Apple Is Pushing iPad Like Never Before

Apple is pulling out all the stops when it comes to selling iPad. We are seeing the company take its most aggressive stance yet in getting existing iPad owners to upgrade. For the first time, Apple is also making a concerted effort to reach prospective iPad owners by targeting PC users. On the surface, these efforts seem like a last ditch effort to save iPad, which faces continued sales declines. However, Apple is guided by a different motive. There are signs of Apple pushing iPad like never before in order to solve its growing Mac dilemma.

Initial Look at iPad Sales

A quick look at overall iPad sales reveals an ominous trend. Sales have declined for 12 consecutive quarters. After topping out 74M units in 1Q14, the annualized iPad sales rate has declined by 42% to 43M units.

Exhibit 1: iPad Unit Sales (TTM)

When iPad is compared to iPhone and Mac, its sales weakness becomes even more pronounced. The sales gap between iPad and Mac continues to shrink. This has drawn into question Apple's vision for iPad and whether or not the device is the best representation of the future of personal computing. There are even people beginning to question some aspects of the post-PC era as steady Mac sales suggest consumers aren't moving away from laptops and desktops. 

Exhibit 2: iPhone, iPad, Mac Unit Sales (TTM)

For the past four years, we have seen various theories put forth to explain the significant drop in iPad sales. Longer upgrade cycles, larger iPhones, inferior software, lack of professional apps, and even poor Apple storytelling have been given as factors driving iPad sales weakness. 

iPad Strategy Changes

As sales have declined, Apple has implemented a number of significant changes in its iPad strategy. Many of these changes have occurred within the past year and a half. The latest changes were unveiled last week when Apple announced the new 9.7-inch iPad. (My complete review of Apple's new product announcements is available for members here.)

iPad Pro. The most obvious change relates to the iPad Pro line. The defining features of the iPad Pro are the Apple Pencil and Smart Keyboard support, which were introduced in 2015. One of the biggest criticisms facing the iPad over the past few years is that it is a consumption device used primarily for watching video. The iPad Pro seeks to change that narrative. The overall strategy with the iPad Pro is to release higher-priced SKUs offering additional functionality and capability.

Additional Simplicity. The iPad Air era is officially over at Apple. By positioning the new 9.7-inch iPad as the iPad Air 2 successor, the overall iPad line is much simpler. In fact, the iPad line contains the most simplicity in years. The "iPad Air" nomenclature had lost much of its meaning last year following the 9.7-inch iPad Pro unveiling as each device shared similar dimensions and identical weight. 

As seen below, Apple reduced the iPad line by 20% (five models down to four) and simplified the branding. 

By removing the iPad Air from the line, Apple made the iPad buying equation that much easier for consumers. This simplicity is a sign of Apple doubling down on the 9.7-inch iPad as the flagship iPad size. (The actual screen size may change slightly going forward depending on the screen to bezel ratio.) The choice is either between an iPad Pro or an iPad. Meanwhile, the iPad mini will become niche, available for consumers wanting an iPad with a smaller footprint.

Aggressive Pricing. Apple slashed the entry-level price for the 9.7-inch iPad to $329 from $399. Special $299 pricing for education institutions is also available. This is an aggressive pricing strategy considering that Apple was selling the 9.7-inch iPad Air 2 for $499 as recently as 12 months ago. The iPad mini had represented the entry-level iPad model when it came to pricing. Since the company is now positioning the smaller iPad as a niche device, the new distinction comes with a higher price.

Clearer Storytelling. Apple recently launched its largest iPad ad campaign to date. In what is called "Real Problems... answered," Apple showcases real tweets depicting computing problems and then demonstrates how the iPad Pro offers solutions. The ad campaign is a big deal for Apple and a sign of management directly reaching out to PC users as potential iPad purchasers. The company has been quite aggressive with its airing of the ads in recent weeks. 

One of the more interesting observations about the ads is how they end up making long-time MacBook users nervous. Apple is positioning iPad Pro as a better computer than laptops, and by extension, MacBooks.

Closer Look at iPad Sales

In order to properly assess all of the recent changes to iPad strategy, a closer look at sales is needed. While overall iPad sales have been in decline for years, reports of iPad's death have been greatly exaggerated. There is much more going on behind the scenes.

iPad sales have faced one major headwind in recent years. This item explains a significant portion of the sales decline. It's not inferior software, weak storytelling, or even a longer upgrade cycle. Instead, the iPad's problem has been the iPad mini.

People aren't buying as many iPad mini devices these days. Excluding 7.9-inch iPad mini sales from overall iPad sales results in a completely different sales picture. As seen in Exhibit 3, iPad mini unit sales have declined 70% after peaking in 4Q13 and 1Q14. The product's value proposition has been permanently reduced due to larger iPhones. Apple has clearly experienced Peak iPad Mini. It's not that the iPad mini form factor is going away, but rather that it will play a smaller role going forward. 

iPad mini sales weakness has masked stronger sales trends for larger iPads. In what will come as a surprise to many, the iPad Air 2 has been the best-selling iPad to date. In addition, more than half of people buying an iPad Air 2 were new to iPad. These are very promising signs for the iPad business. Not only are large screen (9.7-inch and 12.9-inch) iPad sales relatively unchanged over the past four years, but they actually have increased year-over-year this past holiday quarter. The iPad Pro line played a major role in this sales rebound. 

Exhibit 3: iPad Unit Sales by Screen Size (TTM)

Given iPad mini sales weakness, management is placing a big bet on larger iPad screens. By lowering the entry-level cost of the 9.7-inch model to $329, Apple is looking to make the most appealing iPad size more accessible. At the same time, the company is offsetting margin and ASP pressure by moving up market with more capable iPad Pro SKUs and accessories. The Apple Pencil accessory is one of the most underrated Apple products in years. 

Solving the Mac Dilemma

Since large screen iPads having shown much more resiliency over the past few years, Apple's recent iPad changes seem peculiar. Why double down on the iPad now?

Apple is pushing the iPad like never before in order to solve its Mac dilemma.

