tablet market forward by looking at the high-end of the market where a superior experience is able to be sold at a premium price. 

By selling a device that is truly designed from the ground-up with content creation in mind, the iPad line can regain a level of relevancy that it has lost over the past few years. In every instance where the iPad is languishing in education and enterprise, a larger iPad with a 12.9-inch, Force Touch-enabled screen would carry more potential. Simply put, the iPad needs to stand out from the iPhone and Macbook. The iPad Air and iPad mini aren't doing it.

Education. Instead of pushing the idea of every student having an iPad, which is difficult when considering costs and the fact that most students already have a smartphone and laptop at home, school districts could set up "iPad Plus" rooms with 20-30 of the larger iPads reused throughout the day by various classes. A new larger iPad with nearly 80% more screen real estate than the iPad Air, dedicated accessories like a smart pen, and better covers and stands can go a long way. It can become part of art and design classes, not to mention a number of different disciplines, including those where writing is involved.  Writing a term paper on an iPad mini or even iPad Air is not fun. A larger tablet with full-size on-screen keyboard using Force Touch to resemble the haptic feedback of a real keyboard may be a game changer. 

Enterprise. A larger iPad could be positioned as a laptop replacement whereas today's iPads are stuck in a weird place as a secondary computer. Any design-oriented field would instantly see value in using these larger iPads while traditional industries such as finance and banking would see a much easier adoption rate if legacy products like Excel are made that much more easier to use. 

Consumer. A large iPad could continue down the path of replacing old laptops and desktops, becoming a user's primary computing device. The much easier ability to type means that nearly every possible computing use case would be covered. This 12.9-inch iPad Plus will begin to look much like the Mac in terms of sales with a slow and steady sales uptick, followed by an orderly upgrade cycle. The key for such a device will be once again redefining where a tablet should sit in someone's product portfolio. We know everyone will have a smartphone. The question would be if a new type of device can exist between an iPad Air and MacBook. 

Over the years, we have come up with differing degrees of the "perfect combo" for computing. It used to be an iPhone and iPad. Then it became an iPhone and iPad mini. Now many say iPhone and MacBook. The question will be whether or not a product can be created that will serve as a high-end creation device that compliments an iPhone. 

What Does Success Look Like with a New iPad?

An iPad Plus does not need to sell like an iPhone or even like an early edition iPad to succeed. As long as the product has use cases that are sheltered from other products, Apple would be able to reposition the iPad line for a more sustainable path not just for growth, but ultimately for outright survival. If the end goal is to ship devices that help solve users' problems, Apple will have a winner on its hands. A more capable iPad Plus has a much better chance of becoming relevant in a world where the iPhone is already the all-powerful device everyone owns. The early days of the iPad era provided many opportunities to see how the definition of work is changing. A new tablet subcategory that does a better job of pushing the definition of work forward is needed. Tablet computing has a much brighter future than just being used to watch Netflix and YouTube. 

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