The Changing iPhone User Base

A new 4-inch iPhone is coming. The best way to understand why Apple is releasing a new 4-inch iPhone in 2016 is to look at the changing iPhone user base. Apple is now selling iPhones to an installed base of more than 550 million users with a multitude of wants, needs, and desires regarding their smartphones. Apple is making a bet that it is time to expand iPhone development to three different screen sizes in order to appeal to the 20% of the user base that prefer single-handed iPhone usage over larger screen options. Releasing a new 4-inch iPhone would be an admission by Apple that the only way to maintain a vibrant iPhone upgrade cycle is to expand the iPhone line. 

The Old iPhone User Base

Over the span of nine years, the iPhone user base has undergone a significant transformation with much of the change taking place in just the past year and a half. In the early years, the iPhone user base was a relatively "small" group numbering in the tens of millions. The base displayed monolithic tendencies toward technology trends and Apple's mission with the iPhone. Even when the iPhone base grew, the homogenous nature of the user base remained quite resilient. As depicted in Exhibit 1, even though the iPhone has gone on to represent a quite sizable 15 percent of the smartphone market, this 15 percent has been concentrated at the high-end of the market characterized by higher average selling prices and stronger profit margins.

Exhibit 1: Smartphone Industry Price Pyramid (iOS vs. Android)

By targeting the premium segment of the market, Apple spent years developing a loyal iPhone base of hundreds of millions of users willing to spend an above average amount of money and time on their iPhones. This trend stood in stark contrast to the vast majority of smartphone sales taking place at the low-end of the market where consumers used their phones very differently.

The high level of loyalty and usage trends found within the iPhone user base was apparent when looking at hardware and software upgrade patterns. Once Apple released a new flagship iPhone model each year, a significant portion of the iPhone user base showed a willingness to upgrade to the latest device over the following year. A similar phenomenon occured whenever Apple released a new iOS version. Within a few weeks, the vast majority of users upgraded to the new release. In such a world, the belief was that wherever Apple went in terms of iPhone product decisions, be it larger screens or new features, the user base would follow in its entirety. 

The New iPhone User Base

Beginning in early 2015, the iPhone user base showed signs of change. After 590 million cumulative iPhone sales, the base was no longer acting monolithic. Even though Apple was still targeting the same premium segment of the market, iPhone users were beginning to show a broader range of opinions and preferences concerning technology and Apple product decisions. The days when the vast majority of iPhone users upgraded to the newest iPhone model in relative short order were over. 

One way to highlight the change that has taken place within the iPhone user base is to look at the difference in iPhone mix between the run-up to the iPhone 6 and 6 Plus launch in September 2014 and Apple's most recent quarter. As shown in Exhibit 2, the iPhone user base consisted of two groups in early September 2014: 3.5-inch screen users (iPhone 4s, 4 and 3GS) and 4-inch screen users (iPhone 5s, 5c and 5). In such a world, the difference between the two groups (and screen sizes) were rather minor. 

Exhibit 2: iPhone Mix by Screen Size - Early September 2014 (Total User Base)

Jump ahead 15 months, and the current iPhone mix now looks like a cornucopia with four different screen sizes as shown in Exhibit 3. Despite 4.7-inch and 5.5-inch screen phones being in the market for well over a year, approximately 50% of iPhone users are still using either a 4-inch or 3.5-inch screen. In fact, 11% of the iPhone user base is using an iPhone that was released more than four years ago and discontinued in 2014. 

Exhibit 3: iPhone Mix by Screen Size - December 2015 (Total User Base)

Factors Driving iPhone User Base Change

While some may look at a changing iPhone user base as merely a byproduct of Apple's move to larger screen iPhones or the result of the iPhone upgrade cycle getting longer, those developments are not the primary drivers of what is taking place within the user base. 

iPhone's Changing Role. The iPhone is occupying a much greater role in users' lives, handling additional tasks formerly given to Macs and PCs. Accordingly, the way users look at their iPhones has become more varied. A large 5.5-inch screen may be preferred by those who treat an iPhone as their primary computer while other users place greater value in single-handed use found with a 4-inch screen. This divide marks quite a difference from the early iPhone years when most users treated their small screen iPhones similarly. As the iPhone gains additional functionality and capability, there is much more diversity of opinion found within the user base in terms of what makes for the perfect device. This environment certainly strengthens the argument that a new 4-inch iPhone is needed as not everyone is interested in fitting a 4.7-inch and 5.5-inch screen iPhone into their lives. 

Used/Leased iPhones. Apple currently has an iPhone installed base of 554 million users. However, when including iPhones purchased in the grey market and hand me downs, there are well over 600 million iPhone users in the wild (the complete methodology behind how these numbers were derived is available for Above Avalon members here). With Apple moving quickly into iPhone recycling programs and annual upgrade programs, there has been an increasing supply of one and two-year old used iPhones that have eventually found their way back into the wild. This trend has resulted in the iPhone user base becoming more diversified in recent years when it comes to opinion and philosophy towards technology. 

With used iPhones effectively serving as the "cheap" iPhone, Apple has begun addressing lower price segments with less expensive iPhones. As a result, the uniformity in ideas and preferences found within the iPhone user base concerning iPhone screen size and usage is disappearing. Apple now has a wider range of users that crave vastly different things from their iPhones. 

It's Time for a New 4-Inch iPhone

Similar to how the iPad Pro was rumored to be released for well over a year, Apple has been rumored to be working on a new 4-inch iPhone ever since introducing 4.7-inch and 5.5-inch screen iPhones in 2014. Why has Apple given the green light for a new 4-inch iPhone now? Management's attitude towards 4-inch screens has changed. The verdict is in: the iPhone user base has not fully embraced larger screens. Over the past year, Tim Cook has provided a crucial metric for measuring how many iPhone users have upgraded to a larger iPhone. Exhibit 4 highlights the rate iPhone users have upgraded to either an iPhone 6, 6s, 6 Plus or 6s Plus. 