Ultimately, management has two options for the Mac:

1. Double down. From a product perspective, there is a clear path forward for the laptop and desktop form factors at Apple. The company could continue bringing elements of mobile to the Mac. Apple can control more of the core technologies powering the Mac, and this would include bringing a version of iOS to the laptop and desktop form factors. The effort would take years to accomplish and utilize a significant amount of resources. 
2. Move beyond the Mac. This option would begin with more sporadic updates to the Mac line and then eventually lead to Apple placing less and less attention on the category as other products gain priority and resources. While Apple would still sell Macs, it would become clear that the company's focus is on newer products designed to handle the tasks currently given to the Mac.

Management faces a difficult choice between the two options as the Mac is still selling very well. The product category is bringing in nearly $23B of revenue per year, $4B more than iPad thanks to a much higher ASP. Some companies are powered by Macs (although Apple executives seem to rely quite a bit on their iPads these days). Tens of millions of users rely on Macs to get work done every day. A portion of these users are adamant that a move away from Mac is nearly impossible given their current workflows.

My suspicion is that Apple is pushing larger screen iPads because management is determined to move beyond the Mac. Apple thinks now is the time to raise awareness that the iPad is a legitimate PC alternative for hundreds of millions of consumers. 

A move away from the Mac goes against much of the public commentary from Apple management. Tim Cook, Phil Schiller, and others have been quick to mention Apple's long-term commitment to the Mac with Phil Schiller even saying the laptop form factor will be around for another 25 years. However, management's recent actions speak louder:

• Tim Cook calling the iPad the clearest expression of Apple's vision of the future of personal computing.
• The new iPad Pro ad campaign elevating the iPad at the expense of Mac.
• Aggressive iPad pricing highlighting Apple's desire to position the device for mass market consumption, while Mac pricing is more reflective of a niche product.

The iPad Strategy

As seen in Exhibit 4, the sales gap between large screen iPads and Mac peaked five years ago. The gap has since closed, with large screen iPad sales bouncing around 30M units annually and Mac sales seeing a slight improvement to 19M units. If Mac were to outsell iPad, this would certainly make Apple's goal in moving beyond the Mac that much more difficult. It would demonstrate how Apple has a serious problem on its hand as the iPad is not able to entice users away from Mac. Management is interested in avoiding that outcome.

Apple wants to push iPad sales now like never before in order to widen the sales gap between iPad and Mac. Large screen iPads have experienced some momentum in recent months. Management is building off that strength to unveil a broader campaign to boost iPad sales. If Apple is successful in increasing large screen iPad sales to a 40M unit sales annual pace (a 30% increase from current levels), iPad would be outselling Mac by 2x. This would certainly help change the iPad versus Mac narrative in the marketplace, giving Apple that much more motivation to dedicate attention and resources to other products. 

Exhibit 4: Mac, Large Screen iPad Unit Sales (TTM)

Apple is making its iPad sales pitch to two groups: existing iPad users and long-time PC users. According to my estimates, there are 100M users still using older iPads (iPad 1, iPad 2, iPad 3, iPad 4, iPad mini). A significant portion of these users are using devices that don't even support the latest iOS release. Management thinks simpler storytelling and an aggressively low $329 price will entice these users to upgrade to the new 9.7-inch iPad.

The fact that 100M people are still using older iPads demonstrates that the product provides value. Apple is also confident that users will see the significant improvement between the latest iPads and models from five to seven years ago. As for PC users, Apple thinks the iPad Pro line is capable of handling the vast majority of tasks currently given to laptops. Apple looks at the iPad Pro line, which includes Apple Pencil and Smart Keyboard, as a better solution for consumers than even the Mac. This is quite telling as to management's long-term motivation. 

While the iPhone has likely reduced the iPad's long-term sales trajectory, the iPad category is being underestimated. Apple thinks that now is the time to become much more aggressive in selling iPad. Fortunately, we will be able to judge Apple's progress by monitoring quarterly iPad sales. With a dramatic price cut, simpler sales pitch, reduced headwind from iPad mini sales, and a differentiated product line, Apple is confident the iPad will return to growth. A growing iPad business will then make it that much easier for Apple to move beyond the Mac and focus on creating a new breed of personal gadgets that make technology more personal. 

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The Curious State of Apple Product Pricing

As Apple pushes deeper into luxury brand territory, the company is making its products more accessible through lower pricing. At $159, Apple is underpricing AirPods. The same can be said for Apple Watch, priced at $269. In just ten years, we have moved from the "Apple Tax" days, when Apple was accused of pricing products artificially high, to Apple products being priced below the competition. Apple is using its balance sheet and scale to grab new users, and in the process, redefine luxury. 

Underpricing AirPods

After using AirPods for the past three months, one takeaway relates to pricing. It is clear that Apple is underpricing AirPods. While this statement may sound outlandish considering that a pair of EarPods is included in every iPhone box, AirPods are not just any pair of headphones. The combination of accelerometers, optical sensors, Apple's new W1 chip, and a well-designed charging case, position AirPods as Apple's second wearables product. AirPods are computers for your ears. This distinction does a better job at framing the device's surprisingly low $159 price. 

Contrary to the conclusions found in most headphone buying guides, AirPods should not be compared to lower-priced, wired headphones. These buying guides not only lean on sound quality to unfairly shortchange truly wireless headphones, but also misidentify why consumers want to buy wireless headphones in the first place. AirPods' primary value proposition isn't found with sound quality but rather with not having any wires. Accordingly, the product should be compared to other truly wireless headphones. 

It is very difficult to find a pair of wireless headphones priced lower than AirPods. In the run-up to Apple unveiling AirPods this past September, the wireless headphone market consisted of the following players: 

• Kanoa: $300
• Bragi Dash: $299
• Erato Apollo 7: $289
• Skybuds: $279
• Earin: $249
• Motorola VerveOnes+: $249
• Samsung Gear IconX: $199
• Bragi Headphone: $149 

Given the preceding list, a strong case could have been made for Apple to price its new wireless headphones at $249, or even $299. The fact that Samsung priced its Gear IconX at $199 seemed to suggest a sub-$200 retail price for AirPods was unlikely. Instead, Apple sent shockwaves pulsing through the market by pricing AirPods at only $159. The action instantly removed all available oxygen from the wireless headphone space. The idea of Apple coming out with a new product that would underprice nearly every other competitor was unimaginable ten years ago. 

