A Facebook Experiment

I deleted Facebook off of my iPhone six months ago. I had one simple reason in mind: I thought I would be able to analyze Facebook more accurately and completely by not using it or its companion apps, cold turkey. Purchasing an iPhone 6s Plus at launch gave me the perfect opportunity to begin my experiment. My initial assumption proved true. In just the first eight weeks, I learned more about Facebook, Instagram, WhatsApp and Facebook Messenger, than the last eight years. I've reached a number of observations over the past six months on Facebook's value and vulnerabilities and a definite answer to what was once a seemingly difficult question: Are Facebook and Apple becoming competitors? 

Observations

I had five overarching observations from not using Facebook properties for the past six months: 

1) Facebook is a habit, not an addiction. Within a few hours of not using Facebook, it was easy to see how much time I had been dedicating to Facebook. I began grabbing my iPhone but not knowing what exactly to do with it. Typically, I would open the Facebook app and waste a "commercial" amount of time - a minute or two of taking in random content from friends. Instead of downloading a few iOS games to keep my attention, Facebook had become my go-to game. If I was at a doctor's office waiting to be seen, Facebook would serve as that perfect attention filler. I now needed to find something else to occupy my time.

During the first few weeks of my Facebook experiment, I did have an urge to find my old iPhone 5s (which still had the Facebook app installed on it) and take a quick peek at my News Feed. However, this desire never got to the point of interrupting my daily routine, a prerequisite for a form of addiction. Instead, I realized Facebook had become a habit. As time went on, the solution to handling my Facebook habit was simply to find other apps that would fill my time. Those apps turned out to be Apple News and Twitter (and eventually Slack). Each one of those apps would offer different forms of content capable of grabbing my attention. 

2) Facebook is no longer a social network. Facebook stopped being a social network years ago. Up until this past September, I had used Facebook daily for more than 10 years. I was among one of the early Facebook users relying on the site to literally see who lived next door. As the years went by, my Facebook wall became a News Feed and with the change, Facebook changed from being about what my friends and I were doing to what my friends thought was interesting around the web. I discovered that those two things produce very different kinds of content. Facebook lost all resemblance of a social network with the presence of brands, ads and algorithms. 

3) My core communication was never on Facebook. After I stopped using Facebook Messenger, I wasn't sure if my communication with family and friends would deteriorate. Instead, I discovered that my most important communication channels were never on Facebook properties to begin with. I still used the phone app on my iPhone for most communication while iMessage also continued to play a significant role. For other forms of communication that were indeed found with Facebook, I reverted back to relying on word of mouth. The events and occasions that I needed to know I ended up finding out about, just through a third-person. The type of communication that did suffer by not using Facebook was the email variety, or messages to acquaintances with little real-world connection.  

4) I'm less informed of the local world around me. There is no denying that I am less aware of what is going on around me in terms of random daily news and events by removing myself from Facebook. I am still keenly aware of global news thanks to Twitter and apps like Apple News. In fact, I've had more time to follow those kinds of news stories since deleting Facebook. However, I have lost touch with much of the local news likely to impact my daily routine. Facebook had turned into my local paper, all the way down to nearby high school sports scores and recaps. Instead of reporters relaying the information, parents would upload pictures and stories of how their children did at the game. Not having access to that type of news makes me feel a bit more disconnected to the community around me since there is no other app or source capable of recreating that news medium other than a traditional paper or news periodical sent through the postal mail (which is still the only way I know the bare essentials of what is happening around me). 

5) Facebook's success is dependent on my time. I used to think that Facebook's success was dependent on me being an active participant by uploading content or sharing links. Instead, Facebook simply needs me to open a Facebook property for the company to remain relevant. With news organizations and other content sites now relying on Facebook for traffic, I turned from an active participant uploading content daily to a passive observer that paid Facebook with my time (and data). Facebook's transformation from a site that required me to spend time and energy to create a profile and engage with others to an app that fed me content from around the web without me needing to do much is why Facebook has become so quintessential to so many people.

Takeaways

After not using Facebook for six months, I was able to clearly see why Facebook is so incredibly popular around the world, the guiding motivation behind Mark Zuckerberg's actions, and where the company is headed tomorrow. 

What is Facebook? Facebook is a curated version of the web. Having 1.6 billion people participate in building this new version of the web is ultimately why Facebook had become a habit for me and so many other people using smartphones. There is literally a never-ending stream of information and content to consume. Talk about the advantages of having massive scale. Using the Safari or Chrome app on a smartphone to surf various websites is a pain, not to mention energy-consuming, which explains Facebook's aggressive moves in recent years to bring even more content into the News Feed. If Facebook wants to turn habits into addictions, they need to include the most sticky portions of the web including news, videos, and eventually live sports and make it remarkably easy to consume content. This explains the motivation behind Instant Articles and marketing the feature as accessing and reading news quickly and effortlessly. 

There is one very important takeaway from Facebook being a curated version of the web. Some people won't be interested in consuming this version of the web, and as I have shown by having not used Facebook for the past six months, there are other versions of the web available. Creating a non-Facebook version of the web involves more effort and dedication, but it is possible. I have found a handful of apps and websites (Apple News, iMessage, Twitter, Slack) that have contributed to a new curated version of the web. This helps explain why the 50% of the connected world that is not on Facebook can get by just fine without it and probably will not be embracing Facebook's version of the web anytime soon. If there is still any mystery as to why Facebook cares so much about connecting the rest of the world's seven billion people to the internet, look no further than those people representing Facebook's growth engine where additional users leads to a stronger version of the web and consequentially more advertisers.

The reason Instagram has become so incredibly popular is similar to how the News Feed offers a curated version of the web within the traditional Facebook app. Instagram is moving down the same path only with pictures. This opens so many more doors since photos and cameras have played an integral role in the smartphone boom. We now use our smartphones as tools to capture and interpret the world around us. Taking these photographs and then using the massive scale with hundreds of millions of users produces another version of the web that is even easier and more enjoyable to consume than compared to the traditional Facebook News Feed. 

Messaging Apps. Once the iOS versus Android war matured to a point where there were no longer the same fierce battles between the two platforms, many tech pundits and analysts turned to messaging as an answer for where consumer tech trends and interest were headed. For Facebook, both Messenger and WhatsApp were positioned as potential threats not only to iOS, but also to Android. Grandiose visions of everything and anything being put into Facebook Messenger and then crowding out competing platforms ended up being the subject of countless blog posts around the web. In reality, this messaging vision has been grossly exaggerated and like much of the tech analysis, void of reality. While 800 million people use Facebook Messenger and a billion people use WhatsApp, we rely on multiple communication channels throughout the day. The simple fact that many (most) young people are addicted to Snapchat shows that there is room for multiple messaging apps since we segment our communication channels according to our social network. And we haven't even discussed the Lines and WeChats of the world.  

When I stopped using Facebook, it became clear that iMessage, not Facebook, was the place I kept 100% of my family communication. This trend has only intensified in recent years as additional family members have purchased iPhones. While messaging will indeed continue to advance and be able to handle much more in the way of delivery content and utility, the industry is not a winner-take-all, but rather a handful of winners with the possibility of new start-ups coming in and also becoming a winner in terms of communication (hello Slack). 

Facebook vs. Apple. Facebook and Apple are unequivocally not competitors. In fact, Facebook and Apple are partners. Facebook's curated version of the web requires hardware, and Apple is a key player selling smartphones, tablets, and laptops/desktops. Instagram's growth has been fueled by smartphone camera innovation, which Apple has played a major role in. Add in Messenger and WhatsApp, and it's clear that Apple's 640 million iPhone users play a role in Facebook's success (and vice versa as many Apple consumers enjoy using Facebook properties on their iOS devices). 

However, it would be incorrect to assume the degree of competitiveness found within this Facebook and Apple relationship has remained static. Upon closer examination, Facebook and Apple are increasingly chasing similar goals. For both companies to remain relevant over time, they will need to occupy a greater share of our time and attention. Up to now, both companies are able to accomplish this goal without harming the other. A user reading an Instant Article in Facebook on his or her iPhone 6s Plus would be considered a win for both Facebook and Apple. However, listen to Mark Zuckerberg's vision for Facebook, and it's not difficult to see Facebook competing more directly with Apple. 

At first glance, Mark Zuckerberg's ideas on Facebook and virtual reality (VR) seem far-fetched, but when considering how Facebook is a curated version of the web, wanting to deliver immersive video content to users makes plenty of sense. According to Zuckerberg, instead of using our smartphone or tablet to open the Facebook/Instagram app and scrolling through a timeline of content, we can put on a pair of glasses/goggles to get a much more engaging and encompassing view of the world through VR. In essence, we would be able to see the world through other people's eyes. I still hold an incredible amount of hesitation and doubt that we will be willing to wear computers on our face throughout the day, but there is no denying that Facebook is betting big on a future beyond using Facebook on a smartphone.

The key development in Facebook's virtual reality bet has been its Oculus acquisition. With Oculus, Facebook entered the difficult world of hardware development, placing itself that much closer to taking on Apple as a more direct competitor. Of course, hardware is notoriously difficult, and I am skeptical Facebook's culture meshes well with prerequisites needed to succeed in hardware. While things are extremely early, a world where Facebook-branded VR glasses begin to take up users' time instead of iPhones or iPads would obviously mark a new type of competition. However, Apple isn't standing still and is not only investing in VR, but also showing interest in moving into entirely new categories such as personal transport and jewelry.  

While one of Apple's biggest competitors is itself (an iPhone's greatest competition is its year-old sibling), any company that is trying to build an experience out of the combination of software, hardware and services needs to be monitored. Facebook as of today does not meet the criteria for being classified as a formidable Apple competitor. However, a world in which Facebook continues to invest in hardware (much easier said than done) and begins to embrace ideals that go beyond software and hardware would certainly keep Apple executives up a few more nights.

Facebook Success

Mark Zuckerberg didn't position Facebook to replace the web. We don't use Facebook to search for something akin to a traditional Google search. Instead, Zuckerberg was interested in creating a new version of the web based on a different kind of search, one initially powered by our social fabric. For now, Wall Street and Silicon Valley seem to think both Facebook and Google can coexist peacefully despite what seems like obvious overlap in capabilities and ambition. Google's new corporate identity built around Alphabet certainly plays a role in showing that Google is looking for a future beyond search.

The primary takeaway from my Facebook experiment over the past six months is that while Facebook's popularity is unmatched on the web, the company is not invincible. Facebook's success will depend on its ability to deliver a compelling content consumption experience to its 1.6 billion users. As long as Facebook can occupy users' time, the company will do well with advertisers, helping to fund future endeavors. However, there continues to be a world outside of Facebook where billions of people live and enjoy technology with no regrets of not using a Facebook property. This world remains a vibrant place for both innovation and different ideas, leading to startups like Snapchat and Slack which begin to attract a growing amount of time and attention once given to Facebook. All the while, Apple's quest to embrace a new form of luxury will likely cap any potential near-term rivalry between Facebook and Apple. 

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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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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: 

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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. 

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. 

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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Strategy Behind Retailers Discounting Apple Watch and iPad

One noticeable trend evolving over the past few weeks in the U.S. has been significant sales on Apple products at some of the country's largest brick and mortar retailers. Best Buy and Target have offered sales on Apple products in the past, but this year feels different. While some have looked at these promotions as signs of waning Apple product demand and a directive by Apple to push excess supply through the distribution channel, the reality is much different. Retailers are positioning Apple Watch and iPad as the top gifts of the year, betting discounts for those two products will drive foot traffic into stores and page views to online stores. The end goal for retailers offering Apple Watch and iPad discounts is to generate the needed buzz and revenue to better compete with one of the best performing retailers: Amazon.