Exhibit 4: iPhone Upgrade Rate to 4.7-Inch or 5.5-Inch Screen (Installed Base)

According to Cook, approximately 60% of the roughly 400 million users that made up the iPhone installed base in early September 2014 have still not upgraded to 4.7-inch or 5.5-inch screen iPhones. This number is likely higher than management was expecting, especially when considering that the average iPhone upgrade cycle is approximately 20 months. The evidence would seem to suggest that approximately 20% of the user base has no interest in moving to larger screen iPhones. As a result, iPhone sales have taken a hit, the iPhone upgrade cycle appears to be getting longer, and a significant portion of the iPhone user base does not have access to new Apple services such as Apple Pay due to sticking with old 4-inch screen iPhones. 

For some, the thought of using a 4-inch screen iPhone instead of its 5.5-inch screen sibling makes little sense. To these users, the 4-inch iPhone's small form factor makes the device look and feel like a toy. Meanwhile, other users look at a 4.7-inch iPhone as simply too large for single-handed use, not to mention mobility. These users consider the 5.5-inch screen iPhone more like a tablet than phone. It is this varying degree of opinion that is new to the iPhone base as the differences between 3-inch, 3.5-inch and 4-inch screen iPhones were never too significant over the years.  

Apple's decision to release a new 4-inch screen iPhone is an admission that the only way to get everyone to upgrade their iPhone is to expand the iPhone line. More than 200 million users have continued to use their iPhone 5, 5c, and 5s instead of buying a larger iPhone. Instead of looking at that as a sign that the iPhone business is trouble, it is a clue that the iPhone business is maturing, and it is time for Apple to increase screen size options in order to appeal to as many users as possible. 

This diversification in screen size perference is the same reason why Apple is simultaneously moving just as fast at the high-end of the iPhone line with the iPhone Plus model. In the future, it is not unfathomable for the larger screen iPhone to see greater differentiation compared to its siblings, and the possibility of Apple releasing an even larger iPhone is no longer a stretch. 

The Future

The iPhone line will eventually consist of a range of screen sizes each having their own strengths and weaknesses. For a 4-inch iPhone, single-handed use and mobility will be the marquee features. The iPhone 5 ad narrated by Jeff Daniels concerning a 4-inch screen appearing to be perfectly sized for thumb use may still have relevancy in today's market. Meanwhile, at the other end, Apple could play up the 5.5-inch screen iPhone as being a different kind of productivity device where the additional screen real estate comes in handy. As shown in Exhibit 5, there will likely be dedicated segments of the iPhone user base that prefer different sized screens. 

Exhibit 5: Future iPhone Mix by Screen Size

While the iPhone nomenclature will likely change in the coming years, the idea of Apple selling at least three different iPhone screen sizes will continue. We will get a pretty good look at this future when Apple unveils a new 4-inch iPhone. 

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Additional commentary and analysis on defining and estimating the iPhone installed base and iPhone user base is available for Above Avalon members here. 

The Tim Cook Legacy

Tim Cook's message to customers last week regarding iPhone security will mark a defining moment for his legacy as Apple CEO. While the legal and technological ramifications resulting from the San Bernardino iPhone case will take months and years to play themselves out, the business implications are already visible. One of the major questions facing Apple in the post-Steve Jobs era was how the company would be managed in such a way as to maintain its unique culture while keeping the product front and center. By remaining true to his promise regarding security and privacy, Tim Cook continues to build his legacy of strengthening the Apple experience by embracing principles and values that transcend hardware and software. 

The Apple Experience

There have been a handful of events since 2011 that have served as key milestones in Cook's tenure as CEO. The Apple Maps debacle, Apple Retail turmoil, Apple supply chain working conditions, environmental activism, and data privacy and security, have each played a role in laying the groundwork for Tim Cook's legacy. With Jony Ive focused on Apple's product vision, Tim Cook has been playing to his strengths dedicating much of his attention to nurturing the Apple experience by focusing on six values: security and privacy, trust, equality and ethics, and environmental responsibility. The following diagram highlights how Jony Ive's product vision is combined with Cook's value-oriented focus to create the Apple experience.   

For each of these six values, there have been specific events where Cook's actions demonstrated his leadership style and vision.

Security and Privacy

Tim Cook's long-standing stance on security and privacy were thrown into the public circle last week with the U.S. Department of Justice getting a federal judge to order Apple help them break into an iPhone involved in the San Bernardino terror case. Cook's hard-line stance against such an order should not have come as a surprise. Since becoming CEO, Cook has embarked on an unwavering campaign to regard security and privacy as human rights. This position is not just different from other technology companies, but is downright remarkable given the amount of risk Cook is willing to take on by believing so firmly in those stances. 

Last year, Cook gave a speech at the Electronic Privacy Information Center's Champions of Freedom event where he came down harshly on companies monetizing user data and not doing enough to educate customers as to how their personal information is being used. While some thought Cook was being a hypocrite by not recognizing what is seemingly the contradiction found with Apple's future and greater data collection, Cook's message regarding privacy was focused on the customer. The number one priority is to let the customer know what data is being collected and how it is being used. Apple knew that type of practice is simply not found in Silicon Valley, and Cook was determined to keep Apple on a different course.