Many wireless headphone companies have been forced to cut pricing in an attempt to better compete with AirPods. Even after price cuts, competitors are still unable to come close to AirPods pricing. While some of these competing headphones include additional capabilities and functionality, much of this benefit is overshadowed by the lack of Apple's W1 chip. When it comes to contributing to the premium experience found with AirPods, the W1 chip is near the top of the list.

Underpricing Apple Watch

A similar pricing dynamic is found with Apple Watch. After cutting the entry-level price $50 to $299 in March 2016, Apple unveiled a new Apple Watch pricing strategy last September. Apple upgraded the first generation Apple Watch device with a new dual-core processor, the same processor found in the higher-priced Apple Watch Series 2 models. In addition, Apple gave the Watch a new name, Apple Watch Series 1, and a $30 price cut to $269.

At $269, Apple Watch Series 1 is one of lowest-priced smartwatches worth buying in the marketplace. Attractive pricing was one key factor driving record Apple Watch sales this past holiday quarter. In fact, even the Apple Watch Series 2, at $349, is one of the lowest-priced smartwatches in its class:

• Fossil Fenix 5: $599
• Garmin Forerunner 630: $399
• Michael Kors Access: $350
• Samsung Gear S3: $349
• Fossil Q Founder: $275

Apple's aggressive pricing strategy has also gone a long way in shrinking the price gap between Apple Watch and dedicated health and fitness trackers. There is now only a $70 difference between an Apple Watch Series 1 and Fitbit Blaze. 

Three Pricing Theories

There are three theories to explain Apple's AirPods and Apple Watch pricing strategy. 

A) iPhone as Hub. Instead of making a profit on Apple Watch and AirPods, Apple is underpricing the devices in an effort to boost iPhone sales. The logic is that since Apple Watch and AirPods are being positioned as iPhone accessories, Apple views the devices as tools to keep consumers attached to their iPhones. Apple compensates for the lack of Apple Watch and AirPods profit by selling high-margin iPhones and Services. 

B) Manufacturing Scale. This is the most straightforward theory. Apple has simply gotten better at making products at a lower cost. With a sizable production ramp (millions of units), Apple management can use scale and its existing supply chain to quickly bring down component and manufacturing costs for a new breed of personal tech gadgets. 

C) Consumer Segmentation. Management is using product pricing to grow Apple's user base. On one end, management cuts entry-level pricing in an effort to make products more accessible. However, management then pushes at the other end of the pricing spectrum with premium SKUs targeting a different part of the user base. The higher-priced SKUs help boost Apple's overall margin profile. 

History

On the surface, each of the three preceding theories seem to contain some logic. The iPhone is not only Apple's best-selling product, but also the most effective tool for growing the user base. At the same time, Apple has seen much progress in keeping component costs contained across its product line.

However, upon further examination, there is a serious flaw found with Theory A (besides the fact that Apple is moving beyond the iPhone as Hub product strategy). AirPods and Apple Watch pricing doesn't reflect a new strategy designed to juice iPhone sales. Instead, Apple has actually been traveling down this pricing path for years. Apple's decision to unveil the initial iPad at $499 in 2010, and then come out with a $329 iPad mini just two years later, marked a sea change in the way Apple approached product pricing. 

In the mid-1990s, Apple made a series of strategic mistakes related to the Mac. Instead of trying to grow market share, management chased profit. Apple introduced a variety of high-priced Macs targeting existing Mac users. Apple was having difficulty targeting new users in the face of the strengthening Windows empire. Apple was doubling down on niche instead of chasing mass market. 

Apple took a completely different strategy with iPad. With iPad, Apple cared much more about grabbing market share. This attitude was born from motivation to not repeat Apple's dark days from the 1990s. Up until last year, there was thought to be one major caveat to Apple's market share ambition. Apple was interested in initially grabbing share in the premium segment of the market and then gradually working its way down market. There is evidence to suggest this attitude is now changing a bit as Apple is selling wearables.

Apple's Pricing Strategy

AirPods and Apple Watch pricing demonstrate how Apple is looking to own not only the premium segment of the wearables market, but rather the entire market. As Apple runs deeper into luxury, the company is reducing entry-level pricing. This is a curious development as one assumes the opposite would have occurred - Apple would keep prices high to maintain a certain level of exclusivity or scarcity. Instead, Apple is redefining the concept of luxury in order to sell mass-market products. 

Consider Apple's approach to Apple Watch pricing. With $269 and $369 Apple Watch options, Apple is very competitive with nearly every smartwatch. However, at the other end of the product line with Apple Watch Hermès and Edition starting at $1,149 and $1,249 respectively, Apple is selling different materials, and a different kind of experience, at much higher prices. Apple is segmenting the product line to appeal to a wider variety of users. 

With Apple's entry-level Apple Watch pricing, management isn't necessarily targeting a premium segment of the smartwatch market, but rather its going after the entire market. AirPods represents an even more extreme case study of this mass-market appeal. 

Apple is able to sell product at low prices by utilizing its strong balance sheet and powerful supply chain to secure very attractive component orders. In addition, the company's efforts to own its own silicon and other core technologies are starting to pay dividends from both a performance and pricing perspective. Apple's growing vertical integration is allowing the company to run with lower pricing yet still maintain historically high margins. The growing legal battle between Apple and Qualcomm isn't just about Apple being unhappy with Qualcomm's business model. Rather, it's about Apple wanting to eventually get into the baseband processor business. (A full primer related to the lawsuit is available for members here.) This will come in handy when selling a cellular Apple Watch down the road as Apple can create its own system on a chip (SOC) containing its own AX processors, GPU, and an LTE modem chip. 

