The Mac Is Turning into Apple's Achilles' Heel

April 12, 2017 by Neil Cybart

Apple's decision to change course and develop a new Mac Pro has received near-universal praise from the company's pro community. While developing a new Mac Pro is the right decision for Apple to make given the current situation, it has become clear that the Mac is a major vulnerability in Apple's broader product strategy. The product that helped save Apple from bankruptcy 20 years ago is now turning into a barrier that is preventing Apple from focusing on what comes next.

Apple's Mac Meeting

There were three takeaways from Apple's recent on-the-record meeting with five journalists in Cupertino to discuss the Mac.

Apple is sorry about the lack of Mac updates targeting pro users.
The current Mac Pro suffers from a fatal design decision (although the device will continue to be sold).
Management debated the Mac Pro's future and decided to change strategy and begin work on an entirely new Mac Pro. The company will also work on an Apple-branded pro display to go along with a new Mac Pro.

(My complete review of Apple's emergency Mac meeting is available for members here.)

It is easy to look at this highly unusual meeting as being just about the Mac Pro and Apple trying to prevent influential content creators from jumping to a competing platform. However, read between the lines, and it becomes clear that Apple has a much bigger problem on its hands than simply an outdated Mac Pro.

The Mac has become a major headache for Apple, and management is on the verge on going down the Mac rabbit hole, funneling an increasing amount of resources and attention into a product category that doesn't represent the future of personal computing. The risk is that Apple will be stuck with a $25B legacy business and corresponding user base that will threaten the company's increasingly ambitious product strategy.

Tale of Two Apples

Apple is like a novel where two characters are battling each other in the post-PC era. When it comes to mobile, Apple's success is unmatched. The company is connecting with the mass market like never before. The iPhone is bringing more than 100M new people into the Apple ecosystem each year. Apple Watch momentum is building with a user base surpassing 20M people. Early AirPods sales trends look even more promising. More importantly, Apple executives have been on the same page with each other when it comes to strategy.

This cohesion in strategy extends to how Apple continues to place big bets in an effort to control its own destiny in mobile. Recent news of Apple developing its own GPU solution is the latest step in the company's quest to ship a single system-on-the-chip (SOC) powering a range of mobile and wearable devices. This will give Apple a competitive advantage measured in decades. The company is also placing big bets on mobile services such as mapping and payments, items that will serve to create a competitive advantage in the changing tech landscape.

In stark contrast, Apple's Mac strategy looks like a slow-motion train wreck. While Apple has made some progress with bringing elements of mobile such as Touch ID, multi-touch displays, and ARM processors, to the Mac, years of sporadic updates have overshadowed the positives. Apple's relationship with its pro Mac user community has deteriorated and can now be described as toxic. To make matters worse, there appears to be a growing rift among Apple executives concerning Mac strategy.

As for why Apple's problematic Mac strategy hasn't caused too many issues for the company up the now, the business has become niche. As seen in Exhibit 1, Apple is selling more than 250M iOS devices per year. In comparison, they are selling fewer than 20M Macs. The Mac accounts for just 11% of Apple's overall revenue. More importantly, the Mac is no longer the primary way new users enter the Apple ecosystem. In addition, one can also argue that pro Mac users haven't had much in the way of alternative platforms up until recently, although this is still being debated.

Exhibit 1: The Post-PC Era at Apple

The Achilles' Heel

Apple's Achilles' heel is becoming visible. As Apple gets better at making technology more personal for the mass market, the company is losing touch with its legacy pro users. The situation came to a head last week with Apple announcing that it began work on a new Mac Pro. While one can chalk up a new Mac Pro as a one-off cost for keeping iOS app developers engaged in the platform, Apple's vulnerability extends much deeper than one Mac model.

There appears to be a growing rift among Apple executives when it comes to Mac strategy. Apple Industrial Design and Apple management have spent the better part of the past 10 years focused on devices designed to move hundreds of millions of people beyond the Mac. However, this strategy did not address 30M Apple users dependent on pro Mac hardware and software. While this segment only accounts for 4% of Apple's user base, it is responsible for creating content consumed by the other 96% of Apple users. These content creators have played a major role in Apple's mobile success.

