AirPods

AirPods will turn out to be one of the more strategically important hardware products Apple has released this decade. However, you would never know it judging from the way Apple unveiled the device last week. I suspect that was intentional. While the press remains focused on the short-term debate surrounding the iPhone's lack of a 3.5mm headphone jack, few have realized that Apple just unveiled its second wearables platform. 

AirPods 1.0

Apple introduced AirPods as a $159 solution to a problem that many iPhone users never thought they had: wired headphones. By accelerating the transition away from wired headphones, Apple is convinced that the user experience found with mobile devices will be improved. While AirPods are designed to handle most of the tasks currently given to wired EarPods, a look inside shows that Apple aims to do much more with the device. Apple's new W1 chip, the company's first wireless chip, addresses traditional shortcomings attached with wireless headphones. However, when the W1 chip is combined with additional sensors, including voice accelerometers, AirPods become Apple's latest product that capitalizes off of Siri.

After spending some time with AirPods in the demo room at the Apple keynote, there were four items that stood out to me:

  1. Easy to use. The AirPods setup was so incredibly simple (just open the AirPods charging case), I figured I must have been missing a step or two. It is clear that Apple spent much time addressing the known shortcomings found with many of the current wireless headphones available in the market.  
  2. Designed for Siri. AirPods are designed just as much for voice capture as they are for delivering sound. Even in the boisterous demo room, AirPods were able to capture my Siri command and then quickly provide the response from the nearby iPhone.
  3. The touch interface. A double tap on the outside of an AirPod activates Siri. It is easy to see how Apple will expand this touch interface in future hardware versions to activate or control additional actions. 
  4. Siri in my ear is more intuitive than in my hand or on my wrist. Using AirPods to query Siri and then quickly receive a response is incredibly intuitive, more so than my typical use case of looking at my iPhone or Apple Watch display to see Siri's written response. In addition, by having my primary interface with Siri be a small wireless device in my ear, I also gain an increased level of privacy. We will eventually get to the point at which I will be able to whisper or even mumble and AirPods will capture my command and deliver a Siri response. This will make the behavior of talking across the room to my iPhone or Amazon Echo seem downright archaic. 

There is also much intrigue found not just with the AirPods themselves, but also with the charging case. The AirPods case contains enough battery life for 24 hours of listening time while AirPods provide up to five hours of listening time on one charge. This means that I will be able to use the case for up to four to five quick recharges. (A 15 minute recharge will be enough for 3 hours of listening time). Apple ID appears to be telling us that AirPods are designed to be charged while not in use but if in a bind, an emergency recharge is possible. We see this same thought process when looking at the design given to the Apple Pencil and Magic Mouse 2.  

A New Wearables Platform

AirPods are not just a pair of bluetooth headphones or an iPhone accessory. Instead, AirPods represent Apple's second wearables platform. When thinking of AirPods in this way, it becomes much easier to envision where Apple may bring the product category over time. Not only will Apple expand the functionality found with AirPods, which is obvious, but there is opportunity for Apple to introduce a range of AirPods models that share a design language. 

Consider how far Apple has pushed its first wearables platform, Apple Watch, in just 16 months. The Apple Watch is already a $10 billion business. Apple now has five distinct Apple Watch models ranging in price from $269 to $1,499 and dozens of SKUs. While each model has the same design language (rectangular watch face and interchangeable bands), there are also key differences when it comes to features and functionality. In addition, Apple has been aggressive in building out the Watch ecosystem by releasing various Watch bands and other accessories.  

Apple's First Wearables Platform (September 2016 - 16 Months after Launch)

I expect AirPods to follow a similar pattern as Apple Watch. Additional models will eventually be introduced to address a wider portion of the wireless headphone market. While there will be some commonality between models, such as containing basic health and fitness monitoring capabilities, there will also be models that will be able to handle more differentiated use cases for certain environments such as schools and the workplace or for specific activities like running. Apple included its W1 chip in a few models of wireless Beats by Dre headphones. This move, while unusual for a company like Apple, does suggest that Apple has the intention of eventually expanding the AirPods line to include a range of models.

While Apple's two wearables platforms are inherently different from each other based on how they are designed for different sensory inputs, the two are in fact complementary to each other. The Apple Watch is designed to take advantage of the wrist's superior line of sight. This explains the device's rectangular display, designed to show as much text and other consumable information as quickly and efficiently as possible. Meanwhile, AirPods are designed to capitalize on the very powerful notification capabilities found with the human ear.

Items that are currently given to Apple Watch, such as tap notifications, may end up making much more sense for a device like AirPods, while Siri responses such as location or sports scores make sometimes make sense to be shown on an Apple Watch display instead of simply through voice in the ear. Apple's two wearables platform may end up working hand-in-hand, or maybe I should say wrist-in-ear, to provide a seamless user experience based on the most personal tech gadgets that Apple has ever sold. 

Strategy

The product strategy behind AirPods is based on what I coined the "Apple Experience" era. (My article introducing the term can be read here.) Apple will move beyond the iPhone by offering users the ability to create custom Apple experiences involving various form factors and software platforms. Apple services will help to connect everything together. 

There is a very straight-forward premise underlying the Apple Experience era: The iPhone will not be the hub of everyone's digital lives. This may seem counterintuitive considering that the iPhone has become the most valuable computer for hundreds of millions of users. However, it is this greater dependency on iPhone that opens the door for new, more personal products to flourish.

Just as our iPhone has become more powerful and capable over the years, the percentage of our daily tasks and responsibilities that we give to iPhone has been on the rise. The ongoing debate as to whether an iPad can handle all of the tasks given to a Mac ignores the fact that many have already positioned an iPhone as being able to handle many Mac tasks. We saw a few examples last week during Apple's keynote of how this trend is only going to intensify going forward. For example, the iPhone 7 Plus has a dual-camera system capable of capturing depth of field. The possibilities associated with that kind of technology could very well represent the next wave of smartphone innovation. 

While this increased functionality will increase the iPhone's value to hundreds of millions of users, it sets in motion the scenario in which room is created for new personal technology devices to begin to handle some of the more simpler tasks currently given to iPhone. For example, instead of looking at our iPhone to see who sent that incoming email, we can quickly glance at the notification on our wrist saying we received a new email. Instead of looking at our iPhone to see if we are at the right location for lunch, we get a small notice from Siri in our ear that we need to walk another two blocks for lunch. It's not that the iPhone will become less valuable in these scenarios. Rather, the value found with more personal gadgets will increase. 

By allowing consumers to pick and choose which products will handle their technology needs, we see the Apple Experience product strategy beginning to come to life. For some people, the iPhone will remain the primary hardware in their lives while others will find that Apple Watches and AirPods make much more sense for their lifestyle. We already see this evolutionary phenomenon materializing with the rise of wrist wearables. AirPods will usher in a new group of wearables that also begin to handle tasks formerly given to iPhones. 

Writing Is on the Wall

Apple is officially positioning AirPods as the beginning of the end of wired headphones. I would go much further. AirPods are the latest clue that the post-iPhone era is approaching. The writing is on the wall. A pair of AirPods (or even just one AirPod in an ear) and an Apple Watch with cellular connectively will eventually be able to handle many of the most popular tasks currently given to an iPhone.

 
 

It will begin with simply leaving the iPhone at home while taking Apple Watch and AirPods on a run. Then it will expand to being able to leave the iPhone at home when running a quick errand. Soon, the iPhone will become the dedicated device for tasks like watching video and writing emails. Eventually, the iPhone will begin to be treated like an iPad or Mac, serving as the device we turn to for those times we need a more powerful device. All the while, more and more tasks are given to Apple Watch and AirPods. 

Throughout this process, Apple services such as Siri, iMessage, and Apple Maps will play a big role in making this transition away from iPhone possible as the very nature of computing tasks are simplified. As third-party developers embrace Apple services in new ways, the way we interact with these services will also change. 

Apple is learning from lessons experienced with the Apple Watch to approach AirPods in a much more modest way as seen with the way management discussed the product on stage last week. AirPods are being given a very simple directive today. It may be difficult to believe, but AirPods contain the potential to eventually become a more important product for Apple than even Apple Watch. Many possibilities are created by having Siri in our ear. AirPods are a very big deal. 

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The Apple Services Myth

The narrative surrounding Apple Services has taken on a life of its own. While many people think Apple is moving to embrace a more services-oriented culture in response to slowing iPhone sales, the reality is much different. It's time to dispel the myth that Apple is becoming a services company. 

The Myth

Apple Services was thrown into the spotlight this past January when it became apparent that Apple would soon report its first year-over-year decline in iPhone sales. In an effort to get Wall Street to focus on something other than slowing hardware sales growth, management began to weave a new Apple narrative involving terms such as "installed base related revenue" and "installed base related purchases." Apple's goal was to provide Wall Street with a different way to think about Apple's business. 

The plan made sense on paper. Apple had amassed a loyal customer base of more than 750 million people spending an increasing amount of time and money on iOS apps and content. Apple was sitting on a $20 billion per year stream of services revenue growing at 20% per year. 

However, many company observers misinterpreted the change in narrative as Apple looking to pivot into a services company. Given Facebook's and Google's successful narratives on Wall Street based on recurring revenue streams, it was thought that Apple management must be trying to follow a similar path.

The Apple Services myth was born. We have gotten to the point where seemingly every report chronicling iPhone sales declines quickly turns to Apple's supposed push into services. Articles about slowing Apple hardware sales include boilerplate language about management looking to boost recurring revenue streams. Relatively minor Apple moves such as bringing paid search to the App Store are now being classified as signs of management's new strategy of becoming more like a services company.

The Actual Story

Apple's original services narrative has been taken completely out of context. Management's goal in pointing out service revenue was to emphasize the value found within the iOS ecosystem, not to explain an upcoming pivot away from hardware.

Here's Tim Cook on Apple's 1Q16 earnings call explaining Apple's services business: 

"[A] growing portion of our revenue is directly driven by our existing install base. Because our customers are very satisfied and engaged, they spend a lot of time on their devices and purchase apps, content, and other services. 

They also are very likely to buy other Apple products or replace the one they own. And because of the enduring value of the device, their replacing is likely higher to be given or sold to someone who will also love and use it often. 

So, as a result, our install base has been growing very fast and has recently reached a major milestone, crossing 1 billion active devices for the first time. This is an unbelievable asset for us. Because our install base has grown quickly, we have also seen an acceleration in the growth of our services business, another large and important source of recurring revenues."

Cook is making the case that Apple's service business is seeing strong growth because of the growth in the install base driven by hardware sales. Nowhere did Cook discuss a new Apple directive aimed at increasing services revenue. Specifically, Cook is taking the information found in Exhibit 1 and flipping it on its head.

Exhibit 1: Apple Revenue

At initial glance, things look pretty grim for Apple with sizable year-over-year revenue declines expected in every major hardware segment in 2016. However, one fact that isn't easily visible in Exhibit 1 is the amount of new people Apple added to its installed base over the past year. I estimate the iPhone alone is responsible for adding nearly 100 million new people. In terms of unit sales growth, this may not be enough to keep the iPhone in growth territory, but it sure goes a long way in eventually boosting services revenue as Apple positions apps, content, and services such as Apple Music to these 100 million new people. Cook wanted to tell Wall Street to look beyond declining hardware sales and instead think of this installed base growth and the implications it has on Apple's recurring revenue stream. 

Services Revenue

A closer look at Apple's financials goes a long way in demystifying the Apple Services myth. Exhibit 2 highlights the growth in services revenue since 2010 in relation to Apple's hardware revenue. The ratio between the two has actually declined over the past six years. In 2010, Apple services represented 14 percent of Apple's hardware revenue, lower than the 12.5 percent expected in 2016. This may be quite shocking to those who figured Apple has been focused on growing its services business over the years. 

Exhibit 2: Apple Revenue (Services vs. Hardware)

However, circling back to Cook's actual services narrative, the point isn't that Apple has been focused on growing its services business but rather that strong services performance is an outcome of strong hardware sales.

Apple is making the claim that the much higher "red" bars found in Exhibit 2 denoting Apple's hardware sales will eventually end up boosting Apple's services revenue as the installed base grows and people spend more time and money in the Apple ecosystem. Apple hardware is needed to grow Apple Services. Instead of Apple becoming a services company, Apple will continue to be an experiences company selling hardware products that include Apple services. Only when this occurs can Apple support a larger recurring revenue business in terms of apps, content, and services. 

Apple's Services Goals

Even though Apple is not becoming a services company, it is incorrect to assume that there isn't a role for services to play within the Apple ecosystem. Specifically, Apple has had two long-standing goals when it comes to services: increase the value and functionality of Apple hardware and leverage Apple platforms by delivering content to users. 

Increase Hardware Value and Functionality. Management looks at services as a key differentiator that helps to increase the value found with Apple hardware and software. Services such as Apple Pay, iCloud, App Store, iMessage, and FaceTime are meant to make Apple hardware more functional. If a consumer has the choice between an iPhone and a competing smartphone, Apple wants the services found on iPhone to give the device the edge. 

Apple Services are not built to be stand-alone profit centers. Instead, their value is found by increasing the value of Apple hardware. The two complement each other. Without one, the other becomes less valuable.  

As an example, it is doubtful that Apple Pay, given the service's current economics, will become a revenue driver for Apple anytime soon. Apple users would need to transact more than $1 trillion through Apple Pay for Apple to earn $1.5 billion. However, the presence of Apple Pay may have played a role in Apple selling hundreds of millions of iPhones for approximately $300 of gross profit per device. In addition, some of the 15 million Apple Watches that Apple has sold to date may have been bought by people who were attracted to Apple Pay on the wrist. In a similar way, items such as iCloud and AppleCare service contracts, items within the "Services" line item, won't amount to much from a revenue perspective. Instead, these services play an indirect financial role by straightening the Apple experience and contributing to Apple hardware sales. 

Even services such as Siri, iMessage and FaceTime, despite serving hundreds of millions of users, currently don't contribute directly to Apple financials. Instead, Apple's goal is to position these Apple-exclusive services as ways of increasing the value found with Apple hardware. For Apple to actually become a "services company," not only would the way Apple approach services need to change, but the company would inherently be placing less importance on hardware. This isn't going to happen.  

Delivering Content. The second goal Apple has for services is to be a major player in delivering content to users. This is not a new Eddy Cue directive given priority due to slowing iPhone sales. Instead, Apple has had a long-standing ambition of leveraging its platforms to become a leading content distributor for music, video, and apps. 

Apple has been dedicating significant resources to make the jump from its iTunes empire where paid downloads ruled the day to the new frontier found with streaming. With Apple Music, Apple is looking to own the entire music industry by removing oxygen from the paid streaming market. We see Apple leveraging its balance sheet to obtain artist exclusives and in the process, become a type of music label. The Apple Music/Frank Ocean exclusive was a result of Ocean working with one person from Apple with the goal of trying something unique and different. 

Apple is also displaying all of the signs indicative of a broad push into the paid video streaming industry. Shows such as "Planet of the Apps," and Dr. Dre's "Vital Signs" have the markings of being test runs for what likely will be Apple's plan for investing in a range of original content programming. Similar to Apple's approach to music, Apple would aim to become a big player in video streaming. Apple's goal by getting into original content programming is to speed up the process of apps becoming the main way content is delivered to Apple users. 

The primary reason Apple has been involved in delivering content to users is that  the company is well-positioned to leverage its platforms (nearly 950 million iOS devices, 95 million Macs, and 25 million Apple TVs) to deliver high quality content to hundreds of millions of users. Having Apple Music work with other Apple services such as Siri for hundreds of millions of users gives Apple Music an advantage that competitors lack. 

One potential wildcard concerning Apple and content services involves content bundling. It is easy to envision Apple eventually offering a content bundle subscription that provides a consumer access to all of Apple's content including Apple Music and a future Apple video streaming service. While this wouldn't change Apple's approach to services, it would go a long way in demonstrating the value found in the Apple installed base and broader ecosystem. A bundle may end up being one of the largest Trojan horses in the media entertainment business as Apple could add additional paid content to this bundle over time. 

Doubling Down on Hardware

Apple isn't turning into a services company. The narrative that Apple management tried to sow earlier this year with Wall Street wasn't meant to foretell a shift to new recurring revenue streams. Instead, Apple wanted to give investors a different way to think about Apple hardware sales. Apple can still grow the installed base despite year-over-year hardware sales declines. 

It may seem counterintuitive, but given the way Apple is approaching services (increasing hardware functionality and delivering content to users), management is actually doubling down on hardware. Without hardware, Apple's services business would lose much of its value. 

It is telling that Apple management curtailed its service narrative on the 2Q16 and 3Q16 earnings conference calls. I suspect this was done to slow what had become a services narrative that was being misinterpreted outside of Apple. There is a critical role for services to play within Apple. When looking at Apple's future with Project Titan, services such as ridesharing and new ownership models may play a large part in increasing the value of an Apple Car. However, it would be incorrect to say Apple will become a services company. Instead, Apple's goal will continue to be to sell products that impact people's lives. 

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Jony Ive Is Making People Uneasy

Apple pessimism is on the rise. New Apple products are being questioned like never before. Even some of Apple's most loyal customers are beginning to wonder about Apple's direction. While many are directing criticism towards Tim Cook, nearly all of the criticism pointed towards Apple can in one way or another be traced back to a different person: Jony Ive. 

Apple Power Brokers

The two most powerful people at Apple are Tim Cook and Jony Ive. While Cook is tasked with making sure the Apple machine is being run by the best team possible, Jony's role is much more abstract. Cook aims to foster collaboration at the top of Apple's functional organizational structure. If something goes wrong, much of the criticism is quickly pointed at either Cook or one of his top lieutenants. (Phil Schiller and Eddy Cue seem to take the brunt of the criticism.) Cook has also taken on the more traditional CEO role of representing Apple in the outside world. 

However, the one area Cook does not have complete control over is product strategy. That distinction belongs to Jony. It may seem hyperbolic to consider Jony the most powerful person at Apple. He no longer spends much time managing anyone on a day-to-day basis. He doesn't speak on Apple's earnings conference calls. Wall Street knows very little about him, and neither does Silicon Valley. In fact, following his recent promotion to Chief Design Officer, Jony doesn't even spend as much time at Apple HQ these days. Yet Jony has such a significant influence over Apple's product strategy, it is safe to say we are firmly within the Jony Ive era at Apple. 

Design Led

Jony holds an incredible amount of power because Apple is a design-led company. Apple's functional organizational structure and culture are set up in order to give the Industrial Design (ID) group absolute power. ID holds more power at Apple than any other group. 

This structure was put in place more than 15 years ago with the iMac being the first product to take advantage of this new culture. Up to the late 1990s, engineers held the most power at Apple. Designers were merely tasked with skinning Apple products created by engineers. With the iMac, ID was afforded the freedom to move ideas from conception to reality without compromise. While Steve Jobs was the primary architect of this new power structure, the relationship he had with Jony undoubtedly played a role.

 
 

This transition from an engineering-led organization to one based around design was not easy, leading to high turnover throughout Apple's engineering ranks. Jon Rubinstein and Tony Fadell are widely believed to have been pushed out due to Apple's design-led power structure. The primary motivation for Steve Jobs to give ID absolute power was to allow Apple to make big bets and not have them get watered down by compromises that arise from having too many cooks in the kitchen. Jobs saw design as the best way to keep the user experience the most important priority during product development. ID was given the task of overseeing the user experience. 

Doubling Down

Much of the criticism pointed towards Apple today is a by-product of Apple executives doubling down on Apple's design-led philosophy. The logic behind the move is pretty clear: The strategy works. Jony, Richard Howarth, VP of Industrial Design, and the rest of the ID team have more power today than at any other point in Apple history. Jony grabbed additional power during the first major management reshuffle under Tim Cook in 2012. His promotion to Chief Design Officer in 2015 reflected Jony receiving even more control. In fact, Jony has so much control, he now is able to spend more time away from Apple HQ (which I suspect is related to Project Titan). 

ID has complete reign over Apple. This may seem like an overstatement, but take a look at how ID has impacted Apple's overall product direction during the Tim Cook era.

  • Apple's move into wearables, health, and fashion? Jony and the ID team. 
  • Apple's move into cars and transportation? Jony and the ID team.
  • Apple's eventual move into clothing? Jony and the ID team. (Give it a few years.)

This isn't to suggest that Apple isn't empowering other groups within Apple, including those focused on developing services, machine learning and other core technologies. In addition, it would be a disservice to not point out the hardware engineering talent Apple has been accumulating. These groups work closely with ID on turning ideas into products, often creating brand new manufacturing apparatuses from scratch. However, at the end of the day, Apple executives depend on ID to look after the user experience like never before. 

Examples of Criticism

It would be incorrect to position Jony as single-handedly guiding every Apple product from conception to shipped product. Not only would such a statement grossly mischaracterize how much input actually comes from the rest of the ID group, but Jony has traditionally doled out the lead designer role for each product to different people. For example, Howarth was tasked to oversee iPhone design and ended up playing a crucial role in iPad, along with Christopher Stringer. 

Instead of playing a day-to-day role, Jony's influence at Apple reveals itself in terms of the company's overall product direction and narrative. 

There are five examples of how Jony is making people extremely uneasy. 

