Above Avalon Turns Two

Today marks the second-year anniversary of Above Avalon's launch.

This past year has been a busy one. Above Avalon reached sustainability and continues to be 100% supported by members. Along with weekly articles and podcast episodes, there were 192 daily updates focused exclusively on Apple that were sent to members over the past year. In addition, an Above Avalon group in Slack was established for members this past January and is now home to a thriving, daily discussion about Apple.  

As I prepare for the next year, I would like to share a few observations and lessons that I've learned about Apple and the dramatically changing media landscape since starting Above Avalon in 2014. 

Apple Observations

1) Apple is changing. Apple is not an opaque object, unable to be analyzed and studied. The company's intense product-driven culture is reflected in most of management's decisions and actions. The key to understanding how Apple views the world is to approach the particular topic at hand with this product-driven culture in mind. While Apple remains unpredictable, especially when it comes to items such as product marketing, the company's broader strategy has displayed a pattern of rationality.

With that in mind, there are clear signs that Apple is changing. While Apple still values product secrecy, the company has become much more open in terms of using the press and social media to weave a narrative. In addition, Apple management has become more straightforward when discussing Apple's product direction. Apple is not afraid to try new things, even if it means the company will look differently in the future. 

2) Jony Ive is Apple's product visionary. Over the past year, I published 38 weekly articles. The one that surprised me the most in terms of reader feedback was "Jony Ive Is Making People Uneasy." The article's premise was that under Tim Cook's leadership, Apple's industrial design group has continued to consolidate power within Apple. With Jony Ive positioned as overseer of Apple design, his influence on Apple's product direction cannot be overstated.

However, much of the reaction I received questioned not only Jony's power, but also the fundamentals that underpin Apple's design-led culture. Tim Cook is not Apple's product visionary. More importantly, Cook was never expected or groomed to be Apple's product visionary. Instead, Apple's industrial design group is in full control of the user experience, and by extension, the product. This structure was put in place more than 15 years ago to ensure that the product is always placed ahead of everything else. Despite other tech giants increasingly dipping their toes into hardware, no other company has Apple's design-led culture. 

3) Apple continues to think differently. It may be cliché, but when it comes to nearly every major topic that Apple faces criticism over, whether it is machine learning, AI, AR, VR, or voice, such criticism is misplaced. The old adage of "think different" is being turned on its head. While consensus remains focused on figuring out when these technologies will hit the mainstream, Apple is dedicating resources to better understand how these new technologies can be used to make technology more personal and improve the user experience. The question isn't when Apple will embrace these new ideas, but rather how Apple will approach these new technologies. 

4) Transportation and wearables represent Apple's future. One of the more intriguing topics over the past two years has been Apple's transportation ambitions with Project Titan. While the project has seen significant changes in recent months (my current thoughts on where things stand with Project Titan are available here and here), it would be incorrect to conclude that Apple's interest in transportation is waning. The same can be said about Apple's long-term plans for Apple Watch and the broader wearables category.

Despite a number of recent head fakes across the industry, the transportation industry will see more change in the next 10 years than seen in the past 100 years. The fact that such a statement doesn't actually say much given the lack of prior change demonstrates why a company like Apple will ultimately enter the industry. As for wearables, Apple's growing interest with health will end up being positioned as a key factor for driving wearables adoption. The wearables category likely contains the most potential to have a product that reaches smartphone-like penetration in the marketplace. 

5) Apple's biggest risk is losing focus. Over the past two years, I have periodically received a variation of the question, "What is Apple's biggest risk?" The usual answers passed around the web involve Apple missing some type of technology wave or being unable to adapt to the changing tech landscape. In reality, the one item that has the potential of threatening Apple's product-led design is management choosing to do too much.  

Thoughts on the Changing Media Landscape

1) Changing consumption patterns. The shift to mobile continues to impact how we are consuming content. Curated versions of the web, also known as Facebook and Twitter, are gaining even more power in terms of news and research dissemination. However, drawbacks to this development are beginning to appear. Interestingly, email has become a very powerful antidote to these drawbacks. People are using email as a way to build an ad-free curated stream of written content. The company to watch going forward is Slack and whether or not it can better position itself as a destination for content consumption. Judging by the Above Avalon team in Slack, there is much promise. 

2) Rise of the independents. One byproduct of this shift in content consumption has been a schism when it comes to media publications. This has led to a rise of the independents, a new breed of sites built on lean, low cost structures and scalable business models based on various forms of paid subscriptions. These sites are focused not on chasing page views or unique visitors, but instead on building high-quality relationships with readers. The reason these sites are able to compete against much larger peers with additional resources is that they are in a better position to build communication channels with readers. Along with Above Avalon, sites such as Stratechery and The Information have found a core audience. I expect this list of sites to expand and diversify as we move forward.   