Lower-priced Apple products result in increased sales, which leads to Apple's ability to place even larger component orders. Apple will soon be on pace to sell 20M Apple Watches per year. For AirPods, annual unit sales will likely be even higher. These sales numbers provide Apple flexibility to reduce the pricing of older models even further. Meanwhile, competitors are unable to get a foot in the door. We saw a version of this dynamic unfold in the tablet market during the early 2010s. The same thing is now taking place in the smartwatch market, and it could even expand to the wireless headphone industry. 

Things to Monitor

Given Apple's revised pricing strategy, there are a few developments worth monitoring: 

1. Apple Watch. A $199 Apple Watch is inevitable at this point. On the other end of the pricing spectrum, new partnerships with luxury brands similar to Hermès seem likely. 
2. AirPods. It is not unreasonable for Apple to eventually have an entire AirPods platform comprised of lower-priced models with certain features and components as well as higher-end options targeting a more premium segment of the market. Interestingly, Apple started towards the low end and may work its way up market as additional functionality is added. 
3. iPhone. Stronger than expected demand for the higher-priced iPhone 7 Plus tells us that higher-priced iPhones are coming. Higher prices will be justified as iPhones morph from being computers that fit in one’s pocket into personal augmented reality navigators utilizing the most capable cameras to ever fit in a pocket. Meanwhile, Apple continues to reduce entry-level iPhone pricing. The most recent example is Apple bringing back the iPhone 6 in a few select markets and pricing it a bit lower than iPhone SE. 
4. iPad. Given the iPad's position within Apple's broader product line, the product category is following the iPhone in terms of higher-priced models. On the other end, there may not be much room left for Apple to lower iPad's entry-level pricing to significantly less than $269. 

Redefining Luxury

Apple's pricing strategy is ultimately about bringing new users into the Apple ecosystem. While the iPhone remains the most effective tool for accomplishing this, Apple wearables will increasingly represent another new user tool at management's disposal. It may be difficult to believe, but AirPods likely represent the first Apple product for more than a few people. Additional value will flow to companies selling multiple wearables products to the same user. As it currently stands, the average Apple user owns more than one Apple product. This trend will only intensify as time goes on when considering Apple Watch and AirPods. 

The trickiest aspect of Apple's pricing strategy is running with lower prices while at the same time, becoming more of a luxury brand. In essence, Apple is redefining luxury. While other luxury brands have utilized lower-priced items to serve as brand entry points, Apple is taking the practice to an entirely new level by pricing products below the competition. Apple is making luxury much more accessible with the idea that low-priced gadgets can create an experience just as luxurious as that of premium gadgets. It's going to be difficult for other consumer tech companies to play in this game. 

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The New Leader in Wearables

There has been a sea change within the wearables industry. In a remarkable turn of events, Apple looks to have grabbed the wearables unit sales crown from Fitbit this past holiday season. It's time to begin thinking about wearables not just as standalone devices for the wrist, but rather platforms containing a number of products designed for different parts of the body. In this environment, Apple has become the new wearables leader.

Change Is in the Air

Over the past few years, the wearables industry had come to revolve around two product categories targeting the wrist: 

• Health & fitness trackers
• Smartwatches

Fitbit and Apple have been the top two companies selling wearables in volume. While Fitbit's assortment of health & fitness trackers outsold Apple Watch in terms of unit sales, the higher-priced Apple Watch gave Apple the revenue edge. After initially positioning Apple Watch as a mini iPhone on the wrist, Apple changed strategies last year in an effort to close the unit sales gap between Fitbit and Apple Watch. Management shifted Apple Watch marketing more towards health & fitness while lowering the entry-level price and expanding the product line to include more fitness-oriented Watches. 

The ingredients for an interesting holiday quarter for the wearables industry seemed to be in place. The debate centered on whether or not Apple would be able to entice people to embrace smartwatches instead of dedicated health & fitness trackers. However, Fitbit had an early November surprise announcement. The company disclosed a sudden deterioration in customer demand in 3Q16, and the negative trends had continued into October. The slowdown caught Fitbit off guard. Management was forced to issue very weak financial guidance for the upcoming holiday shopping season. More worrying, management didn't seem to know what was driving the sudden decline in demand. While Apple Watch was a prime suspect, Fitbit has never publicly viewed Apple as a competitive threat.

Despite lowering sales expectations, Fitbit still ended up missing its holiday sales forecast. The company hit a brick wall in terms of sales growth. Demand for Fitbit products completely evaporated at the end of the year with the company seeing a 21% decline in unit sales in 4Q16. Just one year earlier, Fitbit had reported 55% unit sales growth. 

While Fitbit saw weakening consumer demand, other wearables players reported much more positive results. Apple reported record Apple Watch sales in 4Q16. Fossil and Garmin also saw promising smartwatch trends. (My Fossil and Garmin 4Q16 earnings analysis is available here and here, respectively.) Garmin even described a scenario of robust smartwatch demand during the holidays. While consumers turned away from Fitbit health & fitness trackers during the second half of 2016, smartwatches have been gaining momentum. 

By the Numbers

The shift in consumer preferences regarding fitness & health trackers and smartwatches is visible when comparing Fitbit and Apple Watch unit sales. As seen in Exhibit 1, Apple nearly closed the unit sales gap between Apple Watch and Fitbit last quarter. During 4Q16, Fitbit sold 6.5M devices at an average selling price of $85. Meanwhile, Apple sold 5.6M Apple Watches at an average selling price of $372. 

Exhibit 1: Fitbit vs. Apple Watch Unit Sales

Exhibit 1 would seem to suggest that despite significant sales trouble, Fitbit was still able to keep its title as the best-selling wearables company in the world. Upon closer examination, there is more to the story. Apple was not able to meet Apple Watch demand during the holiday quarter as Apple Watch Series 2 faced severe supply shortages. Meanwhile, Fitbit was stuck with elevated inventory levels throughout the holiday season. Accordingly, on a sell-through basis, Apple Watch and Fitbit demand was likely neck and neck. This is an astounding turn of events from the previous holiday quarter when Fitbit outsold Apple Watch by 1.7x.

