AirPods Kick off Apple's Battle for Our Ears

AirPods are Apple's surprise hit product of 2016. While their simplicity may evoke comparisons to previous Apple blockbusters like iPod, AirPods are something very different. We are witnessing a new chapter unfolding at Apple in which Jony Ive and the Industrial Design group press down on the wearables accelerator. While Apple Watch wages a war for our wrists, AirPods are kicking off Apple's battle for our ears. 

A Wireless Future

There were hints that AirPods were going to be popular. Back in September, at Apple's annual iPhone event, the focus didn't end up being on the iPhone 7 or 7 Plus, or even new Apple Watches, but instead on a pair of wireless headphones. While Apple SVP Phil Schiller did not talk up AirPods much on stage, Apple's Chief Design Officer, Jony Ive, didn't hold anything back. The fact that AirPods received its own Jony video spoke volumes. Here's Jony describing the motivation behind AirPods: 

"We believe in a wireless future. A future where all of your devices intuitively connect. This belief drove the design of our new wireless AirPods...We're just at the beginning of a truly wireless future we've been working towards for many years where technology enables the seamless and automatic connection between you and your devices."

On the surface, Apple's focus on a wireless future seems to describe the company's efforts to remove wires from our lives. As our iPhone and iPad usage have increased, the number of headphone wires and charging cables in our life have grown in number as well. However, Apple's interpretation of a wireless future isn't just about the lack of wires. Instead, Apple is focused on empowering people through a new collection of personal technology devices. This ends up serving as a good background for AirPods, Apple's second wearables product. 

Impressions

I have been using AirPods for the past week. Here are my impressions:

Wireless Headphones. AirPods are Apple's answer to rethinking headphones. Relative to Apple Watch, AirPods contain much less risk as a product category. Given our increased dependency on consuming content via smartphones and tablets, headphone usage has been on the rise. In addition, wireless headphones had already begun to gain momentum in the marketplace. AirPods can best be described as wireless headphones that can do a little bit more. The wireless headphone part of the product will drive sales today while the "little bit more" part represents the vast potential found in a wearables product for the ear. 

Pricing. At $159, AirPods are Apple's lowest-priced wearables device. The starting price for Apple Watch is $269. AirPods are also priced very competitively considering Samsung's Gear IconX retail for $199 and Bragi's Dash goes for $299. While there are much less expensive headphones available, including the free pair of EarPods that come with every iPhone, the value proposition found with AirPods centers around not having to deal with any headphone wires. In addition, there is value found with being able to seamlessly connect AirPods to my Apple devices. Given historical trends, it's safe to assume there will one day be a sub-$100 pair of AirPods. The prospects of a $99 wearables device from Apple goes a long way in redefining mass-market luxury. 

Usage. I do not find myself wearing AirPods throughout the day. Instead, usage is heavily dependent on my current environment. While sitting at my desk, AirPods often remain in their case. However, AirPods become incredibly more valuable when I'm on the move. The lack of wires makes AirPods an ideal product for fitness activities and various workout routines (such as snow shoveling). 

Comfort. Even though AirPods have a near identical shape to Apple's wired EarPods, the lack of wires gives AirPods a noticeably more comfortable feel. Without wire tension, it is extremely easy to forget that AirPods are in my ears. This will have many implications when AirPods receive additional functionality down the road. It is not difficult to envision a scenario in which we will want to wear AirPods for long durations (or at least until the battery dies). 

Fit. AirPods are without question more snug than EarPods. Throughout my week of usage, I didn't have one instance of AirPods falling out or becoming loose. One reason I suspect AirPods are much more snug than EarPods, despite having a very similar shape, is their ability to sit at a slightly different angle in my ear. With wired EarPods, the device has to be worn at a particular angle due to the hanging cord. While AirPods fit my ears, others have had significant issues with AirPods fitting in their ears. It's difficult to put a number on the people impacted by ill-fitting AirPods. It probably isn't trivial. There is too much on the line for Apple not to eventually address various ear shapes with a few different AirPods sizes. 

Sound. AirPods sound better than Apple's wired EarPods. With that said, wireless headphones don't strike me as a product category in which sound quality is high on the value proposition list. Instead, AirPods derive much of their value from the lack of wires and ability to seamlessly connect to my devices. For the vast majority of consumers, AirPods will sound just fine. 

Siri. Double tapping on an AirPod will bring up Siri. It took a few days of practice to figure out how to get the double tap just right to activate Siri nearly every time. After a week of using AirPods, I have seen a modest increase in my Siri usage. While it is nice to have Siri access through AirPods, I haven't found it to be a game-changing experience...yet. Half the time I wear AirPods, I end up just saying "Hey Siri" since my iPhone is close by. While some people are jumping with both feet into a voice-only paradigm of computing pushed by devices like Amazon Echo and Google Home, I still have major reservations. Voice is an incredibly inefficient way to transfer data, and I am finding that I really don't want to talk with my computers. Siri's potential continues to be found in being more of a proactive assistant. In that scenario, Siri and AirPods will be incredibly useful in my life. We aren't there yet.

Simplicity. Apple was deliberate in maintaining a high degree of simplicity with AirPods. There is only one control available on AirPods. A double tap to an AirPod enables one to either activate Siri or answer a call. This produces a rather obvious drawback when it comes to music playback controls. The user is required to either use Siri or a controller (nearby iPhone, Apple Watch, iPad etc.) I think Apple made the right decision in not adding a lot of controls to AirPods V1.0. If not done correctly, additional controls such as swipes and triple taps could lead to a disaster. In terms of music playback, I find using 1) Apple Watch 2) iPhone 3) "Hey Siri" to be adequate options. For the first time, Apple Watch's Digital Crown proved to be useful when it controlled the music volume for my AirPods. 

Design. AirPods are designed to be worn and seen. Everything about AirPods, from their white color and long stem to their charging case, screams Apple Industrial Design (ID). The product is an example of how the Apple ID group is firing on all cylinders when it comes to its push into wearables. 

 
 

Given Apple's culture and functional organizational structure, the ID group holds near to absolute power within Apple. This structure is one of the most critical elements to keep in mind when analyzing Apple's product strategy, including AirPods' trajectory. I have been very outspoken about Apple ID gaining power within Apple. 