Apple's Achilles' heel is found with the niche devices at the tail end of the business. As seen in Exhibit 2, when compared to smaller screen unit sales, devices targeting pro users barely register. Apple has come to the realization that these niche devices, instead of being cast off or ignored, need ongoing attention and resources.

Exhibit 2: Apple Device Sales Mix (Screen Size)

Path to Today

It is fair to ask how Apple got into this predicament.

The Mac isn't like the iPod, a device cleanly and quickly cannibalized by a newer Apple product. iOS and multi-touch are not able to handle all of the tasks given to Mac. This is one reason why Apple has been extremely vocal about continuing to invest in the Mac despite running forward with iPhone and iPad. The debate was never about whether or not Apple will continue to sell Macs, but rather about how best to bring the Mac into the future.

One path forward was for Apple to consolidate resources and place a bet that higher-end MacBook Pros and iMacs would be able to handle the needs of most Mac Pro users. Apple ended up being partly right. A majority of pro Mac users have transitioned their workflows to MacBooks and iMacs without incident.

Apple ran into an issue when it came to addressing the niche of the niche. Millions of pro users could not make the jump from Mac Pros or other high-end PCs to a MacBook Pro or iMac. Apple needed to support these users for no other reason than they create the content consumed by the rest of the user base.

Issues

Apple's decision to work on a new Mac Pro raises a number of red flags.

Resource strain. Even though Apple has $246B of cash and cash equivalents, the company is resource-constrained when it comes to time and attention. Apple's functional organizational structure produces a constant battle among products and teams to grab that finite amount of management's attention. For management to dedicate attention to new pro Mac hardware, the company may need to take its foot off the accelerator with other products. This may seem like a major flaw, and judging from the amount of criticism directed towards Apple's organizational structure, such an opinion is widely held. However, Apple's structure is put in place in order for the product to be put ahead of everything else. It is not a disadvantage or weakness, but rather one of Apple's secrets to success. There is value found in having Apple's Industrial Design team, along with Tim Cook and his inner circle, move from product to product throughout the year in order to place a select few big bets.

Broader cultural differences. Some may argue that Apple is capable enough to develop mobile and wearable devices while selling pro Macs at the same time. This ignores the much more complicated aspect of Apple satisfying vastly different user needs with pro Macs. Apple would not only be developing a new Mac Pro or standalone display, but also sustaining a small but influential base of pro users dependent on macOS. Similar to how the iPhone user base is changing, Apple's overall user base has become quite heterogeneous in terms of technology wants and needs. It may be nearly impossible for Apple to satisfy all of its users.

Product strategy hole. According to consensus, the biggest challenge Apple is facing is finding a business as profitable and influential as the iPhone. This extends to Apple not being able to expand its developer and app success to newer product platforms. It has become clear that Apple's inability to move beyond the Mac poses a much bigger long-term risk.

There may be a hole developing in The Grand Unified Theory of Apple Products (shown below). The idea behind the theory is that Mac portables and desktops are positioned as the most powerful machines in Apple's product line. These machines will then serve to push the rest of Apple's product line forward. However, there isn't much evidence of this actually taking place. Instead, iPhones and iPads are being used to decide where to bring MacBooks and iMacs. There is also the awkward situation of iPad Pro beginning to give Mac a run for its money in terms of performance.

Meanwhile, there isn't much evidence of MacBook or iMac features serving as inspiration for Apple's smaller screens. This is a sign of value destruction occurring with larger screens found at Apple's tail end of the business. We are giving more of our time to the smaller screens in our lives. Where does this leave Macs within Apple's broader product strategy? It increasingly looks like an odd fit as the Mac becomes a legacy platform.

Additional Concerns

The need to have a highly unusual private, on-the-record briefing with five journalists to explain a complete reversal in Mac strategy signals a management team on defense. Apple is afraid of influential Mac content creators jumping ship. This is the exact opposite of the aggressiveness Apple has shown with mobile and wearables. The more one looks into the topic, the more worrying things appear.

In an attempt to explain Apple's new Mac strategy, Apple SVP Phil Schiller wiped the dust off the old quadrant product grid. At the same time, Schiller has been increasingly vocal about the Mac being around for the next quarter of a century. Here's Schiller in late 2016:

"The new MacBook Pro is a product that celebrates that it is a notebook, this shape that has been with us for the last 25 years is probably going to be with us for another 25 years because there’s something eternal about the basic notebook form factor. You have a surface that you type down on with your hands, with a screen facing you vertically. That basic orientation, that L shape makes perfect sense and won’t go away."

