Apple 1Q16 Earnings Preview

Investor anxiety heading into Apple's upcoming earnings report is at a multi-year high. Fears surrounding slowing iPhone 6s and 6s Plus sales have morphed into broad questions about the iPhone's long-term viability. While investors are looking for answers that won't likely be provided this week, management has a very clear goal with its 1Q16 earnings report and conference call: set expectations for 2016.  

Overall

My 1Q16 estimate reflects a record quarter for Apple with all-time highs for revenue, operating income, earnings per share, iPhone sales, and Apple Watch sales. My full estimates are highlighted in Exhibit 1. 

Exhibit 1: Above Avalon Estimate for Apple's 1Q16

iPhone

On Apple's previous earnings call, Tim Cook discussed his expectation that iPhone sales would increase year-over-year during 1Q16 on a both a revenue and unit sales basis. Since this unofficial guidance was provided nearly one month into the quarter, it would have taken quite the unexpected slowdown in iPhone shipments for Apple to report anything less than 74 million units. As seen in Exhibit 2, my expectation range is for Apple to report between 75 million and 79 million iPhones with the mid-point of that range representing my 77.2 million estimate. 

Exhibit 2: iPhone Unit Sales Expectation Meter

iPad/Mac

The iPad category still faces significant structural headwinds despite the iPad Pro going on sale two months ago. With 1Q14 being the last quarter that Apple reported iPad unit sales growth, expectations for the iPad category continue to be at all-time lows with few expecting near-term growth. Exhibit 3 highlights my narrow 17 million to 19 million expectation sales range for iPad and my expectation for Apple to report modest Mac sales growth. 

Exhibit 3:  iPad and Mac Unit Sales Expectation Meters 

Apple Watch

Apple sold approximately six million Apple Watches during the first five months on the market from April 2015 through the end of September. Judging by the Watch's expanded retail distribution during the holiday quarter, including $100 promotions at Best Buy and Target, Apple Watch was one of the top gifts of the holiday season. Apple lumps Apple Watch sales in with Other Products. As seen in Exhibit 4, approximately $5 billion of Other Products revenue would convert to my 5.5 million Apple Watch unit sales estimate. Every $500 million increment in Other Products revenue is equal to one million Apple Watches.

Exhibit 4: Apple Watch Unit Sales Expectation Meter

Guidance

Apple's 2Q16 may end up representing the weakest quarter of the year. Accordingly, it should not be a surprise if Apple guides to a year-over-year decline in revenues. Given that Apple beat its 2Q15 revenue guidance of $52 billion to $55 billion by a sizable amount last year, that same range may end up being a realistic target for Apple's 2Q16 revenue guidance. Along with revenue guidance, Exhibit 5 contains my expectations for margin guidance. Apple continues to be in a positive margin cycle with no near-term signs that margins are at risk of experiencing significant deterioration. 

Exhibit 5: Guidance Expectation Meters

Additional Earnings Commentary and Perspective

Over the past week, I published additional commentary and perspective on Apple's upcoming earnings, including the reasoning and logic behind my product unit sales estimates. The following analyses was sent to Above Avalon members: 

Become a member to access this additional earnings commentary and receive future Apple analysis in a daily email containing 2-3 stories (10 - 12 stories a week). For more information on membership and to sign up, click here. 

Apple Is Moving Beyond the iPhone

There are signs that something interesting continues to unfold within Apple when it comes to wearables. While the tech industry's response to wearables remains lukewarm, with Facebook, Microsoft and Google showing greater interest elsewhere, Apple has been thinking very differently about where consumer trends are headed. With the Apple Watch launch in the rearview mirror, Apple's bet on wearables will grow, not shrink. Silicon Valley is underestimating wearables while Apple has spent the past four years planting the seeds for doing the seemingly impossible: moving beyond the iPhone and positioning itself as the driver of the next technological era.

The iPhone Company

Apple is currently the iPhone company. With the product representing 65% of Apple's annual revenue and an even larger share of its operating income, the iPhone is crucial to Apple's current financial success. Exhibit 1 highlights the iPhone's growing share of Apple's revenue and operating income since launch. 

Exhibit 1: iPhone's Share of Apple Revenue and Operating Income

One consequence of Apple's growing dependency on the iPhone has been increased Wall Street jitteriness at any sign of slowing or softening iPhone demand. With Apple's near-term cash flows and earnings heavily impacted by iPhone sales, investors have turned decidedly more pessimistic about the the company's long-term prospects given slowing iPhone growth trends as shown in Exhibit 2. 

Exhibit 2: iPhone Unit Sales Growth (Trailing Twelve Months)

While Wall Street may have turned negative on the iPhone business, when looking at the smartphone landscape, it is easy to see that the iPhone is actually continuing to gain power. China Mobile has proven to be a game changer for Apple, leading to a record number of new users entering the iPhone ecosystem. All the while, Apple continues to hold a monopoly-like grip on smartphone industry profits. Apple finds itself with an extremely lucrative business that has never been stronger, albeit with slowing growth prospects. 