Retailers Are Having a Difficult Year

Traditional brick and mortar retailers have now been embroiled in a tough fight against online retailers for years. The sheer competitiveness found throughout the retail segment is now turning traditional retailers against each other. The single-most important development for the retail landscape has been the smartphone and the exploding phenomenon of "showrooming." Consumers, armed with their smartphones, and in some cases tablets, head out to malls and shopping centers with the goal of trying on or testing products only to then use their smartphones to compare prices across various stores. This process often occurs right in the store and has become quite noticeable in data trends released by mobile app analytics companies. Showrooming is especially common for electronics and other big-ticket items available at a number of different retailers.

To make this year especially difficult for many U.S. retailers, weather patterns have led to unseasonably warm conditions through mid-December, especially in the U.S. Northeast. As a result, apparel sales, traditionally a key component of fourth quarter sales, have been hit hard. When looking at year-to-date sales trends, it quickly becomes clear that 2015 has been a difficult year for most traditional retailers. When comparing their revenue growth trends to those of Amazon, the mediocre results quickly stand out. 

U.S. Retailer Revenue Growth (year-to-date) 

Note: Reflects only U.S./North American revenues where applicable.

New Retail Strategies and Tactics

Traditional retailers have begun to adapt to the new normal. Best Buy has embraced a number of new strategies to compete against Amazon and other e-commerce retailers. Phrases like "price matching" have become engrained in many consumers' minds. Instead of fighting against showrooming, price matching is all about brick and mortar retailers placing foot traffic and online page views above increased margins and profits. Instead of losing a sale to a different retailer online, retailers are willing to lose a bit of profit in order to keep that customer. 

The best retailers have gone even further and begun to turn their physical stores into something more than just a location for showrooming. Best Buy has doubled down on the concept of stores within stores, including 500 mini Apple stores. In addition, customer service, like the Geek Squad, has been positioned as a much bigger reason to venture to a Best Buy store. The long-term strategy behind such a plan would be to make up lost margin related to price matching with high margin service items such as extended warranties and repair jobs.

Niche retailers, like outdoor lifestyle retailers Cabela's and Pro Bass Shop, have been able to turn brick and mortar stores into a type of attraction or amusement where families can literally spend the day. Despite all of these various strategies, all retailers share the same goal: occupying customers' attention and dollars. This is where doorbuster sales and various other high-profile sales on Apple products enter the conversation as such sales are meant to grab buzz and interest. 

December Retail Observations

A few trends become apparent when looking at these recent Apple product sales at brick and mortar retailers. 

Apple Watch is positioned as tech gift of the year. Looking at the tech landscape and the best- selling new devices in recent months, 2015 has been the year of the wrist wearables. Accordingly, Fitbit and Apple are the two leaders of the very young market, taking a 82% adjusted market share. However, for retailers craving buzz, store traffic, and a revenue boost, Fitbit just does not compare with Apple Watch. Not only were Fitbit wearables available in 2014, but they cost approximately a third to a fourth the price of an Apple Watch. In addition, Fitbit does not offer much exclusivity as the devices are available in many retail locations. Meanwhile, this is the first holiday gifting season for Apple Watch, with the product remaining quite exclusive in terms of retailer availability (Best Buy, Target, Walmart, and mobile carriers). The end result is retailers positioning Apple Watch as tech gift of the year. 

Best Buy's Apple Watch sale includes $100 off all models, including both Sport and Watch collections. Meanwhile, Target's Apple Watch Sale includes $100 Target gift cards with the purchase of any Apple Watch.

While Apple Watch remains polarizing within tech circles, the general population has shown to be much more receptive to the product, preferring its simplicity and ability to perform a few tasks, including receiving notifications. If going strictly by Apple Watch reviews on Best Buy's website, shown below, people think very highly of Apple's newest product category. 

iPad is still one of the top tech sellers.  Even though the iPad has suffered from slowing sales momentum in recent years, the device is still a very good seller in absolute terms, especially during the holiday season. In addition, the distribution dynamic seen with the product ends up giving brick and mortar retailers an outsized share of sales compared to products like the iPhone sold at mobile carriers. The end result is the iPad makes one of the most popular gifts, especially for children and teens. It is in retailers best interest to have sales on iPads to appeal to customers and drive traffic into stores. 

Best Buy's iPad sale includes $100 or $125 off all models, except for iPad Pro. Meanwhile, Target's iPad sale includes $50 or $80 Target gift cards with the purchase of select iPad models.

Screen Shot 2015-12-15 at 11.15.19 AM.png

No sales uniformity. Even though more than one retailer is having sizable discounts on Apple Watch and iPad, each retailer has slightly different promotions. Other retailers, like Walmart, don't have any Apple product sales. This tells me that these promotions are not necessarily directed by a third-party, but rather settled upon by each individual retailer.  

What about other tech products? Other than Apple Watch and iPad, there are very few tech products that will sell in the same ballpark in terms of quantity and revenue. The only exception would be Fitbit, which unveiled a very extensive marketing campaign for its range of wearables with the company expecting to sell upwards of eight millions device this current quarter. While Microsoft was able to generate some much needed buzz with the Surface line of tablets, sales are still quite a bit lower than iPad-like revenues. Meanwhile, Amazon Kindles lack the growth and excitment of previous years.   

The Strategy Behind Big Apple Sales

Best Buy and Target are discounting Apple Watches and iPads because they are confident those two products will be able to garner interest and buzz to generate increased foot traffic and page views. Only 2% of Target's sales originate from its website, with Best Buy seeing a bit larger percentage (10%). Accordingly, It is conceivable that these Apple product sales will drive traffic to stores. Given the competitive trends, being able to get a consumer to a store is becoming more difficult and expensive. Once in a store, Target can then do its job and sell additional product. It is a version of the milk and bread strategy where grocers place the milk and bread in the back corner of the store in order to get you to walk through all of the other aisles and items.  

Retailers have long relied on this strategy to boost revenues, but it has taken on greater importance in recent years as competition intensifies. Electronics retailing in the hundreds of dollars represent the keystone of this strategy, especially in the November and December timeframe as people are willing to spend hundreds of dollars buying gifts for loved ones in addition to splurging on gifts for themselves. 

Apple's Involvement with Sales

Similar to any consumer goods company, Apple has working relationships with its third-party retail partners. Unfortunately, when it comes to analysis, these relationships are cast in mystery as the details surrounding contracts are confidential. In addition, the information found in these contracts is often not known by many people and is rather bland, limiting the odds of leaks reaching the press since there is little interest in such details. Traditionally, companies compensate third-party retailers for selling their product by offering lower wholesale prices with a varying degree of built-in margin available to the retailer. This margin is dependent on a number of factors, including the amount of power each party holds in the relationship. Walmart, for example, is well known for its ruthlessness when it comes to its suppliers, demanding low prices in return for significant purchase orders. There are also stipulations where companies can dictate how low a retailer can sell a product for with various incentives in place to have retailers follow such clauses. 

When it comes to Apple's direct involvement with these Apple Watch and iPad sales at Best Buy and Target, the most likely scenario is that Apple is aware of and has signed off on such sales although much of the financial impact is carried by the third-party retailer. Why does Apple allow massive discounts on its products? Temporary discounts during peak shopping seasons of the year have little to no long-term negative consequences on branding. In fact, by embracing third-party sales while maintaining its own "no discount" policy at Apple Retail, Apple is further able to maintain its brand image. If Apple was providing significant kickbacks or compensation to these third-party retailers, such trends would appear in financial trends through the average selling price (ASP). This explains why Fitbit's ASP is well below the actual retail sales prices of its products. Fitbit provides retailers much better margins than compared to Apple. 

Financial Implications

From Apple's perspective, what may end up being the most valuable long-term financial takeaway from these Apple product sales is increased brand relevance for Apple Watch. Apple has sold seven million Apple Watches to date, and I currently estimate Apple will sell another five million Apple Watches during the current quarter. This would suggest that Target and Best Buy have the potential to move upwards of one million Apple Watches this quarter, or $400-$500 million of Apple Watch revenue. This is not a trivial amount for Target and Best Buy and would certainly help offset weakness in other areas such as winter apparel. A very successful holiday quarter will help cap off a successful launch calendar year for Apple Watch with unit sales nearing 11 million. The product category would be well positioned for Apple Watch 2 in the first half of 2016.

For iPad, the iPad mini experiences strong sales each fourth quarter followed by a steady and dramatic drop-off in sales in subsequent quarters. I estimate Apple selling 17 million iPads during the current quarter which means Target and Best Buy could sell up to three or four million iPads, or another $1.3 to $1.7 billion dollars. Combining Apple Watch and iPad sales, these Best Buy and Target sales are likely worth at least $1.5 billion of revenue. When considering the additional product sales resulting from customers visiting stores in search of these Apple products, Best Buy and Target will likely bring in more than $2 billion of revenue this quarter related to Apple promotions. In the competitive retail landscape, discounting Apple products ends up being a worthwhile bet. 

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The Grand Unified Theory of Apple Products

There is much debate and intrigue regarding how Apple's expanding product line fits together. The addition of an entirely new product category with Apple Watch and new models such as iPad Pro have led some to wonder if Apple is losing focus or is unsure as to where the technology puck is headed. However, in a somewhat unpublicized interview for the new iMacs this past October, Phil Schiller, Apple SVP of Marketing, described a new theory for Apple's product line, which I am calling "The Grand Unified Theory of Apple Products."  This theory provides a glimpse into how Apple looks at the world and more importantly, some clues as to where Apple product categories are likely headed over the next few years. 

Product Line Expansion

One theme that has come to represent the Tim Cook era is product line expansion. Over the past four years, Apple has doubled its product lineup from 12 distinct models to more than 24, including a new product category. On a SKU basis, the growth is even more noticeable when taking into account additional finish options and various iPhone models geared toward specific mobile carriers. The ability to not just ship hundreds of millions of iOS devices each year, but to do so while offering so many SKUs, says a lot about Apple's supply chain prowess.

Much of this product expansion has come in the form of additional models reaching lower price ranges. Apple followed a similar method with the iPod in the early and mid-2000s. The difference now is we are seeing this occur with multiple product categories at the same time. Apple's expanded product line has contributed to total revenues more than doubling to $234 billion in FY2015 from $108 billion in FY2011.

Explaining Apple's Product Line

One question that has been raised by Apple's continued product expansion is how do all of these products fit together to produce one cohesive platform and encourage a broader ecosystem? The lines between product categories have become somewhat blurry. Upon closer examination, Apple's methodology of explaining its product line has matured over the years from talking about the iPad and a product's unique role to including the Apple Watch on a single product spectrum where personal choice is required to decide which products to buy. 

Unique Roles. When Apple announced the iPad in 2010, there was much attention and resources dedicated to explaining why a multi-touch tablet with a 9.7-inch screen should exist in a world with 3.5-inch screen iPhones and 13-inch MacBooks. The implied message was that the iPad would fit in most consumers' lives as it was a device that could do a list of things better than both an iPhone and a Mac. The iPad was given a very specific role to play. The now infamous slide Steve Jobs used to introduce the iPad (included below) is considered one of Apple's best marketing slides. It includes iPhone on one side, Mac on the other, and space in the middle with a list of various activities that can be done better by a new type of device.