1) iPhone. There is a growing amount of criticism being thrown at Apple concerning the iPhone's design direction: 

  • Apple is looked at as being too focused on device thinness instead of pushing for better battery as if the two attributes share some kind of direct relationship.
  • Apple's infrequent hardware refresh cadence has led some to question if Apple is losing its smartphone design edge to Samsung.
  • Apple's decision to eliminate the 3.5mm headphone jack from the new iPhones has led many to question if Apple executives have lost their minds. 

For each one of these items, criticism can be traced back to Jony. We are merely seeing Apple continue on the same design path that they were on when the first edition iPhone was launched in 2007. Jony's long-standing goal is to have the iPhone's screen take precedence above all else. This means that ID will likely have the iPhone evolve into nothing more than a display with as few physical distractions or unnecessary additions as possible. Most ports, buttons, and excess bezel will be removed. The design changes rumored to be included in the 2016 and 2017 iPhone models certainly seem to fit ID's long-term goal for iPhone. 

2) Mac. The sheer panic that the lack of Mac updates has caused some people is nothing more than ID shuffling resources and priority. Instead of updating older Mac models merely for the sake of updating, something that isn't that difficult to do, Apple continues to push the boundary with the Mac by mostly focusing on design and the user experience. We saw this firsthand in March 2015 with the new MacBook. All signs point to the second phase being announced soon with an updated MacBook Pro. To complete the Mac line, the iMac will eventually see a redesign in order to give the product an even firmer position in an increasingly mobile world where smaller screens are grabbing all of the attention. Overall, the Mac still has a role to play, but I suspect its priority is continuing to fade in the eyes of ID. This is classic resource allocation at Apple as devices capable of making technology more personal take priority.

MacRumors Buying Guide for Mac

Source: MacRumors

3) Apple Watch. Apple's entry into the wearables space and corresponding deeper relationship with fashion and luxury themes originate with Jony. While a growing number of Apple users are poking fun at the amount of attention Apple has been giving to Watch bands over the past year, the bands go a long way in explaining how Apple managed to sell 15M Apple Watches to date. More importantly, the broader Apple Watch category highlights Jony's quest for using design to make technology more personal. Apple is clearly positioning Apple Watch as the evolutionary outcome for iPhone, something that the vast majority of the population do not yet see as a possibility. 

4) Accessories. New Apple accessories including the Apple Pencil, Magic Mouse 2, and iPhone Smart Battery Case have been ridiculed by many in the tech press. Some people are wondering if Apple has given ID too much power as no one wanted to say "no" to these accessories and their seemingly awkward charging experiences. All of those accessories can in one way or another be traced back to Jony. The Apple Pencil has many trademarks of Jony, including how the top cap is designed to be played with in hand. The Magic Mouse 2 charging position makes plenty of sense when compared to the older battery-powered Magic Mouse. (A one-minute charge gives a half a day's worth of usage.) Listen to Above Avalon Podcast Episode 45, "People Love Accessories," for a more detailed discussion on Apple's accessories.  

Island of "Misfit" Apple Accesories

 

Source: YouTube

 

5) Project Titan. While consensus is still coping with the idea that Apple is designing its own car and it took more than a year for some to wrap their mind around the idea, there is still an elevated sense that Apple must be very desperate to want to move into the auto industry. In reality, the Project Titan startup is a design-led initiative. This goes against prevailing wisdom in the tech industry that says the future of the car will be determined by autonomous driving. I disagree. Instead, design will be the factor that allows us to redefine the car. Jony and Marc Newson are likely the two most powerful people currently working in the car industry given their interest and expertise in industrial design, which includes working with new materials and manufacturing techniques. One of the key aspects of Project Titan will be coming up with new ways to manufacture car parts, a key strength of both Jony and Newson. 

Jony's Apple

One aspect of Apple that is rarely discussed is how the company has seen most of its success in a relatively short amount of time. In the span of just seven years, Apple unveiled three brand-new categories (iPhone, iPad, Apple Watch) that cumulatively bring in $150 billion of revenue per year.

Not enough time has passed for us to get proper historical perspective on how some of the decisions being made by Cook will end up impacting Apple. On paper, things look fine and all indications suggest Apple's product pipeline is healthy. However, it will take years to properly analyze the decisions Cook is making today.

However, when it comes to product strategy, I suspect that in a few years, when we look back at this current stretch, we will refer to it as the Jony Ive era at Apple. 

  • Existing products like iPhone and iPad are seeing evolutionary design changes that fit with Apple's long-standing design language put forth by Jony. 
  • Apple is embracing luxury in an entirely new way, all the way down to how it designs its brick- and-mortar locations and headquarters.
  • Apple is running quickly into automobiles and transportation, which has the potential to shape the direction of the company for the coming decades.

All of these changes are making people uneasy. Some think Apple's design-led culture doesn't fit within today's changing tech landscape. Others think Apple is running out of ideas. Instead, the opposite is true. By doubling down on design, Apple is placing a rather large bet. Apple executives think design will continue to allow Apple to remain focused on the customer experience. It is this customer experience focus that will then keep Apple relevant and able to ride the technology waves like no one has done before. It all comes back to Jony and the ID philosophy that is guiding Apple. If you have doubts about Apple, you probably are uncomfortable with Jony's vision for the company.

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The Art of Simplicity

Apple Watch and Apple Music shared something in common with each other in the beginning. They lacked simplicity. In an effort to give each product the best chance of success, Apple focused too much on telling a compelling story and not enough on letting the product tell its own story. This lack of simplicity explains how Apple Watch and Apple Music were called both resounding successes and utter failures during their first year. 

Early Criticism

At each step along the way, Apple Watch and Apple Music had their critics. Many claimed the initial Apple Watch keynote lacked direction, others thought the Watch didn't seem to do enough, and some claimed that the Watch's interface was too confusing. 

After just a few weeks on the market, it would have been an understatement to say that Apple Watch had become a polarizing product. While some people loved it, others thought it lacked the finish and attention to detail found in other Apple products. As Wall Street slashed Apple Watch sales expectations, what was once deemed the next big thing after iPhone quickly turned into nothing more than a footnote on Apple's quarterly earnings calls.

The Apple Music unveiling wasn't too different from the unveiling of Apple Watch. The introduction during the WWDC 2015 keynote was not good. In the following months, the press turned against the service with some referring to Apple Music as "cluttered," "awful," and even "broken." Reports of a confusing user interface and a list of random problems plagued Apple Music for most of its first year. 

Given how expectations turned sour for both Apple Watch and Apple Music soon after launch, one would have assumed each would end up being massive flops in the market. However, the opposite occurred. 

Successes

During the first 15 months on the market, Apple sold 14.5 million Apple Watches at an average selling price of $435 each. In addition, Apple sold at least five million extra Watch bands as Watch wearers embraced the idea of owning multiple bands. The Apple Watch is already a $10 billion business. It's difficult to describe this as anything other than a success. 

Apple Watch has become not just the best selling smartwatch, but one of the single-best selling devices worn on the wrist in history. In addition, there is growing evidence that Apple Watch has already begun to impact the Swiss Watch industry (evidence here, here, and here). It may be a distant memory now, but the wrist watch had been deemed mortally wounded by the smartphone as recently as a year ago. The percentage of people going around without a watch on their wrist was hitting multi-generational highs. The Apple Watch changed everything. 

Meanwhile, Apple Music garnered 15 million paying subscribers in its first year, a pace six times faster than that of Spotify. Even though music can be consumed for free at Spotify, YouTube, and Pandora, Apple was able to get 15 million people to pay as much as $120 per year to lease music. This is nearly twice the average amount spent per user per year in iTunes. More impressively, Apple Music's 15 million subscribers represents about 15% of all paid music streaming users in the world. 

Lack of Simplicity

How can Apple Watch and Apple Music appeal to millions of people yet be considered flops or failures by others? While high expectations and never-ending comparisons to iPhone success may have contributed to this unique dynamic, neither reason gets to the heart of the issue. 

Apple Watch and Apple Music lacked simplicity. This produced a situation in which the product's key attributes and value propositions resonated with some customers while others saw nothing more than unfinished products.

Simplicity allows a product to communicate with users. The result is a clear understanding of that product's perceived functionality and purpose. One way of accomplishing this is to develop a product in such a way as to allow that product's design to tell a story. Design isn't just about a product's physical attributes. It also involves how the product works. Apple has had success in the past when it comes to selling simplicity. 

  • iPod simplicity. The iPod was designed for one task: listening to 1,000 songs in your pocket. Everything about the device was geared toward making it easy to accomplish that one task. It would be incorrect to say that the device's functionality was limited due to its simplicity. Instead, the iPod became one of the most loved ways to consume music thanks to its click wheel and accompanying user interface.  
  • iPhone simplicity. The iPhone was designed to play music, surf the web, and make phone calls. As with the iPod, simplicity didn't lead the iPhone to be a comprised device with a lack of features. Instead, the iPhone became the most versatile, personal computer in history thanks to the new multi-touch user interface. 

The problem facing Apple Watch and Apple Music wasn't that their launch presentations weren't good enough or that they relied on ineffective marketing campaigns. Those items weren't able to explain the response these products received in the marketplace. Instead, Apple tried too hard during product development to tell a story in order to give each product a strong sales pitch at launch. 

With Apple Watch, Apple pushed the idea that third party apps would transform the device into a versatile gadget with lots of use cases. The thinking was that this would have the Watch appeal to a wide range of consumers. The app revolution had led to much success for iPhone and iPad, so Apple figured this would rub off on Apple Watch. The Watch's user interface was built around the idea of using apps on the Watch as if it was an iPhone or iPad. A honeycomb pattern of app icons was given nearly as much prominence as Watch faces. 

In essence, Apple tried too hard selling the Watch as a mini iPhone on the wrist with which users rely on lots of apps to get through their day. Much more problematic was that Apple never explained how apps would help Apple Watch tell its story. This dynamic made it difficult for consumers to understand the Watch's purpose. Was the Watch supposed to be used like an iPhone or was it some kind of fitness tracker with apps? 

With Apple Music, Apple's problem was more straightforward. Instead of launching Apple Music as an easy to use streaming service that placed an emphasis on music discovery through human curated playlists, Apple tried to make Apple Music a one-stop shop appealing to everyone. It suffered from a lack of purpose. One example of this was the Connect feature with which Apple Music users could follow their favorite music artists. As apps on the Watch may have made sense on paper, something like Connect seemed to initially make sense for Apple Music. However, adding an entirely new social layer within an already crowded app just didn't do much to convey Apple Music's fundamental purpose of making it easy to listen to music.

Solutions

One way to validate the claim that Apple Watch and Apple Music lacked simplicity is to look at this year's WWDC keynote (my full analysis from WWDC is available here and here). WatchOS 3 and the new Apple Music highlight that Apple was aware of a lack of simplicity and had been working for months on removing friction points.  

Apple Watch. After using the Watch for just a few days back in April 2015, it became clear that the device wasn't a regular watch. It was also obvious that it wasn't a mini iPhone. Instead, the Apple Watch was something different. A watch case containing a rectangular face, digital crown meant for scrolling, and sensors used to record data suggests the device had been designed to be a monitoring device. Users could monitor their health/fitness activity, incoming notifications, and other types of information including calendar items, directions, and mobile payments. The changes found in watchOS 3 are meant to allow Apple Watch to better tell its story as a monitoring device. 

Apple is now de-emphasizing apps in the new user interface, instead focusing on complications and Watch faces. Instead of selecting apps from dozens of small icons arranged in a honeycomb pattern, with watchOS 3, we primarily consume information through complications on Watch faces. This is why Apple made it much easier to switch Watch faces in watchOS 3. Even the Watch's side button functionality was altered to make it easier to consume information.

Apple Music. In the revamped Apple Music app announced at WWDC, Apple went back to the basics with the focus being on adding simplicity to the app. Refined tabs, including a more accessible music library as well as rethought "For You" and "Browse" tabs, make it easier to access the most important items. In addition, the Connect tab was removed and instead the functionality associated with Connect was positioned as more of a background item to the app. While there are still some questions as to font sizes and other design elements, it's difficult to argue that Apple didn't make it easier to discover new music daily. 

Simplicity Is an Art

The primary takeaway from Apple Watch and Apple Music lacking simplicity is that simplicity is an art. Simplicity could only be added to Apple Watch if the product had a design capable of telling a story in the first place. If the product is truly flawed, trying to add simplicity in later revisions or versions will lead to disappointment. Similarly, with Apple Music, Apple can only add simplicity to the service if Apple truly believes in using human curation to allow users to discover new music. 

It is easy to say that Apple should have done this or that differently with Apple Watch during the first year. Could Apple have highlighted different use cases? Would skipping third-party apps have led to much of a sales difference? These questions are irrelevant if the underlying product is not capable of conveying purpose in the first place. 

Looking ahead, when it is time for Apple to introduce new products and services, management will likely look at Apple Watch and Apple Music and remember that a product's value is derived much more from the story told through design than by the narrative created with a certain feature set. Without good design, simplicity is unattainable. 

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The iPad's Dark Days Are Over

After a tumultuous multi-year stretch that included massive unit sales declines, declining average selling prices (ASPs), and deteriorating margin trends, the iPad business has turned a corner. The combination of improving upgrade fundamentals, less severe iPad mini sales declines, and a stronger iPad lineup with the iPad Pro and accompanying accessories have positioned the iPad category that much closer to stabilization. The worst is likely over.  

The iPad's Early Potential

The iPad shot out of the gate like a rocket in 2010, instantly becoming the best-selling new Apple product in history. Considering that the iPad was an entirely new category positioned between an iPhone and MacBook, many were caught off guard by how consumers embraced the new form factor. As seen in Exhibit 1, initial iPad sales were nearly three times as strong as initial iPhone sales. Consensus even began to think the iPad would end up outselling the iPhone over time. Needless to say, iPad optimism was riding high. In just 10 quarters on the market, Apple sold 100 million iPads. It took Apple 16 quarters to hit the same milestone with iPhone.

Exhibit 1: iPad and iPhone Unit Sales Post Launch

The Turning Point and Dark Days

In November 2012, just two and a half years after launching the original iPad, Apple unveiled the lower-cost 7.9-inch iPad mini. The goal was simple: Prevent Android competitors from gaining traction under the iPad's price umbrella. Apple did not want to see a repeat of the 1990s all over again. This time it would be in the tablet space where Android would become the new Windows. 

While the iPad mini was well received with many in the press calling it the "real" iPad, the device ended up representing a turning point for the iPad business. After what appeared to be a very successful 1Q13 holiday season for the iPad thanks to the mini, Apple reported its first decline in iPad unit sales just two quarters later. Since then, the iPad business has experienced a brutal three-year stretch. 

The iPad's dark days had arrived. Heading into 2015, the iPad line consisting of iPad mini and iPad Air looked dated and out of place within Apple's evolving product line. This led many to conclude that the tablet may simply be a less attractive product category going forward in a world dominated by large-screen smartphones. In addition, iPad marketing just didn't seem to contain much of a punch. Many of the iPad use cases profiled could be handled just as well, if not better, with an iPhone. Unsurprisingly, iPad expectations turned remarkably low.

In 2013, Apple sold 71M iPads. Apple's 3Q16 marked the 10th consecutive quarter of iPad sales declines. Apple is now on track to report 46M iPad unit sales in FY16. As shown in Exhibit 2, this significant 35% drop in sales, spread out over number of years, has given the iPad a very ominous sales trajectory. 

Exhibit 2: iPad and iPhone Unit Sales Trajectories Post Launch

iPad Problems

There have been a number of factors put forth to explain the iPad's troubles. I suspect much of the iPad's difficult stretch over the past three years has been due to two overarching reasons:

1) Peak iPad Mini. As shown in Exhibit 3, the iPad mini form factor has experienced a more significant sales decline than its larger 9.7-inch sibling. According to my estimates, the iPad mini is responsible for approximately 70% of the iPad's overall sales decline since 2013.

The iPad mini form factor bore all of the competitive headwinds associated with larger screen smartphones, much more so than its 9.7-inch screen iPad sibling. I suspect the iPad mini initially benefited from interest in and curiosity for an iOS device that was bigger than the 3.5-inch and 4-inch iPhones at the time but smaller than the 9.7-inch iPad 2 and 3. Meanwhile, the iPad mini's low price and feature set positioned basic video consumption as a leading use case. This distinction meant that the iPad mini upgrade cycle was basically a myth. When an iPad is used for nothing more than video watching, there is little to no incentive to upgrade. 

Exhibit 3: 7.9-Inch iPad vs. 9.7-Inch iPad Unit Sales (TTM)

2) Longer Upgrade Cycle for 9.7-inch iPad. If 70% of the iPad's decline is due to the iPad mini, the remaining 30% relates to 9.7-inch iPad owners holding on to their iPads for more than two or three years. The iPad upgrade cycle is more like four to five years. The iPad 2, released in 2011, still represents 15% of iPads in use today. This elongated upgrade cycle meant that the 9.7-inch iPad would not follow in the steps of the iPhone, a device that saw sales benefit from a very short two-year upgrade cycle for years. Apple continued to do fine selling iPads to new customers. However, the lack of iPad upgraders meant it was that much harder for Apple to report year-over-year iPad sales growth. 

Signs of Improvement

Just as it seems like people have completely written off the iPad business for good, signs are beginning to appear that point to improving iPad fundamentals. In fact, I suspect the iPad's dark days are already over.  

Better Upgrade Fundamentals. The average age of iPads in use now exceeds three and a half years, as shown in Exhibit 4. This is one of the best developments for the iPad business in years. At the current rate, the iPad business is close to hitting its natural upgrade cycle cadence, likely in mid-2017 to early 2018. I estimate there are approximately 225 million iPad users out in the wild. Assuming the average iPad upgrade cycle extends out to five years, this means that Apple would have approximately 45M iPad unit sales per year just due to existing iPad owners upgrading their devices. Meanwhile, Apple is on track to report annual iPad sales of 45M units for 2016. This number includes both iPad upgraders and customers new to iPad. This suggests that Apple's iPad business is very close to approaching a natural sales run rate at which the combination of upgrades and sales to new users will lead to roughly flat sales growth year-over-year. 

Exhibit 4: Average Age of iPads in Use

One announcement from WWDC provided much credibility to the theory that the iPad upgrade cycle will top out around five years. iOS 10 will not be compatible with the original iPad, iPad 2, iPad 3, and iPad mini, iPad models that are six, five, four, and four years old, respectively. This means there will be approximately 65M iPads that will not get the latest iOS release. That is a very significant number of iPads. While it's wrong to conclude owners of those iPad models will rush out and buy a new iPad as a result of not getting iOS 10, it does provide a few clues as to how Apple is thinking about an iPad's useful life before turning into an inferior experience: between four and five years. 

Less Severe iPad Mini Headwinds. With the iPad mini contributing to 70% of the iPad's overall sales decline in recent years, there is evidence that the period of massive iPad mini sales declines is coming to an end. Given current iPad mini sales, there is simply less room for the device to register the same kind of sale declines seen in the past. Accordingly, overall iPad sales will benefit from no longer having a massive iPad mini sales headwind. For example, in 3Q16, the iPad mini likely represented less than 20% of total quarterly iPad sales. While I remain confident that we have seen Peak iPad Mini, I do not expect iPad mini sales to go to zero. The device represents one of the low-cost entry-level devices for the iOS ecosystem, which will appeal to millions of consumers each year. 

Stronger iPad Lineup. The 9.7-inch and 12.9-inch iPad Pro and accompanying Apple Pencil and Smart Keyboard accessories represent the iPad's future. One consequence of iPhones becoming larger and MacBooks becoming smaller was that the old iPad line felt stale and out of place. Apple needed to shift its iPad strategy to the high-end, as detailed in my article, "Finding iPad's Future," from August 2015. This would be the opposite of the iPad strategy kicked off with the iPad mini at the end of 2012. Not only do the Pros serve as the first genuine iPads worth upgrading to for existing 9.7-inch iPad users, but they also give Apple a much better story to tell in terms of marketing. Apple's latest iPad commercial demonstrates this as Apple is explaining the iPad in a whole new way. The iPad is no longer the product that exists between a smartphone and laptop. Instead, the iPad is a computer. 

iPad Sales Stabilization Is Near

As a very early sign that all of these positive developments are coming together, Apple just reported the best quarter for iPad unit sales growth in 10 quarters, highlighted in Exhibit 5. The 9.7-inch iPad Pro launch certainly played its role. While sales are still declining, on a revenue basis, the iPad business registered its first year-over-year increase in 10 quarters. This is the clearest sign in years that iPad is approaching stabilization.

Exhibit 5: iPad Unit Sales Growth

Even though iPad sales declines will likely continue for a few more quarters, the probability that the iPad business will see significant sales declines from current levels has been reduced. Meanwhile, ASP and margin trends look to have long-term tailwinds as well. Looking ahead, the 40M sales milestone is the leading candidate for a natural sales run rate for the iPad business. This means that iPad sales would have to fall another 10% before reaching that level. To put that decline in perspective, Mac sales have declined more than 10% for the past two quarters. While the days of strong 30-40% unit sales growth will likely never make a return with iPad, it's clear that the iPad will soon enter a new stabilization phase. The dark days for the iPad are over. 