What's next for the iPhone company? If going by business textbooks, Apple should cut iPhone pricing in an effort to expand market share and chase growth, especially in emerging markets. However, there are clues that Apple not only has little interest in that strategy, but has already been thinking of new products in an effort to move beyond the iPhone. Management is aware that iPhone growth will not continue indefinitely and that at a certain point Apple's resources will be better spent coming up with new products that can do an even better job at making technology more personal. 

Laying the Groundwork

Management has spent years planting the seeds for an era in which Apple will no longer be known as just the iPhone company. While that statement may seem comical today considering how dominant of a force the iPhone is in Apple's business, Apple is no stranger to the process of coming up with new products despite selling much more lucrative and popular devices. We got our first glimpse of those first small steps of moving beyond the iPhone back at the Flint Center in September 2014. The hype surrounding the event was quite high, primarily built-up by Apple, with the anticipation coming second only to the iPhone keynote seven years earlier.

When compared to the iPhone keynote, the Apple Watch unveiling seemed a bit lacking. This uneven comparsion between the iPhone and Apple Watch launches have come to symbolize the Apple Watch's first year on the market. When compared to the iPhone, the Apple Watch looks very inconsequential. The fact is that when comparing anything to the iPhone, it is nearly impossible to match the iPhone's popularity. This is not a sign that the iPhone will forever remain the most important device in our lives, but that a new device will appear lacking for many tasks, but attractive for a few dedicated uses.

Apple has been laying the groundwork for its vision of a world where our growing dependency on smartphones actually creates possibilities for new devices to enter the equation, similar to how smartphones didn't replace laptops and desktops but began to handle certain tasks once given to larger and more powerful PCs. The only way for Apple to plant the seeds for a post-iPhone era is to ship a product that seems woefully inadequate for replacing the iPhone today, but remarkably intriguing in how it can make technology more personal. The goal for this new product is not to "replace" the iPhone, but instead to be able to handle a growing number of tasks once given to the iPhone. 

The Strategy

Apple's strategy to look beyond the iPhone depends on a few steps that may seem extremely counterintuitive but are essential for driving consumers to embrace new forms of personal technology. 

1) Increase our dependency on iPhones. The best way to move beyond the iPhone is to give the iPhone an even greater role in our lives. This process has been occurring for years, but Apple needs to push even harder in positioning the iPhone as the most valuable computer in our lives.

2) Begin addressing friction points created by greater iPhone dependency.  By giving the iPhone a larger role in our lives, there is a much greater likelihood that friction points will develop around small, seemingly inconsequential tasks like checking the time, reading messages, paying for items in a store, using maps to find a destination, and communicating with friends and families. It's not that iPhones can't do any of these tasks, but because the iPhone is positioned as our primary computer, there is room for a simpler device to handle these tasks in a much more efficient and easy way.

3) Embrace luxury and fashion themes. The iPhone is the most personal computing device for hundreds of millions of users. Therefore, one way of coming up with even more personal devices tasked with handling simpler tasks is to remove any remaining barriers between the user and technology. As soon as we talk about devices worn on the body, new themes around luxury and fashion have to be considered. This is where the technology industry is finding much difficulty as very often these themes are intangible and more of an art than a science. 

4) Nurture new use cases. Despite the iPhone's growing popularity, there are certain things that the smartphone form factor will never be optimized to handle, including health monitoring and biometric identification. 

5) Give software room to breathe. Apple needs to develop a platform for third party developers that embraces new ideas and methods. Much like how the app revolution changed the smartphone's trajectory, having developers embrace new types of devices will give the category that much more potential. It's still too early to say if wearables will have a similar "app" moment. A convincing argument can be made that the very fundamental nature of an app will change for wearables given a vastly different user input method (no software keyboard) and smaller form factor (much less screen real estate).

Apple has already spent a great deal of resources on the the first three steps on this list. Steps four and five are very much a work in progress.

Early Signs of Success

Judging by 2015 trends, Apple's strategy of looking beyond the iPhone is seeing some early success. Contrary to much of what has been reported in the tech press, consumers spent the year embracing wrist wearables. The two market leaders of the industry, Fitbit and Apple, likely sold approximately 35 million wearable devices for the wrist in 2015. On a revenue basis, the two companies brought in close to $7 billion for devices worn on the wrist. For Apple, we will get a better look at Apple Watch sales with earnings next week, but there is no question that Apple sold at least nine million Apple Watches in the first eight months on the market, with the possibility of up to 12 million.

While these numbers pale in comparsion to smartphone sales, that type of comparsion misses what is happening at a ground level. Tens of millions of consumers are finding a place in their lives for technology on the wrist, an area of the body that was once controlled by watchmakers and other fashion players. The fact that a growing number of consumers were choosing not to wear anything on their wrist likely told Apple there was potential for change. A more appropriate measure is to compare Apple Watch sales to early iPhone sales after launch. By that measure, the Apple Watch is the second best selling Apple product out of the gate. 