The intriguing aspect of the slide was that it was geared toward consumers more so than analysts and technology pundits. Apple made it very clear as to why someone should buy an iPad. Judging from the early sales success, Apple's clear messaging worked. However, the broader implication from this marketing was that each Apple product had a particular role to play in our lives. Since Apple sold a handful of products, it wasn't much of a stretch for a consumer to buy every product category as each had its own unique role. Fast forward five years, and the product dynamic has changed to such a degree that the iPad seems like a redundant device to many people. The space between an iPhone and Mac continues to shrink, and iPad sales are declining. Apple's previous strategy of selling the idea that there was room in our lives for every Apple product category was beginning to come undone. Apple needed a new way of explaining its product line. 

A Spectrum. At the Apple Watch introduction keynote, Apple changed its tune when explaining its product line. Instead of positioning product categories in such a way that each product played a specific role in our lives, Apple began moving down the path of consumers picking and choosing the devices that made the most sense for them. The now classic, "product profile" slide made its debut (pictured below).  All of Apple's primary products fit on one spectrum. 

The message behind the slide was simple: each distinct product category possesses a different ratio of personal technology and power. The smaller the device, the more personal the technology. Meanwhile, the large iMac is positioned as the ultimate computing machine. The best choice as to what to buy or use is dependent on the individual. All of a sudden, Apple had a way to explain iPad's declining sales momentum (cannibalization by other Apple products), while also planting the seed that not every one will want an Apple Watch in the near-term. Instead, it's all about personal preference. It seemed that Apple under Tim Cook was moving towards a company tasked with selling a range of computing devices to allow the average consumer to choose what makes the most sense for him or her. 

While this message may seem to answer most lingering questions regarding Apple's product strategy, it still contains a number of drawbacks and questions. From a customer viewpoint, there is still confusion as to how all of these products come together. Look no further than the tricky iPad versus Mac debate. In addition, the descriptions used for each device concerning powerful technology on our wrist, in our pocket, or in hand are still somewhat vague and open to interpretation. From an analyst viewpoint, Apple's desire to look at its products on a spectrum has resulted in a rather wide range of opinions, including many pessimistic views on Apple's broader product strategy.

The Grand Unified Theory of Apple Products

This past October, Phil Schiller, in a rare interview with Steven Levy, talked about the new iMac. He took the opportunity to discuss a new way of thinking about the Apple product line, and I found it to be most revealing from a strategic perspective. Instead of describing how each product has a new unique role in our lives or simply placing Apple's entire product category on the same spectrum with an Apple Watch on one end and an iMac on the other, Schiller gave each product a job: make consumers feel like they don't need a larger, more powerful, Apple device in their lives. 

Schiller's theory is best viewed by taking his comments to Steven Levy and breaking them out by product category.

  • Apple Watch: "The job of the watch is to do more and more things on your wrist so that you don't need to pick up your phone as often."

  • iPhone: "The job of the phone is to do more and more things such that maybe you don't need your iPad, and it should be always trying and striving to do that."

  • iPad: "The job of the iPad should be to be so powerful and capable that you never need a notebook. Like, Why do I need a notebook? I can add a keyboard! I can do all these things!"

  • MacBook: "The job of the notebook is to make it so you never need a desktop, right? It's been doing this for a decade. So that leaves the poor desktop at the end of the line, What's its job?..."

  • iMac: "It's job is to challenge what we think a computer can do and do things that no computer has ever done before, be more and more powerful and capable so that we need a desktop because of its capabilities. Because if all it's doing is competing with the notebook and being thinner and lighter, then it doesn't need to be."

The first thing to notice about Schiller's new product theory is that it is actually a series of goals that also serve a dual purpose: help describe the product. What is the Apple Watch? It is a device that is supposed to handle a growing number of tasks once given to your iPhone. What is the iPhone? It is a device that is supposed to handle a growing number of tasks once given to your iPad. The argument can be made that all of this is just theory and that reality is not exactly keeping up with this vision, but that is exactly why it is called "The Grand Unified Theory of Apple Products." Upon closer examination, there is quite a bit of evidence to suggest that this theory actually does a good job of describing Apple's product line. In fact, Schiller's message provides the clearest clue yet as to how Apple management views its product lineup, even more so than the previous product theories put forth with the iPad and Apple Watch introductions. 

There are three major takeaways from Schiller's new product theory:  

1) The Apple Watch is a classic Apple bet. The very fundamental underpinning to Schiller's new product theory is that Apple Watch holds the most potential for making technology more personal. When looking at Apple's strategy over the years, the one overarching theme that transcends everything is the desire to make technology more personal, removing the barriers and allowing consumers to develop new and engaging relationships with technology. I continue to think the Apple Watch is being underestimated as elevated expectations for the product were reset over the past few months. The mistake many people continue to make when thinking of Apple Watch is looking at it as an inadequate iPhone replacement. Instead, Schiller's comments about Apple Watch denote a subtle distinction - the Apple Watch's role is to handle a growing number of tasks formerly given to the iPhone. For now, those tasks may be just simple notifications and things like checking time, but similar to how Apple handles product development, the Watch will soon handle more in the way of finance, health, identity, and communication. In many ways, the Apple Watch is setting up a classic Apple bet that a simpler device will eventually be able to handle many of the tasks currently given to larger and more powerful devices.

2) Greater iPhone differentiation is coming. While the recent debate has been stuck on whether the iPad can replace PCs, the real discussion that we should be having is how iPhones are replacing PCs. The iPhone is nothing more a smaller iPad. Of course, that subtle distinction ends up being the difference between a product selling 50 million units a year and 250 million units a year. The iPhone's form factor gives it the secret to success: mobility. Similar to how computing needs vary with the Mac and iPad, this same variability will come to the device being positioned to replace them. The writing is on the wall: expect the iPhone line to see greater diversification with a Plus model standing out from other models. So far, that diversification has primarily taken the form of screen size, but over time I would expect new ways for the Plus model to stand out from its iPhone siblings. 

3) Don't expect an iPad/Mac hybrid. Apple will not follow Microsoft down the iPad/Mac hybrid path. While it is easy to focus on the iPhone and Apple Watch as the future, it is crucial to note the role the Mac plays in Schiller's product theory. The Mac is the device that pushes everything forward. It may sound extreme, but Apple looks at a future Apple Watch as one day being just as useful as a current iMac. However, that goal is only possible if the iMac continues to receive the attention and resources to see what is possible at the upper limits of personal computing. A iPad/Mac hybrid would run against this trend as such a device is an explicit acknowledgement that the Mac is flawed as a product category. Instead, there is still much that can be done to push the Mac forward. 

A Roadmap, Not Destination

Schiller's grand product theory serves as a roadmap for where Apple wants to bring its current product line over the next few years, but it is important to not think of it as a destination. In a few years, the work from Apple's Project Titan will represent a new direction for Apple. While an electric car may not seem to fit in with a portfolio of watches, smartphones, tablets, laptops, and desktops, it is important to not get caught up by form factors but instead to look at what all of these products have in common: creating a experience. The simple fact that a device is used on a desk, held in hand, worn on the wrist, or sat in, doesn't change Apple's fundamental goal: make technology more personal.

For us to even be in a position to say that a 5-inch piece of glass held in our hand can replace a MacBook or iMac should help show that personal technology is about taking complicated tasks and breaking them down into more granular tasks, which are then able to be accomplished by smaller and simpler devices. This process will continue until we find ourselves in a position to begin looking up from our Apple Watches and iPhone screens but still feel connected to the world. The connected room era will have officially begun and Apple thinks those connected rooms will have four wheels. 

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Listen to this week's Above Avalon podcast episode (Episode 44: The Grand Unified Theory of Apple Products) for more information on this topic: Above Avalon, Overcast, iTunes.

Peak iPad Mini

The iPad mini's best days are behind it. Using app analytics data from Fiksu and Mixpanel, along with my own iOS device sales estimates and projections, I was able to derive iPad mini sales since launch. Over the past two years, iPad mini sales trends have deteriorated much faster than most people think. When taking into account the move to larger iPhones and iPads, the iPad mini's value proposition has likely been weakened to such a degree that the decline in sales is permanent. We have experienced "Peak iPad mini." More importantly, by analyzing the iPad mini's sales trends, we have better insight as to where the iPhone and iPad product lines are headed and the iOS platform's overall direction when it comes to form factors. 

iPad Mini Has Fallen Out of Favor

Conventional wisdom would suggest that the iPad mini has been the better performing iPad line due to its low price and feature set. In reality, the iPad mini has seen much weaker sales trends compared to its larger 9.7-inch screen sibling. As shown in Exhibit 1, when looking at iPad mini sales on a trailing twelve month (TTM) basis, the device's multi-year sales decline becomes quite obvious. Apple would need to sell close to double the number of iPad minis sold over the last 12 months to set a new sales record, a feat that is looking very unlikely. 

Exhibit 1: iPad Mini Unit Sales (TTM)

While everyone is aware of the iPad's sales troubles, one surprising observation is that most of the iPad's sales decline can be attributed to the iPad mini line. As seen in Exhibit 2, the 7.9-inch screen form factor has seen a dramatic 50% drop in sales on a TTM basis over the past two years while the 9.7-inch iPad line has seen much more resilient sales. This trend seems counterintuitive but provides a very strong clue as to how consumers are thinking about the iPad. When taking into account this granular iPad sales data, Apple management likely had a much easier time deciding to launch the larger iPad Pro. The trend towards larger iPads has already been years in the making.  

Exhibit 2: iPad Unit Sales by Screen Size (TTM)

What Happened?

There has been a polarizing debate as to what happened to iPad sales. Some have blamed slowing sales on longer life cycles while others have pointed to iPhone cannibalization or a combination of the two. The latest theory is that iPad software issues and a flawed App Store are to blame. When considering that the smaller iPad mini is becoming less popular than the larger models, many of those reasons fall by the wayside.

In reality, the iPad was a victim of its own success. The combination of a very popular iPad 2 (decent weight, okay screen, and good battery) and the launch of a smaller iPad mini (with a low price) led to a boom in sales that resulted in iPad sales growth peaking only three months after the iPad mini went on sale.

In retrospect, the iPad mini served as a great precursor to the phenomenon known as larger screen iPhones. There was likely significant demand for an iOS device larger than the current iPhone at the time (iPhone 5's 4-inch screen) but a bit less bulky than the 9.7-inch screen iPad. Soon, all of these reasons began to be wiped away with new, larger iPhones and thinner iPads. While the iPad mini's low price meant the device was the more popular iPad for gifting around the holidays, which is likely still true today, the need for an iPad mini was increasingly being met by the iPhone and larger iPads. 

iPad Mini's Declining Value Proposition

A slowdown in iPad mini sales is not enough to lead to the conclusion that the product line will see a permanent reduction in sales. The Mac serves as great example of this as the product seemed to have seen peak sales, only to come roaring back in subsequent quarters. Instead, the Peak iPad mini theory is predicated on the idea that the device's position in the market has fundamentally changed, leading to a weaker value proposition and corresponding cut in sales. One example of this type of value destruction is found with iPod and how the smartphone led to less demand for dedicated music players. Peak iPod occurred in 2008, a year after the iPhone was released. 

The very significant move towards larger screen iPhones has altered the iPad mini's ultimate sales trajectory. As shown in Exhibit 3, when the iPad mini was first introduced in 2012, the world was predominately using 3.5-inch screen iPhones. Meanwhile, the Android phablet movement was only just beginning to take off.  Over the course of the next two years, iPhone sales trended towards bigger screens. Today, a vast majority of iPhones sold include a 4.7-inch or 5.5-inch screen. These larger devices are increasingly serving as better consumption devices, taking away a key value proposition previously held by the iPad mini. 