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Apple 3Q16 Earnings Expectation Meters

Expectations headed into Apple's 3Q16 earnings report are at a multiyear low. I expect Apple to report double-digit unit sales declines in each one of its major hardware categories. In addition, management's guidance will likely portray another quarter of double-digit revenue declines. Apple management has an opportunity to take advantage of low expectations to work on weaving a new Wall Street narrative around the company and stock. In addition, Wall Street is eager to hear management explain many of the moving parts found in the iPhone business.

Exhibit 1: Above Avalon's AAPL 3Q16 Estimates

My full perspective and commentary behind all of my estimates are available in my 3Q16 Earnings Preview available here for Above Avalon members. (Click here for more information on membership). 

Apple is expected to report its weakest quarter for iPhone unit sales growth since the iPhone has been launched. Management's guidance implies approximately a 20% year-over-year unit sales decline. There are a number of warning signs appearing in the iPhone business which is making growth much harder to achieve. 

Exhibit 2: iPhone Expectation Meter (3Q16)

I expect the iPad and Mac to join the iPhone in terms of double-digit unit sales declines. While the iPad's problems remain structural in nature as the smartphone has impacted the tablet category's ultimate sales trajectory, the Mac is suffering from a lack of hardware updates. This negative development should resolve itself in a few months as Apple is expected to unveil updated Macs at its September hardware keynote. 

Exhibit 3: iPad and Mac Expectation Meters (3Q16)

Apple will report a year-over-year decline in Apple Watch sales. My 1.6M Apple Watch unit sales estimate implies a 38% decline from 2Q15 results. While on the surface this may seem like a surprising development, Tim Cook indirectly implied Watch sales would decline year-over-year when comparing the Watch to the iPod.  Apple expects to sell approximately 40% of its annual Watch shipments around the holidays. 

Exhibit 4: Other Products and Apple Watch Expectation Meters (3Q16)

Management's revenue guidance for 4Q will likely contain a portion of opening weekend sales for new hardware announced at the September keynote. However, the variable that will likely end up playing a larger role for revenue guidance will be any perceived drop off in sales in July and August as customer anticipation builds for new iPhones, Apple Watches, and Macs in September. 

Exhibit 5: Revenue and Gross Margin 4Q16 Guidance Expectation Meters

Apple is currently undergoing a significant expectations reset on Wall Street. The company is transitioning from a growth stock to a value stock. One consequence of this current situation is that Wall Street's reaction to Apple earnings may end up surprising many observers. A big bump up will serve as evidence that Apple's transition to a value stock on Wall Street is complete and that the company has begun to be judged by metrics other than iPhone unit sales growth. A drop in share price would reveal that there are still a few large shareholders that need to adjust their positions due to Apple becoming a value stock. 

Above Avalon members have access to my detailed Apple 3Q16 earnings preview (five parts):

  1. Methodology
  2. Services, Mac, iPad, Apple Watch
  3. iPhone
  4. 4Q16 Guidance
  5. Thoughts on AAPL

Members will also receive my exclusive earnings reaction notes containing all of my thoughts and observations on Apple's earnings.

To access my Apple earnings preview and receive my earnings reaction notes, become a member by visiting the membership page. 

The Great Apple Expectations Reset

Apple is in the midst of its weakest growth period in 15 years. Despite deteriorating financial trends, Apple's stock has held up remarkably well in 2016. There are a number of clues that suggest we are in the latter stages of a major Apple expectations reset on Wall Street. The implications are significant not just for AAPL, but also for the amount of leeway given to Tim Cook and Luca Maestri over the next two to three years. 

AAPL: The Growth Stock

On May 22nd, 2015, Apple's prospects were running high. AAPL shares had just closed at an all-time high of $132.54, giving the company a $769 billion market cap. Excluding the cash and cash equivalents on the balance sheet, Apple's enterprise value was $619 billion. Three weeks earlier, Apple had reported record 2Q15 earnings. The iPhone 6 and 6 Plus drove strong 40% year-over-year growth in iPhone unit sales. In addition, Apple had just experienced its largest product category launch ever with Apple Watch. Expectations were that the Watch would quickly become a key Apple revenue driver. 

While a few analysts voiced concerns about Apple's dependency on the iPhone for revenue and profits, there were others projecting Apple would become the first trillion dollar market cap company. Apple financial expectations were quite high as many analysts and investors were modeling 20%+ EPS growth in 2016 and 2017. Apple was the largest growth stock on Wall Street. 

The Apple Reset

Over the subsequent three months following AAPL's record-high close in May 2015, AAPL shares declined 20%. The Chinese stock market had crashed, and fears began to grow that there could be a spillover effect on iPhone demand. Wall Street eventually began to doubt whether or not Apple would be able to maintain its revenue and earnings growth rates given China's slowing economy.

In October 2015, only a few weeks after the iPhone 6s and 6s Plus launch, reports surfaced that the new iPhones were not selling as strongly as expected. While the iPhone business had contained so much promise just a few months earlier, things were beginning to look much more fragile. Analysts began to cut their iPhone sales estimates on growing fear that the iPhone business was headed into a rough patch. 

Apple's 1Q16 earnings report back in January confirmed that fear. Apple was able to grow iPhone sales by a mere 311,000 units year-over-year, and management's 2Q16 guidance implied Apple would report its first year-over-year decline in iPhone sales. Meanwhile, Apple Watch sales were not living up to Wall Street's lofty expectations.

In the days following Apple's miserable 2Q16 earnings report this past April, expectations took another step down, resulting in AAPL shares bottoming at $90.34 on May 12th, 2016. During the twelve-month span ranging from May 2015 to May 2016, AAPL shares had declined by 32%, wiping out $271 billion of market cap. Excluding cash and cash equivalents, Apple's enterprise value had declined by $274 billion. Apple had just gone through a year-long expectations reset concluding with Apple no longer being considered a growth stock.

The Expectations Game

Apple's reset over the past year has been guided by Wall Street's expectations game. Analysts and investors make projections about a company's future stream of cash flows and earnings. These expectations help explain how one company's stock can perform poorly the day after reporting strong earnings while another company's stock can outperform the market after posting a weak earnings report. 

Apple suffered from two primary problems pertaining to the expectations game. Management never had a cohesive narrative for how investors and analysts should judge Apple's financial success. In addition, there was evidence that Apple management was caught off guard by slowing iPhone 6s and 6s Plus sales, which made it difficult to communicate clarity with top Apple shareholders and analysts.

Establishing a Narrative. A narrative provides a management team an avenue to explain its business to analysts and investors. Companies can use everything from SEC filings to the prepared remarks found in the beginning of a quarterly earnings conference call to help establish and then nurture a narrative. The strongest Wall Street narratives are those that are easiest to explain and understand. Examples of well-received narratives include Facebook owning the most attractive mobile properties for advertisers or Amazon forgoing near-term profits in order to invest in long-term investments and bets. For each narrative, investors monitor certain financial metrics in order to judge how a management team is performing in comparison to benchmarks. 

When it came to Apple, the company has never had a functioning narrative on Wall Street. Instead, the only way investors have come to judge Apple's success has been to look at whatever hardware product was the top seller at any given moment. In the early 2000s, it was the Mac and iPod. Eventually, the focus turned to the iPhone, and soon, iPad. Once the iPad ran into sales trouble, the iPhone then became the center of attention. Nothing else mattered but iPhone unit sales growth. This was a recipe for disaster considering how Apple's business model is based on profit share, not market share. Once iPhone unit sales growth slowed, the closest thing Apple had to a Wall Street narrative fell apart. 

Managing Financial Expectations. Companies have additional tools at their disposal to help guide investor's near-term expectations. Providing financial guidance is one of the more common methods used to establish an adequate framework for expectations. Management teams can issue estimate ranges for what they think is achievable in terms of revenue, income, or metrics such as monthly users. Another option that is less talked about, but at times far more effective, is for management teams to keep open communication channels with top shareholders and financial analysts.  

Even though Tim Cook and Luca Maestri have been providing quarterly guidance as well as communicating with top shareholders, the two were not able to adequately manage financial expectations surrounding the iPhone business. There is evidence that even Apple management themselves were caught off guard by slowing iPhone sales and that this contributed to the lack of proper messaging and explanation. 

AAPL: The Value Stock

After a year-long expectations reset that saw a 30% drop in Apple's stock price, there is evidence that AAPL is now considered a value stock on Wall Street. This new distinction is likely playing a big role in Apple's resilient stock price in the face of deteriorating financial trends. As AAPL shares declined over the past year, Apple's shareholder base underwent significant changes. Investors focused on earnings growth sold their shares to investors primarily focused on value. This shareholder rotation has led to the average Apple investor now holding very different opinions about Apple and how to judge financial success.

In what will likely end up serving as a symbol of Apple's newly appointed value stock distinction, Todd Combs and Ted Weschler of Berkshire Hathaway bought a $1 billion stake in Apple in 1Q16. To have such value-oriented investors take a stake in Apple is quite telling. 

Implications

There are three key implications related to AAPL now being considered a value stock. 

Different Expectations. Given shareholder rotation, Apple now faces different expectations when it comes to its financial performance. Wall Street has become much more accepting of what was once unimaginable only a few months ago, iPhone sales declines. This change in expectations will play a role in Apple's earnings release next week as the company is expected to report the weakest quarter for iPhone sales performance since the product launched in 2007. (My complete Apple 3Q16 earnings preview is available here.)

Management Flexibility. Given the amount of shareholder rotation and reduced expectations surrounding growth, Tim Cook and Luca Maestri have been given additional time by Wall Street to position Apple for a post-iPhone era. It remains in Apple's best interest to come up with a long-term narrative that includes some aspect of hardware but is not based on unit sales. 

Capital Management. Apple's capital management strategy will play an increasingly important role for value-oriented investors. Apple's announcements surrounding annual dividend increases and share buyback authorization changes will likely garner much more interest. 

The Big Picture

Apple's stock has hit rough stretches in the past. However, this most recent drop and the resulting expectations reset stands out from the rest. For the first time, Wall Street is dealing with an Apple with declining revenue. In the past, Apple revenue declines were only discussed as worst-case scenarios. The reality of what is taking place in the iPhone business has likely shaken the AAPL investor base much more than any other event over the past 15 years.

While it may seem like this kind of expectations reset should have resulted in more than a 30% drop in Apple's stock price over the past year, I suspect Apple's share buyback program will provide some much-needed answers. Management has been buying back approximately $30 billion of AAPL shares per year. This is an unprecedented amount of buyback. Since 2012, Apple has bought back 16% of its shares outstanding. These were shares formerly held by investors with expectations of Apple as a growth stock. Accordingly, Apple's buyback program played a role in rotating Apple's shareholder base by removing shares that would have otherwise been sold to other investors in the marketplace. 

One sign that a company's expectations have truly been reset is that company's stock price increases on negative news. This serves as an indicator that the investor base has likely been flushed out and expectations have been reset. We will be able to test this theory when Apple releases its 3Q16 earnings report. 

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Apple's Plan to Own the Entire Music Industry

Apple's ambition in music continues to be misunderstood. Most of the focus remains on the battle between Apple Music and Spotify for paid music streaming subscribers. However, the much more interesting development relates to Apple's desire to grab music mind share. Apple is aiming to leverage its strong balance sheet to control the music narrative, and in the process, remove all of the oxygen from the music streaming industry. 

Music Is in Apple's DNA

Music not only served as inspiration for the iPod, but also justified Apple's first major foray beyond hardware and software. Apple got into the messy business of distributing and selling digital music because it believed hardware and software expertise gave the company advantages that other companies lacked. Apple saw the increasing amount of chaos in the music industry as an opportunity to package and sell a superior customer experience. The one thing that Apple was missing: access to songs. 

To make the case that Apple should have access to music catalogs, Steve Jobs explained to the big five record labels, BMG, EMI, Sony, Universal, and Warner, how Apple would control the entire music experience. Everything from running the store that would sell the songs all the way to selling the device used to listen to those songs would go through Apple. The goal was to impress the labels and have them see how no one was better positioned than Apple to offer a superior customer experience. Since the iTunes store was initially sold as being available only on a Mac, if things turned out negatively for the labels, the Mac's low market share meant the mistake would be contained.

The sales pitch worked, and the world quickly embraced Apple's model of buying single songs for $0.99. A million tracks were downloaded in the first six days. Over the next few years, the iTunes store became the go-to place to buy music, and more importantly, it grabbed a significant amount of music mindshare. Eventually, the first thing that came to mind when talking about music was either iTunes or iPod. Apple had captured the music industry. 

The Beats Acquisition

The iTunes juggernaut remained relatively unscathed for more than a decade. During this time, Apple held nearly complete control over the changing music landscape. However, behind the shiny facade, cracks were appearing. Start-ups focused on music streaming were gaining traction. By early 2014, Spotify had amassed 55M users, Pandora was flying high on Wall Street, and YouTube was the most popular destination for listening to free music. While the iTunes cash cow of paid song downloads was still growing, it was clear that change was in the air. For the first time in years, Apple wasn't the one selling that change.  

Acquiring Beats in 2014 for $3 billion, nearly five times more than it spent on its previous most expensive acquisition, was an admission from Apple that iTunes was in trouble. While management never officially positioned the acquisition as such, the fact that Beats co-founder Jimmy Iovine was selling a "solution" to Apple was a clear giveaway that something was indeed broken and required a solution in the first place. 

Strategy to Own the Music Industry

Following the Beats acquisition, I see Apple striving to take back the music narrative with the goal of eventually owning the entire music industry. There are four distinct steps to Apple's strategy. 

  1. Pivot into paid music streaming.
  2. Leverage a strong balance sheet to control the music narrative.
  3. Remove oxygen from the music streaming industry by grabbing revenue share.
  4. Create an environment for independent artist sustainability.

Although each step becomes progressively more difficult, ultimately, the four are interrelated.  

Step 1: Pivot into paid music streaming. Apple's first step in owning the music industry is the most straightforward: work with music rights holders to successfully pivot from paid downloads to paid music streaming. The paid music streaming industry is still in its infancy with approximately 90 million people paying for some kind of music streaming. This number will undoubtedly rise over the coming years. In 2015, revenue from paid music streaming outpaced revenue from paid downloads in the U.S. for the first time. It's clear Apple had no other choice but to make the jump into streaming. 

Apple's entrance into paid music streaming last year will be remembered as a mixed bag. For users with iTunes playlists, Apple Music was hit or mess as Apple oversold its ability to seamlessly combine streaming with legacy iTunes. However, for mainstream users living firmly in streaming, Apple Music was much better received. Last month at WWDC, Apple unveiled an improved Apple Music that addresses some of the larger friction points that came to light over the past year. 

When judging Apple's performance in paid music streaming, the primary metric to monitor has been the number of paid subscribers. Accordingly, much attention has been given to the feud between Apple and Spotify, the current leader in paid music streaming. With more than 30 million subscribers, Spotify has nearly twice the number of paid subscribers as Apple Music with their 15 million. However, Apple Music has shown much promise as it took less than a year to reach that 15 million paid subscriber benchmark. It took Spotify six years to reach the same number of paid subscribers.

Despite a few missteps, Apple has successfully accomplished the first step in its mission to eventually own the entire music industry. In just a year, the company has the second most popular paid music streaming product in the world with Apple Music. 

As seen in Exhibit 1, Apple Music's subscriber growth trajectory has ramped much faster than Spotify's. Apple was able to take advantage of its vibrant mobile ecosystem, a broad geographic reach, and a much more mature music streaming market. 

Exhibit 1: Apple Music vs. Spotify Paid Subscribers

Looking at recent subscriber trends, things become trickier to analyze. There is evidence that Spotify is moving the goalposts as its paid subscriber count is becoming diluted due to increased use of price discounts and promotions. These offers are inflating Spotify's paid subscriber numbers. Since Spotify has nearly 70M subscribers on its free tier, the company is likely trying to capitalize on this large user base by dangling discounts and promotions to entice upgrades. Apple Music has not seen this same level of price promotion. This means that the Apple versus Spotify battle will need to be judged along new metrics in the coming months. 

In terms of other paid music streaming competitors, the industry remains disjointed. Riding on the back of big exclusives, Jay Z's Tidal has positioned itself as the third-largest paid streaming service with more than four million subscribers. Deezer, Rhapsody, and Pandora are close behind in terms of the number of paid subscribers. Meanwhile, SoundCloud's recent move into paid music streaming has not caused much of a stir.

Step 2: Leverage a strong balance sheet to control the music narrative. Apple's next step to own the music industry is to leverage its strong balance sheet in order to better position itself against the largest streaming players. Apple will use a portion of its $234 billion of cash to accomplish three things:

  • Obtain music exclusives. Apple is betting big on music exclusives. By working closely with top music artists, Apple believes exclusives won't just help sell Apple Music subscriptions, but also go a long way in placing Apple Music in the center of the music discussion. Exclusives help drive buzz and press. As an example of how powerful exclusives can be, most of Tidal's 4.2M subscribers are a result of album exclusives from Beyoncé, Kayne West, and Rihanna. Meanwhile, Apple has seen exclusives from Drake, Future, and Chance the Rapper. 
  • Create original content. Instead of focusing just on exclusive songs and albums, Apple has shown a desire to work with labels and music artists to produce other forms of original content including feature-length movies (the Taylor Swift concert documentary), Beats 1 programming, and even scripted television series (Dr. Dre's "Vital Signs"). All of this exclusive content demonstrates how "winning" in the music industry is no longer just about having access to music. Music and video are becoming intertwined. 
  • Fund artists. Apple is increasingly looking and acting like a record label these days. While the company isn't exactly forthcoming in disclosing the extent of its involvement, we know Apple is bankrolling a number of artists when it comes to marketing expenses. Apple has produced a handful of music videos for Drake, M.I.A., The Weeknd, and Eminem. 

Apple's goal with these three items is to place Apple Music in the center of the music discussion. If something big happens in the music scene, Apple wants it to occur within Apple Music. The key ingredients to accomplishing this step include lots of cash and the right kind of industry relationships. The Drake exclusive reportedly cost $19 million. It's clear this is where the battle is being fought for subscribers in music streaming. Spotify recently hired Troy Carter as global head of creator services and getting exclusives is a top priority. 

Step 3: Remove oxygen from the music streaming industry by grabbing revenue share. With a successful pivot into paid music streaming, and now a focus on getting exclusives and building music relationships, Apple's next step toward owning the music industry is coming into focus. Apple will look to gain music streaming revenue share in order to form stronger relationships with music rights owners. In the process, Apple hopes to remove much of the oxygen in the streaming space.

The ultimate goal is to create a feedback loop in the music industry. If Apple Music is the top revenue source, the belief is this would lead to stronger relationships with music rights holders. In turn, stronger relationships would lead to a better Apple Music service with more exclusive content and additional access to artists. The better content will then drive additional paying subscribers and a larger piece of industry revenue share. Completing the loop, the higher revenue share will give music rights holders an even greater incentive to work with Apple. It was this goal to get close with music rights owners by going after industry revenue share that led Apple to bypass a free tier to Apple Music. This continues to be regarded as a controversial move given how Spotify has shown the ability to use its free tier as a tool to grow its paid tier. 

By seeking to control much of the revenue in music streaming, Apple would be looking to make the streaming market that much less attractive for competitors. Removing the oxygen from the room would add further strain to music streaming companies' balance sheets. This is where Apple's rumored interest in Tidal comes into play. Any deal for Tidal would not be about getting access to the service's 4.2 million subscribers. Instead, Apple would be interesting in gaining access to Jay Z and friends. Losing out on Beyoncé, Rihanna, and Kanye West album exclusives over the past year irked Apple. While Apple Music eventually got access to most of the exclusive content, the amount of attention and breathing room that Tidal received was obviously not something Apple enjoyed. Acquiring Tidal and bringing Jay Z on board Apple Music will be a way for Apple to make Apple Music more attractive and capable of getting additional revenue share. (My complete analysis on the Apple/Tidal acquisition talks, including my thoughts on Tidal's current price tag, is available here.)

Step 4: Create an environment for independent artist sustainability. The last step for owning the music industry is arguably the most difficult but also the most intriguing. Up to now, we have largely focused on Apple attempting to gain control of the music industry by appealing to the top one percent of music artists, those who hold the most power in the industry. These artists are the ones that go on tour and are overall able to do things capable of shaking the boat when it comes to deals and news. In essence, these are the artists that are not relying on music streaming to find sustainability. 

Missing from this strategy are indie artists, the musicians trying to find a way to not just reach their fans, but also find sustainability. I am not optimistic that paid music streaming is the answer for these artists. Something else is needed. This is where a platform that makes it possible for smaller artists to connect with their fans and then monetize their art can go a long way in adding sustainability to the music industry. If Apple is successful in acquiring the most valued music listeners, the company has a fighting chance to own such an indie platform given greater odds that people will spend money. However, as seen with the growing troubles surrounding the App Store and independent developer sustainability, it's clear that this step is still some distance from fruition. 

The combination of owning a significant portion of the music industry's revenue share and having a platform that offers sustainability to all musicians would give Apple much of the available power in the music industry. By consolidating power, Apple would hold the strings to the entire music industry. 