Exhibit 3: Early Apple Product Sales

Some have looked at Apple Watch's widespread availability, especially when compared to the limited launches of iPad and iPhone, as evidence that Apple Watch adoption is not as strong as absolute sales may suggest. While that argument is valid, it fails to recognize the Watch's primary objective, which is to handle a few tasks currently given to the iPhone. Such a dynamic produces a situation in which Watch adoption may be artificially low in the beginning.

If additional evidence is needed to demonstrate early success with wrist wearables, the luxury watch industry, and in particular those companies with products in the same price range as Apple Watch, look to be in downright panic mode with nearly every data point coming from the industry since summer of 2015 showing deteriorating market conditions.  

Thinking Differently

The buzz surrounding smartphones has declined. While there is still plenty of innovation left for the small computers in our pockets both in terms of hardware and software (the iPhone home button is turning into a limiting factor), evidence is growing that Apple has been thinking about "what comes next" for years. One would think that many of Apple's competitors are just as focused on embracing this next era and the idea of wearables beginning to handle a growing number of tasks given to our smartphones, but reality is very different.

While no one is outright ignoring or betting against wearables, very few are showing the focus or interest in wrist and other "non-eye" wearables like Apple. Google has Android Wear and is showing continued fascination with smart glasses, as demonstrated by Tony Fadell's increased involvement, but for a company that is all about conducting R&D in public view, the lack of progress is noteworthy. The same can be said for Facebook and Microsoft, companies that have shown much greater interest in augmented and virtual reality glasses. When considering how so few companies are even capable of doing much in the wearables space given either a shortcoming when looking at hardware, software, or both, not to mention luxury and fashion expertise, the lack of excitment surrounding wearables is understandable.

One of the most remarkable things about Apple looking beyond the iPhone is that on paper it makes little sense. The iPhone is the single most successful consumer tech product in history, bringing in more than $150 billion of revenue a year. Why should Apple come up with something that will eventually replace the iPhone? Exhibit 4 highlights how the iPhone went from being just a footnote next to iPod sales in 2007 (chart on the left) to making ten million Apple Watches look like a footnote just eight years later (chart on the right). 

Exhibit 4: Apple Footnotes (iPhone in 2007 vs. Apple Watch in 2015)

However, Apple thinks differently. Apple knows that one day the world will move beyond the iPhone. That day won't be tomorrow, next month, or even next year. It may not even be for another five years. Apple could very well make another trillion dollars of revenue from the iPhone. But it is inevitable that the iPhone will eventually lose relevency. Apple knows the best way of navigating such a future is to be the one that makes the iPhone irrelevant. 

Exhibit 5: Apple's Long-Term Game Plan

While the world is still preoccupied with wondering what comes after smartphones, notice how much progress Apple has made in moving beyond the iPhone (Exhibit 5). The Apple Watch is on the market, and signs point to Apple coming up with additional devices for different parts of the body. Meanwhile, Apple is busy building its largest startup ever. The iPhone company is planning for a day when it is no longer the iPhone company. 

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The Two Apples

There are two Apples: AAPL, the stock, and Apple, the company. While it would seem logical that one is merely a reflection of the other, in reality, the two are guided by vastly different parameters. Over the long run, Apple and AAPL will likely be at odds with each other due to the very nature of Apple's long-term mission of making products that people love. It is the classic Wall Street vs. Silicon Valley battle, and 2015 was likely just a taste of what is to come. 

AAPL's 2015

It would be an understatement to say that AAPL had a weak 2015. When looking at stock price performance, AAPL's underperformance was quite striking. While GOOG, FB, and AMZN saw strong double-digit stock price increases, AAPL reported a rare 3% decline, the first annual decline since 2008. Even more striking, AAPL's performance meant that the market removed $46 billion of market cap from AAPL in 2015, whereas AMZN and GOOG were given nearly $350 billion of additional market capitalization. Exhibit 1 highlights the dramatic performance difference between AAPL and its large cap tech and mobile peers as well as the major indices. 

Exhibit 1: AAPL Underperformance in 2015

Apple's 2015

Even though AAPL shares recorded a remarkably weak year, Apple, the company, had a much more successful 2015. As it did in 2014, the Apple machine spent most of the year operating at full speed. In what should not come as much of a surprise, Apple updated the vast majority of its product line. The iPhone's continued rollout at China Mobile led to a large wave of new users entering the iOS ecosystem in 2015, leading to iOS making further inroads in its battle against Android. Apple unveiled the iPad Pro and related accessories as a way of defining the iPad's category future. 