Exhibit 3: iPhone Sales Breakdown by Screen Size

Meanwhile, on the other end of the spectrum, the iPad Air's resilient sales (as shown in Exhibit 2) suggest that an increasing number of consumers are looking to use an iPad as a laptop and desktop replacement. Accordingly, the iPad mini's smaller screen is not preferred as the reduction in screen real estate leads to a less useful product for media consumption, web surfing, and other basic computing tasks. 

Some have said that the iPad is being squeezed between the iPhone and Mac. In reality, the iPad mini is being squeezed between larger iPhones and the iPad Air and iPad Pro. 

iPad Mini's Price Advantage is Overrated

The iPad mini was launched in 2012 as a defense against Android OEM competitors potentially underpricing the iPad and risking a repeat of the Windows vs. Mac battle. In reality, the iPad mini is still too expensive to compete with pure media consumption devices running Android, but there is no evidence such devices pose a threat to iOS. Many now point to price as the iPad mini's secret weapon that should not be underestimated. In reality, this strength is likely overrated. At $399, a new iPad mini is only $100 less than a new iPad Air and the same price as a year-old iPad Air. This pricing dynamic likely explains why the iPad mini sales have declined more than sales of the more expensive iPad Air models. 

Meanwhile, the year old iPad mini is still $70 more than the entry-level iPod touch, which is the lowest cost entry point for the iOS ecosystem. While some may look at the iPad mini as holding a better future than the iPod touch, that isn't exactly saying much considering the iPod touch's lackluster sales. 

iOS Sales Spectrum

The iPad mini's declining sales provides clues as to iOS form factor trends. Instead of looking at the iPhone and iPad as separate product categories, I like to think of them as existing on the same iOS spectrum but occupying different screen size segments. The fact that iPhone and iPad rely on the same mobile operating system makes this view reasonable. In Exhibit 4, iOS sales according to screen size are depicted for 2013 and 2015. 

Exhibit 4: iOS Sales Spectrum (2013 vs. 2015)

In the span of two years, screen size preferences have shifted to larger screens (reflected by the blue line in Exhibit 4 shifting to the right in 2015). Notice the iOS screen sizes that saw the largest sales declines between 2013 and 2015: 3.5-inch iPhone, 4-inch iPhone, and 7.9-inch iPad. A better way to see this trend is to picture the lines in Exhibit 4 as waves, depicted in Exhibit 5. Note two differences: The new sales peaks (in blue) are now found with 4.7-inch iPhones and 9.7-inch iPads while the amplitude of the wave at 4.7-inch iPhones is increasing. Over time, it is conceivable that the wave in blue continues to shift to the right with a higher iPhone crest. 

Exhibit 5:  iOS Sales Spectrum (2013 and 2015)

A few takeaways:

1) Consumers are increasingly allowing iPhones to play a greater role in their lives. Consequentially, purchasing habits are trending to larger screen iPhones. Apple will likely look to the 5.5-inch iPhone form factor as positioned well for potential sales growth, not to mention increased revenue and profit share. There is room for Apple to slim the device's bezels, making the device easier to hold in one hand while maintaining the 5.5-inch screen. 

2) The iPad Pro is positioned well to see an increasing share of iPad sales as consumers position the device as a laptop and desktop replacement. While this replacement transition is not possible for everyone at this time, the definition of work is changing and for many consumers typing is becoming one of the last barriers to switching completely to iPad. 

3) The 7.9-inch iPad from factor is caught in the middle.  It is too big to be put in a pocket or held in one hand but too small to replace a laptop or desktop. 

iPad Mini Is a Fading Star

Apple is still selling too many iPad minis for the product to be mothballed. However, the more likely path will be a slow yet steady slide into irrelevancy. The product will see more sporadic refreshes, which has already happened with the iPad line, while the value proposition continues to become less compelling. Holiday quarters will represent iPad mini's best sales times, and it will possibly even outsell the iPad Air during certain months, but the elephant in the room will keep a lid on iPad mini's upside. Ultimately, the iPhone is the single biggest threat to both the iPad mini and the broader iPad category as Apple pushes forward in differentiating the iPhone Plus line. Such a device holds the best chance of being the most popular and useful iOS form factor. From Apple's perspective, having the iPad mini be cannibalized by an iOS device with a higher profit margin may actually turn out to be a long-term positive from a financial and strategic perspective.   

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Making the Case Against an Apple Television Set

The Apple TV and iPhone were both formally introduced to the world on January 9th, 2007. One went on to sell over 700 million units and is now responsible for an active installed base of approximately 500 million users. The other was classified as a hobby and went on to sell "only" 20 million units. In 2014, Apple reportedly shelved the idea of selling its own television set. Given renewed focus around the launch of a new Apple TV platform, have the odds of Apple having second thoughts about selling its own branded television set gone up? No. Upon closer examination, there are very few reasons to justify an Apple-branded television set. In fact, a very strong case revolving around the television's ultimate value in a mobile world can be made demonstrating why an Apple television will not receive the green light to market.

The Long Journey to Today

The technology industry has struggled for the past decade in trying to define TV's future. Countless attempts to make TVs "smart" never caught on. The problem wasn't that companies weren't thinking outside the box, but rather that they were overthinking it. The future wasn't going to be found by turning our television into a desktop computer with an accompanying keyboard. Instead, TV's future became visible only after recognizing that a television is inherently a consumption device in need of content and an easy user interface. 

The new Apple TV is a product that has literally been years in the making, dating back to Apple's sneak preview of the "iTV" project in late 2006. Over the years, as the iPhone and iPad gained momentum and priority within Apple, Apple TV and the entire television category was negated to a long-term opportunity. While early Apple TVs were okay for consuming iTunes content, the value proposition to the average consumer just wasn't too appealing. We knew television was going to change and had a general framework as to what was needed to make that change happen, but we weren't sure when that change would unfold. All the while, speculation grew that Apple would unveil its own branded television set with a built-in Apple TV box.

Enter Netflix, Hulu and HBO Now. With a growing number of new content companies gaining strength and giving the consumer revamped content bundles that went up and beyond what we were used to with traditional broadcast and cable programming, the future started to come into focus. Meanwhile, instead of pushing forward with its own television, Apple reportedly canned the project to instead focus on taking lessons learned from iPhone and iPad in terms of how voice and touch could create a user interface that works with large screens positioned a few feet in front of us.  

The New Apple TV

There are two key elements to the new Apple TV that make the product stand out from previous reiterations: a new voice-based interface and an App Store.

New Voice-Based Interface. I had one "wow" moment while interacting with the new Apple TV for the first time: using Siri to navigate my television. Relying on Siri to search for movies or TV shows, and in the process being able to avoid the tedious task of using text to search, demonstrates that voice is an attractive way to navigate a large screen positioned a few feet away. I found voice so compelling that not being able to use Siri to search for videos within YouTube quickly led me to avoid using the YouTube app on Apple TV altogether. I simply had no desire to search by manually typing each letter one at a time using finger swiping on the Siri remote. While at first it sounded like a gimmick, using Siri to check the weather, stock prices, or sports scores was quite compelling even though I could have gotten the same information on my iPhone or Apple Watch. The ability to simply press a button and talk casually was riveting. I found the error rate with Siri on the new Apple TV to be low with the only hiccups resulting from asking questions that will likely be supported in future versions.

App Store. This past May at a conference in Germany, Netflix CEO Reed Hastings declared the future of TV would revolve around apps. A few months later, Apple threw its support beyond the app model as well. After using the new Apple TV for a few minutes, it's clear Netflix and Apple are correct in getting behind the app model. Apple TV's primary purpose is to consume content. Without third party apps like Netflix, HBO, or Hulu (and active subscriptions), Apple TV's value proposition would decline dramatically. 

An app's value is rather straightforward when it comes to consuming content on a television. Instead of one company pushing the same content to all viewers, an app makes it possible to have a very tailored and personal viewing experience, even within the same household. An app also makes it possible to search a wide variety of content depending on our current interests and mood. 

When Apple introduced Apple TV this past September in San Francisco, much of the press focused on the device's App Store and how gaming will be revolutionized. An App Store for Apple TV was craved by core Apple users ever since 2008 when Apple launched the iOS App Store. While apps are likely the future of television, I remain a bit more contained in my enthusiasm for many of the apps currently being paraded around. While there may be a loyal group of users that will be attracted to gaming on Apple TV, I am skeptical gaming will be able to move beyond its niche focus. Instead, apps that are focused on helping the user consume content in a more personal way have an incredible amount of potential. 

Saying No to an Apple-Branded Television

This past May, the WSJ reported that Apple had shelved its television plans in early 2014. While the exact details may forever be kept to a select few, Apple simply was not able to make the case for why an Apple-branded television deserved the green light. The WSJ article gave hope to long-time Apple television proponents by saying that the television project was never officially killed. Apple will have a hard time justifying selling its own television due to two reasons: TVs are impersonal devices meant purely for consumption, and the television's future in a mobile world is up in the air. 

An Impersonal Consumption Device. While some may look at the new Apple TV as a device capable of turning our television into an iPhone, in reality the device's features reinforce the fact that television is inherently used for consumption. Such a scenario makes it extremely difficult for Apple to position a television screen as being able to produce the kind of premium experience users have come to know from Apple. Everything from the new voice user interface to the App Store is built to make it easy to find and consume content while sitting a few feet away from a large piece of glass. While Apple has previously sold devices like the iPod for consumption, the iPod contained a certain level of personal connection to the user - through how it was meant to be carried, touched, and even worn. We see that these personal ingredients are needed to produce premium experiences with Apple Watch, iPhone, iPad, and the Mac. The end result is that consumers are willing to value and appreciate such premium experiences. A television's inherently impersonal and immobile nature gives Apple less opportunities to make an Apple-branded television stand out from alternatives. If Apple positioned a television to be used for more than just consumption by adding cameras or sensors, the problem would be that we don't live in a vacuum and will likely have even more capable devices in the form of smartphones and tablets nearby that could handle such tasks. 

Television's Questionable Future. Apple TV may very well represent television's future, but in an increasingly mobile world, the television screen will likely play a declining role, regardless of 4K or future technological trends. As a prime example of how a large television screen will likely remain a consumption screen with consumers, after using the new Apple TV with my television for a few minutes, I found myself increasingly looking down and interacting with my iPhone. I don't think this was by mistake. While I may be entertained for a few minutes by a few apps on Apple TV, its purpose is to display long-form content that I am not interested in viewing on my mobile devices. Over time, this dynamic may change as we rely even more on our iPhones and iPads to watch content. For a company that is willing to make very few big bets every few years, putting resources into a product like a television set with a future that is inherently opposite to themes found with mobile seems counterproductive for Apple. Meanwhile, content born out of mobile like short video clips found on Vine, Instagram, and YouTube feel off when viewed on a large TV screen. Instead, being able to consume such videos on our smartphones makes much more sense. Meanwhile, new products like the iPad Pro are designed with content consumption in mind with a superior speaker system and large screen. The end result is more people will consume video content on an iPad Pro as time goes on while momentum remains on the side of mobile.

Looking Beyond Dollars and Cents

Notice the lack of "revenue," "profit," or "margin" in the preceding paragraphs for why it doesn't make sense for Apple to sell its own branded television. This wasn't by accident, but rather those financial metrics are simply byproducts of Apple being able to sell a premium experience. Apple doesn't sell a product simply because it meets certain financial criteria. Instead, management evaluates if it can improve a product to the point where it possesses certain characteristics that lead to a premium experience. Metrics such as TV life cycles, low margins, or the fact that Apple would likely only be able to sell one unit to a household simply don't play a role in the fundamental case against an Apple television set. 