Another incident highlighting Cook's passion regarding security and privacy was on display when he sat down with Charlie Rose following the iPhone 6 launch (and a few weeks after the iCloud celebrity hacking incident). When referring to rumors that Apple had created a backdoor to its servers, Tim Cook exclaimed to Rose, "they would have to cart us out in a box" before Apple created a backdoor. The message was clear. Apple was going to fight for its users and would be willing to go as far as the U.S. Supreme Court (which now seems quite likely).

Trust

Another key attribute to Tim Cook's legacy has been trust. Over the years, two events have come to demonstrate Cook's intense belief that customer trust is one of the most important values behind the Apple experience: the Apple Maps debacle and Apple Retail turmoil.

In 2012, following the botched Apple Maps launch which saw a mapping service in rough shape in terms of accuracy and usefulness, Tim Cook took it upon himself to issue an apology to Apple customers. The first and last paragraphs of the apology letter highlighted Cook's underlining motivation:

"To our customers,

At Apple, we strive to make world-class products that deliver the best experience possible to our customers. With the launch of our new Maps last week, we fell short on this commitment. We are extremely sorry for the frustration this has caused our customers and we are doing everything we can to make Maps better... 

Everything we do at Apple is aimed at making our products the best in the world. We know that you expect that from us, and we will keep working non-stop until Maps lives up to the same incredibly high standard."

It has been reported that Scott Forstall, who oversaw iOS software and Apple Maps, was fired due to his refusal to officially apologize for an inferior Apple Maps product. From Cook's perspective, Forstall's actions posed a threat to the Apple experience with trust at the heart of the issue. Apple had spent years building goodwill with customers with the end result being hundreds of millions of users trusting Apple that its products would lead to a top-notch experience. With Apple Maps, Forstall put this Apple experience at risk, and Cook took decisive action. This intense focus on the Apple experience soon became Tim Cook's primary motive in everything he has since done leading Apple. 

Cook's focus on nurturing customer trust was also seen in his handling of Apple Retail. After Ron Johnson left as head of Apple Retail in 2011, Apple's retail operations entered a tumultuous period. The iconic stores were still seeing incredible levels of traffic and sales per square foot, but the customer experience was deteriorating. Cook ended up making one of his biggest blunders to date by hiring John Browett to take over Apple Retail. Instead of focusing on the experience produced by the Apple Retail stores, Browett looked at physical Apple Retail locations as profit centers.

After being on the job for just 10 months, Cook fired Browett. Along with the Apple Maps fiasco, Browett's quick dismissal showed that Cook was comfortable admitting mistakes and taking swift action to correct those mistakes. More importantly, Cook learned from those mistakes. A year later, Angela Ahrendts was brought on board to lead Apple Retail. Her success at Burberry was a result of taking the luxury retail playbook and ripping it up by embracing technology. Ahrendts placed the experience above all else. In fact, Ahrendts has publicly mentioned she doesn't consider herself "a great retailer" but instead someone who understands people and the importance of building the right kind of retail team. This caught Cook's attention. He knew that Apple Retail stores were a great tool to build customer trust in terms of the personal touch that Apple Retail employees provide such as sales support, service and workshops. 

Equality and Ethics

In 2012, The New York Times published its "The iEconomy" series, which took a closer look at the negatives associated with globalization. Apple's supply chain was thrown into the spotlight. Apple's reliance on its supply chain was illustrated through descriptions and tales of unacceptable working conditions. It has been reported that Cook thought The New York Times investigative series was not accurate and very misleading. Instead of being content with the progress Apple had already been making with its supply chain, the iEconomy series seemed to reenergize Cook. He was on a mission to place Apple as the champion of human rights that went well beyond what other companies were doing.  He wanted Apple to be the undisputed leader.

Cook placed Jeff Williams as the executive monitoring third-party contract manufacturer and supplier working conditions. While there is still much progress to be made, Cook's focus on human rights issues once again relates back to the Apple experience. There is a story behind every Apple product, including how it is made, and Cook understood that the Apple experience began all the way back with the raw materials at factories and mines.

In addition, Cook has pushed for equality in other parts of daily life, becoming much more vocal in current political affairs by using Apple's power and standing to extend his reach. While it may be hard to find the direct relationship between these actions and Apple products, Tim Cook's motivation is clear: Apple is a company that stands for everyone. 

Environmental Responsibility

Apple's aggressive stance on green initiatives has been well chronicled in the press, but the motivation behind the actions are still being underestimated. Whether it was creating working forests in Maine and North Carolina, or building extensive solar projects in China, Cook has embarked Apple on a mission to minimize its impact on the environment. Cook hired Lisa Jackson, former Environmental Protection Agency chief, in 2013 to oversee Apple's environmental practices. It's not that this focus on being environmentally-focused started with Cook's imagination, especially since we can look back at how Apple embarked on more environmental friendly decisions in its product lineup under Steve Jobs. However, Cook felt that Apple's leadership status in the global economy placed it in an unique position to serve as an example for others. 

The Product

Apple's mission is to create products that people love. When judging Tim Cook's performance, the mistake many people have been making is analyzing the Apple CEO position as a seat that has to be filled with a product visionary like Steve Jobs. Not only is this faulty logic, but it fails to comprehend Cook's strengths. Tim Cook is Apple's CEO because he is not a product visionary.

Apple's current success was not due to Steve Jobs carrying the company on his shoulders. Thanks to Apple's revamped public relations strategy, we have gotten a better look at how the Apple machine actually operates. There is much more going on behind the scenes than a dictator not allowing debate, disagreement, discussion and collaboration.

Even though Cook is not a product person, this fact does not take anything away from Apple or his legacy since Jony Ive is purveyor of Apple's product mission. In fact, evidence would suggest Jony Ive has actually been the purveyor of Apple's product philosophy for over 15 years. Cook is confident that the executive team he has assembled will promote debate and discussion, just like in the past, leading to products that people love. Meanwhile, Cook dedicates his time and energy to overseeing the management team responsible for this debate and discussion while strengthening the Apple experience by looking at values that go beyond the tangible product. 