A New Product

On a sell-through basis, Fitbit may have been able to just squeak by Apple Watch to retain the title of best-selling wearables company over the holidays. However, there is still a missing piece to the discussion. The definition of wearables has changed. This past holiday season saw the introduction of AirPods, Apple's second wearables product. 

After a two-month delay, Apple began selling AirPods in mid-December. When taking into account AirPods launch sales during the last two weeks of December, I estimate Apple sold more wearables devices than Fitbit during the holiday quarter.

Apple's 4Q16 Wearables Sales:

• Apple Watch: 5.6M units (my estimate - details are available here)
• AirPods: 1.0M units (my estimate - details are available here)
• Total: 6.6M units

Note: This total does not include Beats headphones containing Apple's W1 chip. 

When taking into account AirPods sales, the sales data from Exhibit 1 looks a bit different. As seen in Exhibit 2, Apple sold more wearables than Fitbit for the first time last quarter. Considering how both Apple Watch and AirPods were supply constrained (AirPods are still severely supply constrained), it is responsible to assume Apple could have easily sold eight or nine million wearables devices last quarter. This would be 60% more than the number of Macs sold and 65% of iPad unit sales. 

Exhibit 2: Fitbit vs. Apple Watch and AirPods Unit Sales

Platform Play

On Apple's 1Q17 earnings call, Apple introduced a new way of describing Apple Watch and AirPods. Here's Tim Cook: 

"With AirPods off to a fantastic start, a strong full first year for Apple Watch, and Beats headphones offering a great wireless experience using the Apple-designed W1 chip, we now have a rich lineup of wearable products. Their design, elegance, and ease of use make us very excited about the huge growth potential for wearables going forward."

The wearables industry is rapidly turning into a platform play. The winners will be those companies offering a range of wearable devices. Apple Watch, AirPods, and W1 chip-equipped Beats headphones represent Apple's wearables platform. As seen in the following diagram, the wearables market is best viewed as a collection of distinct battles for real estate: wrists, ears, eyes, and body (i.e. clothing). At this point, the wrist and ears are the two areas ready for mass-market products. Additional battles for the eyes and body remain R&D projects at this point given design and technological barriers. 

Apple is currently the only company playing in at least two wearables geographies at scale (wrist and ears). Many are underestimating the benefits associated with this type of control over a wearables platform. Similar to how strong loyalty and high satisfaction have resulted in low churn within the iPhone installed base, satisfied Apple Watch owners are that much more likely to buy AirPods and vice versa. As consumers embrace a full suite of wearables products, it doesn't hurt Apple to have an existing user base of more than 800 million people. 

Changing Competition

The significant change found at the top of the wearables market with Apple overtaking Fitbit in terms of unit sales signals a broader shift within the industry. Consumers are gravitating toward greater utility on the wrist. Dedicated health & fitness trackers are displaying many of the same characteristics shown by cheap MP3 players at the beginning of the iPod era. Consumers are beginning to bypass cheap alternatives with limited functionality and reliability and instead value additional functionality. 

Fitbit's growing struggles provide a new perspective on how competition is unfolding in the wearables market. Instead of the battle existing between wearables companies, the true competition is found between wearables and non-wearables. Apple's primary wearables competitor isn't Fitbit, Garmin, Fossil, or Samsung. Instead, Apple is competing for the same wrist real estate as legacy watch and jewelry companies. Even bare wrists represent prime competition for Apple Watch. Going forward, this battle for real estate is only going to intensify and expand to the ears. 

A closer look at Fitbit's strategy would reveal the company misidentified its competition. Instead of looking at bare wrists and non-wearables as the competition, which would have led Fitbit to push much further and faster up market in terms of capability and functionality, Fitbit assumed its only competition was multi-purpose smartwatches retailing for four or five times the price of Fitbit. Management assumed the dedicated health & fitness tracker and smartwatch segments were distinct enough to coexist and appeal to different target markets. In reality, the pricing gap between the two categories had been rapidly shrinking, and the two product categories were increasingly chasing after the same group of people, which only made matters worse for Fitbit. The company got caught with an inadequate product line that didn't resonate with consumers. This would explain Fitbit's recent decision to reduce its product line in 2017 and instead go up market with its own smartwatch.

As for Apple, the company is showing all of the signs of placing a very big bet on wearables. Not only is management completely on board with wearables, but the company's Industrial Design group has been moving towards wearables for years. As seen in Exhibit 3, the wearables segment represents a key growth opportunity for Apple. In 2016, there were approximately 50M wearable devices shipped (not including cheap step and sleep trackers). This compares to the nearly 175M tablets and 1.5 billion smartphones shipped. It is only a matter of time before wearables outsell tablets. 

Exhibit 3: Wearables, Tablets, and Smartphones Unit Sales (2016)

The body represents a new battleground in tech. A vibrant wearables platform consisting of Apple Watch, AirPods, and Beats headphones has positioned Apple as the new leader in the wearables market. While Apple still faces various risks and challenges in the wearables space when it comes to adoption, the amount of progress seen in just the past two years bodes well for wearables playing a pivotal role in our lives.

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Apple Doesn't Need to Buy Netflix

Calls for Apple to buy Netflix are getting louder. Instead of evaluating whether Apple should buy Netflix, a more valuable question is whether or not Apple actually needs to buy Netflix to accomplish its goals. Upon closer examination, it becomes clear that calls to buy Netflix are misplaced as Apple is chasing after something entirely different in the video streaming space.

Music Streaming Lessons

One way to judge Apple's approach to video streaming is to look at how the company approached music streaming. In 2014, Apple had a growing problem on its hands. A music streaming startup called Spotify had amassed 40 million subscribers by positioning free music as a carrot for signing up to paid music streaming, for which there were 10 million paying subscribers. While Apple was still seeing increasing revenues from its paid music download empire, the company lacked a viable music streaming alternative. iTunes Radio wasn't an answer as it was chained to the paid download model. 

With $147 billion of cash on the balance sheet at the end of 2013, Apple could have bought Spotify for $15 billion in 2014. Apple would have not only acquired an entirely new business model for content, but also solved its music streaming service problem overnight. Spotify would have had a difficult time turning down Apple's offer since $15 billion would be overvaluing the firm.