Schiller is likely guided by the desire to calm pro Mac users' fears. Arguing that the Mac will be around for 25 years means that these users won't need to worry about transitioning away from the Mac during their careers. However, this stance places Apple in an awkward situation. Nowhere is this seen more clearly than in Apple's recent iPad Pro ad campaign. On one hand, Apple is saying it thinks the laptop form factor will be around for 25 years. However, Apple then launches a marketing campaign positioning the iPad Pro as a better computer than MacBook.

The Way Forward

My suspicion is that instead of trying to get around its Achilles' heel, Apple will try to be more cognizant of it. It is likely that a majority of Apple's senior executives, including Apple's Industrial Design group, still view the iPad and iOS as the more promising platform than Mac and macOS for the next 25 years of computing. Apple is pushing iPad like never before. New pro Mac hardware will not change this dynamic. However, it has become clear that Apple realizes its previous Mac strategy fell short as there was no viable path forward for tens of millions of pro Mac users.

Apple disclosed a few facts about its pro Mac users as measured by pro software usage. The data contains clues as to where Apple's product strategy may be headed. According to Apple, 70% of the Mac user base does not use pro software and would not classify as pro users. This is another way of saying that the iPad Pro could do quite well serving the needs of 70M Mac users. Meanwhile, the other 30% of the Mac user base wants and needs the power and flexibility that Apple has historically had trouble selling.

Apple will likely position the Mac as a computing platform for legacy pro users while iOS will be targeted to everyone else. This will entail a few steps:

1) Triple down on iPad. The writing is on the wall. Apple will not be able to address its Achilles' heel until iPad can be used for developing apps. This will involve Apple ramping investment and resources into iPad software, hardware, and accessories. While consensus assumes Apple should look to the Mac for iPad software inspiration, the more appropriate course of action is to look at the iPhone for inspiration. There is a reason that the iPhone is outselling the Mac by 10x. People enjoy iOS as a computing platform. After all, the iPad is just a bigger iPhone.

2) Continue to be aggressive with Mac design. Apple Industrial Design will continue to be aggressive in bringing the Mac experience forward. There have been some controversial Mac design decisions taken recently, including decisions about the Touch Bar and the insistence that multi-touch does not make sense on vertical Mac displays. Some may argue that Apple needs to look at a new Mac Pro as a hardware engineering problem and have the Industrial Design team take a back seat. This may be a recipe for disaster. It just goes to show how tricky of a proposition pro Mac hardware is for this management team.

3) Running fast with new endeavors. The Mac does not represent Apple's future. Instead, the changing tech landscape will require Apple to play in new industries. The company needs to be extra aware of the long-term damage done by the Mac becoming a resource strain and jeopardizing other initiatives.

Figuring Out What Comes Next

Apple still needs the Mac. Tens of millions of users aren't able to pack away their large displays and embrace iPhones and iPads. However, the Mac debate has never been about whether or not Apple will stop selling Macs. Instead, the question has been, how will management be able to retain the value of the laptop and desktop form factors in today's mobile world?

The most important thing for Apple to do when it comes to the Mac is to think about what comes next. Apple's broader mission is to use devices capable of making technology more personal to inspire a new generation of content creators. It is clear that iPhone and iPad are already inspiring tomorrow's content creators. Apple Watch and AirPods are not far behind in terms of being able to inspire.

When taking into consideration new technologies such as augmented reality, it is fair to wonder just how important large screens will even be in our lives in the future. Small screens are going to transition from being just tablets, smartphones, and smartwatches to being augmented reality navigators. In such a world, large screens will look like relics. The path forward for Mac looks bumpy.

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Apple Is Pushing iPad Like Never Before

March 29, 2017 by Neil Cybart

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.

Real problems... answered. Your computer could be better than a computer, if your computer was an iPad Pro. Learn More: http://apple.co/2l9DB3A

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:

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.
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

March 15, 2017 by Neil Cybart

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:

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.
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.
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.
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.

The New Leader in Wearables

March 02, 2017 by Neil Cybart

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

Screen Shot 2017-02-28 at 3.49.30 PM.png

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.