A Defining Moment

Tim Cook's message to customers last week regarding iPhone security will go down as one of the defining moments of his tenure as CEO because it perfectly encapsulated Cook's motivation as CEO. According to Cook, the best way to keep Apple's mission statement focused on the product is to embrace and strengthen ideals that strengthen the relationship with customers.

One paragraph from Cook's letter stood out: "While we believe the FBI's intentions are good, it would be wrong for the government to force us to build a backdoor into our products. And ultimately, we fear that this demand would undermine the very freedoms and liberty our government is meant to protect."

Cook's letter wasn't just about an iPhone 5c or encryption. Instead, Cook took a stand protecting the very same ideals that the U.S. government is tasked to protect. Apple is known as the iPhone company today but could very well be known as a personal transportation business in 20 years. Despite this changing product mix, Cook knows the ideals he is focused on promoting within Apple's culture will remain unchanged. The Tim Cook legacy will one day be remembered as the era in which these ideals were established and engrained into the Apple experience. Even though the product will always be at the center of it all, hardware and software can only go so far in advancing humanity. 

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Standing on Tesla's Shoulders

Elon Musk's goal for Tesla is amazingly simple yet incredibly difficult: create sustainable transportation. When combined with SpaceX, Musk is dedicating all of his time and energy to pursuits aimed to advance humanity. Even though Musk's ambitions and motivation are not up for debate, the degree to which Tesla will be able to complete Musk's goals are once again being drawn into question following Tesla's recent earnings report. As long as Tesla remains an automobile manufacturer, Apple is the best positioned company to rethink personal transportation. Instead of buying Tesla, Apple will look to stand on Tesla's shoulders. 

Tesla, the Pioneer

Much to critics' disappointment, Tesla will forever be known as a pioneer in personal transportation. The company didn't just build an electric vehicle, which is not too difficult to achieve, but successfully designed and manufactured an electric car that was able to produce an emotional connection with its driver. Tesla made electric cars cool.  Electric cars were once cast off as boring vehicles that were purchased as an act of charity to the environment. However, Tesla was able to show what technology and software can do when added to a legacy industry where there hadn't been any successful new U.S. entrants in 50 years.

It is this focus on product that has served as fuel for the "Apple should buy Tesla" suggestions that began to pop up a few years ago. As tech enthusiasts bought the Model S and experienced the same emotional connection with a car that they had with their iPhone, something felt wrong. These Model S owners wondered why Apple didn't create the Model S. Tesla seemingly beat Apple to the automobile punch. Accordingly, in order to fix this cognitive dissonance, the theory was that only after Apple bought Tesla would the world once again make sense with Apple selling the best smartphone and car. 

Of course, that type of thinking is not just grossly misguided, but intellectually dishonest. There is no rule or law that says every great product must come from Apple just as it is incorrect to assume Apple should or needs to buy a company simply because it has a product that people love. Unfortunately, this focus on Apple & Tesla M&A has led to many ignoring two important trends: Tesla is facing a growing dilemma as an automobile manufacturer, and the auto industry is showing signs of incredible change that will question the car's definition. 

Many have pointed to Tesla being not only an automobile company, but also a software start-up or energy company. While that claim contains some truth, as seen with Tesla's Gigafactory, Supercharger network, and Powerwall systems, one can not ignore the fact that at the end of the day, Tesla is building its own cars. Raw material enters Tesla's Fremont factory at one end, and Model S and Model X vehicles come out the other. Unless this dynamic changes and Tesla moves away from building its own cars, the company is an auto manufacturer and risks remaining a pioneer. 

Tesla's Dilemma

For the past few years, Tesla has been able to sprint forward on the energy associated with the Model S launch. Good press and reviews led to growing consumer interest and a subsequent increase in sales. It would appear Tesla made it. As shown in Exhibit 1, Tesla has been able to ramp up production each year by healthy percentages. In 2015, the company shipped approximately 50,000 Model S and Model X vehicles, which was less than Elon Musk's 55,000 initial goal. 

Exhibit 1: Tesla Vehicle Deliveries (Model S and Model X) 

While all may seem strong, under the hood, things are much more concerning. Tesla appears to be operating with a very slim margin of error. With $1.2 billion of cash on the balance sheet and capital requirements totaling $400 million to $500 million per quarter, Tesla does not have much excess capital, a critical ingredient for Musk's current strategy to create sustainable transportation. On the company's most recent conference call, management considered $1 billion to be the minimum amount of cash the company can hold in order to run the business. 

Tesla faces a cash dilemma, and nowhere is this more apparent than management's very own production guidance. Tesla is targeting 500,000 car deliveries by 2020. On the surface, this may seem like any other aggressive goal that a young company sets for itself, but dig a bit deeper, and this target seems problematic.

Exhibit 2: Tesla Vehicle Delivery Estimates

Note: Vehicle delivery estimates for 2016 and 2020 are from Tesla. 

The company will need to find a way to increase automobile production by 10x in just five years in order to meet its delivery goal, all the while having very little excess cash. It's not that this day wasn't predicted to happen by nearly every legacy auto executive, but an increasing number of observers thought Elon Musk would find some way around it, where "it" was the inevitable. An auto manufacturer needs immense levels of capital in order to produce a profit, and Tesla's strategy for reaching that type of profitability is being drawn into question.