Instead of buying Spotify, Apple bought Beats for $3 billion in 2014. Three years later, many are still not sure what to make of the acquisition. Beats was a headphones company with a questionable balance sheet. The company also had a fledgling music streaming business via its MOG acquisition two years earlier. These items didn't position Beats as a traditional Apple acquisition target. If management wanted quick access to a successful music streaming service, the obvious path forward ran through Spotify, not Beats.

However, Apple wasn't looking to buy just a music streaming service. Instead, Tim Cook and Eddy Cue, Apple SVP of Internet Software and Services, were looking for a long-term vision as to how Apple should approach music content. Beats co-founder Jimmy Iovine was selling that vision. In fact, Iovine had tried to sell that vision to Apple more than a decade earlier as co-founder of Interscope Records. With Spotify gaining power and cracks beginning to appear at the edges of the iTunes empire, Apple decided it was time to buy into Iovine's vision in 2014. Instead of buying Spotify, Apple bought Jimmy Iovine. 

Music M&A

Apple relies on a very particular M&A strategy. Management acquires companies in order to fill holes in product strategy. As a result, Apple uses M&A primarily to buy technology and teams of people behind a certain technology. In such a scenario, the product is placed above all else. In recent years, Apple has been an active acquirer, buying 15 to 20 smaller companies every year. 

Apple looked at its music strategy and concluded that the product hole involved more than just streaming technology. If that were the case, Spotify would have done a great job at plugging up that hole for Apple. Instead, management saw weakness when it came to talent, ideas, and a broader vision for content. Apple wanted fresh connections and relationships with the music industry - items Spotify lacked. Management was searching for a vision as to how it could strengthen its relationship with Hollywood, push the music industry forward, and strengthen the iOS ecosystem. Jimmy Iovine and the Beats team, including former music industry executives such as Larry Jackson, had the relationships Apple was chasing.  

Streaming Results

By acquiring Beats, has Apple's streaming music plans worked out? Would Apple have done better by acquiring Spotify? As seen in the following chart, Apple Music has done well when looking at the number of paid subscribers. While some thought the product had little chance of gaining adoption out of the gate, Apple now has more than 20 million paying subscribers after just 17 months in the market. Apple management is likely pleased with that total. The service has obviously benefited from Apple's extensive marketing campaign as well as prominent placement within the iOS platform. The company has unofficially positioned its goal as surpassing 100 million paying subscribers. 

When it comes to assessing Spotify's performance, the task becomes more complicated. On the surface, Spotify's paid subscriber growth rate appears to have remained steady following Apple Music's launch. The streaming service last disclosed 40 million paying subscribers. The problem is that Spotify has moved the goal posts when it comes to paid subscribers. The term has lost much of its meaning due to Spotify's heavy usage of promotions and bundling. In addition, Spotify's disclosures have become more sporadic when it comes to paid subscribers. Apple Music's disclosures have remained consistent to date. 

There are also questions regarding Spotify's business model and sustainability. It's not clear when or how those questions will be answered. This has placed a shroud of mystery over the music streaming space. 

In the meantime, Apple appears to be running fast with Apple Music as it positions "Planet of the Apps" and "CarPool Karaoke: The Series" as the first two original video shows for its streaming service. Apple's efforts with Apple Music don't appear to have been jeopardized by passing over Spotify as an acquisition target. It remains unclear if Spotify will serve as a ceiling to Apple Music's user growth. This is why Spotify's financial well-being is such a crucial topic to consider when thinking about Apple's long-term strategy to play in the music streaming space via Jimmy Iovine.

Why Acquire Netflix?

When it comes to the world of video streaming, Netflix is in an even stronger position than Spotify. With close to 90 million paying subscribers, Netflix has seen an incredible amount of success in getting people to pay for video content.

The crux of the argument for why Apple should buy Netflix centers around revenue growth. However, a few other reasons are often cited.

1. Revenue growth. By owning Netflix, Apple management would be well on its way to reaching their goal of doubling the Services business in four years. A $12 billion per year stream of subscription revenue (100 million Netflix customers paying $10 per month) is approximately 40 percent of Apple's annual Services revenue.
2. A different business model. Subscription revenue would help smooth the lumpiness found with Apple hardware sales and could eventually help the company make a push into a more encompassing subscription/service business model.
3. Original content. Netflix would give Apple a shot in the arm when it comes to original content programming. Instead of spending years to build something from scratch, Apple would quickly be in a position of producing enough original video content to match ESPN. 

Netflix Acquisition Lacks Rationale

Upon closer examination, calls that Apple should buy Netflix are misplaced as they do not take into account how Apple actually views the world. Many of the arguments assume Apple's current hardware-centric revenue model is in trouble. In addition, each of the three primary reasons cited for why Apple should buy Netflix contain significant gaps in logic and rationale. 

1. Revenue. Apple doesn't, and shouldn't, use M&A to directly acquire revenue streams. Apple didn't buy Beats for its revenue-generating headphone business. Instead, Apple bought Jimmy Iovine's music vision. A headphones business just happened to be attached to that vision. If M&A is used as a tool to grow revenue, Apple's effort to place the product above everything else is put into jeopardy. This logic explains why Apple doesn't acquire the large companies often paraded in the press as possible acquisition targets.
2. A different business model. Apple has already shown the willingness to embrace change when it comes to selling product. This is a company that pivoted from a very successful paid music download model for iTunes to paid subscriptions with Apple Music. With more than 20 million paying subscribers for Apple Music after only 17 months, the streaming service is already 20 percent the size of Netflix - and this is with little to no video content.
3. Original content. There is no evidence to suggest Apple wants to own large portfolios of video content. Instead, the company is still focused on being a content distributor with its iOS platform. In addition, rather than buying legacy content portfolios (Time Warner, Viacom, Disney, etc.) or original content initiatives found at tech companies masquerading as media companies (Netflix, Amazon), Apple is more interested in buying great ideas. This was very much on display with Apple's approach to music streaming. 