Apple TV's Role

Instead of simply controlling the large piece of glass in our living room, Apple TV's more valuable role is to further position Apple as a content distributor. When looking specifically at video content, Apple's interest in creating a slimmed down bundle of broadcast and cable programming can help the company provide a full assortment of video content to its users. This range of video content would then be able to be viewed on the hundreds of millions of personal Apple devices being sold each year including iPhones, iPads, and Macs. In a way, the Apple TV is Apple's trojan horse to gain power in the quest to become an improved content distributor. This characteristic is much more interesting from an experience-building perspective than compared to the idea of selling a large piece of Apple glass. Apple was right to shelve plans to build its own Apple television. 

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Decoding Apple's North San Jose Land Mystery

Apple has big plans for north San Jose. In the past few months, Apple has spent more than $300 million quietly purchasing or leasing land close to San Jose International Airport and only 11 miles away from Apple Campus 2. When adding up the possible square footage of office space that can be built on this land, Apple would be able to erect another "Apple Campus 2." At initial glance, there are three likely scenarios that can explain Apple's motivation buying land in north San Jose. However, after looking closer at Apple's employee and office space growth as well as the company's product development strategy and pipeline, the most likely scenario is that Apple is building an R&D center for Project Titan, specifically a prototyping and testing facility for a range of automobile products.  

The Property Transactions

After a few months of rumors within Silicon Valley commercial real estate circles, Apple's play for north San Jose began to take shape this past July when reports came out that the company signed a lease for a 290,000 square foot office building close to San Jose International Airport. Over the following four months, Apple has reportedly had three additional transactions resulting in the company owning or leasing nearly 90 acres.

July, 9, 2015. Apple reportedly leases a 290,000 square foot building from Ellis Partners at 2325 Orchard Parkway. The building is able to support 1,450 employees with 12 adjacent acres approved for 665,000 square feet of additional office space. The proximity of this building and open land to San Jose international airport (bottom left corner) can be seen below.

Apple's initial land transaction in north San Jose.

August 3, 2015. Apple purchases 43-acres of open land for $138 million from Lowe Enterprises at 2347 North First St. The 2.8M square feet that is approved for the land could support up to 14,000 employees. As shown below, the 43-acre plot of land is touching land Apple had been leasing from Ellis Partners.

Apple's second land transaction in north San Jose.

September 25, 2015. Apple buys a building previously leased from Ellis Partners, along with 12 adjacent acres of open land, for $166 million. Apple now owns enough land to support approximately 3.8 million square feet of potential office space. 

Apple's third land transaction in north San Jose.

October 22, 2015. Apple leases a 202,000 square foot building at 2509 Orchard Parkway from Steelwave. The land is adjacent, as shown below, to previously purchased land from Ellis Partners and Lowe Enterprises. Apple now owns enough land to support approximately 4.3 million square feet of potential office space. 

Apple's fourth land transaction in north San Jose.

Three Possible Explanations for Apple's Land Purchases

When contemplating Apple's plans with these land transactions, three scenarios seem to rise to the top: stockpiling land for eventual use in the future, building additional office buildings for a growing employee base, and building a research and development facility for Project Titan and Apple's growing automobile ambitions. 

Stockpiling Land for the Future. This theory is mostly based around the fact that land in Silicon Valley is a hot commodity. With little to no leased office space remaining in Cupertino and Sunnyvale (one estimate pegged Apple as representing 40% of Cupertino's office jobs), this theory positions that Apple management is looking to buy land in order to have room for future growth. While Apple may not have immediate plans for the land, the optionality provided by owning land in an up-and-coming geographic area somewhat close to Cupertino would give management enough reason to begin "stockpiling" land.

Upon closer examination, there are a number of holes in this stockpiling land theory that lead me to believe Apple is not just simply buying land to hold on to it for some undetermined future use down the road. The first is that Apple has never shown the desire to buy land indiscriminately without having a specific purpose or function for the land. Apple's focus mantra does not fit with a strategy of just buying large swaths of land with no clear agenda in mind. When looking at prior Apple land transactions, everything has had a purpose or reason. Apple purchased the land that is now home to Apple Campus 2 from HP years before construction began. Management has since gone on record to say the land had been purchased with a new headquarters in mind. Across the U.S. and the world, Apple's land transactions (both purchased and leased) have been conducted with specific growth plans in mind and include various locations in California, Austin, Texas, data centers in various states, Ireland, and recent sustainable forest transactions in North Carolina and Maine, as well as renewable energy initiatives in China.

One can also question the viability of a strategy where a company is spending close to $300 million dollars on land (much of it open land) simply out of fear of not having enough space to grow in the future. It just doesn't add up. Similar to how the Apple Campus 2 land became available due to rough times at HP, it is unreasonable to assume additional land wouldn't eventually become available around the Valley during an economic downturn or simple evolution of technology. It doesn't seem likely that Apple is stockpiling land in north San Jose just in case it may need it in the future. Recent reports seem to validate this stance as Apple is already working toward a development agreement with city officials. Apple has something specific in mind for this land.

Additional Office Buildings for Employees. The next plausible theory is that Apple needs additional office space for a growing employee base. This essentially represents the safe answer as to what Apple may be doing in north San Jose, and it is the one often paraded around in the press. Apple discloses its total employee count in 10-K filings each year. However, additional work is needed to break down this number into Retail Segment employees, temporary or part-time workers, and full-time non-Retail employees. Upon closer examination, I estimate Apple has approximately 60,000 full-time non-Retail employees across the world. As seen in the exhibit below, this employee count has grown significantly in the past five years and, assuming 10-15% growth each year over the next few years, it will not be long before Apple crosses 100,000 non-Retail full-time employees. It would then seem logical that Apple is looking to buy land to house all of these additional employees. 

However, a few things about this theory don't quite sit right with me. The first is that Apple is building a brand new headquarters (Apple Campus 2) with the stated goal of having most of its employees located in one large building in order to foster collaboration. Apple management has been very vocal with this reasoning, even taking journalists to tour the construction site to highlight the building's unique layout. Apple is taking pride in what they are building at Apple Campus 2. 

In order to gain perspective on how much land Apple now has in north San Jose, Apple Campus 2 will have 3.4 million square feet of office space compared to the 4.3 million square feet of potential office space in north San Jose.  I'm doubtful Apple is looking to build a sprawling campus that is larger than Apple Campus 2. The much bigger reason that I'm skeptical is that building an even bigger campus away from headquarters just doesn't fit with Apple's long-standing narrative as to how it views its functional organizational structure. 

Additional doubts that Apple is planning on building another large Apple Campus in north San Jose are raised when looking at some of the details around Apple's employee base. Apple Campus 2 will be able to house 14,200 employees. While large, the building is not large enough to house the roughly 20,000 Apple employees that work in the Cupertino/Sunnyvale area. Accordingly, Apple will continue to use its current headquarters at 1 Infinite Loop (home to 3,000 employees) and surrounding buildings. Run the math and once Apple Campus 2 is finished, Apple would actually be able to consolidate buildings. Why would management spend hundreds of millions of dollars to buy enough land in north San Jose to be able to build another Apple campus for nearly 20,000 employees when Apple Campus 2 has been the multi-year focus and cornerstone of the company's infrastructure development? I suspect the reason is that Apple isn't actually planning on building 4.3 million square feet of office buildings for 20,000 employees in north San Jose. Instead, Apple has a different type of structure in mind for the land. 

Research Facility for Project Titan. What if instead of building another large office building in north San Jose, Apple is looking to build a research facility?  What if this facility is actually a giant R&D complex in order to work on automobiles prototypes and conduct regulatory and safety testing? All of the evidence seems to point to such a thing. 

While we have no confirmation from Apple that they plan on building an electric car, there are enough clues to have a very high level of certainty that Apple is actively working on a self-driving electric car. Everything from a litany of recent automobile-related hires to Apple's interest in self-driving car testing facilities, a recent ramp in R&D spending, and overall automobile industry trends, not to mention accurate reporting from WSJ and at a handful of other publications, point to Apple planning something big with personal transport. 

Recent rumors peg Apple's Project Titan as being housed in leased office space in Sunnyvale, California, closer to Apple HQ. Apple has reportedly leased additional space in Sunnyvale to accommodate Project Titan employee growth. While this location might be a suitable place for employees to work, it is unlikely there is enough room to conduct a full range of electric car testing, including researching manufacturing techniques. 

Even though I suspect Apple is looking to build a Project Titan facility in north San Jose, I have doubts that this location will become the official Apple Car factory. As seen in the map below, there are currently two plots of land (shaded in red) that Apple has still not purchased or leased in north San Jose that are adjacent to Apple's recent land acquisitions. One is open space and the other has three buildings located on it. Even If Apple were to buy these two pieces of land, Apple's total ownership would measure approximately 140 acres. While this plot of land is indeed massive, it's quite small for it to be the location where an "Apple Car" would be manufactured at any level of scale. The lack of nearby rail also raises doubts that this location will become the primary location for manufacturing cars as rail is a cost effective way to transport finished product, not to mention receive raw material. Instead, this site's acreage would be more suitable for R&D purposes, a fact that even Apple has gone on record to discuss when questioned over these recent land purchases. 

Apple's previously acquired/leased land (green) and property currently not owned by Apple (red).

It is difficult to discuss electric automobile testing and assembly in Silicon Valley without mentioning Tesla's Fremont Factory (shown below), the former Toyota car factory located only 20 minutes away from north San Jose. Coming in at 340 acres (nearly four times the size of Apple's current north San Jose land holdings), the Fremont factory is overwhelming. Most of Tesla's assembly occurs on only roughly 120 acres of the site. However, it is important to remember that Tesla is only producing 50,000 vehicles a year, a far cry from the millions produced by the automobile industry's giants. One takeaway from the Fremont Factory is that building electric cars involves much more than just one big building. Instead, the ancillary buildings needed for handling incoming raw materials, producing components, assembly, and parking lots for finished product and transport infrastructure (like railroads), all point to these factories resembling cities rather than just factories. Looking at Apple's north San Jose land holdings, it's tough to see a similar operation like the Fremont Factory being built unless Apple plans on buying out dozens of additional buildings and hundreds of acres of land, something that doesn't seem too realistic or logical when looking at a map of the surrounding area. 

The Tesla Factory in Fremont, California

Additional evidence suggesting Apple would need much more space to actually manufacture an Apple Car in north San Jose can be found with BMW. The company's i-series electric cars, along with other models, are produced in a factory that measures 23 million square feet. As a reminder, Apple's acquired land holdings in north San Jose amount to 4 million square feet of possible space. 

The clearest answer for what Apple has in mind for north San Jose likely rests with Apple's product philosophy and strategy. Apple will likely rely on the same manufacturing process undertaken with most of its products, including the iPhone. Instead of actually building its own car in its own factories, Apple would look to contract manufacturers to build components and conduct the actual assembly. The important point about this strategy is that Apple would still need to conduct vehicle prototyping and research in order to figure out what should or shouldn't be included in an Apple Car. Testing facilities for Apple Car would likely require a hundred acres by itself. The scale required for car development cannot be stressed.

Elon Musk is right when he said two months ago in an interview with a German newspaper that Apple can't just go to Foxconn and say, "build me a car." Look at how the iPhone became a reality. Apple didn't just go to Foxconn saying, "build us a phone." Instead, Apple needed to figure out how to put together an iPhone and come up with new machinery and processes along the way. Only after that R&D phase had been conducted, did Apple executives head to China and work with Foxconn on learning and replicating the process. As Tony Fadell recalled about iPhone development, building the first iPhone was the easy part. The much harder part was being able to produce millions of iPhones. While early stage iPhone prototyping was done at Apple HQ, in addition to testing (recall Apple's iPhone antenna labs), the actual assembly occurred in China.