While Apple's services were said to have experienced more of a mixed bag in 2015, it is difficult to call Apple's new products flops. The Financial Times reported Apple Music having 10 million paying subscribers in six months, positioning the service well in its long-term goal of finding sustainability for the music industry. Meanwhile, Apple Pay saw a successful rollout in the U.K., although retailer support in the U.S. remains disappointing. New services such as Apple News were positioned as a way to keep users' attention hooked on Apple properties while using Apple gadgets. 

Apple launched its first new product category last year with Apple Watch, and despite the tech press not quite understanding the device, the device's early sales success reveals Apple has a hit on their hands. 

However, the primary takeaway from Apple's 2015 wasn't related to any one particular product but rather the transformation Apple began to show in terms of embracing a new type of luxury. The ramifications from this change will likely play themselves out over the next 5-10 years. Once Apple began selling a $17,000 Apple Watch, the company was never going to look the same. This change will manifest itself in terms of Apple's ongoing quest to make technology even more personal.

Given all of these constructive long-term fundamentals, how did AAPL register such a weak 2015, underperforming its peers by a wide margin? AAPL, the stock, and Apple, the company are each guided by vastly different ideals and parameters. 

AAPL: The Story

At a very fundamental level, a share of company stock provides an investor a way to own that company's balance sheet, including income-producing assets. The degree to which these assets can be utilized to generate future cash flows helps investors determine how much a share should be worth. With every investor having different expectations and required returns from a company, a stock's ultimate value is determined in the marketplace as the point at which demand for those shares (buyers) equals supply (sellers). In 2015, the marketplace determined that Apple was worth $46 billion less at the end of the year compared to January 2, 2015.

Stories are important on Wall Street, and the story surrounding AAPL took a decidedly negative turn in 2015. While some will point to concerns surrounding slowing iPhone 6s and 6s Plus sales as leading to AAPL's first annual stock price decline in years, there are likely other, much more significant issues at play. Wall Street wants predictability or at least the appearance that things will be predictable in the future. AAPL has very rarely been able to give investors that sense of predictability. Just look at the sources of Apple's revenue over the past 15 years. Apple has gone from being the "iPod company" to the "iPhone company," and now there are genuine questions as to where the company goes from here. 

Meanwhile, just as skepticism around AAPL began to take over, the stories developing around some of Apple's largest peers grew noticeably more optimistic in 2015. It should not be ignored that much of this renewed optimism surrounded founder-led companies: Alphabet, Facebook, and Amazon. For Alphabet and Facebook, the narrative switched to how the two companies are able to make money from giving away products for free, a strategy in which each party to the transaction is paying in different ways. For advertisers it is cash, while for users it is time and attention (not to mention data). Meanwhile, Amazon took the bear case surrounding its stock and flipped it on its head by purposely showing that Amazon could be much more profitable if management chose to be. Not to mention, the company is seeing sheer success in terms of e-commerce.

Where does AAPL fit into all of this? What is the narrative surrounding the stock on Wall Street? Apple is the company searching for the next big thing. There continues to be skepticism that management will be able to grow profits from hardware in a world being overtaken by software and cloud services. Investors are also showing a lack of confidence that iOS and Mac users will stay within the Apple ecosystem, paying for new services and buying new products. AAPL investors need confidence that Apple will be able to utilize its balance sheet to supply a particular level of cash flows in the future. The belief is that AAPL will have trouble maintaining its current success. Even though Apple may be strong today, Wall Street has concerns about the Apple of tomorrow.  

Apple: Embracing the Unknown

Just as Wall Street is nervous about AAPL's changing revenue sources, Apple's ultimate success is built on that very ideal. Even though Apple was the "iPod company" yesterday and the "iPhone company" today, management's goal is to make sure that Apple will one day be known as something else, such as the "car company" or the "personal transport company." This isn't to suggest that Apple will change its culture and mission statement depending on where growth can be found. Instead, management looks to enter product categories that make it possible to advance Apple's goal of making technology more personal. In the beginning, such a goal was achieved with the Mac but soon included the iPod, then iPhone and iPad, and now Apple Watch. Exhibit 2 highlights Apple's changing revenue mix since 2002. 

Exhibit 2: Apple Revenue Mix

Note: Adjusted revenue excludes revenue from non-core product groups. 

Note: Adjusted revenue excludes revenue from non-core product groups. 

When news broke that Apple was interested in designing its own electric car, reactions seemed to fall into two buckets. Some saw what had to be faulty reporting or a company that is unsure where to turn next in the face of slowing smartphone sales. Many seasoned tech industry watchers could not come to believe the thought of Apple, the maker of pocketable gadgets, designing a car. The "expanded CarPlay" narrative spread like wildfire, almost as a way to make sense of the Apple Car madness, even though that reasoning demonstrated a fundamental misunderstanding of Apple. Meanwhile, the other type of reaction was based more on how Apple actually looks at the world, searching for opportunities to rethink how things are done. 