Potential Problems and Risks

With each step, Apple faces challenges and risks in its quest to own the music industry. Spotify continues to demonstrate skill and talent when it comes to understanding how consumers listen to music. The company should not be underestimated. 

When it comes to exclusives, music rights owners have an incentive to make their music available to as many people as possible, potentially complicating Apple's strategy to bet big on exclusives. In addition, exclusives spread out across a number of streaming services are not user friendly, especially when viewed in light of the era of music exclusives found with brick-and-mortar retailers. An extensive expansion of music streaming exclusives may lead to a rise in music piracy. 

For acquiring streaming revenue share, any friction in terms of Apple Music's design or user interface decisions may impact Apple's ability to sell the experience to customers. Finally, for independent artist sustainability, the biggest risk Apple faces is not dedicating enough resources to the cause. In addition, social will end up playing a key role in how artists find sustainability, potentially complicating Apple's efforts in this area. 

Future Implications

If Apple is successful in terms of gaining control of the music industry for the second time in 15 years, there are quite a few significant implications. Apple would be able to pivot from legacy technology (paid music downloads) and win at a new business model (music streaming), despite being a few years late to the game.

Apple would utilize its user platform to establish a beachhead in a new technology and then leverage its balance sheet to find a more competitive position by grabbing revenue share. This strategy provides a framework for how Apple will look at its next content realm: video. While one can argue the music industry has certain qualities that make it much more friendly for a company like Apple to control compared to video, there are qualities both music and video share that Apple will look to exploit. 

Apple's primary lesson from the early iTunes and iPod years was that a focus on the customer experience had an outsized impact on an industry that was undergoing significant change. It was much easier for Apple to offer a superior experience that customers valued when there was much chaos and unknown in the air. Apple's master plan to own the music industry involves adding chaos into the music industry by leveraging its $233 billion of cash. Apple continues to think big with its music ambitions. 

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Apple Watch Is Already a $10 Billion Business

It took fourteen months but it finally happened last week. I began seeing Apple Watches on a daily basis. Just a few months earlier, it would have been rare for me to see someone wearing an Apple Watch. Something has changed. Despite the short amount of time on the market, the Apple Watch has been called everything from Apple's largest flop in decades to the next big thing after the iPhone. In reality, we actually know much more about how the Apple Watch has performed to date, and there is evidence Apple is still just getting started. 

Something Changed at WWDC

Heading into this year's WWDC, Apple Watch expectations were at a low. The most recent comments from Apple management about Watch sales being focused around the holidays implied Watch sales had slowed somewhat materially in recent months. Developer interest and buzz around watchOS was lackluster, and recent price drops introduced questions about customer demand. 

Things changed following Apple's WWDC keynote. It was clear Apple had no plans of slowing down with Apple Watch. More importantly, Apple was willing to make changes to Apple Watch software. As seen with the rethought user interface included in watchOS 3, Apple spent the past year studying how people were using Apple Watch. Friction points such as a clunky interface and little-used features, including Glances, were removed. Instead, Apple went back to the basics with a simpler interface and additional focus on Watch faces as the device's most valued real estate. (Additional thoughts from WWDC concerning watchOS 3 are available here).  

Some people interpreted the changes found in watchOS 3 as evidence that Apple admitted it was wrong with Apple Watch. I disagree. That type of interpretation not only ignores everything that Apple got right about Apple Watch, such as Watch bands, but also ignores reality. Apple Watch financials portray a different story. Apple Watch's first year was not the disaster that many are now implying. 

Apple Watch Financials

In terms of Apple Watch unit sales and revenue, we haven't been left as much in the dark as initially feared. While Apple has kept its official stance of not disclosing Apple Watch sales, management has not been shy about providing clues for reaching reliable Watch financial estimates.

Every three months during Apple's earnings calls, we have been given at least one major clue as to how Watch sales had fared. Here are the key clues that Apple management broadcasted on the past four Apple conference calls:

  • July 2015: "The revenue from Other Products grew sharply [3Q15], up 49% over last year. The contribution from Apple Watch accounted for well over 100% of the growth of the category, and more than offset the decline of iPod and accessory sales...And to give you a little additional insight, through the end of the quarter, in fact the Apple Watch sell-through was higher than the comparable launch periods of the original iPhone or the original iPad."
  • October 2015: "Sales of Apple Watch were also up sequentially [in 4Q15] and were ahead of our expectations."
  • January 2016: "We set a new quarterly record for Apple Watch sales [in 1Q16], with especially strong sales in the month of December [2015]."
  • April 2016: "For some color on how we think about Apple Watch sales, we expect its seasonality to be similar to the historical seasonality of iPod, which typically generated 40% or more of its annual unit sell-through in the December quarter...unit sales of Apple Watch during its first year exceeded sales of iPhone in its first year."

In taking all of these clues into consideration, I have a high degree of confidence that Apple has sold 12 million Apple Watches to date. Exhibit 1 includes my Apple Watch revenue and unit sales estimates broken out by quarter. 

Exhibit 1: Apple Watch Financials (Above Avalon estimates)

While these numbers are indeed lower than initial consensus estimates that came out when the Apple Watch was launched in April 2015, it would be incorrect to brush off a business that generated $6B of sales in its first 11 months.

Valuing Apple Watch Inc.

In an effort to better quantify how the Apple Watch is performing, we can value the Apple Watch business as if it were it a standalone company. One benefit of this exercise is removing the Apple Watch from the iPhone's shadow. Most financial metrics seem inconsequential when compared to the iPhone juggernaut. 

Two items are needed to value a hypothetical "Apple Watch Inc.": 

  1. Financial metrics
  2. Valuation framework

Given Apple's functional organizational structure, the company does not manage the Apple Watch as a separate division with its own profit/loss profile. While we can derive an estimate for Apple Watch gross margins, when it comes to estimating operating expenses, the calculations would prove less useful. Expenses such as salaries, retail costs, and even R&D are shared by Apple's broader product portfolio. 

An alternative is to focus on Apple Watch revenue. This financial metric not only makes sense for measuring a product's success within a functional organizational structure, but also is something that we can estimate for Apple Watch with a fairly high degree of confidence.

When it comes to valuation, we can value Apple Watch Inc. by using a revenue multiplier. We take annual revenue and then multiple it by a certain ratio to obtain how much the market would be willing to pay for the right to own that revenue and future cash flows. This particular ratio can be obtained by using comparable company analysis. We look at how the market is valuing other consumer gadget hardware businesses.

Along those lines, I used three consumer tech hardware peers:

  • Apple: Given the iPhone's share of Apple revenue and operating income, we can use Apple's current market valuation as a proxy for how the market is valuing the iPhone business. Apple currently sells at a 2.6x price/revenue ratio.   
  • Fitbit: Fitbit derives pretty much all of its revenue from wrist wearable hardware sales. This places the company as the most direct peer of Apple Watch Inc. Fitbit currently sells at a 1.1x price/revenue ratio.
  • GoPro: GoPro serves as a good proxy for how the market is valuing a hardware company with slowing sales, increasing competition, and an unknown future. Things aren't looking good for GoPro although the company does appear to be making one last ditch effort to reinvent itself by hiring Danny Coster from Apple. GoPro currently sells at a 1.1x price/revenue ratio. 

The interesting element found with these three peers is that each company is facing significant questions about hardware sales growth. While much has been said about GoPro's and Fitbit's issues, even Apple is expected to report a 15% decline in revenue in 2016. Accordingly, even if we assume Apple Watch revenue will decline over the next year (something that may be possible) this doesn't necessarily imply that the Watch should be rewarded a valuation multiple much lower than Apple, let alone Fitbit or GoPro. 

As seen in Exhibit 2, I estimate that if Apple Watch was a standalone entity, it would be worth $10 billion. This estimate reflects a 1.7x price/revenue multiple, which is higher than Fitbit and GoPro's current price/revenue multiple. A higher multiple is justified due to Apple Watch's strength when it comes to appealing Watch bands, stronger customer loyalty, and deeper software and hardware integration. I am valuing Apple Watch in-line with Apple's enterprise value/revenue multiple. Even though the wearables category is much less established than the iPhone business, growth prospects remain quite attractive for the Apple Watch market in comparison to the mature smartphone industry. 

Exhibit 2: Apple Watch Inc. Valuation Peer Analysis

Even if we valued the Apple Watch business as if it had the same future prospects as GoPro, we would still come out with a $7 billion valuation, which highlights the conservatism found in a 1.7x price/revenue multiple and $10 billion valuation.

Apple Watch Paradox

The preceding valuation exercise showcases the paradox that has engulfed the Apple Watch. While recent Apple Watch changes seem to imply that Apple management is pressing the reset button on the product, in reality, Apple already has a $10 billion Apple Watch business on its hands. This is even before all of the significant changes in watchOS 3 were unveiled on stage at WWDC. Rather than pressing a reset button, Apple is systematically going through the Apple Watch business to fix friction points that developed over the first year. All of this is being done to position the Watch for improved adoption and a valuation much greater than $10 billion. 

There is evidence that Apple is still only getting started with Apple Watch. A closer look at Apple Watch bands reveal much potential and intrigue in terms of both technology and fashion. WatchOS 3 clearly positions Watch faces as a new kind of app for the wrist, which may represent the first genuine answer to the question of how to best interact with apps on the wrist. This could represent the beginning stages of an Apple Watch face App Store and a new stream of recurring revenue. I also think that Apple has major changes planned when it comes to Apple Watch collections, Watch case materials, and marketing. Apple's September keynote is shaping up to be an Apple Watch focused event. Add it all up, and Apple isn't walking or jogging but sprinting ahead with Apple Watch. We will likely look back at the weeks leading up to WWDC 2016 as the bottoming of Apple Watch expectations.

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WWDC Clues Hint at Apple's Post-iPhone Era

This year's WWDC felt different. While Apple's annual developer conference still showcased the company's software strategy for the coming year, last week's keynote also contained an unusual number of clues related to Apple's hardware ambitions. Apple's strategy for eventually moving beyond the iPhone is coming into focus.

Previous Apple Product Eras

One way to see where Apple is headed is to look at Apple through the rearview mirror. The Mac as Digital Hub era was Apple's first genuine product philosophy following Steve Jobs' return to Apple. The idea was simple. Instead of worrying about a growing number of dedicated peripheral electronic devices, Apple would focus its resources on positioning the Mac at the center of the universe. Users would then connect their growing collections of accessory devices to their Macs. 

 
 

As mobile devices became more powerful and occupied larger roles in our lives, Apple dedicated resources to designing Mac peripherals that had the most potential to be consumer blockbusters. First came the iPod, and this was followed by the iPhone. Selling more than just a few Mac models, Apple began thinking of its product strategy in terms of a stool on which each leg represented a different product category, as shown in the diagram below. At the same time, Apple continued to build out its services and cloud offerings to serve as the glue keeping the stool together.

 
 

At this year's WWDC, Tim Cook's message to developers was that Apple's current product strategy revolved around four "category defining and world changing" platforms: watchOS, tvOS, macOS, and iOS. While it may sound like these four platforms have replaced the old product categories found with the Apple Stool strategy, in reality, Apple's current product strategy looks very different. 

As shown in the diagram below, not all software platforms are viewed equally. iOS remains at the center of the universe given the iPhone's sheer dominance and is supplemented by continued iPad popularity. Meanwhile, watchOS is for a product that is still dependent on the iPhone while macOS and tvOS are much smaller platforms with cloudier long-term outlooks. 

 
 

When taking a look at nearly every financial metric, it's clear that we are still firmly in the iPhone as Hub era at Apple. There are nearly twice as many iPhones in the wild as every other Apple product combined. Despite slowing iPhone sales, Apple will still sell nearly five times as many iPhones as iPads in 2016. On a revenue basis, the iPhone is responsible for 65% of Apple's annual revenue and 75% of Apple's annual operating income.

WWDC Clues

Given such lopsided financial metrics, it has been very difficult to envision how Apple will eventually move beyond the iPhone. Some think Apple's only choice is to monetize the iPhone business using services. Others don't think Apple will actually be able to successfully come up with a post-iPhone strategy.

Fortunately, Apple's WWDC keynote last week contained clues as to where Apple's product strategy is headed. One theme found throughout management's slides was a focus on the user experience. Whether it was rethinking the iPhone lock screen or opening up additional iOS services to third-party developers, many of Apple's software changes were done with the user experience in mind. (I reviewed additional themes and observations from the keynote here and here). However, much more intriguing were the two fundamental shifts underpinning this focus on the user experience. Each shift portends an era in which the iPhone is no longer at the center of Apple's product strategy.

App Evolution. We are starting to use apps differently. Apple sees an era in which instead of downloading dozens of apps and arranging them in a grid pattern on our iOS devices, we rely on a number of services to handle our daily tasks. Apple's motivation for funneling developers into Siri, Maps, and Messages will end up making it that much easier for users to consume content and data across a number of hardware form factors. As a prime example of how this shift from an app-centric model to a service-centric framework changes Apple's product strategy, consider the Apple Watch. Apple has said that the Apple Watch is positioned within Apple's product line to handle tasks formerly given to the iPhone. In a world where content formerly found on third-party apps is eventually found within Apple services, while it may have made sense to use an app on our iPhone, it will now make just as much sense to use Siri or Messages on our wrist.

Services. Given the movement of third-party app functionality into services, Google is half-right when saying that it is time to move beyond the device. Services are becoming smarter as we give our devices additional tasks and data. This immense level of data ends up placing more value and capabilities with the glue that has traditionally held Apple's collection of gadgets together. However, Google and other services-oriented companies don't have it completely right. When services become more valuable, one consequence is the altering of how we use different form factors. Hardware does not lose relevancy. Rather, a world in which services are much more useful and valuable ends up elevating new hardware form factors that have access to these services. For example, tasks that may have traditionally been given to the Mac, iPad, or iPhone we will eventually be able to do on wearable devices because of more valuable and capable services. It is difficult to think of a form factor that is unable to utilize Siri in one way or another. 

The Apple Experience Era

Apple will look to move beyond the iPhone by offering users the ability to create custom Apple experiences. These experiences will involve a range of hardware form factors, the software platforms running on those form factors, and the Apple services connecting each form factor. The following diagram depicts this new Apple Experience era. Depending on the user, each form factor will hold varying levels of importance as depicted by the blue circle's size. The dotted lines represent the Apple services connecting all of the form factors. The solid lines represent situations in which there may be a greater level of dependency between form factors. 

Users will then choose which form factors make the most sense for their daily schedules and lifestyles. For some, an Apple Watch equipped with Siri, Messages, and Maps combined with a pair of not-yet announced wireless Apple EarPods will handle most of the tasks formerly given to an iPhone. For others, it may continue to make the most sense for an iPhone to be at center of their digital lives. It is not a stretch to think of more unusual combinations such as an Apple Watch and iPad as someone's two primary computing devices. Meanwhile, an eventual Apple Car will represent another point of contact for customers interacting with the Apple experience and range of Apple services. 

The key aspect of this new Apple Experience era will be Apple's ability to sell an experience tailored to the user. Instead of having a static web of devices in which the iPhone is at the center and everyone uses the other form factors in a similar fashion, this web of Apple products will change depending on the user. In the diagram below, notice how User A places much more value on an Apple Watch and wireless EarPods (depicted by larger circles). However, for User B, the iPhone and iPad hold a greater amount of importance.

Key Tenets of the Apple Experience Era

There are three major tenets of this new Apple product era. 

Hardware plays a crucial role. While nearly every Apple peer wants customers to begin thinking beyond the device and instead focus on the data-rich services connecting various types of hardware, Apple's future will contain plenty of hardware. We need hardware to record and then consume data. In addition, there will always be a human desire to interact with products. Apple will likely position hardware as the variable that makes its services that much more attractive than competing services. Look no further than Apple's decision to locally do all facial recognition as well as object and scene recognition processing in Photos on the device. Being able to use a service on a range of well-designed devices is something that Apple can excel at while other companies would need to rely on partners or others to make this happen. 

Services represent the glue. Apple will position products such as Siri, Messages, Maps, Apple Music and an eventual Apple Video service as the glue that holds various form factors together. 

Experience matters. From Apple's perspective, the key to moving beyond the iPhone is to offer users the option to personalize their technology needs with hardware and services. Apple will use certain criteria such as mass-market appeal to pick and choose which product categories and services end up getting precious Apple resources.

Apple's Challenges

At first glance, it would appear that Apple has all the ingredients in place to move beyond the iPhone. Apple's industrial design capabilities continue to be industry-leading, and WWDC began to peel away some of the mystery surrounding Apple's path for incorporating deep learning into its services. However, there are two big risk factors that need to be monitored very closely. 

Apple remains a resource-strained company. The most valuable resource is time and energy. Given the company's functional organizational structure, management has tangible limitations as to the number of projects that can be undertaken at any one time. As seen in the Apple Experience era diagrams, it would not be a stretch to see the number of blue circles, representing Apple hardware form factors, to increase. However, at a certain point, Apple will begin to find that it is unable to expand in new areas while still supporting legacy industries or products. Management is quite vocal that Apple says "no" much more than "yes" when it comes to new products. In addition, the company is not afraid to cannibalize its own products. These statements will likely be tested in the coming years.

The second risk factor involves Apple being able to learn how to add chaos to new industries. Apple has no experience in the transportation industry. Yet, the company will need to not only place a bet as to where the industry is headed, but also be prepared to pivot in order to potentially use different business models, including different ownership models. 

Moving Beyond the iPhone

Apple's plan to move beyond the iPhone won't be to come out with another pocket-sized computer that is capable of bringing in $200 of profit per device. Instead, Apple will look to build an Apple ecosystem containing various form factors and services that are well positioned to take advantage of the evolving app ecosystem. As the company enters new industries and sectors with new hardware form factors and services, the company will need to embrace new business models and ways of doing business. However, despite this tall order, the focus on the product and user experience will be the guiding light for Apple's goal of establishing a new product era after that of the iPhone.

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No One Wants to Be Apple

Something has changed in 2016. As the smartphone growth era winds down and we begin to look for the next big thing in tech, there has been a surge in pessimism pointed towards Apple's business model. With many of Silicon Valley's software and services giants doubling down on their core competencies and becoming more vocal as to where technology may be headed, one thing is clear: No one wants to be Apple. 

Declining Apple Envy

The iPhone has been a one-of-a-kind product for Apple. With 35% net operating margins and an average selling price of more than $600, the 948 million iPhones sold to date have resulted in more than $200 billion of profit for Apple. The fact that tens of millions of users upgrade to new iPhones every other year has been the financial icing on the cake. Apple's profit from iPhone has contributed to the company's annual net income increasing nearly 15x since 2007. 

While Apple was making more than $200 of profit per iPhone sold, Apple's peers were making much less from the software and services running on those iPhones. Even when taking into account the much larger Android user base, we see that other forms of smartphone monetization just haven't been able to match the profit Apple has received from hardware margins. Of course, Apple's bundled software and services contributed to those high hardware margins.

As iPhone profits grew, Apple envy increased. Meanwhile, Apple's hardware and software integration resonated with premium smartphone users, the most attractive segment for advertisers. As a result, Apple peers began to dabble with hardware along with other Apple strategies. The thinking was that maybe Apple's hardware and software integration strategy was finally seeing validation after nearly three decades of losing. 

The environment has changed in 2016. Apple's quarterly revenue declined for the first time in 13 years as iPhone sales fell year-over-year for the first time. In addition, there are various warning signs beginning to show in the iPhone business.

Accompanying this iPhone sales growth slowdown has been a marked change in attitudes toward Apple's business model. Many have turned pessimistic about Apple's strategy of relying on periodic hardware margins for a majority of its earnings. Peers are now focusing on the downside and risks of being Apple. The prospects of coming up with new products that rival the iPhone seem daunting. Apple competitors have made the decision to end their quest to be like Apple and are now doubling down on their own core strength: recurring revenue associated with advertising and services.

Fading Hardware Envy

The clearest sign of changing attitude towards Apple is Silicon Valley's declining fascination with hardware. While Google made it crystal clear last month at its developer conference that it was ready to begin moving beyond devices, the company had spent the past few years displaying a serious flirtation with those same devices and the idea of recreating Apple's hardware and software integration business model.

Google's $3.2 billion acquisition of Nest in 2014 was positioned as a game-changing transaction that could give Google a formidable head start in the smart home arena. Nest CEO Tony Fadell was even positioned as a potential Google CEO successor to Larry Page. Having a hardware whiz in charge of a data-driven ad company seemed to be quite the intriguing proposition. Just three years earlier, Google had purchased Motorola for $12.5 billion, a transaction that was positioned as a patent defense play but ultimately was born from the fact that Google did not do its own hardware.

In reality, Google's foray into hardware has been nothing short of a complete failure. Google ended up selling Motorola Mobility to Lenovo. Meanwhile, Tony Fadell just announced he is leaving Nest, an ominous sign that Nest's future within the Alphabet web of subsidiaries is now up in the air. 

Google wasn't the only company to flirt with Apple's hardware and software integration model. Microsoft showed a clear interest in copying Apple and controlling both hardware and software. While the strategy was largely a legacy play from the Steve Ballmer era, Microsoft seemed to believe in it enough to have a big hardware-focused NYC event just last October. Eight months later, it is clear that consumer reception to Microsoft hardware hasn't exactly caught the world by surprise. The quest to rethink the laptop with Surface Book went nowhere. 