Tesla's game plan was to use Model S and Model X cash flows to fund production of a mass market car, the Model 3. Once this Model 3 hit the market, Tesla would be able to reach profitability by having additional scale. Producing 50,000 vehicles a year just isn't going to cut it at Tesla's current prices. However, Model X production issues, specifically with the Falcon Wing doors, have led to delays and additional questions about how effective the Model X will be in terms of funding Tesla's production expansion. Whether customers would even want a lower-priced Tesla electric vehicle with fewer bells and whistles than the Model S and Model X hasn't even entered the equation and doesn't play a role in Tesla's dilemma. It is assumed that the demand will be there, and this may end up being grossly optimistic. Instead, Tesla's issues are related to the realities of being an automaker. 

The Changing Auto

There is no denying that the Model S and Model X rethink what an electric car can be, but they don't rethink what a car can be. Auto manufacturers currently compete on three attributes: performance, style and price. For Tesla, performance is how the Model S and Model X stand out. Elon Musk may have been able to beat BMW and Mercedes Benz in terms of performance, but the Model S and Model X remain firmly entrenched in the legacy auto industry. The addition of software and autonomous features doesn't change this fact. 

However, there are signs that the way consumers think of automobiles is changing. In the future, convenience and personalization will trump performance. We see the early stages of this with Uber as consumers now have an easier way of getting from point A to point B. Similar to how the iPhone altered the cellphone's trajectory, a new kind of car will do the same to the automobile, but the Model S and Model X are not the answers. 

While many in tech have been quick to focus on autonomous driving and new car ownership models as the interesting things to watch in the auto space, there will be more important developments to monitor early on. As automobiles include additional cameras and sensors, the car will begin to morph into a different kind of machine capable of capturing the world around us. The car will begin to handle new roles in our lives. Beginning to think of a car as a smart room on wheels naturally leads to the importance of having a fleet of similar "rooms" on the road in order to refine software and build neural networks (deep learning technology). Tesla's Autopilot is an example of software benefiting from having a fleet of 100,000 Tesla vehicles on the road. Accordingly, the important variable in this dynamic is the quantity of cars. Having a large fleet of cars will be essential regardless of car ownership trends. The process of overseeing the mass production of rooms on wheels will be the single most important variable to monitor in the auto space. 

Apple's Interest in Personal Transport

It has been a year since the first reports of Apple's electric car project, Project Titan, were published. In that time, although we have gotten additional clues as to Apple's interest in personal transportation, there still has been very little said of Apple's long-term plans for getting into the automobile industry. 

Apple's motivation for entering the automobile industry will be to fundamentally rethink what it means to use a car and alter the competitive advantages reside in the auto industry. The current auto industry is not set up to handle automobile production where product cycles are measured in weeks and months, and design plays a much bigger role in the production process. Instead, Apple is best positioned to capitalize on this change as the company now has more than a decade of experience using third-party contract manufacturers to produce mass-market personal technology devices. Simply put, owning car factories and producing cars will become a liability, not a strength, in the auto industry. 

Apple will not enter the auto industry if it lacks confidence that it can oversee enough car production to change the industry. Along those lines, Tesla's 50,000 to 100,000 vehicle annual production rate would simply not be significant enough for Apple. In fact, even Tesla's 500,000 vehicles per year goal would not be large enough. Apple is likely thinking how to design and build millions of vehicles per year. As shown in Exhibit 3, a hypothetical 2.5 million annual vehicle delivery rate for Apple nine years after launch would be five times more aggressive than Tesla's already lofty goal. Apple would be using a completely different sales scale to eventually have a multi-million car fleet of smart rooms on wheels. 

Exhibit 3: Tesla Vehicle Delivery Goal vs. Hypothetical Apple Car Sales Target

Selling 2.5 million vehicles per year would represent approximately three percent of the global automobile market. How can Apple reach that goal? Have a lot of cash and rely on third-party contract manufacturers. There is no other company in the world with as much cash as Apple. In addition, Apple has been gathering an incredible amount of experience from working with contract manufacturers to build 230 million iPhones per year (the smaller the device, the more difficult it is to design and manufacture at scale). 

Apple Doesn't Need to Own Tesla

There is no need for Apple to own an auto manufacturer in order to come up with its own electric car. This would be the equivalent of Apple owning a smartphone manufacturer in order to come up with the iPhone. Accordingly, the strategy Tesla is following in which it produces its own cars is not something that would be of interest to Apple. This isn't to take anything away from the Model S and Model X as top cars on the road, but Apple's automobile plans do not require owning car production facilities. 

Even though Apple doesn't need to buy Tesla to change the auto industry, there may be a place for Apple to use Tesla as a supplier. Depending on how effective Apple is in its R&D efforts, Tesla's upcoming Gigafactory may prove to be a viable battery source for an electric Apple Car. In addition, Tesla may end up proving to be a good partner for supplying larger portions of the electric powertrain. Over time, Apple would work to limit the dependency on any one partner and control all major technologies found in the car, but relying on a high-quality supplier in the beginning would contain some validity. 

For Elon Musk, having Tesla serve as a supplier to Apple is not a stretch or loss since such a reality would still align with his long term goals of reaching sustainable transportation. In addition, Musk has gone on record to welcome new companies to the electric car space. With Apple's contract manufacturing partners potentially using parts produced in a Tesla factory, there would be no need for Apple to own its own automobile assembly plants, similar to how Apple doesn't need to own key iPhone assemblers.

Apple will look to stand on Tesla's shoulders by not entering the low-margin vehicle production and assembly businesses and instead focusing on hardware and software design. Tesla laid the path for rethinking electric cars, and Apple will learn from Tesla's early decisions to rethink the car. 