3) Apple news industry. The cottage industry consisting of a few dozen sites focused on Apple rumors, news, and analysis is undergoing some changes. Ad-based rumor sites are experiencing consolidation while the leaders diversify into video, podcasting, and email newsletters to maintain mindshare. Ad-based indie blogs are increasingly turning to podcasting and different types of memberships/patron support for more attractive monetization opportunities. Although a few publications are ramping up their Apple coverage while others dial back efforts, the news portion of the Apple blog sphere remains disjointed. Going forward, I would not be surprised if several of the larger news publications dip their toe deeper into the Apple rumor sphere. This will lead to ad-based rumor sites experimenting with memberships and doubling down on forums/communities. 

Above Avalon

I launched Above Avalon on November 10, 2014 with the goal of studying Apple at the intersection of Silicon Valley and Wall Street. The main takeaway from these past two years is that while I have learned a great deal about Apple, there is much more to discover. I look forward to watching Above Avalon grow and welcoming new faces as Above Avalon members. (To sign up, visit the membership page.) 

Thank you for a great two years. 

Neil Cybart

Apple Is Placing a Big Bet with the New MacBook Pro

For the second year in a row, Microsoft's October hardware event won the hearts and minds of a segment of the Mac user base. While many have been quick to call these past two weeks a renaissance for the personal computer, such proclamations fail to recognize the harsh realities of the mobile era. The new MacBook Pro tells us a lot about Apple's plan for the Mac in today's mobile world, and it doesn't revolve around saving the PC. 

What Is the Mac? 

The best way to describe the Mac is to revisit a product theory that Phil Schiller, Apple SVP of Worldwide Marketing, introduced last year that I coined "The Grand Unified Theory of Apple Products." All of Apple's major product categories are interrelated. The goal or job for each is to gain enough capability to reduce the importance of the next most powerful product. For example, the goal of the iPad is to handle so many tasks that we no longer need a Mac.  

 
 

In this theory, the Mac's role is to serve as the product that pushes the rest of Apple's product line forward. As Schiller put it, the Mac desktop's role is to "challenge what we think a computer can do and do things that no computer has ever done before." 

The Mac Fell Behind

Judging by the way Apple management continues to talk about the Mac, the product category still occupies a surprising amount of mindshare within Apple despite the iPad outselling the Mac by 2.5x and the iPhone outselling both the iPad and Mac by 3.3x in FY2016. Here's Tim Cook kicking off the Mac segment of Apple's keynote last week:

"The Mac is more than a product to us. It's a testament to everything we do and everything we create at Apple."

This follows on the heels of Apple placing the Mac in the spotlight in 2015 by granting Steven Levy a surprising amount of access to one of the Mac labs. Apple had just updated the iMac and introduced the Magic Mouse 2 and Magic Trackpad 2. In retrospect, Apple was likely feeling some of the growing outcry facing the Mac. 

While Apple was pledging continued support for the Mac, the product category became long in the tooth. Circling back to The Grand Unified Theory of Apple Products, the Mac was no longer keeping up with Schiller's proclamation of it being the computer meant to push Apple's entire product line forward. While the tech press has remained infatuated with the debate as to whether an iPad can replace a Mac, consumers have already determined that the iPhone is able to handle most of the tasks once given to the Mac.

The Mac had fallen behind and was no longer challenging what we think we can do with a computer. Instead, the iPhone and iPad were overachieving, seeing much success at handling jobs formerly given the Mac.

Three Paths

Last month's Microsoft Surface event exposed the degree to which the Mac business has fallen behind in the eyes of some Mac users. For these customers, the idea of Microsoft ushering in some kind of PC renaissance was a sight for sore eyes. When it came time to unveil the biggest update to MacBook Pro in four years, Apple's presentation last week could have taken three different paths. 

Option 1: Give Mac users what they think they want. 

In this scenario, Apple Industrial Design (ID) would admit defeat in their long-standing views on Mac design and user experience. The end result would be other divisions within Apple pushing out the most powerful Macs to date from a spec perspective, with plenty of ports and customization. 

Option 2: Write a new chapter in the Mac playbook.

I refer to this option as the "Microsoft." Apple could rethink the Mac with the goal of pushing the boundaries of the modern Mac. Similar to Microsoft, Apple would turn to the tablet for inspiration regarding where to bring the Mac. Apple would strive to place the Mac on a better trajectory in an increasingly mobile world. With a focus on niche, creative use cases, touch-screen Macs would likely make an appearance as the Mac tries to become more like a Mac/iPad hybrid. 

Option 3: Throw the Mac playbook out the window  

In this scenario, Apple recognizes the Mac will never be as popular as iPad but that there is still a need for the Mac in the Apple lineup. The plan would be to position the Mac in such a way as to push the rest of Apple's product line forward. Apple ID would take lessons learned from mobile to rethink the Mac user experience. 