We can also rope in Facebook's and Amazon's infatuation with producing its own smartphone as additional data points about Silicon Valley's previous interest in hardware over the years. Much, if not all, of this interest had been based on Apple's sheer success with the iPhone and iPad. While it was possible to beat Apple in terms of smartphone unit sales or market share, the fact that Apple was making nearly 45 percent gross margins on its hardware gave the company a monopoly on industry hardware profits, a statistic still true today. 

Things are very different now. Slowing smartphone sales and the ongoing tablet market implosion have resulted in mobile hardware having a much less rosy outlook. Apple peers are now becoming much more vocal that it is time we move beyond hardware and focus on the services and networks running on hardware. No one wants anything to do with Apple's hardware business.  

Fading Retail Envy

Another example of a change in attitude towards Apple strategy relates to brick and mortar retail. While Sundar Pichai was on stage at Google I/O 2016 explaining why it was time to move beyond mobile devices and embrace an "AI-driven" world, Apple was putting the finishing touches on its new Union Square Apple Retail store a few miles away in San Francisco. The juxtaposition of these two events symbolized just how different Apple is thinking from the rest of Silicon Valley when it comes to technology in 2016. 

Apple's Union Square wasn't just any new Apple Retail store. Instead, the location showcased Apple's new Retail store design strategy. Along with a fresh, new look thanks to input from Jony Ive, one of the store's main features is a reimagined customer service area. The infamous Genius Bar had been replaced with a Genius Grove since "Bar" may bring up unpleasant connotations. Apple wanted to improve the experience customers received when getting help with Apple products. A customer can now chat with an Apple Retail store employee while literally sitting under a tree in Genius Grove. 

In many ways, rebranding Genius Bars into Genius Groves is very Apple. While some may just see a subtle name change, the very different atmosphere created by the new setup can go a long way in making Apple stores feel less crowded, more approachable, and relaxing. All three of those attributes denote improvements to what had been increasingly positioned as friction points in Apple Retail stores in recent years. 

Apple's continued investment in brick and mortar retail isn't surprising. However, many of Apple's peers who envied the company's success in retail are now having second thoughts. Microsoft's aggressive retail expansion has led to nothing more than lots of empty retail stores. Samsung's store strategy has no rhyme or reason as the company struggles to produce a cohesive product strategy following the Galaxy line of smartphones. There were ongoing rumors that even Google was close to jumping into brick and mortar retail. We can't forget those mysterious Google barges that popped up in 2013 with the best guesses being that Google was interested in unveiling Google Glass showrooms.

The only tech company other than Apple still showing a genuine interest in brick and mortar retail is Amazon and even then, Jeff Bezos isn't so much looking to be like Apple but instead eventually establish a web of locations to pick up and drop off Amazon packages.  

The New Envy

Instead of wanting to be like Apple by doing hardware and getting into brick and mortar retail, Silicon Valley is now infatuated with data and the services meant to capture such valuable data. Google's vision of a world moving beyond hardware seems to represent a significant threat to a company like Apple. It's not just Google. The Amazon Echo has turned into a poster child for this "post-device" world in which some users could theoretically do less on their iPhones and iPads and instead use their voice to interact with a bunch of speakers and a microphone in a stationary tube. In addition to Amazon and Google, Microsoft and Facebook have extensive resources and attention focused on similar types of data collection and aggressive plans with artificial intelligence. 

It should come as no surprise that companies with no formidable hardware strategy are now more vocal about tech's future not revolving around hardware.

A growing number of industry observers think if the device doesn't matter as much going forward, Apple's core competency when it comes to hardware becomes less valuable. The argument then extends to Apple's business model not being suited to produce best-of-breed services geared towards data capture. This seems to give Apple an even more dire outlook. 

In reality, Apple envy has flipped. Companies once jealous of not doing their own hardware are now doubling down on their core competency: data collection. Facebook has spent more than a decade building a curated version of the web in order to have users stay on a Facebook property and in the process, share more data. A similar dedication to data collection can be found at Google, Microsoft, and Amazon. 

Finding the Puck

With all of this change swirling in the air, there is increased uncertainly as to how Apple will proceed. As peers move away from envying Apple's position in tech, will Apple management feel the need to change or adapt and become more like everyone else to compete? 

There is no question that Apple has holes or deficiencies in its product strategy. While some of these holes have been, and continue to be, filled by M&A and outside hires, Apple has historically seen much success by changing the game and narrative. Along those lines, we have still not seen Apple's response to Facebook's and Google's developer conferences. This is why Apple's developer conference next week takes on a different tone than that of previous years when Apple envy was much higher. With that said, Apple management will likely take its time to respond to the growing number of criticisms lobbed towards Apple's business model.

At the end of the day, Silicon Valley and Wall Street are figuring out how to connect some of the last remaining dots found with the smartphone growth era. While some will want to say that the future has already been determined and either machine learning or even voice will quickly replace much of the current smartphone and tablet paradigm, in reality, the future has not yet been determined. AR and VR still have a long way to go before reaching mass-market appeal. Voice interfaces are in their infancy and contain a number of troubling aspects and problems. Artificial intelligence and machine learning are still mostly buzz words with plenty of time and room left to see where technology trends. Wearables are quickly moving to the point of being the de facto evolutionary next step for the smartphone. And of course, the smartphone is ushering in a revolution in the transportation industry. 

As Apple envy winds down in Silicon Valley and Apple peers no longer see the allure of being like Apple, Tim Cook and the executive team are familiar with finding ways to prove skeptics wrong. The next big thing after the smartphone has not yet been figured out, and Apple has a few ideas on where it thinks the puck is headed. While everyone is headed in one direction, Apple thinks the intersection of technology and liberal arts will be found in a different place. 

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Apple M&A Is Entering a New Phase

Apple's mergers and acquisitions (M&A) strategy is misunderstood. Consensus has settled on the view that Apple needs to change its rigid philosophy towards M&A and begin using its $233 billion of cash to buy larger competitors and find new sources of revenue. These suggestions are misplaced. Apple's M&A strategy has actually seen quite a bit of change over the years, and there is evidence that we are about to see even greater change going forward. Apple's investment in Didi Chuxing marks the official start of Apple M&A entering a new phase as the company pivots into transportation. 

Apple M&A Activity

The best way to begin analyzing Apple's M&A strategy is to look at the company's acquisition activity. There is a perception that Apple does not acquire many companies. The numbers tell a different story. Since 1997, Apple has acquired more than 70 companies. When including the smaller transactions that were never disclosed, Apple's acquisition list likely exceeds 80 companies over the past nineteen years. Exhibit 1 breaks out Apple's publicly disclosed acquisitions by year. 

Exhibit 1: Apple Acquisitions (Publicly Disclosed)

One reason why it seems like Apple has not kept pace with its peers in terms of M&A is that Apple often purchases technologies and small teams of talent. A consequence of this strategy is that Apple's acquisition activity doesn't garner the same type of press coverage as a big, headline-grabbing transaction would receive. In addition, no single M&A transaction has ended up representing a significant percentage of Apple's cash levels, which leads many to conclude that Apple is not placing as significant of a bet with any one acquisition. To quantify these statements, I turned to Apple's cash flow statements.

Each quarter, Apple discloses the amount of cash spent on M&A as "payments made in connection with business acquisitions." While the line item may not catch the full amount spent on acquiring teams of talent and assets when taking into account stock-based compensation, or intangible assets like patents, and of course investments in machinery, it does a good job at estimating the amount spent to acquire companies. As shown in Exhibit 2, while Apple has clearly been spending more on M&A in recent years, the absolute totals are still low compared to Apple's growing cash levels.

Exhibit 2: Apple M&A Activity (Business Acquisitions Payments)

Note: Inflation adjusted

* Includes $1 billion investment in Didi 

Apple M&A Observations

After analyzing 19 years of Apple M&A activity, I reached two primary observations that are useful for determining where Apple's M&A strategy is headed. 

Apple M&A Is Evolving. Contrary to popular belief, Apple M&A has actually experienced quite a bit of change over the years. The first major difference is that management has increased the M&A pace. Apple acquired more companies from 2013 to 2015 than they did in the previous 16 years leading up to 2013. When looking at the amount spent on M&A, the purchases between 2013 and 2015 accounted for 70% of the total amount Apple spent on M&A since 1997.

Another example of a changing M&A strategy involves price. Apple management is not opposed to paying a large sum of money for an acquisition. Apple's $3 billion Beats acquisition in 2014 was six times as large as the second-highest price paid for a company (NeXT in 1997). In fact, Beats represents 40% of the total spent on M&A over the past nineteen years. Excluding Beats, the average price paid per acquisition was less than $30 million.

Management's M&A Strategy Is Very Focused. Despite a changed strategy, there is evidence that management is still guided by the same principles and ideals when acquiring companies. There is no evidence that Apple purchases companies in order to directly boost revenue or earnings. Instead, acquisitions continue to be used to enhance Apple products. This product-focused mindset is one reason why most Apple acquisitions are eventually incorporated into Apple's product line. While some deals, such as Quattro Wireless, a mobile advertising company, may not pan out exactly as management envisioned, there are very few acquisitions that have turned out to be failures leading to significant write downs. In addition, there are no signs that Apple management has used M&A for pet projects or to appease foreign governments or regulators.  

M&A Phases

Given that Apple's M&A strategy has undergone a significant change in recent years, I took a closer look to find the fundamental driver behind this change. Adding a bit more context to the first exhibit ended up providing much clarity. The iPhone was the catalyst that ended up driving much of the change in Apple M&A. As seen in the table in Exhibit 3, which categorizes each Apple acquisition by the product category it ended up benefiting, there have been two distinct M&A phases (Mac and iOS) with the iPhone's launch in 2007 marking the bridge between the two.  

Exhibit 3: Apple Acquisitions Categorized by Product Category

For 10 years starting with the NeXT acquisition in 1997, all but one Apple acquisition were related to strengthening the Mac platform. While this may not come as a complete shock given Apple's product line at the time, it is noteworthy that M&A was not used for the iPod or to expand into other product categories or industries.

Apple then experienced five years of limited to no M&A activity from 2003 to 2007. While the outside world did not know it at the time, this "buffer" zone ended up being pivotal years for iPhone development. 

Since acquiring P.A. Semi in 2008, every acquisition but one has been focused on strengthening the iPhone and broader iOS platform. This new iOS focus ushered in a significant increase in both the pace of M&A and the amount of cash spent buying companies. In addition, Apple has shown an appetite for a wider range of target acquisitions to enhance iOS ranging from intelligent assistants, music streaming, and maps to mobile processors, cameras, and fingerprint sensors.

Connecting the Apple M&A Dots

Taking what we know about Apple's M&A activity and the significant change that has taken place as the iPhone ushered in a new iOS-focused M&A phase, there are a few logic explanations that help explain Apple's changing M&A strategy. 

Apple's M&A strategy is built much like the company's functional organizational structure in which the product is placed above all else. Management's primary goal for M&A is to support Apple's evolving product line. As the company moves from industry to industry, management relies on M&A to purchase new core competencies. The end result is that Apple M&A does indeed undergo changes in terms of pace, amount spent and scope. However, similar to how Apple's culture remains intact despite a different product line, Apple still relies on the same underlying philosophy when it comes to acquiring companies. 

In the early 2000s, Apple's M&A activity was dedicated to enhancing software that supported its Mac-as-the-hub product strategy. Apple acquisitions focused on video and photo editing in addition to music and other forms of content that were meant to strengthen the Mac and make it the center spoke for a range of peripheral devices. Once Apple pivoted into the phone industry with the iPhone, management began to use M&A to buy new core competencies in mobile. There was only one acquisition before the iPhone was unveiled in January 2007 (FingerWorks in 2006) that went on to play a major role in iOS development.

Management saw at a very early stage that owning the core technologies found in iPhone would end up giving Apple a competitive advantage over its peers. Some of this thought process was a carryover from the Mac. In order to have the Mac stand out from Windows in terms of content creation, Apple acquired Raycer Graphics. Similar motivation led to a number of acquisitions meant to set the iPhone (and iPad) apart, including P.A. Semi (mobile processors), Siri (natural language processing) and AuthenTec (fingerprint sensors). Instead of placing revenue generation as the primary motivation to own these companies, management's goal was to expand Apple's capabilities with mobile devices and strengthen the iOS platform.

As iOS devices began to handle a growing percentage of our daily computing tasks, Apple's M&A pace sped up to include a wider range of areas including search, mapping, and recently, AR, VR and AI. Each one of these fields represents a new chapter for Apple, something with which Apple may not have had much experience, and positioned M&A almost as a learning tool used to buy teams of talent and technology.  

The New M&A Apple Phase

Despite the iOS platform having plenty of runway left with Apple investing heavily in new wearables, Apple TV and continued iPhone and iPad updates, we are already seeing the beginning stages of a new Apple M&A phase.

Apple's $1 billion investment in Didi earlier this month marks the newest phase of Apple M&A (I went over the Didi deal in detail here.) The deal doesn't stand out because of its financial arrangements. Apple has purchased stakes in companies in the past with mixed results. In 1999, Apple invested $12.5 million in Akamai, a Internet content delivery service, making a sizable profit on its investment during the dot-com bubble. Also, in 1999, Apple invested $100 million in Samsung to help the company with flat panel display production. In 2000, Apple invested $200 million in EarthLink, an Internet service provider, leading to a business arrangement in which Apple would benefit from a Mac user subscribing to EarthLink. Apple later had to write down its investment. Apple also held a significant investment in ARM Holdings for years during the 1990s and early 2000s.

The Apple/Didi deal is intriguing because it is the first M&A signal that Apple is beginning to pivot into transportation. We know Apple is working on an electric car with Project Titan and I actually place the odds of Apple selling an electric car as much higher than most people assume. By investing in Didi, Apple is not only interested in gaining an early foothold in the Chinese auto industry, but also beginning to think about a likely source of demand for an eventual Apple Car. 

This next M&A phase will likely first include Apple buying additional stakes in ridesharing companies ahead of an Apple Car release. The most obvious candidates are those that have entered into a strategic partnership with Didi, including Lyft in the U.S., Grab in Southeast Asia, and Ola in India. Combined, these four ridesharing companies represent the vast majority of today's ridesharing industry as measured by drivers and rides given each day. 

The primary reason Apple would buy smaller, minority stakes in these companies instead of just forming business partnerships or alliances is that the ridesharing industry is still very much in the early innings where startups need capital to compete and gain market share. Along with gaining access to Apple's $230 billion of cash, having Apple has a strategic investor gives these companies an advantage over their peers. Meanwhile, at the other end of the spectrum, there is no clear rationale for Apple to acquire large, controlling stakes in these ridesharing companies.

By investing in ridesharing companies, Apple would be looking to form a demand source for an eventual Apple Car, similar to how they work with mobile carriers to sell iPhones. Ridesharing is changing how the world moves from Point A to Point B, and once electric cars with full level 4 autonomy become a reality, car ownership models will come under pressure. Ridesharing companies are not just taxi hailing services but transportation logistics companies. A case can me made that Apple is getting an early start investing in a core technology for the automobile: demand and supply logistics. 

Once an Apple Car has been released, Apple will then use M&A to further expand its core competencies in the auto space, and this new M&A phase will likely go on to last for decades.  

Apple M&A Embraces Change

Apple's culture embraces change. The only way Apple will remain relevant is to reinvent itself. Similarly, Apple M&A has displayed a similar type of change over the years, and this trend will only intensify when an Apple Car platform is introduced. Instead of buying a company such as Tesla to enter the auto industry with a new product, Apple will instead rely on Project Titan and its own resources to design and sell an electric car. Once a product has shipped, Apple will be in a better position to observe the biggest holes in its product offering and strategy. M&A will then enter the equation in earnest. 

One of the bigger unknowns entering this new M&A phase involves the degree to which Apple can transplant its expertise with iOS into a car. We already know Apple's focus on acquiring mapping assets will play a crucial role in its move into transportation. The same will likely apply to Apple's recent transactions with AR, VR, and AI acquisitions. 

Similar to the FingerWorks acquisition in 2006 (for iPhone in 2007) and Passif Semiconductor in 2013 (for wearables in 2014), Apple's Didi investment will eventually be looked at as evidence of Apple preparing to enter a new industry. The fact that Apple's stake in Didi marks the first time Apple has taken a stake in a company since Imagination Technologies in 2008 foreshadows how Apple M&A is going to change to reflect a new industry.

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Above Avalon Is Officially Sustainable

It has been one year since I launched Above Avalon memberships and began writing my daily updates about Apple. I wanted to take this momentous occasion to recap the first year and look toward the future.

I had two goals in launching Above Avalon memberships back on May 13, 2015. 

  1. Put Above Avalon on a path to sustainability.
  2. Begin to form a thriving community based on a different kind of Apple analysis. 

I am happy to report that I accomplished both goals over the course of the past year. Above Avalon is officially sustainable (and has been for a few months). In addition, I'm now getting to know quite a few Above Avalon members through daily interactions over email and the discussions taking place in the Above Avalon team in Slack. 

Officially Sustainable

There are two parts to sustainability for a company like Above Avalon. The first is tangible: the number of Above Avalon readers and podcast listeners becoming members. This number plays a big role in keeping the lights on at night. Not only was I able to meet my one-year membership sign-up goal in a few months, but I was also able to meet my revised goal. A big thank you goes out to everyone who has become an Above Avalon member over the past year. Members play an important role in making Above Avalon possible.  

The second aspect to sustainability is a bit more intangible: a publishing schedule that contains longevity and vigor. After publishing 200 daily updates for members in the past year, each containing two to three stories, I feel I have found a good balance between the amount of time spent writing about Apple and researching various topics and subjects.

The Daily Updates

My goal for starting Above Avalon was to introduce a different kind of Apple analysis in which all research and perspective originates from understanding how Apple thinks about the world. Only then should analysis focus on the broader Apple operating environment, including competitors. Over the course of the past year and a half, I am more confident than ever that this framework is the best way to analyze Apple given its unique culture.  In addition, it has contributed to Above Avalon research and perspective being one of the more accurate and informed sources available. 

I feel very confident that my perspective on key issues impacting Apple's future, including prospects of an Apple Car, Jony Ive's promotion to Chief Design Officer, and Apple's continuing investments in future products and technologies, were a result of dedicating all of my time and resources to understanding how the product guides Apple. At the same time, critical analysis has led me to be more hesitant and skeptical about certain parts of Apple's business, including iPad and iPhone unit sales growth. 

New Archive & Slack Team

One way to foster an Above Avalon community is to establish a place for members to communicate with each other and discuss Apple trends. Four months ago, I created an Above Avalon team in Slack. I am quite pleased with how things have turned out and feel even more confident today that Slack is the future of team communication. With the member archive and various channels placed within Slack, members now have an easy and convenient way to access previous updates and meet other members. 

Positioning the Slack team as an optional feature for Above Avalon members turned out to be the right call as I have been able to maintain the value of every Above Avalon membership regardless of participation in the Slack team. 

Goals for Year Two

While the past year has been great for Above Avalon, there are a few things that I plan on focusing on over the next year. 

1) A new kind of Apple financial analysis. Above Avalon members have experienced four Apple earnings cycles. While I am confident that each has proven to be quite valuable and enriching, one goal for the next year is to develop a new kind of Apple financial analysis that does a better job of judging how Apple is performing in relation to its goals. Wall Street is guided by narratives and near-term expectations while Apple is guided by intangible factors such as product satisfaction and long-term thinking. This division produces friction, and I want to work on removing some of this friction when analyzing Apple's financial trends. This process begins by determining the numbers and data points that matter and creating new ways of measuring and analyzing that data.

2) Continue to learn about Apple. On one hand, Apple is a creature of habit, using pages from the same playbook that have gotten the company to where it is today. However, there are plenty of signs that changes are afoot and that the Apple of tomorrow is going to look quite different than the Apple of today. The more I learn about Apple, the greater appreciation I have that this is a company that is reinventing itself every day. There are plenty of aspects of the company that I want to dedicate much more time and energy to better understanding.

3) Increase value found with Above Avalon memberships. I am convinced that Above Avalon's future goes hand in hand with building a strong membership base. While a growing number of people agree that Above Avalon memberships contain an incredible amount of value ($10 per month or $100 per year) , I want to focus on making memberships even more valuable going forward. One method for accomplishing this goal is continuing to focus on relevant topics and subjects pertaining to Apple's business and future. The daily update format gives me a great avenue for fostering this discussion over an extended period of time and using current news events to augment the discussion and assess changes to strategy. 

As Apple begins to pivot into new industries, there has never been a more exciting time to study the company.

The past year flew by, and I am excited to begin the second year and look forward to welcoming new faces as Above Avalon members. (More information on membership can be found here.) 

Thank you for a great first year.

Neil Cybart

Apple R&D Reveals a Pivot Is Coming

People are focusing on the wrong thing when analyzing Apple's path forward in the face of slowing iPhone sales. Instead of debating how much Apple will try to monetize the iPhone user base with services (not as much as consensus thinks), the company is instead planning its largest pivot yet. There are only a handful of logical explanations for Apple's current R&D expense trajectory, and all of them result in a radically different Apple. In a few years, we are no longer going to refer to Apple as the iPhone company. 