Apple management has one goal: make products that people love. The iPod met that goal just as the iPhone and iPad went on to do the same. Evidence is now pointing to the automobile industry as being ripe for Apple to place a big bet. Throughout 2015, we learned of Apple's developing interest in cars as Apple was meeting with contract manufacturers in Europe, talking with BMW, looking into autonomous testing centers, hiring automotive personnel, and of course, beginning to leave more subtle hints in interviews and keynotes. We saw the early signs of Apple laying out its future. 

Meanwhile, there has been no denying that the Apple Watch was put through the expectations wringer in 2015. From being labeled as Apple's next big thing since iPhone, something Apple didn't do much to tamp down, expectations quickly did a 180 degree turn and focused on how the Apple Watch seemed like a flop. In reality, Apple's prior success altered the definition of a flop.

Apple's long-term success is based on not being afraid to embrace the unknown. The willingness to place big bets in industries outside their historical core competency is management's strategy for keeping Apple relevant. 

The Divide

While AAPL investors look at changing revenue sources and Apple entering new industries as risk factors, for Apple such characteristics are normal business and according to plan. It is this divide that will likely continue indefinitely, suggesting it is unwise to expect AAPL to one day begin to follow Apple. Just as a declining AAPL stock price is no indication of a struggling Apple, there will likely come a time when AAPL outperforms peers even though Apple, the company, may be struggling. 

One may ask if this type of divide between the two Apples exists with other companies. While it is is true that every stock is ultimately guided by different parameters as opposed to the company it represents, there are very few companies that are trying to follow Apple's strategy. Competitors may say they are interested in following the Apple path of keeping as many mistakes as possible in the design labs, leaving just a very few big bets for the public marketplace, but few practice the strategy. In addition, there are few companies with the corporate structure and culture needed to back up such claims.

From a historical perspective, very few companies have been able to do what Apple is striving to do: remain relevant. While companies like Nike and Disney are often used as models for Apple, in reality, they aren't the best examples. Instead, a company like Sony does a much better job at showing what Apple is trying to avoid: losing sight of the hockey puck and not knowing where it is headed. To accomplish this goal, Apple will need to reinvent itself. If that wasn't difficult enough to do, to expect Wall Street to get behind Apple and such reinvention is overly optimistic. 

Management's Plan of Attack

If this divide between AAPL and Apple is expected to continue indefinitely, management doesn't need to just sit by idly. Capital management actions can be positioned to utilize this ongoing divide between how the world looks at AAPL and Apple's quest for the next big thing. 

If Apple is all about moving from product to product, there will undoubtedly be periods when Wall Street will turn sour on the company. It will be at these times that Apple should use capital management tools to take advantage of what management deems market dislocations. The key to buying back shares is to do so at a valuation that management thinks the market is incorrectly reaching. When it comes to Apple, the time at which this condition will best be met is when Apple thinks it has found the next big thing while Wall Street continues to doubt. We saw this play out in early 2014 when Tim Cook disclosed to the WSJ that management had been buying a record amount of AAPL shares after reporting a "lackluster" earnings report. Taking a look at the subsequent Apple Watch launch seven months later, it is not difficult to see that management was well aware that Apple Watch would be soon launching, and management felt confident this would be the first new product category under Tim Cook. 

If there is one consistency with Wall Street it is that stories change. There will come a time when investors turn more positive on AAPL. Instead of thinking investors finally "got it," in reality, that will be the time when it is even more important to analyze Apple's quest to remain relevant. Estimating future cash flows may be a science, but coming up with products that people love is an art. 

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Introducing New Membership Features and a Slack Team

I'm excited to announce a number of new features attached with Above Avalon memberships. Last May, I began writing daily analysis and perspective about the world of Apple and sending it exclusively to members. How have memberships been going? Great. Things have exceeded my expectations. With members from 38 countries, holding various backgrounds and areas of expertise, a vibrant member community has been formed in just eight months. In terms of numbers, I'm fortunate to have recently raised my one year subscriber goal. 

New Features for Members

Archive. Beginning this week, Above Avalon members now have access to all previous analysis and perspective sent to members. While Daily Updates sent to members are timely and focused on current news events, they include stories that are also quite valuable for future reference. In addition, an archive makes it possible for me to seamlessly link back to previous articles, which was not possible before. 

The archive is found within the Above Avalon team in Slack. 

The archive is found within the Above Avalon team in Slack. 

New Above Avalon Team in Slack. Let me cut to the chase. Slack is the future, available today. I'm not a fan of web forums for many reasons, so I never had an interest in having an Above Avalon member forum. However, after jumping with both feet into Slack, it quickly became obvious that this is something with which I want to associate with Above Avalon. Since more than a few Above Avalon members were already familiar with Slack, I knew the transition would be easy. Over time, I think most teams as well as subscriber and hobby groups will be on Slack. With great iOS apps available for iPhone and iPad and a nice web interface for Mac and PC, Slack has everyone covered. 