This power is manifesting itself in Apple's aggressive push into wearables.

Window into a Wearables World

One of the main takeaways from using AirPods for the past week is that they represent a window into a wearables world. When the Apple Watch was unveiled, Apple talked about a scenario in which one can leave the iPhone by the door and just use an Apple Watch around the house. This hasn't happened. As it turns out, AirPods end up having a much better chance of achieving what the Apple Watch was originally tasked to achieve. AirPods help break the chains that have held me so close to the iPhone. Combine AirPods with an Apple Watch, and an even greater number of chains are broken. While we aren't at the point of being able to move beyond the iPhone, AirPods provide glimpses as to how this process is going to occur. 

Sales Implications

I think Apple is going to sell a lot of AirPods. While the device is not an impulse purchase with a $159 price, AirPods have a few things going for them that should result in significant sales.

  1. AirPods work with any device that supports bluetooth. This gives the product an addressable market that is at least 7x larger than that of Apple Watch. There are faint similarities between AirPods working with Android and the iPod working with Windows. It was that Windows support that set iPod sales on its eventual blockbuster sales trajectory. 
  2. AirPods have a very clear value proposition out of the gate. Many customers are going to see value in AirPods as they are wireless headphones. All of the device's additional functionality found with Siri (available with Apple devices) is just an added benefit. 

The most accurate measurement of AirPods demand will likely be measured in tens of millions of units over the next two years. For context, Apple sold 20M Apple Watches in 20 months while Amazon has reportedly sold 5M Echoes in two years. The ingredients are in place for AirPods to be a multi-billion dollar business within the next few months. It doesn't hurt that sales expectations facing AirPods are much more contained than the lofty goals set for Apple Watch at launch. 

The Battle for Our Ears

Apple Watch kicked off Apple's battle for the wrist. Given the finite amount of wrist real estate available, there is an incredible amount of power found in getting a device on one's wrist. This means that Apple Watch is in one way or another competing against everyone from Swiss watchmakers to fitness & health trackers and jewelry makers. Much of Apple's future strategy with Apple Watch will be guided by this battle for the wrist. 

Apple is now kicking off a new battle with AirPods. This time, the battle is for our ears. Every pair of AirPods sold and worn represents another set of ears ready for Siri. In some ways, Apple has a head start as the company has been selling hundreds of millions of wired EarPods each year. In addition, Beats gives Apple instant access to parts of the headphone market not addressed by AirPods. My suspicion is that this difference in target markets is one reason why Apple has given Beats headphones a bit of independence since the acquisition. However, the message is clear: AirPods are Apple's flagship weapon in its quest for our ears.  

Over time, Apple will expand AirPod functionality to include additional voice capabilities such as translation, various types of audio curation and delivery, biometrics monitoring, and augmented reality. The greater the number of AirPods that are out in the wild, the more valuable these additional capabilities will become.  

As the smartphone battle quiets down, the battles for our wrist and ears are only beginning. Welcome to the wearables era. 

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The Elephant in the Smartwatch Room

Apple is consolidating power within the smartwatch industry at an alarming rate. A growing number of competitors are exiting the space as the anticipation and promise found with wrist computing has materialized for only a select few. For the rest, smartwatches have been nothing but frustration and despair. The writing is on the wall. There isn't a smartwatch industry. Instead, there's only an Apple Watch industry.

The Beginning

Even though it feels like the smartwatch is a relatively new phenomenon, the idea of redefining utility on the wrist is more than five years old. Apple began to investigate a device for the wrist in 2011, just four years after launching the iPhone. The idea was simple: Create a device that pairs with a smartphone. This device would allow the user to spend more time enjoying his or her surroundings while staying informed of need to know data throughout the day.

As the project progressed within Apple, there were ongoing questions as to which parts of the smartphone experience would best qualify to be brought to the wrist. In some ways, this experiment is still ongoing five years later. Some of the earliest smartwatches tried to recreate the entire smartphone experience on the wrist, all the way down to recreating a screen of third-party apps. Others bet that smartwatches with more in the way of dedicated (i.e. limited) functionality would do better. In both cases, smartwatches were looked as a much needed growth opportunity that would partially offset the inevitable slowdown in smartphone sales. 

Industry Sales

When compared to smartphone and tablet sales, smartwatch sales are still having a difficult time showing up on a chart. Since the start of 2015, there have been approximately 35M smartwatches shipped, compared to 385M tablets and 2.9B smartphones. In 2015, for every smartwatch shipped, there were 12 tablets and 80 smartphones sold. In 2016, these ratios are expected to improve slightly. For every smartwatch shipped, 10 tablets and 78 smartphones will have been sold. People are buying smartwatches. The problem for the industry is that not many non-Apple Watch smartwatches are being sold. 

Exhibit 1: Smartwatch, Tablet, and Smartphone Unit Sales (2016E)

The Players

There have been only three legitimate players in the smartwatch industry.

  1. Apple
  2. Garmin 
  3. Samsung

Combined, these three companies have represented 78 percent of smartwatch shipments over the past two years. Even more remarkable, no other company has come close to these three in terms of unit sales. Since the beginning of 2015, only seven companies have shipped more than 200,000 smartwatches in any given quarter. Out of those seven, one will soon be broken up in a fire sale (Pebble), another just announced it was getting out of smartwatches (Motorola), and two have shown little interest in releasing new smartwatches (Huawei and LG). This leaves Apple, Garmin, and Samsung. 

Even more astounding, the "Other" category, the usual industry catch basin for dozens of other companies, is on track to account for just 11 percent of smartwatch shipments in 2016. One group of companies found in the "Other" category are the original sellers of utility on the wrist - watchmakers. The Swiss watch industry continues to dabble with connected watches. However, one would be correct in questioning the motivation guiding some of these companies. TAG Heuer, apparently in an attempt to claim its position as one of the more successful Swiss watchmakers when it comes to smartwatches, announced it will sell just 75,000 connected watches in 2016. Those kinds of sales make the Swiss watch industry completely irrelevant in terms of the broader smartwatch market. 