Screen Shot 2017-03-02 at 2.40.17 PM.png

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

February 21, 2017 by Neil Cybart

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.

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.
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.
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.

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.
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.
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

February 09, 2017 by Neil Cybart

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)

Screen Shot 2017-02-09 at 2.35.36 PM.png

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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Apple 1Q17 Expectations

January 30, 2017 by Neil Cybart

There will be two ways to interpret Apple's 1Q17 earnings report. On an absolute basis, Apple is going to report its best quarter yet. Records will likely be broken when it comes to quarterly revenue, gross profit, iPhone unit sales, Apple Watch unit sales, and Services revenue. However, if judging Apple by year-over-year growth, Apple will report simply an OK quarter. Most line items will show only modest improvement from 2016 results.

The following table includes my 1Q17 Apple estimates.

My full perspective and commentary behind all of my estimates are available for Above Avalon members. (Click here to become a member and access the six parts of the earnings preview available here, here, and here.)

Items Worth Watching

There will be a few numbers holding extra importance when Apple reports 1Q17 results on Tuesday.

iPhone ASP. There has been a notable amount of evidence from the past three months pointing to the iPhone 7 Plus selling well. This has major implications for Apple's iPhone strategy going forward as a strong-performing iPhone 7 Plus suggests there is demand for higher-priced iPhones driven by feature differentiation. In addition, Apple's new iPhone storage configurations likely boosted iPhone ASP. Given that the $399 iPhone SE was not on sale during 1Q16, an iPhone ASP close to or exceeding the $691 reported in 1Q16 would confirm iPhone 7 Plus popularity.
Other Products revenue. Apple will likely report record Apple Watch sales. Similar to previous quarters, Watch results are expected to be lumped in with "Other Products" revenue. The major difference with 1Q17 results is that AirPods revenue will now be included in "Other Products" given the December 2016 launch. This will make it a bit trickier to back out Apple Watch revenue. Accordingly, one should expect a wider variation in Apple Watch sales estimates. In addition, the "Other Products" line item contains revenue from Beats headphones, a good seller during the holiday quarter. Taking into account AirPods and Beats revenue, "Other Products" revenue exceeding $4.5B will bode extremely well for strong Apple Watch sales (5M+ units).
iPad unit sales. The iPad has turned the corner. While unit sales growth may still be out of reach, a unit sales number close to 15M would suggest that iPad fundamentals are continuing to improve.
R&D expense. My suspicion is that Apple's Project Titan was the primary factor driving the significant increase in R&D expense beginning summer of 2014. With Apple making some modifications to the project in recent months, will this change be reflected in slowing growth when it comes to R&D expenditures?
2Q17 guidance. Since Wall Street is forward-looking, management's revenue and margin guidance will likely always have a place on a list containing important quarterly numbers. With a relatively strong year-over-year compare (i.e. 2Q16 revenue growth was weak), management's 2Q17 revenue guidance will likely point to continued top-line growth.

1Q17 Expectation Meters

Each quarter, I publish expectation meters for Apple earnings. These diagrams help add value to what is fundamentally a complicated estimating process. Quite a bit of modeling goes into each Apple financial estimate. Accordingly, there is room to turn single-point estimates into ranges in order to more accurately judge Apple's quarterly performance.

In each expectation meter, the grey shaded area is considered to be my expectation range. In most cases, a result that falls within this range would signify that the product or variable being measured is performing as expected. A result that lands in the green shaded box would denote strong performance, likely leading me to raise my assumptions and estimates going forward. Vice-versa, a result that lands in the red shaded area would have the opposite effect and lead me to reduce my assumptions going forward.

For Apple's 1Q17 earnings report, I am publishing three expectations meters: iPhone sales, iPad, sales, and 2Q17 guidance. My iPhone unit sales expectation range stretches from 77M to 81M iPhones. Any unit sales number within this range would be labeled "expected."

Turning to iPad, unit sales between 15M and 16M would fall within my expectations range. Unit sales in excess of 16.1M would signify the iPad has returned to unit sales growth.

When it comes to guidance, Apple management has displayed a tendency to not play the expectations game and provide artificially low guidance simply to report a big "beat." Accordingly, Apple looks to be in a good position to report a revenue guidance range that exceeds 2Q16 results, implying ongoing revenue growth.