The New MacBook Pro

Last week's Mac event gave us a clear indication as to which path Apple chose. The new MacBook Pro with Touch Bar demonstrates how Apple is placing a very different bet than Microsoft. The sheer amount of criticism pointed at the new MacBook Pro from a small but vocal segment of the Mac user base demonstrates how much risk is found with Apple's bet. Jony Ive and the ID group want to rethink the notebook and are throwing the old Mac playbook out the window.

I was able to spend some time with the new MacBook Pro and Touch Bar in the Apple demo room. I left intrigued. (My complete thoughts and observations from attending Apple's keynote are available here and here). A multi-touch screen positioned above the keyboard with adaptive inputs based on what appears on the screen will alter the way we use a Mac. The change will not be dramatic at first. In fact, for some users, Touch Bar usage may only occur when playing music. However, similar to haptic feedback on the iPhone, the Touch Bar's influence will grow over time.  

Apple is making a very deliberate decision that the Touch Bar, and not a focus on power and ports, is the best way to push the Mac forward in today's mobile world. As Phil Schiller explained to The Independent earlier this week, Apple was expecting pushback from some of its Mac users. This is a sign that Apple was aware that it was placing a big bet with lots of risk. The new MacBook Pro is the first Mac to have a ARM processor, albeit a secondary one with the T1 chip, and a multi-touch display, albeit a narrow strip positioned above the keyboard. However, more importantly, this MacBook Pro begins to question the "Pro" in MacBook Pro. 

Microsoft vs. Apple

No other consumer-facing tech company is going after the Mac with as much vigor as Microsoft. (I view Google's Chromebook as impacting the iPad more than the Mac.) It is often said that this type of competition benefits consumers because it motivates each side of the battle, pushing companies towards greater innovation. I think that adage is outdated. If Apple's motivation to innovate merely came from increased competitive pressure from Microsoft, Apple would have much more serious problems on its hands than slowing innovation.

Instead, the primary benefit to consumers from Microsoft's multi-year push into niche PC hardware targeting "creatives" is that there is additional choice in the marketplace. A look through Microsoft's financials would reveal that there aren't many consumers taking Microsoft up on that additional choice, but that's for another day and weekly article. 

It was very clear in watching Panos Panay, head of Microsoft's Surface division, explain and demonstrate Surface Studio that Microsoft is not copying Apple. Microsoft is truly blazing a trail for itself. However, this isn't exactly a new thing for Microsoft, the company that was vocal about inventing tablet computing ten years before Apple unveiled the iPad.

Microsoft's foray into touch-based laptops and desktops does not represent competition for Apple because each company is on a completely different path when it comes to vision for the user experience. 

  • Microsoft wants users to get lost within Surface Studio hardware (see photo above). 
  • Apple wants hardware to melt away.
  • Microsoft wants its products to help you create and produce. 
  • Apple wants its products to improve your life. 

At the heart of the issue is a difference in motivation and agenda. With the new MacBook Pro, Apple is taking elements of iPhone and iPad to push the Mac forward. This is being done to then serve as a catalyst for pushing the iPhone and iPad forward. Revisiting The Grand Unified Theory of Apple Products, the Mac is positioned as the device that pushes the boundaries of a computer. The consequence is that the iPad, iPhone, and Apple Watch have to then work just a little bit harder to handle the tasks given to the Mac. 

However, Microsoft has a different goal with Surface Book and Surface Studio. Microsoft doesn't have a wrist wearable, smartphone, or dedicated tablet to push forward. Instead, its goal is to redefine the PC for a mobile world. This is why Microsoft is betting on touch-screen laptops and desktops. While Microsoft is betting on a PC renaissance, Apple is using the Mac to double down on mobile. 

The Bet

Apple's bet with the new MacBook Pro is that the Touch Bar will position the Mac as a tool that is able to push mobile devices forward. This is part of a comprehensive strategy that I call "The Apple Innovation Feedback Loop."

As shown in the diagram below, the driving factor that establishes the feedback loop is Apple ID taking lessons learned from making technology more personal with iPhone, iPad, and Apple Watch, and improving the user experience found with more powerful products such as the Mac. As these more powerful products are given additional capabilities, the incentive is to then push the less powerful products forward with improved technologies. 

While much of the criticism facing the new MacBook Pro concerns power, ports, and adapters, the much more interesting item to watch is how users embrace the Touch Bar. The risk found with this bet is that customers do not embrace the new user experience found with Touch Bar and MacBook Pro.

 
 

Combining The Grand Unified Theory of Apple Products with the Apple Innovation Feedback Loop produces the diagram below. The underlying principle that guides both the Grand Unified Theory and the Innovation Feedback Loop is to focus on the user experience created by different input and output mechanisms.  