Consolidating Power

As seen in Exhibit 2, Apple Watch has represented between 45 percent and 65 percent of quarterly smartwatch shipments since launching in 2Q15. Given Tim Cook's recent comments about Apple expecting record Apple Watch sales during 4Q16, Apple Watch is poised to capture an even greater share of industry sales. When considering that the iPod had around 70 percent marketshare in the MP3 market at its height, the Apple Watch is approaching iPod-like sales share within the smartwatch industry. It's clear: Apple Watch has consolidated power after just a few quarters of sales. 

Exhibit 2: Smartwatch Unit Sales Share

The primary question facing the smartwatch industry isn't why most companies have been unable to find sales success. The answer is simple: Most smartwatches haven't been appealing to consumers. Instead, the more intriguing question is found with Apple Watch's success. How has Apple been able to sell close to 20M Apple Watches to date? I suspect there are four reasons: 

1) Design. The Apple Watch is popular because people want to wear one on their wrist. Jony Ive and Marc Newson are on to something with Apple Watch design. In what isn't a coincidence, the best-selling smartwatch is a device that looks the least like a traditional watch. 

Even though the themes of fashion and luxury are no longer discussed as frequently with smartwatches, they remain critical ingredients for Apple Watch's sales success. Apple has positioned interchangeable watch bands as key fashion items for the Watch. In addition, Apple is redefining luxury with Hermès and Edition Watch pricing. 

2) Fun. The Apple Watch doesn't have one "killer" app. Instead, the device is a health and fitness tracker for some and a notification and messaging device for others. In both cases, consumers view the Watch as a fun iPhone accessory. The changes found in watchOS 3, including the greater focus on Watch faces, emphasizes the "fun" theme found with the Watch. 

3) iPhone. With more than 700M iPhone users out in the wild, the Apple Watch has benefited from being positioned as an iPhone accessory. This type of halo around the iPhone is not found with competing devices. Garmin's success has been limited to certain fitness circles. Meanwhile, Samsung has seen some smartwatch sales success by bundling watches with smartphone purchases. Outside of bundling, there is no evidence to suggest the same kind of halo around Galaxy smartphones exists. 

4) Price. In just 17 months, Apple cut Apple Watch's starting price from $349 to $269, a 23 percent reduction. When considering that the cost of a Watch Sport Band has remained steady, the starting price for an Apple Watch case has seen a 27 percent price reduction. In addition, retailers have run with steep discounts for Apple Watch during the holidays. This led to Apple Watch Series 1 going for $199 on Black Friday last month. In what shouldn't come as a surprise, Apple Watch sales have increased as prices have fallen. In addition, these price reductions have left little room for competing devices to breathe. In many cases, Apple Watch pricing is less than that of other smartwatches. 

New Developments

We are getting our first good look at the current state of the smartwatch market. There isn't much to see outside of Apple Watch land. This dynamic will likely lead to a few new developments in the wrist wearables space in the coming quarters.

  1. The sales gap between smartwatches and fitness & health trackers will shrink.
  2. Competition begins to emulate Apple Watch much more closely.

This past November, Fitbit released an alarming earnings report. The company hit a brick wall in terms of sales growth. Fitbit's issues provide a big clue that the market for dedicated health and fitness trackers will have trouble reaching mass market. The fact that Fitbit has already hit a wall in terms of sales growth, despite only selling 55M cumulative devices, suggests the wrist wearables future is much brighter for multi-purpose devices with a screen. This will pressure Fitbit to continue expanding its line and truly enter the smartwatch space. 

The company has been busy acquiring assets, including pools of talent such as Pebble's software engineer team, in an effort to fill obvious resource holes. However, it will be tough for Fitbit. To make matters worse, Apple's reconfigured marketing pitch for Apple Watch Series 2 is targeted squarely at Fitbit. Apple management saw how Fitbit was outselling Apple Watch, although at a much lower ASP, and wanted in on the action. 

As seen in Exhibit 3, the Apple Watch versus Fitbit battle may be nearing a new chapter. In 4Q15, Fitbit outsold Apple Watch by 3.5M units. Over the subsequent three quarters, Fitbit grew its lead. It appeared Fitbit was gaining momentum (discussed in greater detail in the article, "Apple Is Going After Fitbit."). However, taking Cook's recent comments about Apple Watch sales, and Fitbit's guidance, it appears that Apple Watch will cut into Fitbit's sales lead by 25 percent this holiday quarter. Fitbit is on track to outsell Apple Watch by only 2.6M units in 4Q16. 

Exhibit 3: Fitbit and Apple Watch Unit Sales

Meanwhile, on the smartwatch side of the equation, the more successful Apple Watch becomes, the higher the probability that competitors will begin to emulate Apple Watch. We should expect to see competing devices that look much more like Apple Watch in looks and functionality. The design language will increasingly move away from traditional timepieces and instead towards Apple Watch. The design language found with Apple Watch will eventually extend even to luxury watchmakers. 

Road Ahead

The smartwatch industry was born at an awkward time. A product designed to handle tasks given to smartphones launched when the average consumer was still only discovering the value found with smartphones. This has removed much of the oxygen from the smartwatch industry, and it appears that Apple is the only one with an oxygen mask. While Apple Watch sales confirm that wrist wearables are indeed a thing, there is still much unknown as to how far away from Apple this sales success will extend. It increasingly looks like Apple's game to lose. Apple is onto something with wearables, and the rest of Silicon Valley (and Wall Street) haven't yet come to terms with that reality. 

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Milking the iPhone

It feels like cracks are forming at Apple's edges. The company is straining to push out hardware updates. Supply issues are getting worse. Apple is reportedly moving away from selling beloved products like stand-alone displays and wireless routers. Meanwhile, Microsoft, Amazon, and Snap are gaining buzz with new niche hardware while Apple appears to be hanging back and resting on its laurels.

Something feels off with Apple, and the blame is increasingly pointed at Tim Cook. I suspect these feelings are a result of Cook betting now is the time to milk the iPhone. Apple is doubling down on the iPhone to build one of the world's most formidable tech ecosystems, and few are taking notice. 

The Strategy

One key mistake Apple made with the Mac during the early 1990s was to focus too much on profits and not market share. This led Apple to lose its connection with the consumer. Declining sales ensued, leading Apple to make a series of questionable decisions. Apple found itself with a complicated web of Mac models, each with different feature sets meant to chase a particular market niche.