The primary question facing AAPL (the stock, not the company) is, how much will Wall Street care about modest iPhone sales growth or declines? Attention has already shifted to what is being built up as a significant update to the iPhone line later this year. It remains unclear if such a shift in attention is masking a much broader development where Wall Street is focused more on earnings and cash flow stability than on unit sales growth. We will likely get some answers regarding this development in a few days.

Above Avalon members have access to additional commentary regarding my Apple 1Q17 estimates (six parts):

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Grading Tim Cook

January 19, 2017 by Neil Cybart

It's not easy describing Tim Cook's role within Apple. Yes, he is CEO serving at the discretion of Apple's board of directors. However, there is much more than this going on behind the scenes and Cook's formal title. Apple isn't run like an average company and shouldn't be judged as one. This impacts how we should grade Tim Cook's performance as Apple CEO.

A double standard is being used to judge Tim Cook. No other tech CEO is being graded on the same scale as Cook. He is being penalized for not entering questionable product categories. In addition, the new products that Apple has decided to sell are looked at through an iPhone lens. Apple has the best-selling smartwatch in history, with sales approaching 25M units in less than two years, and yet the product is looked at by some observers with a yawn. This type of criticism is just not found when it comes to judging Cook's peers. In fact, some of Apple's largest competitors have voting structures in place that make judging CEO performance a mere formality as boards don't have enough power to do much of anything.

In an effort to grade Tim Cook fairly, one soon discovers that this is no easy task. Apple has a unique corporate culture and organizational structure, and Cook is not your typical tech CEO.

Tim Cook, COO

Tim Cook joined Apple in March 1998 as Chief Operating Officer. His job was to save Apple, literally. Cook quickly went to work drawing down excess Mac inventory in addition to laying the groundwork for Apple's outsourcing strategy. When it came time to build the iPod, it was Cook who built the supply chain and positioned Foxconn as an Apple assembler. When it came time to build the iPhone, it was Cook who made sure all the trains were running on time in terms of procurement and production. When it came to time introduce the iPhone to new customers around the world, it was Cook who negotiated with mobile carriers to begin selling the iPhone.

By the end of Cook's time as Apple COO, a title he held for 13 years, Cook had taken on a role much more similar to that of a traditional CEO. In a little known fact, during the last few years of the Steve Jobs era, it was Cook (and Apple SVP Marketing Phil Schiller) who were tasked with coming up with Apple's corporate strategy. This allowed Steve Jobs to spend time with Jony Ive and focus on the product. Said another way, Tim Cook was the one that allowed Steve to be Steve.

When it came time to relinquish his CEO title, Steve selected Cook as his successor. While the move was met with controversy outside Apple, the selection signaled that Steve didn't look at the CEO position as something that needed to be held by a product person. Much of that belief likely resulted from the fact that Cook had been handling many of the traditional CEO duties himself as COO for years.

Tim Cook, CEO

How has Tim Cook been doing over the past six years?

In trying to find an answer to this question, much more information is needed regarding Cook's actual role within Apple. Is he single-handedly guiding Apple forward or has Cook come to depend on a smaller, inner circle within Apple's SVP ranks? The answer plays a role in determining Cook's contributions to Apple. Meanwhile, how much of Apple's product strategy is actually determined by Cook rather than Jony Ive? This seems like critical information to have when judging Cook's performance.

The Apple Watch serves as a great example of how power within Apple is much more decentralized than many assume. Apple Watch is Jony's baby. As told in the The New Yorker profile of Jony Ive published two years ago, Jony met some resistance among Apple executives regarding the Apple Watch's main tenets involving fashion and luxury. Apple would become a very different company selling a device like Apple Watch. After some convincing, Jony was able to alleviate most concerns, and Apple marched towards Apple Watch. When it came time to manage the Apple Watch team, Apple COO Jeff Williams was eventually put in charge. This doesn't exactly jump out as an obvious decision given that Jeff Williams is a supply chain expert.

With this information in hand, who should we look to as being responsible for Apple Watch's performance? The people in charge of the product's design and user experience (Jony Ive, Marc Newson, and the rest of Apple's Industrial Design group)? Those in charge of Apple Watch development (Jeff Williams)? Tim Cook as Apple CEO?