The Above Avalon team in Slack is a great place to meet and communicate with members from various industries including tech and finance circles. There are four primary channels or "forums":

 
 
  • dailyupdates_archive - An archive of Daily Updates sent to members. 
  • dailyupdates_comments  - A place to talk about the Daily Updates with the group.
  • intros - A place to introduce yourself to the group.
  • random - A place to chat about various topics. 
  • thursday_qa - An opt-in channel for asking questions to be answered in Thursday Q&A, a feature where I answer a few member questions each Thursday. 

It was very important to me that these new features be positioned to increase the value of Above Avalon memberships. This means that joining the Above Avalon team in Slack is optional. All of my analysis and perspective can be found in the daily emails throughout the week. I will not post exclusive content in Slack. If you don't join the Above Avalon team in Slack, you will still receive much value with your Above Avalon membership. That was a key consideration to make Slack opt-in and not a mandatory signup. 

Additional Ways to Consume Analysis. While all Daily Updates will continue to be written for easy email consumption and sent daily via email, members now have additional ways to consume stories including RSS, Twitter and Slack. 

RSS: Available here (membership is required to read content)

Twitter: Available here (anyone can follow, but membership is required to access full content)

Members continue to have the option of a consolidated weekly version of the daily emails for those who prefer to have everything in one spot delivered right to their inbox. 

Subscribe

Membership is the only way to get the full Above Avalon experience and receive all my exclusive analyses and perspective on Apple. My Apple analysis is focused at the intersection of Wall Street and Silicon Valley. I am a former Wall Street analyst with a finance/engineering background. Accordingly, topics will range from Apple financial modeling to product marketing and business strategy. In addition, I cover all of Apple's competitors and the industries Apple is either operating in or looking to enter in the near future.

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Apple Questions for 2016

I'm not a fan of prediction posts at the start of each year. Instead, the much more valuable way to prepare for the new year is to embrace the unknown. By formulating and organizing a series of questions, it becomes that much easier to assess a company's strengths, weaknesses, priorities, and opportunities over the next twelve months. Here are my Apple questions for 2016:

Apple Watch

  • Apple Watch 2. The Apple Watch has become a litmus test for Apple's ability to create compelling new product categories. What features will Apple look to improve when the Apple Watch is updated in a few months? There is low-hanging fruit in terms of features that can see improvement, including an Apple S2 chip and slightly better battery, although the device's small footprint should be taken into consideration when thinking of realistic near-term advancements. Will Apple push ahead with health and fitness and include additional health-related sensors in Apple Watch 2? In addition, how much change will Apple push in terms of the device's physical design attributes?
  • New Watch Bands. Management has been very vocal in pushing the theme of buying additional watch bands to personalize Apple Watch. After only five months on the market, Apple unveiled a range of new Sport bands this past September, including a new leather band option. Will Apple come out with a range of new Watch band options for both the Sport and Watch collections alongside updated Apple Watch cases? It is important to remember that the Watch bands themselves will likely one day contain sensors and play a more vital role than just being a fashion item. 
  • Pricing. Will Apple maintain its current Apple Watch pricing? With the vast majority of Watch sales attributed to the Sport collection, the $349 and $399 entry-level models will be the key ones to watch going forward. It is not a given that Apple will keep selling the original Apple Watch alongside Apple Watch 2. There would be historical precedent for Apple to stop selling the original Apple Watch once the new Apple Watch is released, similar to what occurred with the iPhone and iPad. This has a major implication on Apple Watch pricing as Apple would not have a year-old model to sell at a lower price like we see with the iPhone and iPad in recent years. At the same time, Apple likely has fresh data on how Watch sales fare at lower prices considering Best Buy and Target had $100 off Watch promotions. 
  • Sales Disclosure. Will Apple begin to break out Apple Watch sales numbers in 2016? It is not a question of "if" but "when." From management's viewpoint, there are pros and cons to not revealing Watch sales but at a certain sales point, the material nature of the sales will be too much to keep hidden in the "Other Products" line item.  
  • Marketing. Where does Apple plan on taking Apple Watch marketing? We have already seen some changes in the way Apple describes the Watch with its TV ads, moving away from the "iPhone on your wrist" messaging and embracing a fun device that can do a number of small, convenient tasks.
  • Apple Watch Edition. Leading up to the Apple Watch launch last year, the Apple Watch Edition collection received an oversized amount of attention. However, in recent months there has been little press attention given to the collection. Will Apple sell new Watch case materials, such as platinum or white gold, for the Edition collection? When considering that success for the Edition collection is not measured by unit sales, Apple is likely judging the collection by other factors including material design and allure. Will we get any evidence to suggest if management is pleased with how the world has embraced the Edition collection? 
  • New Luxury Partnerships. Will Apple launch another Apple Watch partnership? Apple's Hermès partnership may end up being one of the sleeper hits of Apple Watch's debut year, as Apple combined the worlds of traditional luxury with personal technology. Additional partnerships involving luxury brands holding notoriety around precious metals would be a logical next step.  