 
 

The Mac's Future

With the MacBook Pro's Touch Bar, Apple is combining multi-touch with a mechanical keyboard. This new input will lead to a different user experience that may position the Mac as a more capable device than an iPad. One example is how an photo editing toolbar is removed from the screen and instead positioned in the Touch Bar, freeing up precious screen real estate. Another example is a music DJ placing a MacBook with multi-touch and a keyboard above an iPad in terms of capability and utility. If a MacBook Pro with Touch Bar appeals to a DJ, Apple's new goal is to come up with a way for the iPad Pro to handle the tasks given to the MacBook Pro.

Apple thinks the Mac still has an important role: to help push mobile and wearable devices forward. This is why Apple management speaks so highly of the Mac. It is quintessentially Apple

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Previewing Apple's 4Q16 Earnings

Apple's 4Q16 earnings release is set within a dynamic environment. Expectations are on the rise. Wall Street is now calling for the iPhone to return to sales growth in 2017. In addition, there are very early signs of light at the end of the iPad sales tunnel. However, given severe iPhone and Apple Watch supply shortages following last month's product launches, 4Q16 numbers won't provide the clearest answers for judging Apple's performance improvement. Instead, a greater than usual amount of attention will be focused on management's earnings conference call and 1Q17 revenue guidance. 

4Q16 Estimates

The following exhibit contains my full 4Q16 estimates as well as expectations for 1Q17 guidance.

Exhibit 1: Apple 4Q16 Estimates

My methodology behind these estimates are available for Above Avalon members here and here. (To become a member, click here.)

iPhone

Management's revenue guidance provided this past July implied approximately 43 million iPhone unit sales in 4Q16. This number would reflect weaker iPhone 6s and 6s Plus sales in July and August, continued robust iPhone SE sales, and the initial round of iPhone 7 shipments in September. While a sales number closer to 40 million units would raise questions, Wall Street will be much more interested in management's commentary regarding 1Q17 iPhone sales. 

Exhibit 2: iPhone Expectation Meter (4Q16)

Mac and iPad

Given an outdated product line, 4Q16 Mac sales will likely be extremely weak. However, with management announcing new Macs later this week, Apple will not get penalized for weak Mac sales in 4Q16. Attention will quickly move to the future and the prospects of an updated Mac line ushering in a return to unit sales growth.

As for the iPad, 4Q16 results will be much more useful for analysis. The 9.7-inch and 12.9-inch iPad Pro represent the future of the iPad. The two devices have increased the probability of the iPad business returning to year-over-year unit sales growth in the coming year. While I continue to include year-over-year declines in unit sales in my earnings model, there is a good chance of Apple reporting the second consecutive quarter of year-over-year revenue increase for iPad. 

Exhibit 3: iPad Expectation Meter (4Q16)

Apple Watch

Similar to iPhone results, 4Q16 Apple Watch results won't tell us the complete sales picture. Very tight Apple Watch Series 2 supply will make it difficult to judge Apple Watch demand. As detailed in my recent article, "Apple Is Going After Fitbit," there is much change occurring in the Apple Watch business as management repositions the Watch given current market dynamics. 

Exhibit 4: Apple Watch Expectation Meters (4Q16) 

Guidance  

The line in the sand for management's 1Q17 revenue guidance is found at $75 billion. A guidance range that includes $75 billion will give Wall Street much confidence that Apple will return to growth in 2017. Meanwhile, a revenue guidance range closer to $71B to $73B may disappoint those expecting a significant turnaround in iPhone growth. 

Exhibit 5: 1Q17 Guidance Expectation Meters (Revenue and Gross Margin)

Above Avalon members have access to my detailed earnings preview, including the methodology behind my estimates (four parts):

  1. Methodology
  2. Services, iPad, Mac, Apple Watch
  3. iPhone
  4. Guidance

Members will also receive my exclusive earnings reaction notes containing all of my thoughts and observations on Apple's earnings. To receive these earnings reaction notes, become a member here

Apple's Trojan Horse into Hollywood

Apple's video content strategy is coming into focus, and the company's plans look ambitious. Management's goal is to develop its own video service to distribute original content to more than a billion Apple devices. Apple will compete with Netflix and every other video content bundle. However, there will be a twist in Apple's strategy. 

Background

While Apple has long held a desire to rethink television, there has been one missing link: content. This lack of content played a part in Apple initially positioning Apple TV as a hobby. Unattractive TV industry dynamics, including a problematic go-to-market strategy, played a much larger role. 