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The iPhone Reality Distortion Field

The iPhone has not only changed the definition of success for Apple, but has altered the perception required to properly sense reality. Similar to the dynamic that exists between rivaling siblings, having the iPhone become the single-most successful consumer technology product in history has produced an environment in which every subsequent Apple product decision has failed to meet the expectations set by iPhone. As a consequence, questions and doubts surrounding new Apple products and services have emerged even though there are tangible signs of success and progress being made. The iPhone has produced a new type of reality distortion field around Apple. 

Reality Distortion Fields

What was once a term used to denote Steve Jobs' charisma and ability to turn the seemingly impossible or improbable into something achievable, the term "reality distortion field" has taken on a few meanings over the years. One of the more recent examples was used by competitors to negatively point out Apple's ability to seemingly compete under different, more hospitable terms. While the term usually took on a negative tone, it always contained positive connotations related to Apple either winning or succeeding in some form. However, in recent years, a new kind of reality distortion field has taken shape and unlike every version before it, this one has negative connotations. The iPhone has produced a type of twisted reality where perception does not accurately measure the amount of success being achieved with new products. Much of this augmented reality is experienced by those closely involved with Wall Street and Silicon Valley.  

The Older Sibling  

The iPhone's sheer success has changed the way we perceive new Apple products, services and apps. Similar to the rivalry that may exist between siblings, the iPhone is the older sibling who has achieved a multitude of milestones and successes, altering the very definition of success for others following in its footsteps. The major takeaway isn't that the bar has been lowered for new products, but rather that progress and achievement are not being accurately measured and milestones are not being recognized. 

Path to Success

It is difficult to argue the iPhone shouldn't change the definition of success for Apple. If management's singular goal is to remain relevant, then a natural extension of that goal is for Apple to build off of the iPhone's success. Some may call this a burden. Others will say it is a gift. However, the dilemma that has formed over the years is that the iPhone's sheer success has altered the way we perceive success and the path needed to achieve greater success. People want Apple to introduce new products just as successful as the iPhone only without the multi-year timeline and version reiterations that the iPhone went through. 

Even though the iPhone was released only nine years ago, much of the product's history has been rewritten through subsequent stories and tales. Many now think the iPhone was a raging success out of the gate, adopted by the masses overnight as everyone from high school students to corporate executives saw the device's potential at first sight. Reality was vastly different.

The iPhone was introduced at a time when it was still taboo to own a Mac on a college campus. The Blackberry was just beginning to take off as the luxury of having work email on a phone was too much for people to pass up. The average consumer was only starting to think about whether it was worth paying for a mobile data plan each month. After launching with one carrier in one country in 2007, it took three years for the iPhone to hit the mainstream with the iPhone 4 launch, highlighted in Exhibit 1.

Exhibit 1: iPhone Unit Sales (Quarterly)

As a sign of the iPhone Reality Distortion Field in full effect, when looking back at the iPhone's nine year journey, observers often shorten and condense the long path to success into a much shorter timeline and then look for new products to follow a similarly quick path to mainstream success.

Case Studies: iPhone Reality Distortion Field

We have three case studies for how the iPhone Reality Distortion Field has impacted perceptions of new Apple products: Apple Watch, Apple Music, and Apple accessories. 

Apple Watch

Even though the Apple Watch has been compared to the iPhone for most of its short life, the true extent of this juxtaposition has been underestimated. In reality, pretty much every single aspect of Apple Watch has been judged through an iPhone filter. From the moment the Watch was introduced in September 2014, the device has been compared to the iPhone all the way down to management's keynote slides being judged as less clear than those found in the iPhone keynote introduction seven years earlier.

When the initial wave of Watch reviews were published, the device was panned as being less useful as an iPhone and not bringing up the same kind of feelings that people apparently had when the iPhone was introduced. Circling back to the older sibling example, the Watch was born into a world where early expectations were nearly impossible to meet.

When management announced that Apple Watch sales revenue would not be broken out in financial statements, the natural next thought among many was that such an action was due to the Watch not being as big of a deal as the iPhone, the single-most financially attractive product in Apple's history. Initial Wall Street sales estimates for Apple Watch were based on iPhone user numbers. Initial Watch upgrade cycle estimates were based on iPhone upgrade cycles. Launch weekend Watch sales were based on launch weekend iPhone sales. As each one of these events turned out to be quite different for Apple Watch, disappointment soon took the place of excitement. 

We know Apple sold at least 10 million Apple Watches in the first eight months on the market, with a high probability of that number being closer to 11 million, highlighted in Exhibit 2. But many haven't stopped comparing Apple Watch to the iPhone long enough to add much-needed perspective to those sales numbers. 

Exhibit 2: Apple Watch Sales (Above Avalon Estimate)

One way of reframing Apple Watch sales is to consider that Apple sold at least 10 million wrist watches, with an average selling price of approximately $475, at at time when large swaths of the population had tuned out watches, let alone spent a few hundred dollars on one. In just eight months, Apple is selling 50 different Watch models grouped into four collections. Add in extra bands and watch faces, and Apple literally offered millions of unique Watch combinations...at launch. Despite these facts, much of this success has been brushed aside because the Watch doesn't have an app experience like an iPhone and was not a good "replacement" for an iPhone. The word "replace" does a poor job at explaining the whole point of Apple Watch in relation to the rest of Apple's product line. 

Apple Music

In just 18 months, Apple went from buying Beats for $3 billion to having a music streaming service available in 113 countries with more than 10 million members paying for music content that is available for free elsewhere. Apple recently launched Apple Music in China and on Android, which will add to that 10 million figure. Despite this success, many have written off Apple Music as a buggy Apple service that shouldn't even exist.