iPhone

  • The 4-inch iPhone. Is Apple planning on positioning a new 4-inch iPhone as a way to entice iPhone 5/5s/5c users to upgrade? There is no question that iPhone unit sales growth will slow in 2016 compared to 2015, a byproduct of strong iPhone 6 and 6 Plus sales in 2015 and what appears to be a slower iPhone upgrade cycle with the 6s and 6s Plus. A new 4-inch iPhone would be positioned as a catalyst to get current 4-inch screen iPhone users to make the jump.  
  • iPhone 7. Similar to every other annual iPhone release, Apple will strive to have three or four headline features with the iPhone 7. Will Apple remove extra bezel from the iPhone in order to make current screens feel a bit better in hand? In addition, an iPhone without a home button seems like an evolutionary next step, although it may be too big of a jump to take in the near-term with current iOS software. The biggest questions surrounding new iPhones relate to the Plus model. Will Apple begin to differentiate the iPhone Plus model beyond just screen size? Adding greater differentiation within the iPhone line would help in terms of ASP trends as well as better position the iPhone as a PC/Mac replacement.  
  • iPhone Upgrade Program. The highlight from Apple's "Hey Siri" keynote this past September was the iPhone Upgrade Program. Creating a process for users to easily buy a new iPhone every year directly from Apple has very significant ramifications in terms of the iPhone upgrade cycle. Currently the service is only available in Apple Retail stores in the U.S. Will Apple extend the iPhone Upgrade Program to additional countries, in addition to bringing the service online? 

iPad

  • New iPad Pro. The iPad Pro was the most noteworthy development for iPad in years. A 12.9-inch screen, combined with four stereo speakers, and productivity accessories, position the iPad Pro as the iPad's future. The iPad Pro pushes the larger iOS multi-touch tablet category forward by distinguishing itself from larger iPhones and smaller Macs. Will Apple push an iPad Pro update in 2016 or should we expect a longer update cycle? 
  • iPad Sales. Will we see early signs of iPad sales bottoming in 2016? The addition of the Pro model to the lineup will help offset some of the iPad mini sales declines, although the much bigger trend of larger iPhones cannibalizing iPad mini will continue. 
  • iPad Air 3. Apple did not update the iPad Air in 2015. Accordingly, does Apple plan on updating the Air in 2016?
  • Apple Pencil. Will Apple ship a new Apple Pencil and extend Apple Pencil support to other iOS devices? The Apple Pencil is the most intriguing Apple accessory in 2015 with a clear directive of being used to mark, draw, or write, and not navigate. Such tasks may end up serving as a clue that Apple does not plan on expanding Apple Pencil support to other iOS devices in the near term.  

iOS

  • iOS 10. What will be the main features in iOS 10? The iOS home screen has been a crucial part of the iPhone user experience from the beginning. However, there are certain elements that are starting to feel a bit dated. I'm using the Spotlight search screen more frequently, and the addition of 3D Touch adds a new element to the conversation. Is Apple planning on rethinking the iOS home screen in iOS 10? Look at the iPad Pro's Springboard, and it becomes easier to conclude: yes, Apple may have something new planned for the home screen.  
  • App Store Debate. Up to now we really haven't seen much of a debate concerning the App Store (across all platforms). Developers have been increasingly vocal with their concerns surrounding app developer sustainability, while Apple has followed its playbook closely, listening much more than acting. With Phil Schiller now overseeing the managerial aspects of the App Store, one would expect Apple to increase its communication efforts with developers leading to an actual debate where we hear two sides of the argument. 

Mac

  • Trickle Down MacBooks. Apple's new $1,299 MacBook was the Mac highlight of 2015. The major theme to watch is Apple bringing features found in the new MacBook to other models in the Mac lineup. 
  • ARM-Based MacBook. Will Apple announce an ARM-based MacBook running an iOS derivative? There have been clues that such a move may be in the pipeline. 

Project Titan (Apple's electric car)

  • Construction/Real Estate. Apple acquired a significant amount of land in North San Jose through a series of closely guarded transactions in 2015. My theory is that this land is related to R&D facilities for Project Titan. Will we see Apple's plans for this North San Jose land begin to materialize in 2016? The level of progress seen in North San Jose may provide clues as to Project Titan's timeline.  
  • Employee Hires & Fires. One of the more tangible ways of monitoring Project Titan progress is to look at employee moves. Will Apple have any additional high-profile Project Titan hires in 2016? Contrary to consensus expectations, Apple may turn to the legacy auto industry for talent, similar to hiring Doug Betts from Chrysler. Even though Apple is focused on rethinking what it means to build and sell an automobile, such legacy auto hires have experience and background that will prove helpful for Apple.   
  • Regulatory Filings. The automobile space is unique compared to previous industries Apple has operated in given the much higher level of government regulation. Apple will need to adapt to these regulations, possibly providing a few early Project Titan clues for those closely monitoring Apple's every move.  