Apple has been following a very different strategy with iPhone. The best way to see this strategy is to look at the changing iPhone line. In 2011, Apple was selling two premium-priced iPhone models, one of which was the previous year's flagship phone. Sales were approximately 70M units per year. Five years later, Apple has expanded the iPhone line to include five models, two of which are last year's flagship versions. Despite still having a very focused product line, iPhone sales have tripled to more than 210M units per year. 

Apple has been following a multi-year strategy of gradually lowering iPhone pricing in order to reach larger swaths of the smartphone user base. While such a strategy seems born out of a desire to boost sales and profits, management is motivated by something else. Apple has been working to make the iPhone accessible to more people. This is the exact opposite strategy that Apple used with the Mac in the early 1990s. New iPhone models, such as the iPhone SE, are not targeting market niches, but instead are meant to expand the iPhone's addressable market by hundreds of millions of users. 

One benefit of keeping the iPhone line lean has been consistently strong profit margins. While the $399 iPhone SE has a lower selling price than its larger siblings, the device's profit margin is similar to that of other iPhone models. By remaining focused on the product, as seen by the limited number of iPhone models, management has been able to maintain industry-leading profit margins. This has played a big part in allowing Apple to continue lowering prices to reach new customers. We are moving to the point when Apple will be able to sell a $299 iPhone, appeal to an entirely new part of the smartphone market, and still be able to maintain profit margins. 

Going After Users

As shown in Exhibit 2, Apple's strategy of focusing on the product has resulted in the iPhone installed base approaching 600M users at the end of September. This is a very different world than that of the Mac days of the early 1990s. When adding second-hand and used iPhones into the mix, there are more than 700M iPhones out in the wild. Much of this underlying iPhone strength has been masked by the preoccupation with slowing iPhone unit sales growth. The iPhone upgrade cycle has slowed, which is impacting the number of iPhones sold to existing iPhone users. However, sales to new users remain robust. 

Exhibit 2: iPhone Installed Base

In FY2015, more than 100M new customers entered the iPhone installed base. In FY2016, the number was even higher, marking a new record. There have been a few drivers for the steady rate of new users buying an iPhone in recent years. The gradual expansion of carrier agreements around the world has helped. In addition, lower-priced iPhones such as the $399 iPhone SE have made the iPhone more accessible.    

Building a Sandcastle

Milking the iPhone in order to build a formidable ecosystem has been one of Cook's defining moments as CEO. Unfortunately, consensus has not been grading Cook's performance as CEO along these terms. 

Instead, many have graded Cook as a product visionary. The problem with that is Cook is not Apple's product visionary. (That title unofficially belongs to Jony Ive). Cook's appointment as CEO was not predicated on his ability to one day become a product visionary. Accordingly, Cook should not be judged as such. In addition, some have compared Cook to former Microsoft CEO Steve Ballmer. This is incorrect. Cook is not Apple's top salesperson. He does not possess Ballmer's keen sense of how to push product into every enterprise crevice. Instead, Cook has delegated that task to others, primarily through partnerships. Accordingly, Cook should not be judged as a salesperson.  

Instead, Cook should be judged on his success in building out the Apple ecosystem. One way of visualizing this Apple ecosystem is to think of a sandcastle. The iPhone represents the highest tower in the castle while the iPad and Mac represent the much smaller outposts. Accessories like Apple Watch and Apple TV as well as services like iMessage and Apple Pay represent the high walls and moat meant to protect the castle against intruders.

 
 

Accordingly, Cook should be judged on his ability to build the sandcastle over the years. Since he became CEO in 2011: 

  • The iPhone installed base has grown by 500M users. 
  • The iPad installed base has grown by 175M users.
  • The Mac installed base has grown by 50M users.
  • Apple introduced Apple Watch, the company's first wearable product. Approximately 18M Apple Watches, a device positioned as an iPhone accessory, have been sold to date.
  • Apple is earning more than $6B per year of revenue through app sales via the App Store.
  • Apple successfully made the difficult jump from a paid music download model to streaming and is approaching 20M paying Apple Music subscribers. 
  • Apple continues to push forward with Apple TV. The company is approaching 10M units sold since the device was updated in 2015.
  • Apple continues to develop key services including Apple Pay, Messages, and Maps. 

(The math behind these figures and estimates are available for Above Avalon members. You can become a member here.) 

It quickly becomes clear that Cook has built a spectacular sandcastle. Apple has never had a stronger ecosystem. There are now more than one billion Apple devices in use and 800 million people own at least one Apple product. More remarkably, the average Apple user owns more than one Apple product. This is even more astounding when considering the competitive landscape.  

iPhone Focus

Apple is making a very bold statement that it is still time to double down on the iPhone. It would be an understatement to say that Apple stands out from its largest peers with that thinking. Look at some of the leading tech companies' primary advertising campaigns:  

  • Apple: a smartphone (iPhone).
  • Amazon: a voice assistant (Echo).
  • Google: a voice assistant (Google Home).
  • Microsoft: a touch-based laptop/tablet (Surface).

The companies lacking a smartphone offering are increasingly trying to get consumers to move on to the "next big thing." Amazon is pushing the idea of using a voice assistant and series of speakers to replace your smartphone. Google is doing the same with Google Home. (Pixel is actually a Google services play.) Microsoft is focused on trying to carve some kind of niche for itself by focusing on touch-based PCs. We can even add Snap to the mix and position Spectacles as early motivation for wanting to impact smartphone usage. 

Meanwhile, Apple is placing a big bet that we are still firmly in the smartphone era. In Apple's view, many of these competing products are distractions trying to get us to move prematurely beyond the smartphone. This stance has contributed to the view that Apple is missing a step and resting on its laurels. While Microsoft pushes Surface Book and Surface Studio and Snap unveils sunglasses with a camera, Apple is still betting on a smartphone, a product unveiled in 2007. 

Cracks at the Edges

This pursuit of milking the iPhone has contributed to cracks forming at Apple's edges. The friction is found when looking at Apple's efforts to build a wider ecosystem that extends beyond the iPhone. There is evidence that Apple management wants to follow a product strategy described in my "Apple Experience Era" article. Consumers can pick and choose a range of Apple products that best fit their lifestyles. This is why Apple is very vocal about continuing to invest in the Mac. In addition, Cook has reiterated his view that the iPad is the clearest expression of Apple's vision of the future of personal computing.