Apple R&D: By the Numbers

As I pointed out last May, Apple's R&D expense saw a significant bump up beginning in mid-2014. It was clear Apple was up to something big. However, after looking at Apple's 2Q16 results, it appears I underestimated the situation. As depicted in Exhibit 1, Apple is now on track to spend more than $10 billion on R&D in 2016, up nearly 30% from 2015 and ahead of even my aggressive estimate. This is a remarkable feat considering that Apple was spending a little over $3 billion per year on R&D just four years ago.

Exhibit 1: Apple R&D Expense (Annual)

One of the more interesting aspects of Apple's R&D expense trajectory in recent years is that the increase has been outpacing revenue growth. As seen in Exhibit 2, given my current iPhone sales expectations for FY16 and FY17, Apple is on track to approach a multi-decade record in terms of amount spent on R&D as a percent of revenue. 

Exhibit 2: Annual Apple R&D Expense (Percent of Revenue)

Unusual R&D Perceptions

The most shocking aspect about the amount of money Apple is spending on R&D is how little attention it has garnered in Silicon Valley and on Wall Street. Other than my R&D post last year, there is rarely any mention of Apple's R&D, and this doesn't seem to make much sense.

I suspect most of this has been due to the fact that Apple does not draw attention to its product pipeline and long-term strategy, choosing instead to embrace secrecy and mystery. Now compare this to Mark Zuckerberg laying out his 10-year plan for Facebook. It is easy and natural for people to then label Facebook as innovative and focused on the future. The same principle applies to Larry Page reorganizing Google to make it easier for investors to see how much is being spent on various moonshot projects. Jeff Bezos is famous for his attitude towards failing often and in public view, giving Amazon an aura of being a place of curiosity and boldness when it comes to future projects and risk taking. 

Meanwhile, Tim Cook has remained very tight-lipped about Apple's future, which gives the impression that Apple isn't working on ground-breaking ideas or products that can move the company beyond the iPhone. Instead of labeling this as a mistake or misstep, Apple's product secrecy is a key ingredient of its success. People like to be surprised. Another reason Apple takes a much different approach to product secrecy and R&D is its business model. Being open about future product plans will likely have a negative impact on near-term Apple hardware sales. Companies like Facebook and Google don't suffer from a similar risk. The end result is that there is a legitimate disconnect between Apple's R&D trends and the consensus view of the company's product pipeline. Apple is telling us that they are working on something very big, and yet no one seems to notice or care. I find that intriguing.

Logical Explanations for Apple R&D

Even though Apple remains tight-lipped about its dramatic increase in R&D expense, there are three logical explanations for what may be happening.

1) Apple's expanded product line requires additional R&D. This theory represents the most straightforward explanation. Essentially, because Apple has grown significantly over the years, the company needs to spend more on R&D just to keep up with its more expansive product line and greater competition. The company is now invested in four hardware categories (iPhone, iPad, Mac and Apple Watch), not to mention various software and services initiatives. 

2) Apple plans on doing more. Keeping with another simple explanation, Apple's increased R&D spend could signal that the company is willing to try its hand at more things. The expectation would be that Apple will begin releasing a greater number of products in terms of hardware, software and services. 

3) Apple is looking to pivot. Apple is ramping up R&D because they have a few big bets that require a massive increase in investment. The two most logical areas for these bets are wearables and personal transport initiatives. In both cases, Apple is moving well beyond its comfort zone of selling pieces of glass that can be held in one's hand. Instead, Apple is literally building a new company with additional capabilities and strengths.

The Most Likely Explanation

After analyzing the three preceding possible explanations for Apple's R&D increase, we can conclude the only one that actually makes sense is the third choice: Apple is looking to pivot. The first two theories fail to hold much water since they do not mesh with Apple's functional organizational structure. Since each senior Apple executive is in charge of his or her domain across Apple's product line, it is not possible for Apple to simply keep expanding the product line without negative consequences. At a certain point, Apple's resources are just stretched too thin to be effective. Some have argued that Apple had experienced some of this resource strain towards the end of Apple Watch development. In reality, Apple is constantly suffering from this resource strain despite having $233 billion of cash and cash equivalents on the balance sheet. 

It is this functional organizational structure that explains why Apple management talks about the need to remain focused and saying no to certain products and industries even though Apple could conceivably see much success. This rules out the explanation that Apple is spending more on R&D with the intent of doing a greater number of things. Apple's R&D follows a similarly focused mantra. While there are always scattered teams of people focused on far-fetched ideas and products, these activities do not amount to much of Apple's $10 billion budgeted for R&D in 2016. Instead, sudden and dramatic increases in Apple R&D are a result of new product initiatives.

One way of validating the claim that R&D is very much product focused is to graph the year-over-year change in R&D in absolute terms. As shown in Exhibit 3, a step pattern becomes apparent over the past 10 years. There have been two discernible increases in R&D expenses followed by periods of flat growth. When taking this step pattern and then overlaying it with Apple product launches, three product development stages become apparent: iPhone and iPad in the mid-to-late 2000s, Apple Watch beginning in 2012, and something new beginning around the Spring 2014. I suspect this latest item is primarily related to Apple working on its own electric car (Project Titan).

Exhibit 3: Apple R&D Expense Growth (Quarterly)

Apple Will Pivot

Apple is not spending $10 billion on R&D just to come up with new Watch bands, larger iPads, or a video streaming service. Instead, Apple is planning on something much bigger: a pivot into the automobile industry. 

The word "pivot" has become a buzzword lately, often misused to simply mean change. In reality, pivoting is actually a sign of strength as a company takes what it learns from one business model in one market and applies it a new one with a different business model. Apple would be taking lessons learned from its long-standing view on the world based on the Mac, iPod, and broader iOS lineup to begin selling an electric car.

This sounds incredibly ambitious and bold, and that is the point. Apple wants to move beyond the iPhone. In this regard, pivot seems like the wrong word to use since the iPhone is a very successful product generating more cash flows than the rest of Apple's product line put together times two. However, it is this success that ultimately serves as the greatest motivation for Apple management to figure out the next big thing.

In terms of how Apple can physically pivot, Apple's functional organizational structure needs to once again enter the conversation. An ability to pivot is the primary reason Apple has a rare functional organizational structure in the first place. By allowing management to put all of its attention on the product, and not internal politics, Apple's organizational structure is a major strength, not weakness. Apple is designed to move from product to product, industry to industry. We see the company do just that by entering the smartphone market, followed by the wearables market and soon, the auto market. 

Project Titan: A Finished Product is Likely

It seemed like many in Silicon Valley and on Wall Street spent most of 2015 debating if Apple even wanted to design its own car. (The answer was obvious: yes.) The discussion has now turned to whether Apple will actually end up selling a car or if management will conclude there isn't enough there to actually lead to a finished product. While Apple does indeed say no to most products and projects, Project Titan is not just any R&D project. 

In reality, people are grossly underestimating the odds that Project Titan will lead to Apple actually shipping an electric car. At this point, I peg odds of Apple selling its own electric car to be at least 80 percent. There is one very simple reason for my high degree of confidence: Project Titan is a long-term pivot. I don't consider Titan to be just another project that Apple has been tinkering around with in the lab for years like an Apple television set or Apple Pencil. Instead, Project Titan is much more about building a foundation for Apple that will literally represent the company's future.

It was recently revealed that Apple has set up a web of Project Titan buildings and infrastructure spread across Santa Clara, Sunnyvale and San Jose. This means that it is incorrect to think of Project Titan as just being about one product or one feature. Instead, Apple is building an entire start-up focused on the electric car industry, giving me a high level of confidence that Apple's efforts will lead to products. When diving deeper into Project Titan, this is where there is greater unknown as to whether a certain technology will ever ship, such as various autonomous driving features, different features for new internal passenger compartments, unique car materials, and the list goes on. Each one of those items should be thought of as an individual project that may not see the light of day. 

Apple has likely spent upwards of a few billion dollars on Project Titan so far when including real estate and stock-based compensation. When considering that Apple will likely be spending upwards of $14 billion per year on R&D by 2017 or 2018, Project Titan could easily end up being a $10-$15 billion project before Apple even ships a product. This is uncharted territory not just for Apple, but for the entire auto industry.

There is much to be discovered from tracking just one line item on Apple's income statement. R&D expense tells me that Apple is planning its most significant pivot yet. 

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iPhone Warning Signs

Apple has spent years proving iPhone doubters wrong. Those who made a habit of calling for the iPhone's demise have watched the product go on to bring Apple over $600 billion of revenue and close to $250 billion of gross profit over the years. Ironically, just when it seemed like iPhone skeptics had thrown in the towel and accepted the iPhone's supremacy, warning signs are beginning to appear in the iPhone business.

Apple's 2Q16 earnings report was not pretty. (I reviewed the full report and management's conference call here and here.) Not only did iPhone sales decline year-over-year for the first time, but management issued alarming guidance for 3Q16, suggesting another very difficult quarter for iPhone sales. In addition, Apple expects iPhone average selling price (ASP) and margin to deteriorate due to the recently introduced $400 iPhone SE. On top of it all, Apple will take a historically large $2 billion inventory adjustment related to the iPhone 6s due to sales coming in below expectations. While some are optimistic that the iPhone 7 and 7 Plus will turn things around in a few months, it's time to become skeptical. The iPhone growth story is breaking apart, and management does not seem to be in control of the situation.

Slowing iPhone Growth

The iPhone business is slowing. When looking at iPhone sales on a quarterly basis (Exhibit 1), it is difficult to see the true extent of the slowdown. 

Exhibit 1: Quarterly iPhone Unit Sales

Graphing sales on a trailing twelve months (TTM) removes the cyclical nature associated with annual iPhone launches and enables us to reach a clearer view of the iPhone's growth profile. As seen in Exhibit 2, the recent iPhone sales slowdown becomes quite visible. Apple's 3Q16 guidance implies Apple will report its first quarterly iPhone sales decline when looking at sales on a TTM basis. This is a noteworthy development. 

Exhibit 2: Quarterly iPhone Unit Sales Growth (TTM) 

Some have argued that recent iPhone sales weakness is due to the iPhone being on a two-year cycle. Accordingly, if the very popular iPhone 6 and 6 Plus are excluded from sales trends, the iPhone's long-term growth trajectory would still be in tact. The numbers tell a different story. When looking at iPhone sales on a trailing 24 months, which helps diffuse some of the outsized impact from the iPhone 6 and 6 Plus, the iPhone business is about to experience its slowest growth yet. As seen in Exhibit 3, while sales growth remains positive, recent trends are cause for concern with the iPhone business quickly approaching no growth territory on a trailing 24 months basis. 

Exhibit 3: Quarterly iPhone Unit Sales Growth (Trailing 24 Months Basis) 

Caught by Surprise

The most alarming aspect of the iPhone's recent growth troubles has been that Apple management appears to have been caught off guard. The company thought the iPhone 6s and 6s Plus would build off of the sales level associated with the very successful iPhone 6 and 6 Plus. Instead, Apple is seeing iPhone sales fall 15% to 20% in 2016.

Rumors from Apple's supply chain had indicated iPhone component orders were cut soon after the iPhone 6s and 6s Plus launch. This was soon followed by additional rumors that Apple had cut iPhone production by 30%. While it is difficult to position these reports as concrete evidence that Apple overestimated iPhone demand, there are clearer signs that suggest management has not been able to completely get ahead of a deteriorating iPhone demand environment.

On October 27th, 2015, Tim Cook mentioned on Apple's 4Q15 earnings conference call that he expected iPhone unit sales to grow year-over-year in 1Q16. Cook based this assessment on the percentage of iPhone sales attributed to Android switchers and the iPhone upgrade rate, or the percentage of the iPhone installed base upgrading to a new iPhone. Three months later, Apple reported total iPhone sales of 74.8 million units, only 311,000 more than the previous year. To make matters worse, the only reason Apple was able to report any growth in iPhone sales was due to 3.3 million iPhones being added to channel inventory. Apple also just barely met its own revenue guidance for the quarter.

Cook has also given recent comments regarding iPhone sales that proved to be too optimistic. On Apple's 1Q16 earnings conference call, Cook said that he did not think iPhone unit sales would decline more than 15% in 2Q16 (in reality sales fell 16%). Cook then said that iPhone declines would trough in 2Q16 with better results during the back half of FY2016 given an easier sales comparison to prior year results. Apple's weak 3Q16 guidance proved that comment to be grossly optimistic. These types of miscalculations are not common for Apple and demonstrate that management has been unable to completely grasp the full extent of slowing iPhone demand. 

Warning Signs

On Apple's 2Q16 earnings call, management positioned pent-up demand for the iPhone 6 and 6 Plus and the weak global economy as the two primary reasons for slowing iPhone sales. While there is tangible evidence to support a portion of that claim, I'm skeptical that the iPhone's slowing growth is strictly related to two iPhone models, currency fluctuations and weaker economic conditions. 

Instead, there are a number of warning signs beginning to appear in the iPhone business indicating underlying deterioration:

Longer iPhone Upgrade Cycle. Much of the iPhone's current success has been a result of iPhone users regularly upgrading their devices every two years. However, there are signs that this upgrade rate is actually much longer than two years. Over the course of the past year, Cook has provided updates as to the percent of the iPhone installed base as of September 2014 that had upgraded to a larger iPhone (6, 6 Plus, 6s, or 6s Plus). At the end of 2015, 60% of the iPhone installed based as of September 2014 had not upgraded to a larger iPhone. That data point is not representative of an iPhone business on a two-year upgrade cycle. Instead, the iPhone installed base is, at a minimum, on a three-year cycle.

Much more concerning for Apple is that the longer the remaining 60% of the installed base delays an iPhone upgrade, the longer the upgrade cycle is extending. It is not unreasonable for the iPhone installed base to extend out to four or even five years. Not surprisingly, these trends were never accurately captured in consumer survey research reports. This is unchartered territory for Apple.

iPhone Growth Catalysts Are Disappearing. While there are legitimate reasons for explaining some of the iPhone's recent sales declines, much more concerning is how the largest multi-year growth catalysts for the iPhone business are either disappearing or turning out to be much less attractive than first thought. 

  1. Mobile carrier expansion is slowing. A significant contributor to iPhone sales growth over the years has been mobile carrier expansion. As Apple brought the iPhone to new mobile carriers, the device's addressable market continued to expand. In early 2014, China Mobile began selling the iPhone for the first time, opening up the iPhone to hundreds of millions of new consumers of which tens of millions were in a position to buy an iPhone right out of the gate. There are no additional carriers like China Mobile waiting in the wings where Apple can expand the iPhone's addressable market. Most of the world's population is now on a mobile carrier that sells iPhone.

  2. India is not the next China. India has recently been positioned as the next big growth engine for iPhone. However, it is becoming clear that this optimism has been grossly misplaced. Cook even admitted on Apple's 2Q16 earnings call that India's smartphone market is where China was seven to ten years ago. That comment is not too reassuring for anyone thinking India would pick up the sales slack from a slowing China market. The country is just not in a position to represent a significant driver for iPhone unit sales given Apple's current pricing strategy.

  3. High smartphone saturation rates. High smartphone saturation rates in the U.S. and other developed countries have removed feature phone users as an iPhone growth catalyst.

  4. Declining number of premium Android switchers. Apple has been very successful over the past year and a half appealing to high-end Android switchers craving larger iPhones. However, there are signs that the easy growth in terms of Android switchers is ending. There are only so many premium Android users in the marketplace, and Apple will need to begin appealing to Android users in lower price brackets to achieve the same kind of user growth. During 2015, there were approximately 1.2 billion people that bought a non-iPhone smartphone, up from a little more than 1 billion in 2014. Of that total, approximately 100 million were likely in a position to even buy a flagship iPhone. This does not exactly leave much room for Apple to grow the number of Android switchers year after year.

ASP and Margin Pressure. During Apple's 2Q16 conference call, management attributed a portion of its weak guidance to the iPhone SE impacting iPhone ASP and margins. Over the past two years, both of those metrics had held up remarkably well despite Apple peers facing increasingly deteriorating conditions. The combination of a higher priced "Plus" iPhone model and iPhone storage configurations provided a significant tailwind for maintaining attractive iPhone ASP and margin trends. The iPhone SE introduces a new headwind into the mix as the more successful the iPhone SE sells, the more pressure overall iPhone ASP and margin will face. 

Apple Has an iPhone Growth Problem

When looking at all of these iPhone warning signs, it is becoming clear that Apple has a significant iPhone growth problem on its hands. The combination of a slowing iPhone upgrade rate and declining number of growth catalysts for expanding the iPhone's addressable market will make it very difficult for management to report unit sales growth going forward given its current strategy. In addition, the iPhone SE highlights how any strategy to fix some of these issues will likely end up jeopardizing iPhone ASP and margin trends. 

It is important to note that the iPhone business is not imploding. Satisfaction rates and loyalty trends remain industry-leading. Apple has a very attractive iPhone installed base numbering close to 550 million users with additional users purchasing an iPhone in the grey market. Each quarter, Apple is still bringing new people to the iOS ecosystem. Instead, it is becoming much more difficult for Apple to grow iPhone unit sales each year. 

How Did This Happen? 

All of this seems a bit surreal. Apple just recorded its best quarter for iPhone sales in 1Q16. How can there now be so many iPhone warning signs only a few months after this milestone to the point that even Apple management was caught off guard?

The iPhone 6 and 6 Plus masked deteriorating iPhone trends. While those two iPhone models ushered in a wave of sales from both existing iPhone users and consumers new to iOS, upon closer examination the iPhone installed base had become much more diverse than first thought when it comes to thoughts on upgrading. In addition, the sheer success associated with launching iPhone on China Mobile made it that much more difficult to see an even greater amount of success in subsequent years. When dealing with unit sales growth, Apple needs to bring in many new consumers just to break even each year. At a certain point, it is just not sustainable. 

Finding the Path Forward

Apple needs to get ahead of this deteriorating iPhone demand environment. There are a few key elements to such a strategy: 

1) Throw out all existing conventions about upgrade cycles. Management cannot assume that iPhone users will upgrade to new iPhones like they have in the past. This will have an impact on how Apple approaches iPhone development schedules. It was clear that the iPhone "S" cycle ended last year, and current iPhone trends all but confirm that to be the case. It is now time to get rid of the "S" iPhone nomenclature as well. A case can even be made that it is time for Apple to change its entire iPhone numbering nomenclature given changing device upgrade behavior. 

2) Keep a pulse on the iPhone user base. It is becoming more critical than ever for Apple to understand the average iPhone customer. There is much change going on within the iPhone user base with a more diverse collection of thoughts towards technology and smartphone features. With Apple rumored to push ahead at the premium end with a differentiated iPhone Plus model later this year, Apple can no longer assume that iPhone users will follow the company in a similar direction. Greater focus needs to be placed on the risk that Apple ends up over serving the market by introducing certain features. It may sound odd, but Apple may end up slowing the introduction of certain new iPhone features and instead focus on other items that consumers are truly craving. 

3) Recognize the iPhone SE's power. The iPhone SE has the power to impact Apple ASP and margins much more than Apple management initially thought. There is an increasing level of risk that there may be unintended consequences associated with the iPhone SE including greater cannibalization of higher-end iPhone models.    

At a certain level, none of this should surprise Apple. The company's long-standing iPhone strategy involved it beginning at the high end of the market and slowly making its way down market, capturing as much profit share as possible at each subsequently lower price tier. At a certain point, this strategy enters a phase where growth slows and the business enters a much more mature product trajectory. The various warnings signs flashing in the iPhone business indicate that point has arrived.  

The good news for Apple is that the company is organized in such a way as to handle these iPhone warning signs better than most other companies. There are signs that Apple has been working to move beyond the iPhone for well over a year with Project Titan and other wearable devices representing the company's future. The one thing management needs to work on is moving the Apple narrative away from iPhone unit sales growth. 

One Steve Jobs quote displayed at Apple HQ will end up doing a great job of describing Apple's path forward for iPhone: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next." 

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AAPL 2Q16 Earnings Expectation Meters

During Apple's 2Q16 earnings conference call, management will continue to sow a new narrative around the company. With hardware unit sales slowing across the board, management is focusing on recurring revenue streams and iOS customer transaction values. 

Exhibit 1: Above Avalon's AAPL 2Q16 Estimates

The details and rationale/methodology behind all of my estimates are available in my 2Q16 Earnings Preview available here for Above Avalon members. (Click here for more information on membership.)

Given management's revenue guidance, Apple will report its first quarterly iPhone unit sales decline. The only question remaining is, just how bad was the drop? As seen in Exhibit 2, an iPhone unit sales decline of 10% to 17% would fall within my expectation range with the center point being a 13% drop from last year. It is important to note that the iPhone SE will be a 3Q16 earnings event given the device's launch timing. 