Over the past seven years, Apple has been trying to create some kind of video content service. In 2009, Apple thought about becoming a cable distributor. The idea was met with little interest from content companies. Apple then turned to partnerships. Time Warner Cable had shown interest in working with Apple on a new type of paid TV service. Apple also approached Comcast with a similar idea of joining forces to launch a cable package with a revolutionary, new user interface. Apple met resistance. Unlike the music industry in the early 2000s, the cable industry was still doing too well financially to look at Apple as some kind of last resort. Apple's plan to partner with distributors was dead. 

Apple's next plan involved bypassing cable distributors and going straight to content companies to deliver content over the internet. The idea was to disrupt the large cable bundle by offering a slimmed down bundle of the most popular 20 to 30 cable channels for a lower monthly price. However, there were severe disagreements over money. Content companies wanted to include more of their channels in the bundle in order to bring in more revenue. Apple knew a low price was needed to insure customer adoption. Even Disney, a company thought to be a close Apple ally, couldn't reach a deal with Apple.  

This left Apple in an awkward situation when it came time to unveil its updated Apple TV box in September 2015. Apple is now positioning apps as the future of TV. The logic is that consumers will rely on a number of video apps from other companies for content. While this situation will suffice in the near-term, Apple has never stopped looking for ways to set itself apart from the competition in terms of delivering content to a global audience. 

Why Video?

For a company that is all about being focused and saying "no" to most product ideas, Apple's continued interest in video content may seem strange. However, Apple is increasingly dedicating resources and attention to video content for two reasons: 

  1. Content (video and music) streaming has become a must-have feature for mobile ecosystems. 
  2. Changing industry dynamics has led to a new breed of content distributors getting into original content creation. 

With technology companies battling each other for our time and attention, offering video content streaming has become a crucial requirement for a vibrant mobile ecosystem. While people may be spending less time consuming content via large cable bundles, an increasing amount of time is being given to smaller content bundles, including Netflix, Sling TV, PlayStation Vue, HBO, Hulu, Amazon Video, and YouTube. 

This move to paid video streaming has altered industry dynamics. New distributors now have the customers to invest significantly in developing original video programming. Netflix is on track to deliver 600 hours of original content this year. The plan is for Netflix to increase that total to 1,000 hours in 2017. Netflix plans on spending $6 billion on content in 2017, which would be close to the $7.3 billion expected to be spent by ESPN this year. It is only a matter of time before Netflix spends more than ESPN on content. Meanwhile, Amazon is on pace to spend more than $3 billion on content this year. One consequence of this development has been a "brain drain" impacting traditional cable companies. Talent, both in front of and behind the camera, is moving to where the eyeballs (and money) are located, which is increasingly found at Netflix and Amazon.

Given these changing market dynamics, Apple in a precarious position as the company increasingly finds itself relying on competitors to provide high-quality content to Apple customers. We see how Apple has tried to avoid or diffuse this type of dependency when it comes to hardware components. The same is now happening with video content. 

Apple's Video Strategy

After years of trying to figure out TV and video content, Apple's latest video strategy marks its most ambitious plan yet. Apple will compete with Netflix, Amazon, HBO, Disney, and every other content company by moving into original video programming. The greater flexibility attached to original video programming will make it possible for Apple to distribute content around the world. Apple will produce its own shows with the goal of launching an Apple Video streaming service. However, Apple has no plans to compete with content companies along traditional terms. 

In 2014, Apple didn't buy Beats for $3 billion just as a music streaming play. Instead, Beats was Apple's content streaming play. The Beats acquisition and resulting Apple Music service will serve as the foundation for Apple's broader content strategy. We are already starting to see the early stages of this plan taking shape. 

Apple's video strategy:

  1. Use Apple Music to mask original video programming ambitions. Check.
  2. Expand to other types of original video programming. Check. 
  3. Position Apple Music as a carrot for an "Apple Video" streaming service by offering a combined Apple content subscription including Apple Music and Apple Video. 

Notice how Apple began its original video programming strategy by creating content for Apple Music - everything from Taylor Swift's concert video to music artist interviews with Zane Lowe, head of Beats 1 radio. Apple then expanded its focus to fund Vital Signs, a six-episode scripted series about Dr. Dre. Since Apple doesn't have enough original content for its own video streaming service, the company's efforts in video are being used to push Apple Music subscriptions. Customers paying for Apple Music will also get access to Apple's original video programming (much of it related to music).

Instead of competing head-to-head with companies like Netflix and Amazon in terms of the offering a certain amount of original programming, Apple would look to bundle its original video programming into a larger Apple entertainment package that includes Apple Music. Over time, Apple could expand to include various types of licensed content including live sports, which Apple has reportedly shown some interest in from time to time.

There is a reason Apple has been so forthcoming with providing updates to the number of paying Apple Music subscribers. In addition, Apple Music executives have been doing quite a bit of press over the past year. Apple is trying to build credibility in Hollywood and boost Apple Music subscriptions. A stronger Apple Music service will give Apple a better chance of success with a streaming video service. 