It may be difficult to see, but Apple Music has also fallen victim to the iPhone Reality Distortion Field. The service's path to success has been warped to such a degree that reality is no longer viewable. Whereas Spotify took eight years to reach 10 million paid users, Apple did it in six months. Many respond that Apple Music's membership total is the result of being a default app on iPhone and Apple having stronger brand recognition. This is evidence that the iPhone Reality Distortion Field is in full effect. Any Apple service that is found on an iPhone is expected to turn to gold overnight with few bugs or problems. 

Apple Accessories

In recent months, Apple has released a series of accessories for Apple Watch, iPad and iPhone. Positioned to play off the intangibles associated with luxury, accessories are meant to make something more useful or versatile, while also helping to create a different kind of emotion that would otherwise cease to exist. However, there has been pushback against some of these accessories as people wonder why Apple is dedicating resources to such minor products that will not sell at the same magnitude as iPhone. Whether it is a $79 Apple Watch charging dock, $99 Apple Pencil, or $99 iPhone battery case, Apple's motivation isn't to sell tens of millions of each accessory, or drive significant amounts of revenue, but to enhance the experience. The iPhone Reality Distortion Field is at the root of the problem as people tend to discount minor products with a small financial impact as nonessential and irrelevant.

Management's Response

How should management work around the iPhone Reality Distortion Field? Instead of spending time in Luca Maestri's office going over Apple financials, the best way to counter this twisted sense of reality is to spend time in Jony's lab. By focusing on product and not financials, it is easier to assess product development success and milestones. 

The root cause of the iPhone Reality Distortion Field is found with the iPhone's immense success. The stronger the iPhone becomes, the more it resembles a black hole, where reality and perspective are twisted. Fortunately for Apple, the immense level of success and opportunity provided by iPhone represents a gift. The more successful the iPhone becomes, the stronger the motivation for Apple to recognize the success but then work to move beyond the iPhone. 

Back in 2012, Jony Ive discussed the motivation behind the work taking place at Apple: "Our goal isn't to make money. Our goal absolutely at Apple is not to make money. This may sound a little flippant, but it's the truth. Our goal and what gets us excited is to try to make great products. We trust that if we are successful people will like them, and if we are operationally competent we will make revenue, but we are very clear about our goal."  

Jony's comments demonstrate Apple's strategy for dealing with the iPhone Reality Distortion Field: let the products do the talking. By focusing on product, Apple can create a development framework for reiteration and improvement, two ingredients for long-term success.

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Apple's Broken Narrative

Tim Cook and Luca Maestri had one goal for last week's earnings conference call: convince Wall Street to begin thinking differently about Apple. For the past two decades, Apple's success has been judged by hardware unit sales growth, a metric that is now becoming increasingly at odds with the long-term strategy being pushed by Jony Ive. Management now finds itself searching for a new Apple narrative as iPhone sales growth slows. Wall Street has effectively declared the old Apple narrative broken. 

Narratives Are Important

Wall Street is ruled by narratives. By coming up with stories, investors and analysts use narratives to understand how companies are performing. When a publicly-traded company reports earnings, the narrative surrounding the company plays a major role in how analysts and investors think about the results. This is why a company may report seemingly weak results yet still have a stock that reacts well. As long as the company performs well in relation to its narrative, Wall Street is in a position to reward management. A company's narrative is the primary way a management team balances near-term demands associated with being a public company with long-term goals aimed at value creation. If a company suffers from a broken narrative, Wall Street struggles to properly judge the management team. The company's valuation suffers as a result.

Amazon represents a perfect example of how important a narrative can be to a company. While many are quick to point to Amazon's sky-high valuation when using earnings multiple metrics, Wall Street has historically judged the company differently, often using either cash flows or a more aggressive form of income to measure management's progress. Narratives can also change on Wall Street depending on a company's performance. Facebook's narrative turned from being a social network with a mobile problem to the single-most promising destination for advertisers in the mobile world. For Microsoft, the narrative was about moving away from Windows. It was this change that provided the company room to report deteriorating sales and earnings trends as management put resources into more attractive businesses.

Management teams certainly play a role in nurturing their own narratives, often disclosing certain data points in order to help Wall Street understand the narrative. It is when management teams try to change a narrative without proper explantation that volatility ensues, like when Netflix, back in 2011, tried to split its business in two.

The Old Apple Narrative

While some are convinced Apple has lacked a proper narrative on Wall Street, in reality, the company has long been judged as a hardware manufacturer selling personal technology gadgets. Accordingly, Apple's success had traditionally been judged by product sales, specifically high-margin hardware unit sales growth. As long as Apple reported strong unit sales growth, the Apple story remained intact. The remarkable thing is that over the past 15 years, Apple was able to do exactly that, transitioning between a number of products in such a way as to never let the narrative break, despite a few speed bumps. 

As seen in Exhibit 1, the Apple narrative based on hardware sales steadily grew from the Mac to iPod and then iPad and iPhone. 

Exhibit 1: The Old Apple Narrative - Hardware Unit Sales (2000-2015)

One of the more amazing business transitions in the modern technology era occurred when Apple introduced the iPhone. In just two years, the former Mac and iPod company became the iPhone company. Apple certainly played a role in this transition, going so far as to change its corporate name from Apple Computer Inc. to Apple Inc. in 2007 to reflect the fact that its product line was changing. 

Soon after the iPhone was launched, Apple then began selling the iPad which only helped to boost the narrative of selling lots of devices. Even when the iPad began to face sales trouble, the iPhone's growth was positioned in such a way as to replace any missed iPad sales. Apple's old narrative was all about shipping new hardware and by all measures, the company was experiencing new levels of success. 

Apple's Narrative Is Broken

There are now signs that the Apple narrative is completely broken. The iPad has essentially been written off by investors with the business having declined by more than 40% since peaking in 2013. Management guidance implies iPhone unit sales will decline this quarter for the first time. Apple Watch shipments remain too small for investors to get excited about, and the Mac is barely growing.