When looking at north San Jose, Apple could turn its recently purchased land into an Apple Car R&D campus complete with a giant testing facility and several smaller office buildings supporting more clerical aspects of testing and more nuanced design R&D efforts. 

Future Clues in North San Jose

Apple is reportedly fast-tracking its north San Jose development plans, having submitted preliminary plans with San Jose officials. If Apple were looking to build an Apple Car R&D facility, I would expect pretty quick progress towards construction to be made in the coming months. The speed at which Apple acquired the land may be a sign of Apple's urgency. The WSJ had previously said Apple is targeting a 2019 "ship" date for an electric car. While the exact definition of a ship date is up for a debate, it's clear that Apple won't likely sit on this land for too long without much action if an Apple Car R&D facility is the ultimate goal.  

I would expect Apple to remain as tight-lipped and secretive as possible in regards to these land purchases and subsequent construction activities. While we will undoubtedly be able to track the project's physical development (via drone), Apple could end up building one large, relatively generic structure with most details hidden from the public. Management would also be able to conveniently use CarPlay or other generic R&D initiatives as reasons for the facility.

Main Takeaway: Apple Is Making Progress With Project Titan

When news first broke that Apple was thinking about designing its own electric car, many company observers were doubters. The thought of a company that had spent years building computers that can fit in a pocket all of a sudden building an automobile was just too much for many to believe. Apple would need to acquire such a significant amount of talent, in addition to constructing new R&D labs, all the while figuring out who would even build the product. However, over the past nine months, we are seeing Apple make progress toward addressing these exact concerns and doubts. Apple has been hiring the people needed for a car, and these land purchases in north San Jose would be the first tangible sign of Apple building the infrastructure for electric car testing and research. If we zoom out and look at the big picture, Apple is moving incredibly fast with its electric car plans. Apple has likely been able to work on much of the internal components of an Apple Car, including the passenger compartment. More granular work involving the battery, electric drive train, and autonomous driving software is also likely to be conducted in relatively traditional office space/commercial real estate. We are likely approaching the next stage requiring much more space and infrastructure. While 2019 seems like still a long time out, it is in fact a very aggressive timeline to develop an electric car considering that iPhone and Apple Watch were developed in 2-3 years.

Apple's $304 million of land purchases in north San Jose hint at something much larger than simple office buildings, yet not quite large enough for a sprawling electric car manufacturing facility. Instead, a R&D complex for prototyping and testing various personal transport initiatives is the leading candidate. 

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Apple Is Buying Back Shares Like There's No Tomorrow

Tim Cook and Luca Maestri are literally buying back Apple shares as fast as they can. When comparing the pace of Apple buyback over the past six months to that of the program's previous three years, it is clear that management made the decision to be opportunistic to take advantage of Apple's languishing stock price. Apple management is showing an increasing level of confidence in its future. 

While everyone quickly focused on iPhone unit sales growth guidance and clues about Apple Watch sales when Apple reported 4Q15 earnings last week, one data point that jumped out at me was the amount Apple spent on share buyback. Management bought more shares in the open market last quarter than any previous quarter. In fact, when looking at the past six months, including the most recent ASR (accelerated share repurchase program), Apple bought back $24 billion of its shares, which is a record for any six-month stretch. All of this is made even more remarkable when considering that Apple's stock price is more than 60% higher than when Apple began buying back its shares in late 2012. This shows management remains quite optimistic about Apple's future and value found in Apple shares at current price levels. 

A closer examination of Apple's buyback activity is required to notice underlining trends. When looking at the pace of buyback on a very simple annual basis (Exhibit 1), nothing stands out from the ordinary. Apple has consistently repurchased shares since launching its repurchase program in late 2012, and it would appear that the pace of buyback slowed somewhat dramatically in 2015 due to a rising stock price and dwindling U.S. cash levels.

Exhibit 1: Apple Share Buyback (Annual - Fiscal Year)

However, if looking at the pace of Apple's share buyback on a quarterly basis, as shown in Exhibit 2, we arrive at a different conclusion as to how Apple has conducted its share repurchases. Apple's elevated pace of buyback over the past few months becomes apparent. As Apple's stock price declined this past summer due to a number of reasons including fears around slowing economic growth in China, Apple management increased its share repurchase activity. The $14 billion spent on share repurchases last quarter ranks as the fourth largest quarterly amount spent on buyback. 

Exhibit 2: Apple Share Buyback (Quarterly - Fiscal Year)

However, looking at share repurchases on a quarterly basis still doesn't do the best job of explaining management's view on share buyback. The true extent of Apple's aggressive buyback activity only becomes apparent when looking at the pace of buyback on a trailing six-month basis, shown in Exhibit 3. This timeframe is able to capture management's changed attitude toward buyback this past summer. Over the past six months, Apple has spent more on buyback than any previous six month period. 

Exhibit 3: Apple Share Buyback (Trailing Six Months - Fiscal Year)

When we look at Apple's stock buyback activity in FY2015, specifically the past six months, management's motivation becomes clear. As displayed down below in Exhibit 4, the yellow highlighted months (February, August, and September) represent the three busiest months in terms of management buying back shares in the open market. In FY2015, Apple spent $30B on share buyback in the open market, repurchasing 255M shares for an average selling price at $117.68. Looking back at the news flow from recent months, the pace of share buyback increased around the time Tim Cook emailed CNBC's Jim Cramer to say that business in China was holding up well. More interestingly, Apple maintained the pace of buyback through September up to the iPhone 6s and 6s Plus launch. These actions don't seem to come from a management team that is too worried about Apple's long-term trajectory.  

Exhibit 4: Apple Share Buyback (Monthly Open Market Purchases in FY2015)

When thinking about the pace of future stock buyback, Apple's U.S. cash levels need to be addressed. The amount of cash held offshore cannot be used for share buyback (or quarterly cash dividends). I previously chronicled the dilemma this presents. Due to strong iPhone sales in China, Apple is earning more cash internationally than it can spend in the U.S. on share buyback and dividends. One near-term solution has been for management to issue debt in order to fund the capital return program. While this plan is not a long-term solution, it is likely the best near-term plan while management lobbies for U.S. corporate tax reform addressing repatriation tax on offshore earnings. In 4Q15, Apple issued $10 billion of debt to fund share repurchases in August and September (shown in Exhibit 5). This is the most likely reason why Apple didn't begin another ASR over the summer.

Exhibit 5: Apple Debt Issuance (Quarterly - Fiscal Year)

When looking at the pace of debt issuance, it is clear that Apple is only able to buy back its stock as fast as it can raise debt. Over the past nine months, Apple has issued $29 billion of debt while buying back $31 billion of shares. When taking quarterly cash dividends and Apple's routine cash needs into consideration, Apple is literally buying back shares as fast as it can. 

While ASRs represent the quickest way to buy back shares, one requirement is to have the cash up front when the ASR is initialized, something that was likely not possible over the summer. Instead of beginning another "modest" ASR of a few billion dollars, Apple management likely wanted to be much more opportunistic with buyback. The second-best alternative was to issue debt across a number of weeks and then repurchase shares in open market transactions, buying a greater number of shares as the stock price continued to drop in August and September. In terms of open market purchases, highlighted in Exhibit 6, 4Q15 was the busiest month since Apple began its buyback program, exceeding the second most active quarter by 75%. 

Exhibit 6: Apple Share Buyback (Quarterly Open Market Purchases - Fiscal Year)

When looking at the pace of debt issued and the resulting pace of buyback, I have doubts Apple management could have done much more to buy shares at a faster pace over the summer given the circumstances and share price. While Apple could have returned the $187 billion of foreign cash back to the U.S., paying the required tax on such funds would not be the most shareholder-friendly option. Stock buyback does not operate in a vacuum with management needing to weigh the costs of returning cash to the U.S. against raising debt. 

It is important to remember that share repurchases, both open market and ASRs, are unable to keep Apple's stock price from declining in the future. There are a number of high-profile examples within the financial sector were management teams were buying back stock in 2007 and 2008 only to then need to raise capital in the subsequent recession as their companies encountered a more difficult operating environment. Instead, the main takeaway from Apple's buyback program is that management increased the pace of buyback as Apple's stock price declined nearly 30% from all-time highs. The striking aspect of Apple's buyback is how management is actually buying more shares as Apple's stock price increases. In 2015, Apple repurchased shares at a $118 average stock price, 25% higher than the average price paid in 2014. When looking back at 2013, Apple was buying shares at price levels that were 65% lower than the current stock price.

Tim Cook and Luca Maestri are likely becoming more confident in Apple's future when looking at iPhone's position in the smartphone industry. The ability to entice Android smartphone owners while serving as an aspirational brand causing consumers to strive to move up to iPhone's price layers represents a long-term positive. In addition, while this may be just a coincidence, Apple management increased the pace of buyback in February 2015, around the time reports came out depicting Project Titan and Apple's growing ambitions with electric cars. Then, over the summer, the increased pace of buyback once again seemed to correspond to new reports indicating new Project Titan hires and a WSJ report in September saying the project received the green light with a 2019 target. Management is now left with $36 billion of remaining share repurchase authorization with the board planning to update the capital return program in 2016. We are seeing a management team that is betting big on a future that the stock market is still unable to see.

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Apple's 4Q15 Earnings Preview

Apple's upcoming earnings report is set within a tumultuous market. We find ourselves in a changing environment with fears surrounding China's economy subsiding and optimism around the U.S. economy and the technology sector on the rise. Last week, large cap tech saw a resurgence as Microsoft, Amazon, and Google all reported strong 4Q earnings compared to expectations. Apple shares have traded up since bottoming at the end of August even though Wall Street continues to question iPhone sales strength. Apple's 4Q15 will provide the clearest read yet on how the global economy did this past summer as the iPhone has become the unofficial economic bellwether for China and global consumer demand.  

The following table includes my estimates for Apple's 4Q15. Where applicable, I have compared my estimates to management's guidance. 

iPhone

Investors remain nervous about iPhone sales. Upon closer examination, this nervousness has been around for close to a year, dating back to when the iPhone 6 and 6 Plus launched in September 2014. Since Apple's 4Q15 earnings reflect iPhones sales from July to September, results will primarily reflect how the iPhone 6 and 6 Plus did in China over the summer. In many ways, Apple's 4Q15 is a transitory quarter as attention will quickly move to FY2016 and iPhone 6s and 6s Plus demand. 

Exhibit 1: iPhone Unit Sales Expectation Meter (4Q15)

I remain above consensus with my 50.5M iPhone unit sales estimate. Much of my optimistic stance rests on the belief that Apple saw continued robust iPhone sales in Greater China over the summer. I am also assuming Apple experienced an average level of iPhone sales seasonality in the weeks leading up the the new iPhone launch. I consider iPhone unit sales in the range of 46M to 51M as close to my expectations. If Apple reports iPhone unit sales of closer to 40 million units, I will need to readjust my FY2016 iPhone sales view as it is likely Apple saw decelerating iPhone unit sales growth in China at a much faster pace that I expected. 

iPad and Mac

Similar to the past few quarters, the iPad and Mac will not make or break Apple's earnings report. When taking a step back from the quarterly fluctuations, Apple is still trying to find the iPad's normalized sales run rate where the pace of iPad upgraders and new customers will lead to stable growth trends. We are not there yet. The Mac continues to perform well in an environment where the laptop and desktop form factors are struggling in the face of smartphones. 