Apple Studios

It will be difficult, if not impossible, for Apple to succeed with original video programming without having the right culture for such endeavors to flourish within Apple. My theory is that Eddy Cue will be given reign over a new Hollywood arm within Apple for producing content. This "Apple Studios" would produce content in house (applies to both video and music ambitions). There were many interesting things going on with Apple's exclusive with Frank Ocean a few months back

Apple Studios would sit uniquely within Apple's organizational structure. As seen in the following chart, Apple Studios would be an entity positioned in such a way as to contain a certain level of independency within Apple. However, Apple Studios wouldn't be completely cut out of Apple.

Apple's primary objective in creating a distinct Hollywood arm is to avoid culture clashes. For example, not long after Apple bought Beats, there were reportedly issues as the two companies did things very differently. Two years later, we still see some of these differences when it comes to how Jimmy Iovine wants to run Apple Music. This same type of situation will undoubtedly rise as Apple pushes deeper into original video programming. Decision making needs to be revised to better suit content development. Apple's strict level of secrecy will need to be rethought. Simply put, Apple's Hollywood Arm will need to approach problems differently than the rest of Apple. This would explain why Apple Studios would be given greater independency.

What About Acquiring Netflix?

Given Apple's growing video content ambitions and desire to build a video streaming service, a natural question to ask is, would it just be easier for Apple to acquire Netflix? With one swoop, Apple would own the most popular paid video streaming service in the world. 

The best way to analyze the rationale for Apple acquiring Netflix would be to take a step back and ask a few, key questions. 

  • Would Apple strengthen its product line by owning Netflix?
  • Would Netflix plug a hole in Apple resources and talent when it comes to video content streaming?
  • Would acquiring Netflix help accelerate Apple's existing video strategy? 
  • Are there unintended consequences associated with acquiring Netflix?

Turning to the first question, acquiring Netflix would not strengthen Apple's product line as Apple customers already have access to Netflix content. Given Netflix's business model of making its content available to as many people as possible, the odds of Netflix no longer being available on Apple devices is very low. In fact, Netflix has an incentive to continue making it extremely easy for Apple customers to access and consume its content. In a scenario where another company acquires Netflix, I'm skeptical the situation would change as the new buyer would likely want to continue to support iOS users. Apple wouldn't need to acquire Netflix in order to guarantee Apple customers will enjoy Netflix content. 

When it comes to Apple acquiring Netflix as a technology play, there are more effective and efficient ways of acquiring streaming capabilities than having to buy Netflix and its 3,500 employees.

There would be some positives associated with acquiring Netflix. In terms of talent, acquiring Netflix would give Apple key personnel with deep knowledge of the streaming industry. In addition, acquiring Netflix would instantly give Apple the lead in paid video streaming. However, there are unintended consequences associated with the deal that would likely offset these gains. One of the biggest is culture shock. Netflix and Apple are not alike. Netflix is increasingly being run by media talent fleeing traditional content companies (remember that brain drain?) while Apple is run by industrial designers. This is why Apple building its own Hollywood arm within Apple has a higher chance of success over time.  

Add it all up, and there just isn't much rationale for Apple to acquire Netflix. Notice how price hasn't even entered the discussion. There are many reasons other than a high price tag that make Netflix a poor acquisition target for Apple. A Netflix acquisition would inevitably boil down to two things: branding and revenue plays. Neither are strong reasons for Apple to pursue an acquisition.  

The Big Picture

Apple is not getting into video content to boost its services revenue. Instead, video and music streaming will be positioned as ways to increase the value found in using Apple hardware.

Apple sees itself as the company best able to bridge the gap between Hollywood and Silicon Valley - a technology company with a range of devices and a loyal base of more than 700 million premium users that values high quality content. In addition to scouting programming ideas on its own, Apple will take a few pages from its Apple Music playbook to embrace, and potentially partner with, existing content companies on original programming ideas if the right opportunities arise. Hollywood isn't Apple's enemy. 

When comparing Netflix and Apple Music paid subscribers, it becomes clear why using Apple Music as a type of incubator for Apple's video streaming service ends up being such an interesting twist. By using original video content to boost Apple Music, Apple already has nearly 20M paying viewers accessing that video content. This compares to Netflix's 83M user count - not bad for a 16-month-old paid streaming service. As the amount of additional video content increases, Apple hopes this will further increase Apple Music subscriptions, thereby improving its video chances. Apple's $3 billion Beats acquisition was a Trojan horse into Hollywood. 

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Apple Is Going After Fitbit

Fitbit is being underestimated. While Wall Street continues to show little interest in the wearables company, Fitbit is on track to quietly sell more than 25 million wrist devices in 2016. Not only has Apple taken notice of Fitbit's sales success, but Apple Watch is being put on a fitness detour to better compete against Fitbit. There is only one genuine battle for the wrist, and it is between Fitbit and Apple Watch. 