Exhibit 2: 2Q16 iPhone Expectation Meter

The unit sales declines are expected to extend to both iPad and Mac. Given my analysis regarding recent iPad sales mix, my 9M iPad unit sales estimate implies a dramatic 27% drop in sales from last year. This is made that much more worse considering the 12.9-inch iPad Pro was released a few months ago, not to mention the iPad category had already fallen 23% last year. The iPad business has essentially been cut in half. Similar to the iPhone SE, the 9.7-inch iPad Pro will be a 3Q16 earnings event given its launch timing. As for the Mac, it is still possible Apple may just barely squeak out unit sales growth. 

Exhibit 3: 2Q16 iPad and Mac Expectation Meters

Regarding Apple Watch, Apple's pattern has been to not disclose any actual revenue or unit sales data. Instead, management has chosen to provide subtle clues or hints as to how Apple Watch has performed. It is possible we may get a broad comment as to how Watch sales have done in the new year. As shown in Exhibit 4, Apple's "Other Products" revenue line item can be converted into Apple Watch unit sales. The usual caveat is that this table assumes an Apple Watch ASP of $425 (lower than previous quarters) and that accessories revenue amounted to $1.6 billion.

Exhibit 4: 2Q16 Other Products and Apple Watch Expectation Meters

As is the case with every Apple earnings report, most investor attention and focus will be put on management's guidance for 3Q16. Expectations over the past few months had Apple's 2Q16 showing the weakest year-over-year revenue performance from an optics perspective. However, in recent weeks, there has been growing concern that Apple's 3Q16 would also show a substantial revenue decline. My expectation is for Apple to guide revenue to -5% and -11%.

Exhibit 5: 3Q16 Revenue and Gross Margin Guidance Expectation Meters

As seen by my 2Q16 AAPL earnings expectation meters, Wall Street is expecting an all-around weak earnings report from Apple. Accordingly, investors will be looking for any surprises that help shed light on how current iPhone sales have been trending following the iPhone SE launch. The $400 iPhone 5s successor may end up representing the one bright spot in an otherwise difficult stretch for Apple regarding hardware unit sales growth.

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Above Avalon members received my detailed earnings preview (available here) and will receive my exclusive earnings reaction note containing all of my thoughts and observations on Apple's results this Wednesday following Apple's earnings release. 

The Car's "iPhone" Moment

The iPhone has never stood out for its voice calling capabilities. A feature phone from 2005 is able to make just as clear of a voice call as an iPhone 6s. Instead, the iPhone went on to do something much more profound than just improve the voice call. The iPhone showed the world that there was another way to think about the phone. Fast-forward nine years, and there are questions about whether the auto industry will experience its own "iPhone" moment. Will a new product or service come along that changes our perception of a car? Is autonomous driving the technology that will ultimately change how we think about cars? Will Uber and other ridesharing companies be able to rethink personal mobility? Does Apple think it has an answer for rethinking the car? Did Elon Musk already change the car's definition with Tesla? The journey to find all of these answers begins by looking at how Apple rethought the phone with iPhone.

Rethinking the Phone

The iPhone was born from a different kind of inspiration. Instead of looking at Blackberries and Motorola RAZR, the most popular phones at the time, Apple used the iPod as an example for what it wanted to achieve with its own phone.

While Blackberry, formerly called Research in Motion, was seeing remarkable success in enterprise by selling a smartphone with a keyboard that gave each letter its own dedicated hardware key, Apple looked at such a feature as a drawback. A smartphone's dedicated hardware keyboard ended up holding back the smartphone's potential. By taking multi-touch technology originally targeted at a large screen and seeing if it could work on a smaller screen, Apple ended up changing the smartphone's trajectory by not just removing the hardware keyboard but replacing it with an alternative that helped to rethink our perception of a phone. 

Of course, the iPhone didn't just add chaos to the smartphone industry because of its hardware design. Apple's existing capabilities when it came to software turned what was a phone in our pocket into a computer. In addition, working exclusively with AT&T gave Apple the flexibility to think outside the box. Even though the strategy was not looked at as a strength in 2007, Apple's control over phone hardware and software made it possible to rethink the phone.

Cars Are Like Phones

Given the iPhone's level of success, it is has become too easy to look at everything through an iPhone lens. Taking what worked with the iPhone and then applying it to other products and industries is a recipe for disaster. However, there are a few reasons that the automobile industry is much more similar to the smartphone industry than what first meets the eye. 

Using a smartphone and sitting in a car both revolve around a relationship between the user and product. For a smartphone, this relationship is straightforward: interacting with hardware in order to utilize software. The feel, look, and sound of a smartphone matter to the user. The car contains many of these same attributes. By simply sitting in an automobile, we are taken into a different environment in which a number of our senses are driven into overload including smell, touch, sight and sound. Both a smartphone and car are capable of containing and fostering unique experiences. Accordingly, it is possible to improve or alter the product in an attempt to create a better experience.

Tesla's success can be attributed to the relationship consumers have with their Model S and the broader experience of buying and driving an electric car direct from Tesla. Uber's success is a result of the experience created by easily getting from Point A to Point B in a safe and comfortable vehicle.

Similar to how hardware and software come together to contribute to a smartphone's experience, a similar dynamic is beginning to take over the auto industry. While it is difficult to call today's car dashboard experience pleasant, products such as CarPlay help to alleviate some of the friction points while autonomous features like Tesla's AutoPilot only exemplify the significant role software and hardware have to play in the car's future.

Rethinking the Car

Since cars and smartphones share a few important characteristics, the best way to discover the car's "iPhone" moment, or a new product or service that changes the long-standing perception of a car, is to look at our relationship with the automobile. What aspect of today's modern car has the potential to fundamentally change how we perceive and think about cars? 

Internal Combustion Engine? Replacing an internal combustion engine with an electric powertrain seems like a good way to improve various aspects of an automobile. Not only are we able to help the environment, but using battery power for propulsion leads to fewer moving parts to maintain on a regular basis. However, an electric powertrain by itself doesn't rethink the car. As the Model S and X have shown, while an electric car is capable of providing a much more enjoyable driving experience than many gas-powered cars, at the end of the day, it is still a car, albeit one of the better cars on the road. The primary reason electric powertrains are being positioned for a comeback is that the price of batteries continue to fall, making electric cars much more economical. 

Human Driver? Having software control a car will certainly change how we use cars. However, people have been sitting in the back seat of cars and having someone else drive them around for a very long time. Uber and the broader taxi industry serve as prime examples for why autonomous driving doesn't fundamentally alter a car's definition. Similar to electric powertrains, autonomous driving features may lead to a better car experience, but more is needed to actually rethink the car. 

Dashboard? Many have positioned a car's dashboard as the modern day version of a Blackberry keyboard - a collection of overly complicated buttons and switches that take away from the experience of driving or simply sitting in a car. Following this thought through, some have argued that allowing our smartphone to integrate with our car's dashboard will provide the familiarity that consumers demand. Unfortunately, improving a car's dashboard does not change our perception of a car.

At a fundamental level, the dashboard is an interface used to control a car. Simplify a car's propulsion system by replacing an internal combustion engine with an electric powertrain, and the need for a complicated dashboard is instantly reduced. Go further and add software that handles everything from autonomous driving features to cabin temperature, and the result is the Tesla Model 3. Replacing a complicated assortment of dashboard buttons with one large tablet screen marks a milestone for the car. However, a self-driving, electric car with a tablet as a dashboard does not fundamentally transform how we think about a car. It is still a box, albeit a much smarter box on wheels that gets us from Point A to Point B.  

The Car's Friction Point

If electric powertrains, autonomous driving, and software dashboards don't change how we perceive a car, it would appear that the auto industry may lack an iPhone moment in the traditional sense of the term. That is unless the answer has been literally sitting beneath our noses for decades. 

While it may seem like of one the most boring parts found in a car, the seat represents the biggest barrier to rethinking the car. If a company can rethink the car seat, our perception of a car will change, and ultimately, the entire auto industry will be impacted. The car seat is the car's version of the smartphone hardware keyboard. 

Seats play the largest role in our in-car experience. Everything from how we feel to where we are looking and what we are doing is determined by a car seat. Given these important roles, it is shocking that the car seat has seen very little change over the years, as depicted in the following pictures.

If cars are nothing more than boxes on wheels, the primary way to rethink the car is to change how we think about the "box." Similar to how the iPhone was inspired by the iPod and not the leading smartphones at the time, the best inspiration for rethinking a car's passenger compartment comes from the mobile products in our pockets and on our wrists, not the best-selling cars on the road.

Smartphones, tablets, and wearables are all about personalization. We want our iPhones and Apple Watches to be specifically suited to our personalities. Both hardware and software help accomplish that goal. With cars, the same type of personalization is nowhere to be found. The average car buyer has a finite number of options available to create an experience specifically suited to them. Once a car is delivered, future modifications and changes are pretty much nonexistent. What if there was a way we could rethink what it means to personalize our car experience? 

It all begins with the seats. By no longer thinking of seats as stationary benches facing forward, we can begin to come up with a way of creating different experiences inside a car based on our mood or merely the time of day. Of course, we have seen examples of this in the real world when it comes to the family car, such as the 2008 Dodge Caravan (pictured below).

However, there is a reason why consumers never embraced this type of setup in numbers: It was clumsy and aggravating to set up, and it was far from personalized. What if there was a way to create a certain kind of car compartment layout for one situation but then be able to switch layouts with an iPhone or even Apple Watch? Or how about creating a seating arrangement on our iPhone for one car, saving it, and then loading that same arrangement in a different car? The way we perceive a car will change. Instead of being just a box on wheels, the car will become a room on wheels. 

By relying on software to create our own unique experience and then taking that experience from car to car, we would have essentially recreated an iPhone-like experience on wheels. 

Competitive Landscape

There are very few automobile companies in a position to combine hardware and software to rethink the car seat. Ironically, the cars that have historically been the closest to delivering this kind of vision have been either large boxes on wheels like Dodge Caravans or an ultra-luxury car like a Rolls-Royce. Even then, the offerings still pale in comparison to what can truly be accomplished with software. 

Despite very high customer satisfaction rates, Tesla doesn't seem close to moving in this direction as it continues to position performance as the primary reason to buy a Tesla Model 3. In fact, the inside of a Tesla is often regarded as the vehicle's weak point. Meanwhile, the Model X internal compartment design is very conservative. This leaves Apple and Project Titan.

Project Titan

It is no secret that Apple's strength is not just hardware and software integration but the design behind the experience created from combining the two. Along those lines, while very little has been said about Apple's rumored electric car project, there are a number of clues to suggest where Apple is likely looking. Marc Newson, the newest member of Apple's industrial design team, has tried his hand at seemingly everything at least once, but one of his most well-known designs was a concept car for Ford commissioned back in 1999 (seen below with orange seats). While the car has ended up being quite a polarizing object over the years, the takeaway from his design was the importance of rethinking conventional wisdom all the way down to how we would enter or exit the car. 

In addition, a company reportedly attached to Project Titan shipped a 1957 Fiat Multipla 600 (the yellow car below) to the U.S. in 2014. Don't focus on that exact car. Instead, consider how the internal compartment would certainly mesh well with the concept of rethinking car seats and turning a box on wheels into a room on wheels. 

In fact, Marc Newson has a pretty extensive history of turning boxes into rooms. He designed the internal compartment of a private jet interior as well as a Qantas A330. 

Add it all up, and it would look like Project Titan has the resources to spend much more time rethinking a car's interior than an electric powertrain or driving performance. 

The Car Seat Opens Doors

If a company can rethink the car seat and the kind of experience possible inside a car, our definition of a car wouldn't just change, but we would be able to fully utilize car features like electric powertrains and autonomous driving.

If a car becomes fully autonomous, what happens to the driver seat? Does it make sense for everyone to face forward when the car is moving? These types of questions don't have clear answers if the car seat isn't rethought. Instead, we are merely occupants in a box that drives itself. Bring in the topic of ridesharing and being able to "load" our individual car compartment settings for a car just about to pull up to our pickup zone, and the possibilities created by rethinking the car seat begin to materialize. While it may seem like safety regulations and state laws may curtail the possibilities in this area, rethinking the seat may actually end up improving safety inside moving cars. The main reason why car companies have not embraced new ideas for the seat is limited customer acceptance. However, instead of it being a roadblock, it should serve as an opportunity for new companies to approach the problem from a different angle. 

The car's "iPhone moment" will likely end up being an idea - thinking of cars as extensions of our homes - personalized rooms on wheels. While most think the way to build such a product is to simply add software to a car dashboard, the answer is actually found by rethinking the most important part of a car - the seat. 

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Examining Apple's Dividend Strategy

Apple's board is expected to authorize an increase in the company's quarterly cash dividend later this month in conjunction with 2Q16 earnings. Ahead of this event, I examined Apple's dividend strategy. All signs point to Apple relying on a stable dividend policy in which dividend expense follows an existing long-term growth trajectory rather than near-term earnings volatility. By finding this dividend growth trajectory, it is possible to for look subtle shifts in trajectory going forward. These shifts will provide clues as to how management views long-term business prospects and profit opportunities. 

Dividend Growth

In order to find Apple's future dividend growth trajectory, we must first take a look at the company's historical dividend growth rate. After a 17-year hiatus, Apple reinitiated its quarterly cash dividend in 2012. Since that time, Apple has paid out $42 billion ($6.84 per share) of dividends while the share price increased approximately $26. Accordingly, the dividend has been responsible for approximately 20% of an AAPL shareholder's total return.

Apple has increased its quarterly cash dividend annually beginning in 2012:

  • 2012: $0.38
  • 2013: $0.44 
  • 2014: $0.47
  • 2015: $0.52

In order to calculate Apple's historical dividend growth rate year-over-year, we take quarterly cash dividends per share and convert them into an annual total, keeping in mind that Apple increases the quarterly dividend midway through its fiscal year: 

  • 2013: $1.64
  • 2014: $1.82
  • 2015: $1.98

We can now calculate the year-over-year growth rate for total dividends per share paid on an annual basis: 

  • 2014: 11%
  • 2015: 9%

Apple discloses in its financial filings that it intends to increase the quarterly dividend annually. It would appear from looking at 2014 and 2015 growth trends that Apple management is on a trajectory in which it will increase its quarterly dividend by approximately 10% each year. However, there is more to the story. 

Apple's share buyback is playing a significant role in defraying the total cost of these 10% dividend increases. As Apple buys back its shares, the number of shares outstanding is reduced. This leads to Apple paying out fewer dividends, all else equal. As long as Apple buys back shares, management will continue to have greater leverage when it comes to raising the quarterly cash dividend. Said another way, current shareholders are seeing an indirect benefit from the share buyback by receiving higher dividend payments per share.

To see how share buybacks have made it cheaper for Apple to pay higher cash dividends per share, consider the amount Apple spends on cash dividends annually:

  • 2013: $10.6B
  • 2014: $11.2B
  • 2015: $11.6B

Since these totals exclude the impact from share counts, we can calculate the growth rate in Apple's annual dividend expense: 

  • 2014: 6%
  • 2015: 4%

Even though the Apple board has been increasing the quarterly cash dividend by approximately 10% over the past two years, the total growth in Apple's dividend expense has actually been only approximately 5% per year. The reduction is due to a lower share count produced by Apple's share buyback. We can now use this 5% dividend expense growth rate as the base line when plotting Apple's future dividend growth trajectory. However, we first need to measure Apple dividend sustainability.

Dividend Sustainability

In order to judge how sustainable it is for Apple to increase its dividend expense by 5% each year, we need to look at Apple's dividend payout ratio. As the name implies, a dividend payout ratio shows the percentage of a company's total net income that is paid to shareholders in the form of cash dividends.  

Apple's dividend payout ratio (dividends / net income) has been trending down:

  • 2013: 29%
  • 2014: 28%
  • 2015: 21%

The declining dividend payout ratio is a sign of improving dividend sustainability because it suggests Apple has remained conservative with its dividend growth policy even in the face of strong earnings growth. When compared to industry averages, Apple's 21% dividend payout ratio is only marginally higher. This is a byproduct of Apple following a stable dividend policy in which the company strives to maintain a certain level of consistency when it comes to dividend expense growth. Even though Apple saw a boost in earnings in 2014 and 2015, management will likely follow its existing strategy of running with a modest 5% increase in dividend expense. There are a few reasons to do this with the main one being that investors value predictability. Apple avoids having to make sudden dividend swings in the future, including cutting the dividend when earnings slow. 

The primary takeaway is that future Apple cash dividends will not be determined solely by the company's earnings. Instead, Apple dividends will be based on a stable growth policy in which management targets a consistent dividend growth rate that does not follow the cyclical nature of its business. By selecting a dividend that appears to be well within their capability of paying, management is indicating they are comfortable increasing their dividend expense by 5% each year. Going forward, management can use the dividend payout ratio as a periodic check to make sure that the company is not playing it too safe with its dividend or vice versa, putting itself in financial distress. 

Charting Apple's Dividend Trajectory

Since we now have a sustainable, dividend expense growth rate in hand, it is time to plot Apple's future dividend trajectory. We assume Apple maintains its 5% growth rate in dividend expense going forward (represented by the blue line in Exhibits 1 and 2) because of Apple's stable growth dividend policy. In addition, two other dividend expense growth scenarios are plotted in Exhibits 1 and 2, including a more robust 10% growth trajectory (green line) and a weaker 2% growth trajectory (red line).

Exhibit 1: Apple Dividend Expense Trajectory ($ billions)

Exhibit 2: Apple Quarterly Cash Dividend Trajectory (Per Share)

Assuming Apple increases its dividend expense by 5% each year and the current pace of share buyback is maintained, we now have five years of expected dividend expense:

  • 2016E: $12.2B
  • 2017E: $12.8B
  • 2018E: $13.4B
  • 2019E: $14.1B
  • 2020E: $14.8B

Converting these totals into quarterly dividends per share (keeping in mind share buyback will lower the share count as time goes on), we arrive at: 

  • 2016E: $0.58
  • 2017E: $0.63
  • 2018E: $0.69
  • 2019E: $0.75
  • 2020E: $0.82

This would suggest that when Apple announces a dividend increase later this month, my expectation is for a 12% increase to $0.58 per share per quarter. When converting these quarterly dividends into annual totals, we get: 

  • 2016E: $2.20
  • 2017E: $2.42
  • 2018E: $2.64
  • 2019E: $2.88
  • 2020E: $3.14

Trajectory Shifts

Of course, a company's dividend strategy does not operate in a vacuum. If the business environment changes, management will need to reassess whether or not the change will result in a permanent increase or decrease in industry attractiveness and profitability. A weaker outlook may lead management to cut its dividend growth trajectory in order to conserve operating income. Vice versa, a stronger outlook could give management room to increase its dividend which would benefit current shareholders, including Apple employees. 

This is where we can use Apple's likely dividend growth trajectory to our advantage by monitoring whether or not management veers off its current course (blue line). Exhibit 3 highlights how a shift in dividend growth can be either classified as a positive trend (green shaded area) or negative trend (red shaded area).

As an example, if Apple reports dividend expense between $12.8 and $14.0 billion in FY2017, then it would fall in the green positive trend area and indicate that Apple management has increased its dividend expectations. If dividend expense is between $12.0 and $12.8 billion, then Apple reduced its dividend expectations. Apple could certainly report dividend expense that is above and below even the shaded regions, which would obviously indicate somewhat major shifts in management attitudes toward Apple's prospects. 

Exhibit 3: Apple Dividend Expense Trajectories

Dividends Matter

Wall Street understands that Apple's earnings are volatile. It is rational to assume that over time, there will be earnings peaks and troughs depending on Apple's current product line at any given moment. Given this volatility, Apple's dividend strategy is aimed at adding a bit of continuity and predictability to the mix. This is just another reason why it is in Apple's best interest to maintain a steady dividend growth rate that can survive the ups and downs of Apple's product line.

While paying a small $0.58 per share quarterly dividend may not seem like a big deal, if Apple grows its dividend expense by 5% each year and continues to buy back shares, Apple will pay nearly $3.15 of dividends per share annually by 2020. At Apple's current stock price, this would equate to a very attractive 2.8% dividend yield. If we assume Apple maintains its current 1.9% yield, Apple's stock price would trade at $165 per share. These two examples show the power behind a dividend, even if it experiences modest growth from year to year. Apple dividends are going to matter much more than many people think.

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Apple Watch's Future Will Include Smart Watch Bands

Expectations surrounding Apple Watch continue to decline. Given slowing sales growth at some of the leading wrist wearable companies, including Fitbit, there is a feeling that the wrist wearable category has been one giant head fake, a fad that just doesn't contain much potential beyond tech enthusiasts. This view not only ignores reality given the number of Apple Watches sold to date, but also fails to understand the path wrist wearables will follow. The Apple Watch's future will not be found just with better Watch cases updated on an annual schedule like an iPhone. Instead, Apple Watch bands deserve more attention going forward as they begin to incorporate technology and gain additional importance for wearable computing. A smarter Watch band will play a crucial role in Apple Watch's future as a personal technology device.

Apple Watch's First Year

Apple sold approximately 10 million Apple Watches during the first eight months on the market, placing the Watch as the second best-selling new product category in Apple's history. For perspective, Apple sold 15 million iPads during its first three quarters on the market. The majority of Watch sales occurred in the U.S., and the lowest-priced Watch Sport collection, which was responsible for a majority of the sales, had seen significant customer interest around the holidays given Best Buy and Target sales promotions. In terms of Watch bands, the Sport Band has proven to be the clear choice with consumers. 