However, Apple's handling of the Mac line has been increasingly questionable. The same can be said of the iPad line. It will have taken Apple at least two years to unveil a line of "Pro" iPad models spanning from 7.9-inch screens to the 12.9-inch model. 

While some have been quick to throw Apple's functional organizational structure under the bus for causing these cracks, the organizational structure is not to blame. The issue doesn't relate to a lack of focus either. Apple still isn't selling that many products. Instead, these cracks are a result of today's changing tech environment. 

When looking at some of the key accomplishments during the Tim Cook era, the installed base growth figures for Apple's top products stand out. For every 100 users by which the iPhone installed base increases, the iPad installed base will grow by 35 users, and the Mac will increase by 10 users.

A vast majority of these new iPhone users will never own a Mac. As iPhones have become larger, odds have increased that these iPhone users may never own an iPad either. The iPhone has gained so much power in recent years that the iPad and Mac's long-term sales trajectory have faded. I suspect this reality explains why iPad updates are less frequent these days. The same can be said of the Mac. More frequent updates for iPad or Mac likely wouldn't increase sales.

Many have been quick to label the new MacBook Pro as flawed and not truly a "Pro" computer. In reality, Apple is focused more on redefining Pro's definition in addition to expanding the MacBook Pro's mass market appeal. This is why Apple is focused on bringing aspects of the iPhone to the Mac (multi-touch screen positioned above the keyboard, Touch ID). 

Risks

Apple faces a major risk in relying so much on the iPhone to build its ecosystem. While this may be heresy in Silicon Valley, ecosystems are not everything. There has never been an ecosystem strong enough to stand the test of time. The App Store is not invincible. At a certain point, Apple will need to be willing to put its iPhone ecosystem at risk. 

There are many signs that Apple management is keenly aware of this since Apple has had to risk its ecosystem multiple times over the past two decades. During the late 1990s and early 2000s, Apple spent years rebuilding the Mac ecosystem. Recall Apple's "Mac as the hub of your digital life" product strategy. The iPod was merely a Mac accessory at launch. However, Apple's decision to eventually bring iTunes to Windows changed the game. The move threatened the very same Mac ecosystem Apple had spent years building. Users would no longer need a Mac to use an iPod. Apple was willing to risk its current ecosystem in order to catch the next technology wave. 

However, instead of doom, the iPod became a household name and played a role in helping the iPhone get off the ground. Meanwhile, the Mac was no longer going to be the center of Apple, and more importantly, our lives. 

This raises an interesting question. Is it possible that Apple management is okay with the cracks that are forming at the edges? While the new MacBook Pro may infuriate loyal Mac users, a strong case can be made that management truly thinks such a product is the right one to ship in today's environment. To see why, notice how Apple is milking the iPhone: having the product appeal to a wider user base. Instead of chasing profits, Apple is following the same strategy with the new MacBook Pro. Apple has no interest in repeating mistakes from the early 1990s and selling product to the smallest of niches. 

Chasing Waves

Apple is confident we are still in the era where it makes sense to milk the iPhone. Consumers are giving even more tasks to their smartphones. This may continue for another two years, or maybe even five years. While Apple may be building a sandcastle around the iPhone today, the company will need to find the next big wave that may topple that very same sandcastle. The company is looking at two industries to pivot into: 

  • Wearables. We are talking devices for the wrist (Apple Watch), ear (AirPods), body (clothing), and possibly even eyes. Apple's growing investment in health is a big clue as to Apple's intentions in this area. 
  • Transportation. Apple would develop an array of personal transportation options in various geographies. With ridesharing and autonomous driving, someone will be in a position to rethink the car within the next 10 years. Apple has many of the ingredients in place to be that company. 

Neither industry is niche. Health is something that will appeal to pretty much every human. Wearables have the potential to have adoption curves similar to smartphones. Similarly, nearly every human has some need for moving form Point A to Point B. More importantly, transportation is the gateway to the grand prize: housing. When contemplating a smart home, there is nowhere better to start than developing smart rooms on wheels. 

In both cases, the ecosystem that Apple has spent the past nine years building with the iPhone will provide the company a head start. It is much easier selling Apple Watches into an ecosystem of 800 million users familiar with Apple products. However, Apple will need to eventually take a leap without knowing exactly where it will land. 

One question facing Apple today is whether opportunities are being passed over because of its iPhone dependency. A convincing argument can be made that Apple's early missteps with Apple Watch were due to the company looking at the device too much through an iPhone lens. What if Apple approached the Apple Watch as something other than an iPhone accessory? 

A Fundamental Theory

This brings us to one of my fundamental theories regarding Apple. For Apple to remain relevant in the future, the company will need to attack itself. Management will need to risk its own ecosystem.

When it comes to catching the next big wave, an Apple Watch with cellular connectivity may end up representing the single biggest game-changing device Apple has shipped since the original iPhone. It would be that big of a deal. The reason such a product contains so much risk for Apple is that it threatens the iPhone. Why buy a brand new iPhone every year when your Apple Watch (with AirPods) are handling tasks that you used to give your iPhone? In addition, a cellular Apple Watch will more than double the device's addressable market to include all Android users.

There is a possibility that Android users may embrace Apple Watch without buying an iPhone, iPad, or other Apple product. Apple would seemingly be giving away the keys to its iPhone sandcastle. However, instead of causing panic within Apple HQ, this would be done by design. Apple would be willing to risk its ecosystem in order to build a new ecosystem around wearables. 

Apple shouldn't get rid of its functional organizational structure. In addition, there is no evidence of Apple needing a management reshuffle. While there is clearly room for improvement in many parts of Apple's business, management's actions are very rational. Apple is taking lessons learned from the 1990s and using them to not repeat the same mistakes with the iPhone. Milk the iPhone today, and then figure out what comes next. 

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Skating to the Apple Car Puck

Recent reports have cast doubt on Apple's automobile ambitions. With Apple shifting its focus to auto software and autonomous driving, many have interpreted the move as Apple giving up on building its own car. I look at the situation very differently. Apple remains interested in transportation, and the case for an Apple Car continues to build.  