It's Fitbit vs. Apple Watch

There was much unknown surrounding wrist wearables when Apple unveiled Apple Watch in September 2014. One of the biggest mysteries dealt with competition. There were at least six potential sources for Apple Watch competition: 

  • Luxury watch industry
  • Technology industry
  • Fashion industry
  • Health and Fitness industry
  • Entertainment industry
  • Other (health insurance industry, etc.)

Over the past two years, we have received some answers as to how these potential competition sources have panned out. It would be an understatement to say that there were a few surprises. 

  • Luxury watch industry: After a year of denial, a handful of luxury watchmakers have embraced the idea of connected watches. None have sold in volume.  
  • Technology industry: Android Wear is irrelevant. Microsoft just canned its Band wearable product. Samsung and its Tizen platform are barely on the map. 
  • Fashion industry: Nonfactor. 
  • Health and Fitness industry: Fitbit is on track to sell nearly 25M devices in 2016. Garmin and other fitness endurance companies remain niche players. 
  • Entertainment industry: Nonfactor.
  • Other: Nonfactor. 

While many thought the battle for the wrist would be between Apple and the Swiss watch industry, in reality, there was barely a skirmish. When ranked according to revenue, Apple was the second best-selling watch brand in 2015 despite having only eight months of sales. On a unit sales basis, Apple has already become the best-selling watch brand. After only a few months, Apple Watch's impact on the Swiss watch industry was being felt. (Evidence of deteriorating Swiss watch industry operating conditions is available here, here, and here.)

The only legitimate Apple Watch competition ended up coming from the health and fitness industry. Fitbit is the only wearables company outselling Apple Watch in terms of unit sales. When combined, Fitbit and Apple Watch represent nearly 40 percent of all wrist wearable devices sold in 2016 year-to-date. This means that there is a 40 percent chance that a consumer looking for additional utility on the wrist will end up buying either a Fitbit or Apple Watch. 

Fitbit Results

Fitbit Co-Founder and CEO James Park, along with Co-Founder and CTO Eric Friedman, have turned Fitbit from a company selling simple activity trackers into a household name synonymous with health and fitness tracking. After going through the Fitbit Force recall in 2014 when adhesives were found to cause severe skin rashes, Fitbit management has gone on to execute extremely well in terms of product, marketing, and distribution. Fitbit devices are available in 54,000 retail stores in 64 countries. 

In terms of unit sales, Fitbit's revenue guidance implies the company is on track to sell 26 million devices in 2016. On a cumulative basis, Fitbit has sold nearly 55 million health and fitness trackers. As seen in Exhibit 1, Fitbit has seen iPod-like sales growth in recent years. Fitbit average selling price (ASP) trends have increased to approximately $100. 

Exhibit 1: Fitbit Unit Sales (annual)

Fitbit's product strategy has been one of diversification. As shown in Exhibit 2, the company continues to build on its core activity-tracking capabilities in order to expand the product line. Devices like the Blaze smartwatch are designed to appeal to consumers wanting more utility on the wrist. In addition, Fitbit has been investing in software and services in order to expand into other mobile realms. Judging by recent M&A, the Fitbit product pipeline likely includes many more health-focused initiatives as well as broader computing features such as a mobile payments offering.

Exhibit 2: Fitbit's Expanding Product Line

 

There have been a few warning signs circling around Fitbit. Sales growth is slowing. In 2015, Fitbit grew unit sales at 96 percent. The company will be lucky to see greater than 25 percent growth this year. Another issue that has plagued the company is the rate at which Fitbit customers stop using their devices. The data suggests that nearly one in three people buying a Fitbit will stop using it within nine months. This is high and has been the source of much skepticism around health and fitness trackers. In addition, there have been questions around some of Fitbit's technology, such as the accuracy found with its heart rate monitors. Despite all of these issues, Fitbit currently has an active installed base of approximately 20 million, which is more than the number of Apple Watches sold to date. 

Apple Watch Results

In some ways, Apple Watch performed much better than Fitbit out of the gate. Since April 2015, Apple has sold 16 million Apple Watches. Not only is that a much faster sales ramp than Fitbit, but it also places the Apple Watch as the third best-selling Apple product post-launch, behind iPad and iPhone. On a revenue basis, Apple is on track to report $4.2 billion of Apple Watch revenue in 2016, $1.5 billion more than Fitbit. I previously valued the Apple Watch business at $10 billion

Exhibit 3: Apple Product Sales Post-Launch

While these Apple Watch numbers are unequivocally strong for a new product, upon closer examination there have been a few developments worth monitoring. Apple Watch sales growth slowed heading into summer 2016. While there are a handful of possible explanations for the slowdown, including the lack of new models and purchases being pushed to the holiday quarter, Fitbit did not see a similar drop in sales. At the same time, Apple Watch ASP has been declining as Apple pushes through price cuts while Fitbit's ASP has been increasing as the company sells higher-priced devices. 