The Apple Watch has undergone an expectations reset over the past year. The device was initially positioned as a mini iPhone on one's wrist. The expectation was that we would use a series of apps positioned in a honeycomb pattern on a small piece of glass worn on our wrist to get through our day. After only a few weeks of use, it became clear that this vision was not going to be the primary use case for most people. The introduction of watchOS 2 in September didn't change the trajectory. 

Apple contributed to these initial Watch expectations in the way they unveiled the device in September 2014 and yet again in March 2015. While Apple's positioning of the Watch as a great way to display small amounts of text and information was on point, management's broader focus on third-party apps hasn't materialized. While some may attribute lackluster developer interest as the primary reason app usage has trended differently than expected, the much bigger reason was that Apple likely tried overselling the Watch. In reality, consumers saw value in a few simple daily tasks like receiving notifications from their favorite apps. Instead of involving searching and then interacting with apps like we would on an iPhone, the Watch required a new, much simpler way of interacting with apps.

The Watch's future is not found by simply taking the way we use our iPhone and putting it on a smaller screen on our wrist. Instead, the Watch will gradually handle tasks we used to give to our iPhones. We already see this taking place in terms of sending and receiving messages and paying for things in stores. In addition, the Watch is beginning to handle new tasks like tracking our health. The commonality among all of these tasks is the need for evolutionary updates and improvements in order for Apple Watch to be positioned to handle many more tasks as time progresses.

Apple Watch Bands

While Apple Watch app usage has trended differently than Apple initially positioned, watch bands were one aspect of the Watch that Apple seemed to get right from the beginning. The wide variety of available Watch bands has contributed significantly to Apple Watch's success. As it is a personal device worn all day, every day, the ability to add personality to one's Watch with different bands has proven popular. Tim Cook recently pointed out that one third of Apple Watch owners regularly change their Watch bands. This amounts to more than three million people buying at least $150 million of what amounts to an Apple Watch fashion accessory. While this may pale in comparison to revenue from Apple's other products, early trends contain much promise. 

As a sign that Apple expects Watch bands to play a crucial role in Apple Watch's future, Apple had a new range of Watch bands ready for sale only five months after launching Apple Watch. At the same time, the Hermès partnership was announced, positioning luxury leather bands as the centerpiece of a new Watch collection. Last month, Apple unveiled additional Watch bands for its "Spring collection." The motivation behind these moves was clear: New Watch bands add a sense of freshness to the product category. A new phenomena developed and instead of buying different Watches from more than one collection, consumers were buying multiple Watch bands and switching them on and off depending on the occasion. It was difficult to miss Jony Ive coordinating his Watch band selection with whatever he was wearing at various Apple keynotes and events. There was something with Watch bands that caught consumers' attention much more than even the Watch cases themselves.   

My Experience

Over the past 12 months, my Apple Watch experience has reflected many of these larger themes that sum up Apple's entry into the wrist wearable category. The Watch's value proposition has revolved around three primary items for me: notifications, timekeeping and fashion. 

  1. Notifications. Apple positioned sending and receiving notifications as a key Apple Watch attribute from the start and with only a few exceptions, this has largely proven true. There is value and convenience in being able to easily see iMessages, incoming phone calls, tweets, and other short reminders without having to retrieve my 5.5-inch iPhone 6s Plus from a pocket or nearby room. 
  2. Timekeeping. Even though it sounds comical, I use my Apple Watch for timekeeping. As there is convenience found with receiving notifications on my wrist, there is value in not needing to find my iPhone to see the time. However, as a sign that Apple Watch is something more than just a watch, I never used my traditional watch to tell time. This may be attributed to the fact that I prefer Apple Watch faces over a traditional watch face.  
  3. Fashion. There is no question that the only reason I wear my Apple Watch every day is because of the Sport band. There is value in forgetting I am actually wearing the Watch thanks to the Sport band's comfort and design. Watch bands play an important role in positioning Apple Watch not just as a personal technology device, but also as a fashion accessory. This was the primary reason I previously wore a traditional watch - not because of its usefulness, but to simply put something on my bare wrist. 

When combined, these three use cases help show not only how effective the first edition Apple Watch has been in serving as an iPhone accessory, but also where Apple can push to bring the device to the next level. One obvious next step involves looking beyond just the Watch case and instead, thinking about my entire wrist. 

It's All About Wrist Real Estate

After looking at my three primary Watch use cases, a few things stood out to me. I enjoy having some type of display on my wrist that is capable of showing me more than just the time. Simple plastic wrist bands or pieces of smart jewelry not having the capability to display text, pictures, and yes, even emoji, don't represent the future of wearable computing. Instead, these devices will forever remain accessories to other screens in our lives. 

The need for some type of display with a clear line of sight means Apple Watch's rectangular display sitting on top of the wrist will remain for the foreseeable future with periodic updates that include faster processors, improved sensors, and evolutionary design changes. I think the Apple Watch case is still a bit thick. The eventual inclusion of GPS and cellular connection will likely represent significant shifts in trajectory for Apple Watch adoption.

Expectations currently point to the first major Apple Watch case revision being unveiled in September. However, instead of looking at these periodic Watch case changes as the extent of Apple Watch's future, there is actually more potential found with Apple Watch bands.

Success for wrist computing involves taking the finite amount of real estate on our wrists and using it to make technology more personal. This doesn't mean just taking technology and putting it closer to our bodies, but rather it means using a device's design to introduce new capabilities. Wearables make it possible to extract additional power from technology without having it take over our lives. One example is paying for an item in a store by using Apple Pay with just an arm swing and double press of a button. Another is turning a gentle tap on the wrist into a form of communication. This quest for making technology more personal has been Apple's singular mission over its 40-year history. 

In terms of wrist real estate, as shown in the picture below, the Apple Watch Sport band takes up nearly four times as much wrist area as a Watch case.

The M/L Apple Watch Sport band takes up four times as much area on the wrist as the Watch case. 

Obviously, this ratio will change depending on the user, but the primary point is that simply utilizing the top of our wrist is not optimal for wrist wearables. While the top part of the wrist is ideal for viewing data, the rest of our wrist can still be used for other purposes.

Including additional sensors, battery volume, and other components directly into Watch bands will better utilize wrist real estate. Instead of having the Watch case be the only "smart" piece, Apple will likely begin selling Watch bands that go much further than just representing pieces of fashion. The fact that thinner Watch cases would seem to stand at odds with the need for additional battery space and the eventual inclusion of GPS and cellular connection may further stand as motivation for pushing certain components into Watch bands.

We likely got a glimpse of this future when looking at the New Yorker's profile of Jony Ive which mentioned that he admitted much of Apple's Watch R&D was focused on the bands and not the rectangular Watch case. 

There are a number of ways Apple could incorporate technology into Watch bands, including even a modular approach, which Apple has patented. One real-world example of this type of setup is consumers' ability to swap out Watch bands for ones with built-in battery, extending the Watch's usability. The user would then be able to further refine the band, adding or removing links containing extra battery. The same can be done for health-related bands containing certain sensors that require a cuff-like product to work properly. This is where Apple could theoretically apply for FDA approval for specific Watch bands marketed to treat or diagnose various diseases and conditions. In this scenario, Apple would avoid putting the entire Apple Watch through the FDA approval process. 

Sales and Price Implications

The addition of smart Watch bands will have major implications for Apple Watch financials. One likely scenario is that customers will use Watch cases for an extended period of time. Meanwhile, smart Watch bands would be positioned as items worth upgrading more frequently. In fact, Apple has already begun positioning Watch bands as something worth purchasing multiple times a year based on the season.

This would suggest that the number of Apple Watch users would be a much more important metric to track than the number of Apple Watches sold. As the number of Apple Watch users increase, the addressable market for various smart Watch bands will expand. In a few years, selling a $199 smart Watch band into an Apple Watch installed base of 30 to 40 million users will lead to much success even if a small fraction of Watch owners buy the band.   

In terms of pricing, instead of highlighting three Watch collections based on Watch case materials (aluminum, stainless steel, gold), Apple could position Watch bands as the primary pricing variable. It appears Apple is already moving in this direction based on their new Watch interactive gallery available on Apple's website (shown below) where there isn't much distinction between the Sport and Watch collections. 

Apple's New Apple Watch Interactive Gallery.

Product Implications

While a rectangular piece of glass sitting on the top of the wrist is an adequate way to to display data today, the Watch band itself will likely one day be able to display data. Over time, Apple Watch could be nothing more than a smart wrist band with a flexible AMOLED display containing a mix of personal technology and fashion. As with its Hermès partnership, Apple could work with existing luxury companies to build Watch bands that contain precious metals and minerals. If watch manufacturers were already concerned about Apple Watch, the move away from dedicated watch cases and to flexible bands capable of displaying information would represent even greater anxiety.

A Hybrid Approach

It is easy to think of Apple Watch case development in terms of iPhone and iPad. Each year, or in the case of iPad, approximately every 18 months, Apple releases an evolutionary update containing various amounts of hardware and software improvements. However, the iPod may end up serving as a better example for how Apple Watch bands will evolve. Comparing the very first iPod released in 2001 to today's iPod touch conveys the message that the product saw not only incremental design changes, but also fundamental shifts in feature sets based on new technology. This would suggest Apple Watch will likely take the hybrid approach. Watch cases will retain much of their familiarity and see more evolutionary changes while Watch bands will become much smarter over time and capable of eventually replacing even Watch cases. While the Apple Watch continues to be underestimated, Watch bands rather than Watch cases will prove to possess the larger amount of surprise. 

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iPhone SE Is Apple's $30 Billion Bet on 4-Inch Screens

Instead of representing a seismic shift in iPhone strategy, the iPhone SE is a byproduct of Apple's current screen size differentiation strategy. Apple has given the iPhone SE a very specific mission: succeed the iPhone 5s and entice a portion of the 240 million iPhone users still using a small screen iPhone to upgrade to newer hardware. Apple is placing a $30 billion bet that a 4-inch iPhone with a four-year old design, updated with newer components, will help accelerate the iPhone upgrade cycle. The iPhone SE is a "special" opportunistic bet set within Apple's existing strategy to expand the iPhone line. 

Background

The best way to understand why Apple introduced the iPhone SE is to look at the iPhone business over the past few years. In September 2014, the iPhone 6 and 6 Plus not only kicked off Apple's entry into multiple screen size iPhone development (4.7-inch and 5.5-inch screens), but also began a global sales bonanza as pent-up demand for larger iPhones, combined with the iPhone rollout at China Mobile, resulted in strong 37% year-over-year growth in iPhone sales for FY2015. 

However, in recent months, a few negative developments began to appear in the iPhone business. While Apple was still bringing new customers into the iOS ecosystem at a steady clip, the rate at which existing iPhone users were upgrading to newer iPhones was beginning to slow. Specifically, 3.5-inch and 4-inch iPhone users were showing hesitation towards getting larger screens. While the reasons for this hesitation vary with some preferring smaller screens and others simply being content with their current small iPhone, Apple had a growing dilemma on its hands: how to get these users to upgrade to newer iPhones. The motivation isn't just found with hardware profits, but also with services revenue since roughly 40% of the iPhone user base is using an iPhone that does not support Apple Pay in retail stores. 

To make matters worse, Apple stopped selling its low-cost iPhone 5c (an OK seller) this past September, which meant the iPhone 5s was Apple's last remaining 4-inch screen iPhone. With the device getting long in the tooth and its third anniversary quickly approaching, Apple would need to make tough choices regarding not just the iPhone 5s, but also its broader 4-inch screen strategy. It was time for Apple to place a few bets. 

The Keynote

Apple VP Greg Joswiak had one objective when announcing the iPhone SE: explain to the press why Apple is selling a new 4-inch iPhone when the trend had been towards larger screen iPhones. Obviously, he couldn't say that Apple needed a way to get existing 3.5-inch and 4-inch iPhone users to upgrade, so instead he framed the narrative that small screens were still popular among iPhone users in addition to serving as an iOS entry point for new users. Specifically, Joswiak pointed out that 13 percent of iPhones sold in 2015 (more than 30 million units) were 4-inch iPhones. Since Apple sells more than 200 million iPhones per year, even a small sales percentage like 10-15 percent is a significant number of iPhones. 

After saying that people (current iPhone users) asked and pleaded with Apple to keep a small 4-inch iPhone in the lineup, Joswiak spent the rest of his time on stage explaining that Apple was going to do just that. Instead of facing the prospect of the 4-inch iPhone form factor possibly becoming extinct in a few months, Apple would take an iPhone 5s and future proof it by adding some of the latest technology to the same "beloved aluminum design" familiar to hundreds of millions of customers. 

Slide after slide, Joswiak ran with the message that the iPhone SE was better than the iPhone 5s. Specifically, Joswiak focused on the features that would matter most to existing iPhone 5s users thinking of upgrading, discussing how the SE was faster than the 5s, had better battery life, included better cameras, and of course, supported Apple Pay.

Apple spent most of the iPhone SE slides comparing the device to the iPhone 5s. 

The message couldn't be clearer. Apple is positioning the iPhone SE as a "special edition" model targeting the 240 million existing iPhone users still on smaller screens. If the SE ends up also appealing to feature phone users or Android users in emerging markets, then the model will have done even better than expected, but this is not Apple's primary target. 

Within just five minutes, Joswiak was able to explain the iPhone SE. The presentation's brevity was due to the device being an iPhone 5s with some 6s internals. The iPhone SE isn't quite an iPhone 6s in smaller form factor as it contains the same screen and home button as the 5s resulting in no 3D Touch or second-generation Touch ID. Meanwhile, the front-facing camera is the same one included in the iPhone 6 and 6 Plus. Instead, Apple picked a component set that would not only appeal to existing iPhone users, but also be able to last for an extended period of time in an iPhone line that would see updated components in six months with new flagship iPhones.  

Future-proofing the iPhone SE.

Price

From Apple's perspective, having 30 million people buy a 4-inch iPhone in 2015 suggested that smaller iPhones still had a future. However, a key question remained. How much of this small iPhone demand was due to the iPhone 5s (and 5c) having a small screen or low price? During the first nine months of 2015, Apple sold the iPhone 5c for $450 while the iPhone 5s went for $549, followed by a $101 price reduction this past September. The fact that a greater percentage of smaller rather than larger iPhone sales went to first-time iPhone users didn't do much to answer the fundamental question concerning screen size versus low price. 

Apple was very deliberate in choosing the iPhone SE's $399 price. The device is not priced as a cheap iPhone 6s, but as an iPhone 5s successor. This means that in a world where a year-old 4.7-inch iPhone retails for $549, a 4-inch iPhone with a four-year old design needs to be priced aggressively to appeal to existing small iPhone owners. 

Pricing a new iPhone at $399 is a significant change for Apple because for the first time, a consumer could own the latest iPhone technology at a 40% discount from the traditional $649. However, instead of this change being a transformational shift in Apple pricing strategy, the move is actually based on Apple's screen size differentiation strategy kicked off in 2014 with the iPhone Plus. Apple has been positioning screen size as a way to determine an iPhone's price. The iPhone SE is the first 4-inch model to go through this differentiation strategy. As seen in Exhibit 1, the iPhone SE is positioned within the iPhone line as Apple's less expensive 4-inch iPhone 5s successor. Come September, the iPhone SE will have year-old technology and be in line with year-old $549 4.7-inch and $649 5.5-inch models. 

Exhibit 1: The iPhone SE's Place Within the iPhone Line (September 2016) 

Similar to how an iPhone Plus is priced at a premium to the flagship 4.7-inch model, a 4-inch model would be priced at a discount to the flagship iPhone model. The iPhone SE's borrowed iPhone 5s design allowed Apple to hit this $399 price without destroying profit margins. In addition, the iPhone SE is still priced at a premium internationally, similar to other iPhone models, suggesting Apple is not looking at the iPhone SE as its "cheap iPhone" emerging markets trojan horse. Instead, the iPhone SE is a special edition 4-inch model geared toward existing iPhone users that crave small iPhones.

The $30 Billion Bet

Apple is making a significant bet with the iPhone SE as billions of dollars in revenue are put at stake by discontinuing the iPhone 5s and positioning the iPhone SE as its only small iPhone. 

Over the next two years, Apple thinks it will be able to use an updated iPhone 5s to entice a certain percentage of the 240 million iPhone users still using small iPhones to upgrade. From a sales perspective, if the iPhone SE can continue to grab the same sales share as the iPhone 5c and 5s in 2015, then the device will bring in $7 billion of revenue in FY2016 (two quarters remain), as shown in Exhibit 2.

However, with the iPhone SE displaying qualities characteristic of a model that will stay around in the lineup for a while, Apple's bet could escalate to $30 billion of revenue over the span of the next two years. Of course, it is conceivable that at $399, the iPhone SE will sell even better than Apple expects and represent as much as 25% of iPhone sales, which would contribute nearly $40 billion of revenue to Apple's top line over the next two years. On top of it all, much of this revenue would be related to iPhone sales that may not have occurred if it wasn't for a new 4-inch model. 

Exhibit 2: Potential iPhone SE Unit Sales and Revenue (FY2016 and FY2017)

If the iPhone SE sells well at $399, then Apple will gain confidence with future 4-inch screen pricing strategy, especially for a completely new 4-inch screen iPhone (likely priced at $499). This pricing strategy would largely be based off of Apple's ongoing screen size differentiation strategy in which larger iPhones are sold for more while smaller iPhones are sold for less. 

A poor performing iPhone SE at $399 will provide even greater insight to Apple. If the iPhone SE doesn't sell well, then Apple knows consumers likely prefer a completely revised iPhone and not just an older iPhone with newer components. The fact that 240 million are still using small iPhones despite being able to upgrade to newer, larger models, suggests there is some level of demand for a small iPhone, even if it represents only 10-15% of the iPhone user base (translates to an eventual 50 to 100 million users).

Apple's iPhone Strategy

Apple employs a business strategy of selling a select number of iPhone models at significant volumes and premium prices in order to maximize profit. Beginning at the high-end, Apple squeezes as much profit out of the smartphone market as possible, gradually working down market, grabbing whatever profit is available at each subsequently lower price tier. The end result is that Apple holds 90 percent smartphone profit share but 15 percent sales share. 

Historically, $649 was the lowest price at which Apple was willing to sell the latest iPhone technology. Meanwhile, older iPhone models with dated technology were offered at $450 and $549. However, these prices were for an iPhone line that lacked screen size diversification. As the iPhone line matures and Apple embraces multiple screen sizes, larger iPhones are priced at a premium while Apple is pricing newer, smaller iPhones at a discount. This dynamic is now taking place with the iPhone SE.

Heading into last week's keynote, expectations were for the iPhone SE to be priced at $399 or $449, so its $399 price is not so much a shock, but rather a sign that Apple is confident it can manufacture the device quite efficiently. Given its four-year old "beloved" design and the fact that all of its components are already being produced at scale and will be included in nearly 200 million iPhone 6s and 6s Plus units sold in FY16, Apple is able to sell the iPhone SE at $399 and still retain respectable profit margins.

Apple is essentially utilizing screen size differentiation as the next step in its long-standing iPhone strategy of maximizing profit by moving downmarket. At $399, Apple would be pushing consumers in the $199-$299 price range to move up and purchase the iPhone SE. This moving up process results in value creation within the smartphone market as consumers are willing to spend more on an iPhone - a byproduct of Apple's existing strategy.  

While the iPhone SE is fundamentally different than the iPhone 5c, both devices share a few characteristics. Instead of each representing a fundamental shift in iPhone strategy, the 5c and SE are targeted Apple bets aimed at addressing friction points within the iPhone business. The iPhone 5c served as a way to sell iPhone 5 technology in a less expensive shell and also differentiate the more expensive iPhone 5s. With the iPhone SE, Apple is answering the dilemma posed with aging iPhone 5s and iPhone users still showing interest in a 4-inch screen. There is no question that the iPhone SE is a different kind of iPhone, but being different does not automatically suggest a fundamental shift in strategy. 

The iPhone SE's Future

It's too early to determine the iPhone SE's future. Since the "special edition" nomenclature denotes the device's goal of bringing in iPhone upgraders, the iPhone SE's popularity may ultimately play a factor in how long Apple keeps the SE on the market and at what price. It would seem likely that the iPhone SE will continue to be sold beyond September when Apple introduces new iPhones. There is no indication that Apple will begin selling another 4-inch iPhone at that time. This would serve as another piece of evidence that the iPhone SE is not a shift in iPhone strategy, but rather a targeted bet. If Apple continues to sell the iPhone SE well into 2017, it is not unfathomable that we would eventually see a $50 or $100 price drop as the device would then be based on a five-year-old design and year-and-a-half old technology. 

Given the iPhone's increased role in people's lives, there will likely be demand for iPhones with a compact design meant to be used differently than larger iPhones. The iPhone SE is essentially Apple's first step with smaller screens set within its screen size differentiation strategy. Eventually, this strategy will create a space for Apple to introduce new smaller iPhones alongside larger siblings. These smaller iPhones would then retain the iPhone SE's low price relative to larger models. 

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