Apple's Video Strategy

In essence, Netflix is like Spotify. Apple could acquire Netflix and instantly become the leader in paid video streaming. However, there is evidence that Apple is instead looking for something different. Apple is searching for another "Jimmy Iovine," new connections and relationships with Hollywood. 

Apple's content goals have a better chance of being reached by working with smaller Hollywood production companies than by acquiring Netflix. This explains Apple's reported interest in Imagine Entertainment. According to The Financial Times, Tim Cook and Eddy Cue discussed a range of possibilities with Imagine Entertainment, founded by Ron Howard and Brian Grazer, including a possible acquisition. The takeaway from those talks doesn't revolve around Apple getting its hands on an existing content portfolio. Rather it focuses on bringing people on board to come up with new ideas. 

Another scenario that would likely interest Apple would be sitting down with a well-known entertainer and producer, such as Oprah, to discuss the possibility of working together on a few big ideas. Such an opportunity would let Apple stand out from the pack in the video streaming space instead of competing head-to-head with Netflix or Amazon Video. Such actions may seem trivial compared to Netflix doing 1,000 hours of original content programming. However, Apple would be looking to compete on different terms. 

The preceding Apple strategy is the cornerstone of my Apple Studios theory. Apple would build a Hollywood arm tasked with coming up with original video (and music) content. Instead of viewing this as a Netflix 2.0, Apple Studios would be more of an incubator for trying out new entertainment ideas. Apple Studios would sit uniquely within Apple's organizational structure in order to have the independency needed to prosper yet not be completely cut out of Apple. 

Eddy Cue and Jimmy Iovine like to say they are positioning Apple Music to be all about culture. When Apple says "culture," the company is actually referring to relevancy. Apple wants to remain relevant in the entertainment space. They want people to talk about what is going on in Apple Music. Eddy Cue recently compared Apple Music to MTV. While the juxtaposition may not be the most flattering thing for Apple Music these days considering MTV's weakened influence, Cue likely meant the MTV of yesterday. The cable channel was a cultural force for decades.

Apple is more interested in acquiring select ideas that have the potential to extend beyond just video or music content than it is in using a portion of its $230 billion of cash to buy huge content libraries. Apple held a monopoly on music mindshare during much of the late 2000s and early 2010s with iTunes. Management wants that mindshare back with Apple Music. This explains Apple's unusual arrangements with artists like Drake, Frank Ocean, and Chance the Rapper. Apple is showing us their blueprint for regaining relevancy.

This drive for relevancy also explains Apple's decision behind "Planet of the Apps." A show about apps doesn't seem to have much in common with a streaming music service. However, Apple Music has never been just about music, but rather it is about capturing relevancy. While the premise behind Planet of the Apps is similar to Shark Tank and The Voice, the integration with iOS is new and different. Planet of the Apps will include video content via an iOS app as well as broader iOS integration by having the apps that appear on the show featured prominently in the App Store. We are still firmly living in an app world. Apple thinks Planet of the Apps can get people talking - the same goal the company has for the broader Apple Music initiative. 

Apple never had iTunes-like mindshare in the video space. That title went to a collection of traditional broadcast and cable companies. Looking ahead, Apple isn't trying to be like HBO, Showtime, Netflix, or Amazon Video by owning large swaths of content. Instead of buying Spotify, Apple bought Jimmy Iovine's vision for regaining relevancy in music. Apple is now looking to translate Jimmy Iovine's music vision around relationships, ideas, and mindshare into a broader strategy for video. The strategy doesn't require owning Netflix. 

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Apple on Track to Buy 50% of Itself in Three Years

A path has appeared where Apple management can realistically buy back 50% of AAPL's outstanding shares within three years. With a stable iPhone business, a growing Services business, and U.S. corporate tax reform, Apple will have close to $300B of cash available to spend on share buyback in the coming years. The numbers are daunting, and as Apple management has shown no sign of curtailing its buyback plans, it's time for Wall Street to take notice. 

Share Buyback 101

Share buyback is the opposite mechanism of an IPO or secondary offering. Instead of raising cash by selling shares, a company uses excess cash on its balance sheet to buy back its shares from investors. These shares are then retired, or removed from the market, resulting in a lower share count. By using cash to buy back stock, a company's assets and equity totals decline while debt remains the same, all else equal.  

There are a few reasons for a company to buy back its stock. 

• Signaling effect. Management teams can use buyback to signal to Wall Street its confidence in future prospects. In addition, share buyback is often thought to be a sign that management views its stock as undervalued.  
• Balance sheet optimization. There is such a thing as holding too much cash on the balance sheet, especially if investors are not properly valuing it. By issuing low-cost debt to buy back stock, some companies will be able to lower their overall cost of capital, which is a value creation activity. 

Buying back shares increases the ownership percentage for existing shareholders. If a management team buys back all of a company's shares except for one, that last remaining share would, in theory, own 100% of the company. Of course, in the real world, this example isn't likely as the last remaining shareholders would have little incentive to sell their shares to the company at a low price. 

A few other considerations regarding share buyback:

• Share buyback is not created equally. Not every company should repurchase their shares. Industry dynamics and company-specific issues may make share repurchases an unwise use of excess cash for some companies. Share buyback has gotten a bad rap on Wall Street in recent years because of its widespread use, including that by companies not in a strong position to be buying back shares. This buyback misuse has overshadowed examples of buyback representing a good use of excess cash. 
• Share buybacks don't create shareholder value. Contrary to popular belief, share buybacks don't create value for shareholders. While existing shareholders do get a greater share of the balance sheet via share buybacks, the act of using cash to buy back shares means they are getting a greater share of a smaller balance sheet. Meanwhile, share buyback does not have any direct impact on how a company performs when it comes to using its assets to generate cash flows. The one example in which buyback may produce a small amount of value for a company is when the overall cost of capital is reduced due to share repurchases. 
• Apple is not using buyback to secretly go private. One myth that has been circulating for years is that Apple is secretly using share buyback to go private. Not only is this false, but it ignores one crucial aspect found with Apple's share buyback program. Management is not holding on to repurchased AAPL shares. Instead, the shares are retired and removed from circulation. Existing shareholders see their ownership stakes rise due to buyback.