Apple's Initial Car Strategy

Apple management began to think about the feasibility of designing and selling its own car in early 2014, and early musings likely stretched as far back as late 2013. This was right around the time that management was becoming confident in Apple Watch becoming a commercial success. It is conceivable that Apple had begun to contemplate new product categories after Apple Watch.

As seen in the photos below, what had seemed like Tim Cook innocently checking out BMW's new i8 electric car outside of Apple HQ in June 2014 took on a whole new meaning eight months later when the Financial Times was the first publication to break the story of Apple thinking about selling its own electric car. 

Source: Twitter

I suspect Apple's initial car strategy was to design and build a premium-priced car that would be bought or leased by consumers. An Apple Car would stand out from peers due to the compelling experience produced by combining Apple hardware, software, and services. 

The plan included Apple's Industrial Design (ID) group coming up with prototypes. Product designers and hardware engineers would then work with ID to turn a prototype into a product capable of being mass produced. In terms of manufacturing, Apple would rely on the same playbook used with most of Apple's other products. Instead of building the car themselves, Apple would have a third-party contract manufacturer assemble the car. Apple management reportedly visited Magna Steyr, BMW, and Daimler to see the feasibility of using contract manufacturing in the auto industry. Apple would then be in a good position to sell an Apple Car through its Retail store network around the world. 

In mid-2015, Apple went on a real estate shopping spree, quickly buying or leasing enough land to build another Apple Campus 2 near San Jose International Airport. I suspect the land purchases were related to Project Titan. Apple also bought various heavy manufacturing facilities around Sunnyvale and Santa Clara, a very obvious sign of its growing automobile ambitions. (More information on each Project Titan building is available here). Project Titan seemed to be firing on all cylinders. The team was given approval to expand to 1,800 employees, and all indications seemed to suggest the pieces were coming together for some type of automobile product in a few years. 

Hitting the Brakes

In what turned out to be the first sign of major trouble, news broke in January 2016 that Steve Zadesky, head of Project Titan, was stepping down. Apple product managers were increasingly battling with those hired from the auto industry. In a stark contrast to iPhone development, Apple had relied on outside hires to boost its auto expertise, especially when it came to auto hardware expertise. This ended up producing a culture clash as each side had a different view on how best to achieve goals in a timely manner. To make matters worse, the goals themselves were changing. Senior Titan managers were reportedly having doubts as to how an Apple Car would be able to leapfrog existing competition from Tesla and BMW. 

As we later discovered, things had deteriorated so much with Project Titan in early 2016 that Apple convinced Bob Mansfield, former SVP of Hardware Engineering, to come out of retirement in April 2016 to take over the project. (A complete Project Titan timeline is available here.) Up to that point, one of the major clues pointing to Apple's growing interest in automobiles was the sudden rise in R&D expense. However, something changed this past summer. As shown in Exhibit 1, Apple R&D expense growth slowed dramatically beginning in July. In fact, Apple reported the slowest R&D expense growth in nine quarters. On a sequential basis, 4Q16 was the third-weakest quarter for R&D growth since 2009. 

Exhibit 1: Apple Year-Over-Year (YOY) Quarterly R&D Expense Increase

As reported in September, Apple had begun to curtail parts of Project Titan this past summer. Dozens of employees, including many focused on automobile hardware, were let go or moved to other divisions within Apple. Ultimately, Apple hit the brakes on Project Titan because the auto industry was rapidly changing and Apple had lost sight of the car "puck." 

Skating to the Puck  

In January 2007, one of Steve Jobs' final slides of his iPhone unveiling keynote included a Wayne Gretzky quote. 

"I skate to where the puck is going to be, not where it has been."

Jobs held the quote in very high regard, saying that Apple had always tried to follow it and that it would remain Apple's goal forever. Over the years, the "puck" quote has been used so frequently that it has lost much of its meaning. Skating to where the puck is going to be does not mean having to predict the future to be right. If that were the case, the probability of success would be quite low. Instead, success is achieved by reading the market and positioning oneself as the catalyst that leads to market change. If we return to the hockey analogy, Wayne Gretzky's skill was found in his ability to read the current situation and position himself to increase the probability of impacting game play. 

Jobs included the quote in the iPhone keynote because Apple felt confident that the iPhone would not just change the smartphone industry in 2007, but would also become the catalyst for change in the coming years. The iPhone would alter the smartphone's trajectory. Apple ended up being right. The iPhone's revolutionary user interface and groundbreaking software positioned Apple well for the eventual app revolution, which only solidified iOS as the most profitable mobile platform.

A more recent example of Apple skating to where the puck will be involves Apple Watch. While many companies remain unsure of where the wearables puck will be in a few years, Apple is laying the groundwork for being a leading wearables player with Apple Watch and soon, AirPods. Apple is betting that it will be well-positioned for the inevitable trend of wearable devices handling tasks that we used to give to smartphones and tablets. 

The Apple Car Puck

When it came to skating to where the car puck is going to be, Apple made a miscalculation. Much of the change now taking place with Project Titan is a result of Apple trying to rectify that mistake. 

If we look at where the car industry was in early 2014 when Apple began to investigate the feasibility of building a car, the world was a very different place.

  • Tesla had sold only 21,000 Model S cars.

  • BMW had just begun to sell its i3 electric car. 

  • Google had just announced it would create a self-driving car without a steering wheel or pedals. 

  • Uber was valued at only $3.5 billion.

From Apple's perspective, the goal for Project Titan was to capitalize on declining battery costs and new manufacturing techniques involving new materials, including carbon fibre. Apple looked at Tesla and BMW as inspirations. The plan was to do to the car industry what Apple had done to the phone industry, namely, use software and manufacturing to rethink the car. Over time, Apple could include self-driving capabilities.

However, after only a few years, the auto industry had undergone significant changes. 

  • Tesla is now producing cars at a rate of 100,000 per year but is increasingly focusing on building the low cost ($35,000) Model 3.

  • Elon Musk expects to have a fully autonomous car by the end of 2017. Tesla has begun equipping all of its new cars with self-driving hardware.

  • BMW's i series electric car program has lost all momentum.

  • Ridesharing adoption is exploding around the world. 