The Fitness Detour

Apple's strategy with the Apple Watch has seen significant changes in just 17 months on the market. The company's initial goal for Apple Watch was to redefine a smartwatch as a fashionable piece of luxury. Apple went so far as to have exclusive showings in the days leading up to the launch, and the star of the show was Apple Watch and the assortment of Watch bands. 

As seen with last month's launch of Apple Watch Series 2, Apple has taken a decidedly different route with Apple Watch. (My initial Apple Watch Series 2 impressions are available here.) Fitness and health are being given a much greater focus. The three main selling features found in Series 2 were framed around fitness activities:

  • GPS: For runners.
  • Water resistant: For swimmers.
  • Better display: For outdoor activities.

Apple is taking a fitness detour with Apple Watch Series 2, placing a bet that the best and most effective way to sell the next 15 million Apple Watches will be to position the device as a health and fitness monitor. Some of this changed strategy is due to the current state of wearables in 2016. Consumers are embracing the idea of using wrist devices to monitor tasks like miles walked or calories burned. In addition, Apple is indirectly admitting that some of the mini-iPhone on the wrist product marketing for Apple Watch was off the mark and not quite resonating with the average consumer. 

A Formidable Competitor

Consensus has never viewed Fitbit and Apple as rivals. Fitbit is often described as a low-end hardware manufacturer that will eventually run out of time or be pushed out of the wearables market by either a premium player like Apple or low-cost competition. Apple and Fitbit have also been operating at pretty different ASP ranges with Apple Watch closer to $400 and Fitbit at less than $100. 

Consensus is wrong.

Fitbit and Apple are not only rivals in the wearables space, but Fitbit's progress in terms of product and brand development is not being fully appreciated. Fitbit is becoming a force within the wearables space, and Apple is left with no other choice than to respond. As a sign of how the two companies are increasingly going after the same buyer, there is a very high likelihood of an Apple Watch Series 1 model selling for $199 this holiday season after retailer promotions, the same price as a Fitbit Blaze smartwatch and $50 less than a Fitbit Surge.  

The Fitbit/Apple Watch situation is no longer akin to the MP3/iPod era during the early 2000s. Despite going up against a number of less expensive MP3 players, the iPod did just fine due to a much better user experience. Many consumers eventually bought an iPod after first trying a lower-cost alternative. This scenario may not happen in health and fitness wearables. Fitbit is iterating much faster than people were expecting. In addition, Fitbit is grabbing both market and mind share. Fitbit ASPs are increasing, and the company is leveraging a strong balance sheet by investing in R&D in addition to M&A. 

There is evidence that Fitbit is succeeding where Apple Watch has been coming up short. One chart demonstrates this scenario and explains why Apple is likely going after Fitbit. Exhibit 4 compares quarterly Fitbit unit sales to Apple Watch unit sales (the blue line). The increase in the Fitbit to Apple Watch unit sales ratio from 4Q15 to 2Q16 denotes a slowdown in Apple Watch sales when compared to Fitbit. The same trend is seen when comparing Fitbit revenue to Apple Watch revenue (the red line). Fitbit did not see the same kind of slowdown in sales this past spring. Exhibit 4 assumes Apple sees an increase in sales due to the Apple Watch Series 1 and Series 2 launch. 

Exhibit 4: Fitbit vs. Apple Watch Ratios (Unit Sales and Revenue)

The Goal

Apple's goal in going after Fitbit is simple: Prevent Fitbit from gaining additional ground in health and fitness tracking. Apple doesn't need to compete with Fitbit on price, but rather on feature set and ease of use. This is one area in which Fitbit has had an advantage by starting simple and then expanding outwards. Apple took the opposite approach with Apple Watch with the third-party app experiment.

In some ways, Fitbit has seen success by keeping it simple and not overselling wrist wearables. Apple appears to be taking notes. Assuming Fitbit continues to see growth in 2017, the company will soon be approaching 30 million unit sales per year. With an ASP of around $100, Fitbit would be on track to sell at least 5 million to 10 million devices that retail for more than $150. That is Apple Watch territory.

Adding Fitbit and Apple Watch sales to date, the two companies have sold 80 million devices. There will be 1.4 billion smartphones sold in 2016. Succeeding with fitness tracking today will increase the odds of winning with health monitoring tomorrow. There are very few things that will end up having more of a mass market appeal than wearables capable of health monitoring (Don't forget about AirPods.) This is why Apple is willing to take a fitness detour in its battle for the wrist.  

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