For more information on share buyback, and in particular Apple's stock repurchase program, an Apple Stock Buyback Primer is available for Above Avalon members here.

Apple's Buyback History

Since kicking off its buyback program in 2012, Apple management has repurchased 20% of outstanding AAPL shares. As shown in Exhibit 1, after peaking in 4Q12 at 6.6 billion shares, Apple's share count has declined by 20% to 5.3 billion at the end of 1Q17.

Exhibit 1: Apple Shares Outstanding (1Q11 to 1Q17)

Apple management has been a very reliable and consistent repurchaser of its stock. This stands at contrast with the average buyback program in which management teams are more interested in the positives associated with announcing a share buyback instead of actually parting ways with cash to repurchase stock. Share buyback authorizations often remain open as companies never finish their buyback programs. Apple has been an outlier in terms of its very aggressive pace of buyback, regardless of share price. 

The Path to 50%

With 20% of shares already repurchased, here's how Apple management can repurchase an additional 30% of shares over the next three years to reach 50% of Apple outstanding shares:

1) Continue to funnel $30B to $35B of excess cash into share buyback every year. Apple is currently relying on operating cash flow (U.S.) and debt issuance to fund its share buyback. With the iPhone business displaying a new level of consistency and with a growing Services business, Apple will likely see similar levels of cash generation in the coming years. If Apple can funnel approximately $30B to $35B of cash into share buyback in FY17, FY18, and FY19, the company will be in a position to buy an additional 16% of outstanding shares by the end of 2019. As seen in Exhibit 2, simply keeping the status quo should bring shares outstanding to 4.5B shares in three years, a 32% reduction from the 2012 peak.

Exhibit 2: Apple Shares Outstanding (1Q11 to 1Q20E)

2) Bring back most of the $230B of cash held in foreign subsidiaries. Apple currently has $230B of cash held in foreign subsidiaries. If Washington passes corporate tax reform and foreign cash is taxed at a rate of 15% or lower, Apple will bring back the vast majority, if not all, of this amount to the U.S. Apple will need this cash in the U.S. if it intends to use it for share buyback. Apple has been maintaining a deferred tax liability (now at $27B) related to foreign earnings as management has been accruing U.S. taxes related to unremitted foreign earnings. This will make it possible for Apple to pay tax on most of this foreign cash without taking a significant EPS hit.  

3) Use $150B of repatriated cash to repurchase another 23% of AAPL shares. Assuming Apple pays taxes on foreign cash at some point in FY17 or FY18, Apple will have approximately $250B of cash, cash equivalents, and marketable securities on its balance sheet. If Apple uses 60% of this total for share buyback, Apple will be able to buy back 23% of outstanding shares. Management could repurchase these shares quickly through a modified Dutch auction tender offer. Even after spending $150B on buyback, Apple would still have close to $100B of cash left over on the balance sheet. While the company's net cash balance would be at a multi-year low given Apple's increasing amount of long-term debt (quickly approaching $100B), the company would still be kicking off $50B of cash each year. As seen in Exhibit 3, using more than 60% of repatriated cash, in addition to keeping the status quo in terms of quarterly buyback, would bring shares outstanding to 3.3B shares in three years, a 50% reduction from the 2012 peak.

Exhibit 3: Apple Shares Outstanding (1Q11 to 1Q20E)

Risk Factors

There are four risk factors that may derail Apple's path to buying back 50% of outstanding shares. Deteriorating business fundamentals may jeopardize the amount of cash flow generation required to maintain a robust buyback program. If iPhone unit sales decline more than 10% year-over-year, this may have a negative impact on buyback. 

When it comes to corporate tax reform, if there are strings attached to the cash Apple brings back from foreign subsidiaries, this would have an adverse impact on Apple's plan to use the cash to buy back a significant portion of outstanding shares. If Washington simply lowers the tax rate on foreign cash instead of getting rid of the tax rate altogether, Apple may have more freedom as to how the cash is spent. Of course, there is no guarantee that Washington will be able to come to an agreement on corporate tax reform, although Tim Cook sounded confident in such reform occurring this year.

Apple's board would need to provide enough buyback authorization in order for management to use a significant portion of its cash to buy back shares. One likely scenario is that the board grants management larger share buyback authorization in FY17, FY18, and FY19, but it's spread out over a longer period. This would give management added flexibility when it comes to timing buyback. 

The last risk factor is a rising AAPL share price. As shares increase in price, it will become that much more expensive for Apple to buy back its shares. If shares rise 10% in 2017, it will be 10% more expensive for Apple to buy back shares in 2018. If Apple shares increase in price, the path to repurchasing 50% of shares becomes that much more narrow.  Of course, if AAPL shares fall in price, Apple will have a much easier time repurchasing 50% of outstanding shares, as buyback would require less cash. 

Calling a Bluff

Apple's iPhone and Services businesses are throwing off more cash flow than management needs to run the business and to invest for the future (M&A and R&D). This produces a very rare situation of a company generating hundreds of billions of dollars of excess cash. 

With shares trading in the vicinity of $130, Wall Street doesn't seem to believe Apple will actually spend $250B on buyback in the next three years. Wall Street thinks Apple is bluffing. Meanwhile, Apple has shown no indication that it will slow its share buyback pace and instead embrace a strategy of retaining excess cash for other purposes. This may set up a situation in which Wall Street calls out Apple on a bluff (i.e. the share price doesn't change much from current levels). In such a situation, Apple is given a clear path to buying back 50% of shares in three years.

The biggest takeaway from buying back 50% of outstanding shares is that Apple's shareholder base would essentially be cut in half. Shareholders as of year-end 2012 would see their ownership stake in Apple double in just seven years by simply holding on to their shares. This is quite rare on Wall Street. As Apple's path to buying back 50% of shares becomes more clear to Wall Street, Apple's share buyback program will gain more attention from investors. 

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