Exhibit 2: iPad and Mac Unit Sales Expectation Meters (4Q15)

Apple Watch

As we saw with Apple's 3Q15 earnings report, due to Apple not disclosing Apple Watch sales estimates, we end up with an "inside baseball" back-and-forth debate among financial analysts trying to back into Apple Watch sales estimates. Consensus seems to have settled on Apple selling 2.5 million to 3.5 million Apple Watches last quarter (I estimated Apple sold 2.6 million). At last week's WSJDLive conference, Tim Cook all but assured us that Apple will have shipped more than 2.5 million Apple Watches in 4Q15. My official Apple Watch unit sales estimate is 3 million, bringing the five month total for Apple Watch unit sales to 5.6 million. 

Guidance

Management's guidance will provide a clue as to how iPhone 6 and 6s Plus are selling. Unfortunately, Apple Watch revenue may make it more difficult to convert revenue guidance into an iPhone unit sales estimate. The debate surrounding iPhone is whether Apple can continue to grow the product category in FY2016. If revenue guidance comes in less than $75 billion, many investors will use that as evidence that Apple will struggle growing iPhone unit sales in 2016. 

Exhibit 3: Revenue and Margin Guidance Expectation Meters (for 1Q16)

Summary

Expectations surrounding Apple are much more varied heading into Tuesday's earnings report. With iPhone sales expectations more subdued this time around compared to previous quarters, it may take less for Apple to please Wall Street. I will be looking for any signs as to how management looks at the pace in bringing new customers to iPhone. While a slowdown in new user acquisition from FY2015 should be expected, the market will likely look favorably upon evidence that suggests the iPhone 6s and 6s Plus are still effective in expanding the iPhone user base at levels similar to iPhone 6 and 6 Plus. Several analysts have already given up on the iPhone 6s and 6s Plus narrative and are now focusing on iPhone 7 in late 2016. 

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Leasing Solves Apple's Cheap iPhone Dilemma

Apple is on track to sell more than 250 million iPhones over the next 12 months. When looking at overall sales share, the iPhone remains a small player, representing only 15% of overall phone shipments. However, on a profit share basis, the iPhone has rewritten the rules guiding the smartphone market, commanding upwards of 90% of the industry's profit. Even though Apple's mission has never been to sell the most of a product, there may be a way that Apple can grow iPhone's sales share rather significantly while retaining control of the smartphone industry's profits. An iPhone leasing model solves Apple's dilemma of how to address a larger portion of the smartphone market without diluting its aspirational brand and iPhone experience.  Leasing will usher in the next major phase of the smartphone industry by solving Apple's cheap iPhone dilemma.

The Changing Smartphone Market

In the early days, the prevailing way consumers bought an iPhone was with carrier subsidies. Instead of paying the $649 up-front price for the base iPhone model, AT&T would "subsidize" $450 of the cost, which would later be indirectly recouped by charging higher monthly service fees. However, as time went on and additional carriers began selling iPhone, the subsidy model represented a declining percentage of overall iPhone sales. A growing share of iPhone buyers were now paying full price for iPhone but in return getting lower monthly service fees from their carrier. Over the past eight years, in an environment where the iPhone's full cost is either born by the consumer up front or the carrier through a subsidy and subsequent two or three year contract, the iPhone was able to grab a commanding share of the premium portion of the smartphone market (>$400) with much less success in the middle market ($200-$400).

Spurred on by competition and unsustainable growth in iPhone subsidy costs, U.S. mobile carriers began to move away from the smartphone subsidy model and are currently embracing a leasing paradigm. Consumers are now able to pay either nothing up front or a small initial payment and then pay back the rest of the iPhone across a number of months, usually 24. Since carriers are no longer on the hook to "subsidize" part of the iPhone's cost, monthly service costs have been reduced although data has continued to become more expensive over the years. 

In an effort to retain the best customers, and as a sign of the iPhone's market power, carriers have included options for iPhone users to lease a new iPhone each year by simply turning in their old iPhone. The end result is a growing number of iPhone owners that lease their iPhone, paying the same price each month, but upgrading to the newest iPhone each year. 

Apple has recently gotten involved in the mix by launching the iPhone Upgrade Program in conjunction with the iPhone 6s and 6s Plus launch. While currently only available at Apple Stores in the U.S., the program is designed for those who want a new iPhone each year with the added peace of mind provided by AppleCare+. Customers apply for a loan financed by Citizens to cover the cost of the iPhone, AppleCare+, and sales tax. After the initial payment is made, the loan holder then has to pay back the price of the iPhone and AppleCare+ in 23 equal installments. However, after the 12th payment, the loan holder can hand in his or her current iPhone at an Apple Store and then upgrade to the newest iPhone by signing up for another 24-month loan. The cycle then repeats itself until the next year. Similar to what is happening at the carriers, the iPhone Upgrade Program is creating a growing number of iPhone owners that lease iPhones which shortens the iPhone upgrade cycle, boosting iPhone sales.

While we are still early in the iPhone leasing movement, early survey results suggest there is interest in leasing programs, including Apple's iPhone Upgrade Program. Since so few iPhone sales occur in U.S. Apple Stores, any near-term impact directly related to the iPhone Upgrade Program will likely be moot. Citizens expects less than one million customers to use the iPhone Upgrade Program over the first 12 months. Longer-term trends, and more importantly, the learning experience Apple is receiving by leasing iPhones, bode well for the program. It would be surprising if Apple does not expand the program to new countries over time. 

The Cheap iPhone Is a Myth

The call for Apple to release a cheap iPhone reached a fever pitch a few years ago when Apple first entered China with China Unicom and China Telecom relationships. Even though Apple has steadily grown market share and unit sales, a certain group of analysts and pundits continue to think the only way Apple would be able to do well in China and emerging markets would be to release a "cheap" iPhone. The problem with this thesis is that there were very few strategies Apple could realistically use to sell a genuinely low cost iPhone without undermining its business.

A base model iPhone 6s retails for $649 and has an gross margin of approximately 45%. In theory, Apple could sell such a device for $350 and break even, but with a business model dependent on making money from hardware, this isn't a viable long-term solution. Another possible way to sell a cheap iPhone would be for Apple to take a base model and strip out features and components. However, upon closer examination, this is much easier said than done. The iPhone's popularity is a result of the experience obtained from using it. Accordingly, it would be very difficult to maintain that experience by selling a stripped down iPhone with lower quality cameras, screens, and processors. Even then, a stripped down iPhone would still likely sell in the $300-$400 price range, which does not address the low-end of the market.

Another option to market a cheap iPhone would be for Apple to segment screen size according to price tiers. A 4-inch iPhone "mini" could sell for a lower price than bigger-screen options. However, recent iPhone sales trends would suggest a 4-inch screen iPhone would likely become a niche device as consumer preferences are overwhelmingly moving towards larger form factors like the iPhone 6 and 6s, with a growing number of users opting for the larger screens found with the iPhone 6 Plus and 6s Plus. 

Apple would have much difficulty selling a low-cost iPhone at a price that would make it competitive in completely new market segments. The most likely scenario that many have not considered is that a cheap iPhone probably wouldn't be as popular as consensus assumes. In fact, I would go so far as to say a low-cost iPhone would likely disappoint on the sales front. The iPhone's success comes from the branding and aspirational feeling attached to the device. By selling a low-cost version of this experience, consumers would likely not value the device in the same way. 

We saw a real-world example of this buyer aversion in 2013 when Apple unveiled the iPhone 5c. Instead of keeping the previous year's flagship phone, the iPhone 5, around and lowering the price by $100, Apple reconfigured the device by giving it a plastic shell. While the iPhone 5c did sell (I estimate approximately 40 million units were sold during its lifetime from 2013 to 2015), it was not enough to change the game. Instead, the device quickly gained the nickname "the cheap iPhone" as the device's colorful plastic shell easily signaled to people it was the cheaper iPhone version compared to that year's more expensive flagship, the iPhone 5s. It was never able to shake its cheap nomenclature. Many consumers buy iPhone for the intangibles that come with such a purchase such as being able to show it (and its high price tag) off to others. The iPhone 5c experiment is a preview of how an actual cheap iPhone would fare in the marketplace: not as well as many assume. 

The much bigger question to ask with a cheap iPhone is what is even considered "cheap"? Even though the iPhone 5c was mocked, the device still sold for a not cheap $549. A stripped down iPhone selling for $300 to $400 wouldn't classify as a cheap iPhone either, especially with other smartphone manufacturers selling product in the $150 to $200 range. The cheap iPhone may be a myth, but Apple is able to recreate many of its benefits, as well as come up with new benefits, by embracing the leasing model. 

Leasing is the Answer

A world in which iPhones are leased solves Apple's cheap iPhone dilemma. With leasing, multiple owners are able to value the same product differently. For some, there is value in being able to use the latest and greatest gadget while for others, the value is in low cost and being able to hold on to a device for a long time.

An iPhone leasing paradigm depends on a few variables including a functioning grey, or resale, market and healthy residual values. A grey market where buyers and sellers are able to transact in a low-cost, convenient, and safe manner is required for a leasing model to effectively move iPhone units from initial buyers to the next group of buyers. Since iPhones retain a good portion of their value as time goes on due to the device's build quality, popularity, and lack of lower cost models, the iPhone has high residual values. Accordingly, iPhones are able to be leased in a cost effective manner. If the iPhone did not hold on to its value well, leasing would prove to be a very expensive option as customers would end up paying most of the iPhone's retail price during the first year of ownership. As a result, the incentive to trade in an iPhone and upgrade would not be high. However, with a high residual value, an iPhone leasing model involves paying only 50% of the iPhone's retail price during the first year. In such a scenario, many would be willing to trade an iPhone in after a year for a new model since most owners currently hold on to their iPhones for two years. 

Leasing creates supply of one-year-old gently used iPhones that can be resold to new customers for less than the cost of a one-year iPhone sold by Apple. If we continue with this example for another year, leasing would create a supply of two-year old iPhones that can be resold to new customers for much less than the cost of a two-year iPhone sold by Apple. With leasing, iPhones make their way down to segments of the market that are not addressed by Apple. Even in an environment without leasing, there is a thriving grey market due to resales. Leasing would only legitimize and expand the grey market. The following chart compares new iPhone pricing at Apple to used iPhone pricing at Gazelle and eBay. Notice how used iPhone pricing currently stabilizes around $200.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

While Apple would not make money on these iPhone resales, Apple would benefit by selling new iPhones to its installed base each year. Apple would therefore be able to address a larger portion of the smartphone market while not jeopardizing its profit share. The cheap iPhone dilemma would be solved. 

The key reason someone would purchase a used iPhone that was previously leased instead of a cheaper iPhone with stripped down parts is that used iPhones retain Apple's aspirational brand characteristics. Instead of using a cheap iPhone that either looks or behaves differently than other more expensive iPhones models, used iPhones would appear and act the same as brand new iPhones. The iPhone user experience remains intact much more in a leasing paradigm. We see this play out in the automobile industry where premium brands such as Mercedes-Benz, BMW, and Audi each have vibrant leasing ecosystems where consumers can lease two to three-year-old automobiles for a much lower price rather than buy scaled-down, low-priced models that question premium car brand attributes.

Follow the iPhone

To better understand how leasing can help Apple address the low-end of the smartphone market, we can follow the path of an iPhone from original purchase to final destination a few years down the road, taking a look at the various owners and pricing along the way. 