For additional evidence that the Apple narrative is broken, AAPL's valuation contains plenty of clues. Apple's stock has had a very difficult past 12 months. After significantly underperforming peers and the broader market in 2015, AAPL shares took another dive following 1Q16 earnings last week. Apple shares are now trading like a junk bond with a free cash flow yield exceeding 15%. Either the market expects Apple's cash flow to decline substantially within the next few years, or there is a fundamental problem with the Apple narrative.

While there is no denying that Apple's earnings growth will slow in the coming quarters, the pessimism priced into Apple shares would seem to point to investor anxiety over Apple's long-term hardware strategy. This type of doubt is representative of a narrative problem. Investors are no longer sure how to judge Apple's results.

Wall Street has already declared Apple's old narrative dead. This is how Apple can be trading at such a low valuation yet still be the most valuable company in the world. Apple's top stockholders have taken it upon themselves to come up with their own Apple narrative. However, there is no one single Apple narrative out there that Wall Street can get behind. 

A New Narrative

Apple management appears to be ready to push a new narrative on Wall Street. With management's revenue guidance implying iPhone unit sales will decline 10-15% and iPad sales will fall another 15-20%, it is clear Apple is entering a period of slowing hardware unit sales growth. While it is still possible for growth to return, it is in Apple's best interest to focus on establishing a new narrative. Apple has a base of more than 650 million users with loyalty that is unmatched in technology. There is value found with this user base, but management needs a new way to explain it to Wall Street. 

Management is positioning the reoccurring nature of its services revenue as the critical piece of a new narrative. In an attempt to strengthen its services story, management used last week's earnings report and conference call to introduce new disclosures meant to get Wall Street to focus on business metrics other than slowing hardware unit sales growth. Apple disclosed there are one billion devices that have engaged with Apple services over the past 90 days. In addition, management introduced a new services revenue total called Installed Base Related Purchases, which reflects the total amount spent on content and services in the Apple ecosystem, including the revenue remitted to third-party app developers and certain digital content owners. Exhibit 2 highlights management's first attempt at forming a new Apple narrative that moves beyond hardware unit sales. 

Exhibit 2: Apple's First Attempt at a New Narrative

Whereas in the past, Apple's earnings contained one of the more straight-forward reports in tech with investors simply checking a few sales numbers to make sure the company was on track, Apple issued a supplemental packet with 1Q16 earnings, a sign of a more complicated narrative being formed. 

While some have classified this new narrative as "Apple, the services company," management likely has a different goal by focusing on services revenue. Since Apple still makes 95% of its operating income from hardware sales, management is likely trying to get Wall Street to think differently about its existing user base. One way of doing that is to emphasize how financially lucrative the user base can be by looking at the amount of money the average Apple user is spending on services such as iTunes, the App Store, Apple Music, and Apple Pay. 

"Apple, the Services Company" Narrative Problems

Apple management faces an uphill battle trying to position Apple as a services company. Wanting Wall Street to focus on services revenue makes sense on paper because services revenue is one of the few Apple income line items still growing. Instead of talking about numbers that are declining, focusing on the only thing driving growth seems practical. 

However, by talking up services revenue, management is moving away from Apple's strength at the intersection of hardware, software, and services. Positioning Apple as a services company would also mean that Apple's competitor list just got a lot longer with a slew of new players including Facebook, Netflix, Spotify and Hulu. This comparsion seems highly problematic for Apple since the company is known to have limited resources, and to not have a new narrative built around one of its strengths is questionable. 

Ingredients for a Successful Luxury Narrative

When thinking about a successful new narrative for Apple, it is important to focus on a few key ingredients. 

Growth. This may seem obvious, but it is important to point out that growth is a crucial element in any Wall Street narrative. Apple management needs to find the right kind of variable that can effectively demonstrate growth over time. Along those lines, one metric stands out as something to monitor: relevancy. For management to remain successful in the future, Apple needs to remain relevant. One way of including relevancy into a new narrative is to focus on metrics such as time spent on Apple products or amount of money spent on Apple products (notice management moving down this route last week). Engagement levels may also represent a useful metric to measure relevancy. A metric that may seem important but contains incredible risk for building a narrative around is user base. For a company that has taken on a much more refined strategy built around luxury themes, championed by Jony Ive, Apple's success is likely not aligned with the need to constantly expand the user base over time.  

Hardware. Apple's strength is hardware, and a long-term narrative should include hardware in some respect. Considering that Apple's mission statement revolves around coming up with new products, hardware is very important. Instead of focusing on hardware unit sales growth, Apple could look at adoption rates within its user base as a metric to monitor. If there is evidence that a new hardware product, such as Apple Watch, is seeing steady adoption within the Apple user base, the takeaway could be that Apple is succeeding with its mission statement. This metric would also go a long way in validating Apple relevancy and user loyalty. 

A Personal Technology Company

A long-lasting narrative for Apple needs to reflect ideals pushed by Jony Ive. There are signs of a refined Apple strategy playing out in nearly every product category. Apple is pushing much farther and faster at the high-end of each market (iPhone Plus, iPad Pro, the new MacBook, Apple Watch). Given a user base of more than 650 million people, Apple is showing a willingness to hold the line on margins and instead build the intangibles surrounding the Apple brand. Management is now in a position to turn slowing iPhone unit sales growth into a strength by moving past a broken narrative on Wall Street and instead building a new narrative for Apple. By focusing on relevancy and engagement levels, in addition to user adoption rates, success will be measured by management's ability to come up with new products that people love: the one metric that will determine Apple's long-term success as a personal technology company. 

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