Services

  • Apple Music. All indications point to Apple Music currently appealing to a small base of iOS users (5-10M members) and to a lesser extent, Android users. Will Apple lobby the record labels to lower the $9.99 monthly membership price in order to attract a wider base and compete with Spotify? 
  • Apple Video. Bloomberg reported that Apple suspended its plans to launch a slimmed-down cable bundle. Will content companies have second thoughts and be willing to cooperate with Apple in order to launch some type of new package? 
  • Apple Pay. Despite improved financial institutional support, retailer support is still lacking, especially when it comes to reaching universal support. How will Apple increase customer awareness of Apple Pay, in addition to achieving much broader retail support? 

Financials

  • Share Buyback. Management spent the second half of 2015 buying as many AAPL shares as possible with the stock price declining in the face of slowing economic growth in China and concerns surrounding iPhone 6s and 6s Plus sales. Given Apple's current valuation of 10.8x forward earnings (6.9x forward earnings excluding cash and cash equivalents), how will management and the board respond when it comes time to update Apple's buyback authorization in April? 
  • Dividends. Apple's board is expected to increase the quarterly cash dividend in April. What payout ratio does the board feel comfortable targeting given Apple's cash needs for organic growth?
  • Foreign Tax Reform. In what is turning into a reoccurring question, will we see any U.S. tax reform regarding taxation of overseas profit? Apple currently has $187 billion of cash and cash equivalents held overseas. 
  • EU Tax Investigation. The European Commission is expected to announce its decision regarding Apple/Ireland's tax dealings sometime in 2016. What financial impact, if any, will Apple face? If using the recently announced Apple settlement with Italian authorities regarding taxation as a barometer, the European Commission's investigation into Ireland's Apple tax treatment may result in some type of payment from Apple. Overall, there is skepticism that any judgment against Apple would result in long-term headwinds for the company or stock. 
  • R&D Expense. Apple's R&D expenditures increased dramatically during the summer of 2014 and remained elevated throughout 2015. Should we expect Apple's R&D to continue to outpace revenue growth in 2016?  

Management

  • Jony Ive. It has been approximately six months since Jony Ive officially relinquished day-to-day managerial control over Apple's industrial and software design teams. How will this change manifest itself in Apple product development in the long-run? There is little to no evidence to suggest much will change. However, additional time is the only way to confirm that the managerial change has been effective. 
  • Executive Turnover. With Apple Watch's debut now completely in the rearview mirror and the next big thing (Project Titan) likely at least two years away, will any senior Apple executives decide now is the time to retire/take a break? On the surface, no one executive comes to mind as being close to the exit door. Phil Schiller was recently given additional responsibilities while Cue, Federighi, Maestri, and Ahrendts are only now hitting their stride. 
  • Project Titan Leadership. Similar to Jeff Williams being put in charge of the Apple Watch team, when will Apple place a senior executive to oversee Project Titan? The logical choice is once again Jeff Williams, although this appointment may end up occurring in 2017 or later.  
  • Jeff Williams. Speaking of Apple's new COO, his stock is on the rise within Apple. Given Williams' increased visibility in 2015, should we expect Williams to play an even bigger role in Apple keynotes and the company's public image?
  • Kevin Lynch. Will Kevin Lynch's stock continue to rise in Apple? The leader of Apple Watch software appears to be in a position of increasing power within Apple, and any continued move into wearables will only result in additional attention being given to Lynch.  

Wildcards

  • New Marketing Direction. Apple's hire of Tor Myhren as VP of Marketing Communications is intriguing on many levels. What should we expect from Myhren? With such a well-regarded and surprising senior hire, it is safe to expect something big in terms of Apple marketing campaigns from this development.  
  • Carl Icahn / Shareholder Activism. The longer a public company sits on a strong balance sheet while experiencing a declining valuation and languishing stock price, the more likely investors will become agitated. Even though Carl Icahn continues to pledge his support for Tim Cook and the rest of the management team, it would not be surprising to see individual Apple shareholders become a bit more vocal with "suggestions" for Apple on how to increase its valuation.   
  • M&A. In what areas does Apple feel the need to bolster its resources in 2016? Apple has been quite active on the M&A front in recent years and after considering Apple's product pipeline, continued M&A activity related to augmented reality and personal transport seems likely. 
  • A New Kind of Wearable Device. With a finished product from Project Titan still a few years out and the Apple machine busy cranking out iPhone, iPad, and Mac updates, the wearables category represents the best wildcard for a completely new Apple product. The leading candidates for new Apple wearables include a ring and wireless EarPods, both of which would be positioned as health-related iPhone accessories. 

The Apple news, products, and events not reflected in any of these bullet points represent the unexpected. 

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