  • Step 1: A customer buys a new iPhone 6s 16GB for $649 at an Apple Store using the iPhone Upgrade Program. A two-year loan was originated to finance the cost of the iPhone and AppleCare+.  
  • Step 2: At the end of the first year, the original owner returns the iPhone 6s to Apple. The original loan is then paid off. The one-year old iPhone 6s is then transferred to a third-party specializing in recycling or reselling used smartphones. The original owner leases a new iPhone from Apple with a new two-year loan. 
  • Step 3: The gently used one-year-old iPhone enters the grey market and is resold to a different customer for $450. A comparative one-year-old model would sell at Apple for $550. 
  • Step 4: A year later, the now two-year-old iPhone can still fetch $200 in the grey market. The second owner then decides to sell the device to someone on eBay for $200. A comparative two -year old model would sell at Apple for $450. 

In this timeline, a $649 iPhone was able to be "bought" by three customers over the span of three years for a collective $1,299. The difference in prices helps facilitate the grey market transactions. A larger and more robust leasing paradigm would make this process much more efficient and legitimate, similar to how leasing used cars pretty much involves the same process and players as leasing a new car. Over time, used iPhones would be able to be purchased or leased at many of the same locations where new iPhones could be purchased. 

One consequence of additional iPhone supply entering the grey market as a result of additional iPhone leasing is that resale prices may fall in order to match demand. However, there appears to be significant room for prices to fall without impacting the leasing paradigm, as displayed in the following chart. The black dashed line represents the point where iPhone resale values could fall to in order to still work with Apple's iPhone Upgrade Program.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

Financial Impact

Apple currently has an iPhone installed base of approximately 500 million users. When taking into consideration hand-me-downs and the resale market, the total number of iPhone users exceeds 500 million. If we were to assume leasing will be the only method by which iPhones will be purchased in the future, than theoretically, Apple would sell 500 million iPhones a year (every iPhone user would simply lease a new iPhone every year). A 500 million iPhone annual sales rate would be 98% higher than the current 253 million sales that I expect Apple to sell over the next 12 months. 

In reality, we are still in the very early innings of the iPhone leasing model, and not everyone will want to lease their iPhone. However, running with conservative estimates of 20-25% adoption rates for iPhone leasing over time, it does not take much to begin seeing a tangible benefit to Apple's iPhone sales. At 20% adoption, Apple would sell an additional 50 million iPhones a year. Said another way, if 100 million iPhone users leased their iPhones each year, Apple would see a 50 million unit boost to unit sales each year. The other benefit from leasing would be that used iPhones would help expand the iPhone user base benefitting the iOS ecosystem which may come in handy as Apple continues to push on content deals (Apple Music, Apple Video in 2016) and services such as Apple Pay. 

With iPhone leasing at 20% adoption, it is conceivable for iPhone's smartphone sales share to increase by 4-5% to 20% without even needing an entry-level low-cost iPhone to boost sales.  

iPhone Leasing Momentum

Ultimately, the only reason leasing iPhones makes sense in the first place is that the iPhone is becoming the primary computing device for hundreds of millions of people. There is a significant need and desire to use the newest iPhone each year. This would be a new type of hardware paradigm compared to previous computer technology eras where consumers bought and then held on to gadgets for years. Another reason an iPhone leasing model works is that consumers have noticed Apple's iPhone development cycle and the company's ability to ship new iPhone features each year. Mediocre annual iPhone upgrades would likely make leasing a much harder sell as consumers would decide just to hold on to their new iPhone for a few years, a much cheaper alternative than leasing. Ultimately, leasing changes the smartphone game by expanding Apple's addressable market and solving the company's cheap iPhone dilemma. 

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Apple Uses Good Design to Marginalize Industries

What makes a great product? 

How can one product change an entire industry?

One of Apple's most significant accomplishments has been a dedication to design that borders on the line of obsessiveness. As people decipher the driving factors behind what makes a product like the iPod, iPhone, and iPad so successful, it is crucial to recognize how a product's design has the potential not just to alter industries, but go so far as to marginalize them. The iPhone relegated the mobile phone to a single app. Apple Watch is being positioned to turn the modern Watch industry on its head. Apple's ambitions with the automobile will be nothing short of a transformational shift in how we think and use automobiles. When a company places only a few big design bets every few years, the resulting bets need to be huge, and Apple positions good design as the guiding light with all of its bets. 

What is Good Design?

Apple has thrust the topic of design into today's society. There is more cultural awareness of design than ever before. While this may sound like a good thing, the definition of design has seemingly expanded along with its growing popularity. The end result is growing confusion as to what design even means. Apple has always positioned design as a guiding principle even though consumer demand for such design is still a recent phenomenon. The world needed to see what the lack of design in the PC market looked like before craving Apple products born from the rebirth of the design-led process in the late 1990s.

With good design, a product is able to tell the world something about the person who created it. Good design is born during the product development stage when a fragile idea is allowed to advance and mature without compromises. So much of the corporate world is built in such a way as to stifle good design. The end result is that we are left with industries that play a crucial role in our lives but are susceptible to being altered by products that are created with additional care and intuition. The difficult part is looking at these legacy industries in a way that allows one to discover how they can be improved. While a handful of companies may realize the pieces to the puzzle for unlocking good design, there are even fewer companies that actually possess those pieces. An Apple led by Jony Ive is currently one of those companies, and Apple's $200 billion of cash is one tangible piece of evidence that Apple has possessed these pieces for years. 

Software Represents Additional Design Tools

Software allows good design to posses a different dimension. Similar to how a new paint color added to one's palette can result in a completely different picture, software allows a designer to add something to a product and to accomplish what would otherwise be impossible. It's not that software should be looked at as completing good design, but it provides a set of additional tools to interpret the world. Software makes it possible for us to interact with products in new ways that once seemed unimaginable. 

Turning Phones into Computers

When Apple executives began to seriously consider entering the cellphone industry, the motive was clear: come up with a phone that people want to use. Even though the iPhone is only eight years old, the world was a much different place in the mid-2000s. The cellphone industry was being built on a paradigm where phones were used to dial a long list of numbers in order to speak to someone. Innovation came in the form of a better keyboard; each button moved from having three letters to having its own letter. The world accepted these products with open arms because we were able to send and receive email when away from our computer. 

A cellphone's keyboard was quickly turning into a limiting factor, a feature that was holding back the device's potential. Few saw this taking place, especially the phone industry leaders. Even more remarkable was the untapped potential for the phone form factor: a device that could be small and light enough to be carried around with us all day. 

The iPhone ended up representing a simple question: Is there something better than a physical phone keyboard? The iPhone's design represented the answer. By removing the keyboard, a smartphone's potential was unleashed. Of course, those industry leaders clearly invested in the old paradigm not only did not understand the appeal of not having a keyboard, but also lacked an understanding of the potential now created by removing the keyboard as a limiting factor.  

The iPhone's design doesn't just stop with the lack of a physical keyboard. Everything from hardware design elements like physical volume button placement to software features like pinch-to-zoom told us something about who created the device. The iPhone stressed intuitiveness above all else, and this goal ended up positioning the iPhone a good five years ahead of the competition. The iPhone was one product that was able to upend not just the mobile phone market, but the entire computer industry. 

The iPad's Magic

The iPhone was a byproduct of research and development originally geared for a larger tablet device. With lessons learned from iPhone development, Apple returned to what ended up being unveiled to the world only three years after the iPhone: the iPad. 

The iPad has since had a storied history, despite tallying only five years. It came out of the gate as the fastest selling consumer gadget in history, (Apple sold 19 million iPads in the first year on the market) but the device is now experiencing waning sales momentum as the entire tablet market has shown structural issues. 

When the iPad was first introduced to the world, many called it a big iPod touch in an effort to discredit Apple's design foray into the tablet market. In reality, the iPad's greatness resided in it being "just" a big iPod touch. The device's intuitiveness was nothing short of earthshaking. The iPad's recent sales struggle isn't so much an indication that multi-touch computing has hit a saturation point or is being replaced by another computing paradigm. Instead, consumers are still experimenting with multi-touch screen form factors. For many people, a larger iPhone is a more optimal form factor than an iPad. Accordingly, we are left with a situation where smaller iPads are seeing weakening sales momentum while Apple moves faster at the high-end of the market. This is likely just the start of where the iPad is headed. Ultimately, the iPad was a computer designed to have the hardware melt away during use, leaving the software as the primary user interface. Apple's quest to make the most personal computers came to fruition. 

Apple Watch's Mission

Good design was used to question a cellphone's keyboard, unleashing the device's functionality. Similarly, the Apple Watch is given a mission to redefine utility on the wrist. As both Jony Ive and Marc Newson have mentioned publicly, Apple Watch wasn't born out of disgust with the modern wristwatch. There was something else at play, and the Watch's design gives us clues about this driving motivation and why Apple Watch represents a pivotal turning point in the watch industry.

Apple Watch design represents a simple question: can a device worn on the wrist include additional utility? Giving Apple Watch a rectangular watch face, something that was steadfast from early in the Watch development process, emphasizes the device's purpose to display text in the most space-efficient manner possible. The Apple Watch's design does not imply that the device is trying to be a mini iPhone, but instead a device that is meant to take certain tasks once destined for the iPhone (checking the time, receiving notifications, tracking health and fitness) and display information in a location with proper line of sight to the wearer. Haptic feedback serves to replace line of sight for some users as well as create another form of notification. 

Design is also found in the Apple Watch bands, demonstrating that the Watch is a fashion accessory worn on one's body and on display to the world. In a way, watch bands can be thought of as a form of software. It is perhaps fitting that with the Hermès partnership, Apple introduced leather watch bands in addition to software specifically designed for the Hermès collection. 

The end result, and one that we find ourselves in the early innings of, is a watch industry coping with the prospects of adding additional utility on the wrist. The Apple Watch draws into question how timelessness and craftsmanship should enter the buying equation (both are now largely marginalized in their current form). While some still think certain segments of the luxury watch market will be able to ignore the smartwatch movement, the aggressive moves Apple is making in the fields of traditional luxury, including the Hermès partnership, should serve as an indicator that few watch makers will be able to avoid the future brought on by software on the wrist. 

Marginalizing the Auto Industry By Looking Inside

With the automobile, Apple will once again look to position good design to marginalize a legacy auto industry that is more than 100 years old and has played a defining role in how we live our lives. The modern day automobile is not intuitive. Drivers need to learn to operate an automobile. Passengers have to conform to a car's existing seating arrangement with only marginal modification. Software has the potential to change all of these limitations. 

While Tesla has become a pioneer in electric vehicles and BMW continues to slowly build momentum in the space, both companies have not actually altered the automobile's fundamental purpose. Nowhere is this seen more than inside the Tesla Model X and BMW i3. While the dashboards have seen a change, in Tesla's case most of the dials and knobs having simply been converted into software and placed on a large tablet. There is much room for improvement. 

The way we think about automobiles today will be different than how we look at the automobile in the future. Good design is powerful enough to alter our prevailing attitudes and views of a product. Simply put, we are being held back by our prevailing attitudes of what an automobile is. With Apple Car, Apple would reposition the car as a connected room on wheels. The car interior is being held back by both legacy automobile design and the lack of software. Take into account how software holds the potential to add magic to a user's iPhone or iPad, and the same can apply to the experience in a car. We are still stuck in the era of trying to improve the smartphone keyboard when it's time to drop the keyboard altogether. This would mark a significant departure for an auto industry that has rode the combustible engine to the end of the road. 

Good Design Is All About Taking Risks

The one recurring theme found with all of Apple's products unveiled over the past 15 years is they were all high-risk. The iPod, iPhone, and iPad were all bets that the consumer would place value in doing something in a different way. The Apple Watch is a bet that people want additional utility on the wrist. Project Titan will be positioned as nothing short of a bet-the-company play in the automobile industry. Failure would be measured not only in billions of dollars, but more importantly, in time. 

Good design contains risk, the same risk that legacy companies did not want to take to move their industries forward. 

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