  • Uber is valued at $65+ billion, Didi at $35+ billion. 

Putting the pieces together, we see that the car industry has embraced ridesharing much more quickly than it appeared to be a few years ago. Meanwhile, autonomous driving is no longer looking like a pipe dream that will take 10 to 20 years to become a reality. In a world with self-driving electric cars that are part of a ridesharing fleet, relying on a traditional buy/lease model for a premium-priced electric car doesn't sound like the puck worth tracking.

The Blackberry of the Auto Industry

Electric car sales remain quite niche in the auto industry. In 2015, electric car sales represented only 0.66% of all car sales in the U.S., down from 0.74% in 2014. Optimistic sales forecasts have had to be dialed back time after time.

There has been much speculation that Tesla's Model 3 will significantly alter the auto industry, serving as the catalyst that will finally place electric car ownership in the mainstream. This would impact not only legacy automakers struggling to sell electric cars, but also Apple's car plans. I suspect Apple's original goal with Titan was to sell an electric car to consumers, helping to expand electric car adoption. However, the world is changing.

Electric car ownership may turn out to be the "Blackberry" of the auto industry, a near-term phenomenon that will end up being a head fake and not representative of the future. The combination of ridesharing and self-driving cars threatens to undermine car ownership as car utilization would be improved. (Currently, the average car is not used 96% of the time.)

Titan Reset

According to published reports, Bob Mansfield is overseeing significant changes to Apple's car strategy. Project Titan has been rearranged into three teams:

  • Software

  • Sensors

  • Hardware

The focus has been put on autonomous driving, and auto hardware has been put on the rear burner. These changes reflect a type of reset as Apple rethinks were the car puck is headed. By placing autonomous driving as Project Titan's focal point, Apple is giving us a clue that it now thinks ridesharing is the future worth betting on. It is worth pointing out that Apple made its $1 billion investment in Didi soon after Bob Mansfield had announced major changes to Project Titan with a focus on autonomous driving. The timing between these events surely doesn't seem coincidental.  

Instead of owning cars, consumers will share cars. It is just too difficult to make a case for owning a self-driving electric car in the future. Even Tesla is showing early signs of embracing a different kind of business model in which Model 3 cars could be used to form a ridesharing network. If Apple is unable to come up with autonomous driving, the company's successes in auto hardware or manufacturing would be wasted. 

While Apple has reportedly scaled back its auto hardware ambitions, much of this reduction does not preclude a future revamp if Apple's autonomous driving research proves successful. However, Apple may approach auto hardware differently next time in an effort to improve odds of ultimate success. We know that Apple held talks with McLaren concerning some type of strategic investment. (My complete thoughts and observations on McLaren are available here.) These talks reportedly occurred after Mansfield had refocused Titan, which included de-emphasizing auto hardware. This tells me that the odds of Apple partnering or acquiring an established team of auto hardware experts have increased. 

The Big Picture

All of the evidence still points to Apple being extremely interested in transportation. The company apparently has retained all of the buildings and land associated with Project Titan, including the massive amount of open land near San Jose International Airport. Apple is now doubling down on auto software and autonomous driving talent, which includes rebuilding the QNX team in Canada. Recent Apple M&A related to augmented reality has been tied to the company's autonomous driving efforts. Apple has a seat on Didi's board. In addition, Apple ID has the freedom to continue working on car ideas.

As to where Apple thinks the car puck is headed, a self-driving smart room on wheels is the leading contender. In the beginning, these self-driving cars may be limited to specific routes or geographies with the expectation of being rolled out to additional locations over time. Apple would need to embrace new business models and partners. Apple can leapfrog the competition by keeping focus on the user experience attached to the product.

Ford 021C concept car from Marc Newson, a key member of the Apple ID group.

In a world where we share cars, there will be a significant desire for the ability to change the inside of a car for the current occupants. With control over various services including mobile payments, communication, mapping, and entertainment content, Apple will be one of the companies better positioned to come up with a premium experience in the auto industry. And of course, we can't forget Apple ID's contribution to such a product as design contains the most power to alter the car industry. Apple is still thinking about where the car puck is headed. 

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (3 stories per day, 12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

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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iPhone 7

The iPhone 7 won't be remembered for being the first iPhone without a dedicated headphone jack. Instead, we will look back at this year's flagship iPhone as the starting point of Apple's major push into augmented reality. The two cameras that make up the dual-camera system found in the iPhone 7 Plus are a pair of "smart eyes" that will alter the way we use an iPhone. As wearable devices become proactive assistants monitoring a greater portion of our daily routines, the iPhone will be positioned as the most powerful piece of glass for hundreds of millions of people. 

Using iPhone 7

Each year, Apple's goal with the iPhone business is to come up with a new model that is more capable and functional than the previous year's model. Apple accomplished that goal with the iPhone 7. I have been using a Jet Black iPhone 7 Plus since launch. Without question, it is an upgrade from my iPhone 6s Plus. The three new features that have stood out include stereo speakers, a more expansive rollout of haptic feedback, and the dual-camera system.

Having used stereo speakers with a 12.9-inch iPad Pro, I was well aware of how significant a role the feature played in terms of improving the user experience. Given the increasing amount of content I consume on my iPhone, the double increase in sound output with the iPhone 7 is noticeable and welcomed. 

In what came as quite a surprise, I have been impressed with the haptic feedback expansion seen with the iPhone 7. Everything from editing photos to setting clock alarms now includes subtle vibrations. The primary reason the additional haptic feedback has stood out to me is that the feeling of using a smartphone has changed. Instead of just typing and swiping on a piece of glass, it now feels like I am interacting with the same piece of glass in a different way. 

However, without question, the one iPhone 7 feature to stand out the most has been the camera. Using optical zoom on an iPhone Plus was a genuine "wow" moment up there with using Siri for the first time or using my fingerprint to unlock an iPhone. Such a feature not only makes us rethink the iPhone's capabilities, but also leads us to imagine the future possibilities. 

The iPhone 7 Camera

Apple has relied on the camera to accomplish its goal of shipping new iPhones that are more capable and functional than their predecessors. Apple reportedly has an 800-member team of engineers and other specialists focused just on the iPhone camera. 

Management spent 12 percent of the Apple keynote earlier this month talking about iPhone cameras. (My thoughts and observations from the keynote are available here and here.) After going over all of the new features that position the iPhone 7 camera as the best camera Apple has ever shipped in an iPhone, Apple SVP Worldwide Marketing Phil Schiller turned to the iPhone 7 Plus camera. Rumors of Apple including a dual-camera system in an iPhone had been around for more than a year. In April 2015, Apple's LinX acquisition was a giveaway that the iPhone camera was going to see an upgrade in a very big way.  

The dual-camera system found in the iPhone 7 Plus is a game changer. With a wide-angle 28mm lens and a telephoto 56mm lens, an iPhone now has 1x wide angle, 2x optical zoom, and software zoom up to 10x. After a few days of use, I'm confident in saying 2x optical zoom by itself would classify as a worthy iPhone upgrade for many iPhone users. 

 
 

In addition to optical zoom, the dual-camera system is capable of a few other items with much more important long-term implications. Here's Schiller: 

"There's one other use of this [dual-camera system] that we challenged our engineering team to do as an extra credit project. It really was. It's something that is incredibly challenging and takes a lot of amazing invention. But what they have been doing is astounding and it's something that is a big breakthrough in photography..."

The iPhone 7 Plus is capable of producing a depth-of-field effect using machine learning. This serves as the foundation for turning the iPhone into an augmented reality device. By using the distance between the two cameras located on the iPhone Plus, software allows an object's distance from the iPhone to be calculated using triangulation. A 3D depth map can then be created. As seen in the graphic below, two cameras and software are able to create a depth map from a photograph. One result is that two people in the front are kept in focus while a blur is applied to the background. All of this is done in real time. 

Here is how Apple describes the dual-camera system found in the iPhone Plus 7: "This is the best camera we have ever made in an iPhone. This is the best camera ever made in any smartphone. For many of the customers who have it, it will probably be the best camera they have ever owned to date. But more importantly, it allows them to create beautiful pictures with incredible creative tools."

Notice how Apple is not positioning the dual-camera system as the beginning of its move into augmented reality. Instead, Apple is marketing it as a way to take great pictures. In this way, the dual-camera system is similar to Siri, Touch ID, and 3D Touch as features with humble beginnings.

Humble Beginnings

Over the years, many of the most important features to come to the Apple ecosystem were launched as somewhat basic and rudimentary iPhone features.

  • Siri told funny jokes. 
  • Touch ID unlocked iPhones.
  • 3D Touch made Live Photos come to life.

In each case, a feature was introduced not to set the world on fire overnight, but rather to serve as a foundation for future innovation and functionality. Siri has grown from giving funny, canned responses to being one of the most widely-used personal assistants that relies on natural speech processing. Touch ID is now used to facilitate commerce with Apple Pay. 3D Touch has transformed into an emerging new user interface revolving around haptics and the Taptic Engine. 

The dual-camera system found in the iPhone 7 Plus will be added to this list of essential iPhone features with modest beginnings. While currently billed as a great tool for photographers, the dual-camera system will eventually redefine the iPhone. 

Augmented Reality

While much has been written about augmented reality, very little has actually been said about the technology's potential. Up to now, augmented reality has been mostly a buzz word, defined by mobile apps that overlay data in a real-world setting. Most augmented reality demos don't exactly leave much to the imagination. In the beginning, it was an app that would show directions to the nearby subway station. More recently, Pokemon Go bought this same basic idea of augmented reality to the masses. 

The value in augmented reality won't be found by just interlacing objects with a real-world layer. In such a scenario, we are simply throwing data at our surroundings. Instead, augmented reality's promise is actually found by extracting data from the world around us and then using that information to enhance our surroundings. This is why I think of augmented reality more as "enhanced reality" and why powerful cameras will play such an important role. 

The iPhone 7 Plus dual-system camera is able to extract more data than any other iPhone camera. When combined with software and other technologies, this data will become incredibly valuable for Apple's augmented reality efforts. In an effort to obtain those specialized technologies, Apple has been on a buying spree for augmented reality startups including Metaio, Emotient, Polar Rose, Faceshift, PrimeSense, Flyby Media, and Perceptio. The dual-camera system found in the iPhone 7 Plus is the first step in Apple turning the iPhone into a key component of an augmented reality platform relying on much of the technology acquired these past two years. 

A Platform

While the Phone will become a key part of Apple's augmented reality platform, there will be a range of devices capable of enhancing reality through both visual and audible feedback. One reason why Apple has no other choice but to get into transportation is that automobiles will end up representing a superior use case for augmented reality. As it stands now, riding in an automobile provides a warped sense of reality. This can be seen by the different perception obtained when driving down the road or walking along the same roadway. When walking, much more information and data is obtained. It almost feels like an entirely different road. Accordingly, the automobile will present a perfect opportunity to bring augmented reality to a "room" on wheels. Even AirPods will likely play a role in Apple's augmented reality play. A device that will be able to extract data (sound waves) from the real world will be able to enhance one's surroundings through audible feedback. 

The Most Powerful Piece of Glass

We are beginning to see the early stages of a new product era at Apple. New devices are being introduced that will ultimately be able to handle many of the tasks that we currently give iPhone. In 2015, Apple unveiled its first wearables platform with Apple Watch. Seventeen months later, Apple has sold 15 million Apple Watches. Earlier this month, Apple unveiled its second wearables platform with AirPods. These devices are going to be positioned as monitoring devices that guide us through our daily schedule. 

In this new Apple Experience era, the user determines the products that add the most value to their lives. For some people, wearables will play a crucial role. These users will assign products like Apple Watch and AirPods tasks that are currently given to iPhones, iPads, and Macs. In this example, while wearables gain value, it is not a given that the iPhone would lose value.

Instead of becoming something like an iPod, a product that will lose nearly all of its value over time due to other products handling the same roles, the iPhone will likely be able to retain its value because of the camera. The iPhone will be able to stand out among a world of wearables given its powerful cameras and ability to extract data from a scenario. Hundreds of millions of people will find a need for such a product, even if it isn't the hub of their digital lives. By turning the iPhone into an augmented reality device, Apple will be positioning the iPhone as the most powerful piece of glass in our lives, and it all started with the iPhone 7. 

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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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