One can repeat this exercise with every major Apple product and initiative. Should Tim Cook be judged by Apple's success or failure in music and video streaming even though that is clearly Eddy Cue's domain?

Cook's Inner Circle

Tim Cook is leading a different type of Apple than that which existed under Steve. Things are done differently, down to how decisions are made and then communicated throughout Apple. This leads to a theory that may seem controversial today but is becoming increasingly clear as time goes on. It is impossible to grade Tim Cook as CEO without grading Cook's inner circle.

While Cook has at least seventeen VPs and SVPs reporting directly to him, a very high number, there is evidence that many of the key decisions regarding Apple's strategy are determined by a much smaller group of SVPs. This team likely includes Eddy Cue, Phil Schiller, and Jeff Williams. The three have been at Apple since the 1990s, experiencing Apple at its best and also worst. Eddy Cue joined Apple in 1989.

Instead of grading Cook by himself, on his own contributions, it makes more sense to grade this inner circle with Cook as its leader. The primary reason is that it is difficult to differentiate where and how Apple strategy is decided within this group. Notice how some of the key product responsibilities have been doled out in recent years:

Jeff Williams, COO: Oversees Apple Watch development and Apple's health initiatives.
Eddy Cue, SVP Internet Software and Services: Controls Apple's expanding content strategy into music and video streaming although he is also in charge of Apple's overall services strategy.
Phil Schiller, SVP Worldwide Marketing: Took on more responsibility with the App Store and developer relations, items that lack a direct relationship to product marketing.

Apple's most important new product and initiative (Apple Watch and health) are run by a member of Cook's inner circle. In addition, the items that have caused the most pain and controversy for Apple in recent years (services and the App Store) are now run directly by people in Cook's inner circle.

Outside board seat appointments provide another clue as to the power held by this inner circle.

Tim Cook sits on Nike's board.
Eddy Cue sits on Ferrari's board
Phil Schiller recently joined Illumina's board.

It is not a coincidence that Apple's product road map includes plenty of wearables and fashion (Nike), transportation (Ferrari), and health (Illumnia).

The removal of Scott Forstall as SVP of iOS back in 2012 takes on a new level of importance when discussing the topic of Tim Cook and his inner circle. It has been reported that Forstall did not get along with other Apple executives. While we have never officially heard Forstall's side of the story, which is odd, Cook's desire for a powerful inner circle does support the theory that Forstall was removed in order to position this tight-knit group of Apple SVPs as a type of brain trust. Forstall was clear in his ambitions to one day be CEO. Cue, Schiller, and Williams don't hold similar ambitions. Instead, ideas are bounced off each other and disagreements are hashed out within this group before being funneled to the rest of the company. Forstall threatened to throw off this dynamic and risk having Cook's leadership structure collapse.

There is one missing piece pertaining to Cook's inner circle. Who is in charge of the most important thing at Apple, the product? This is where Jony and the Apple Industrial Design group enter the equation. Cook and his inner circle have given much more power to Jony and the Apple Industrial Design group in recent years. The biggest benefactor in terms of grabbing power from Forstall's departure was Jony.

Jony has taken on the role of Apple's product visionary while Tim Cook's inner circle has taken on the role of running Apple. In attempt to visualize this leadership structure, the following diagram depicts Apple's leadership structure.

Tim Cook and his inner circle look after Apple's day-to-day operations, while the Industrial Design group look after Apple's product strategy. Meanwhile, Jony Ive as Chief Design Officer is left to do what he wants. If that role sounds familiar, it is the exact role formerly held by Steve Jobs.

Evaluating Cook and His Inner Circle

With this new framework regarding Tim Cook's inner circle in mind, let's grade their performance:

Product Strategy. While companies like to think they have a lead against Apple when it comes to the next "big thing," it's difficult to find major fault with Apple's overall product strategy. We have been in the iPhone era for the past six years and unsurprisingly, the iPhone has performed well. Apple's primary new product initiative, Apple Watch, is starting to gain momentum. Apple is on track to sell more than 10M Apple Watches in 2017. This would position Apple very close to taking the title of best-selling wearables brand away from Fitbit. Meanwhile, AirPods will likely end up outselling Apple Watch. Blemishes when its comes to Apple's product strategy include sporadic Mac and iPad updates, seemingly slow progress with Siri, questionable user interface choices with new products like Apple Watch and Apple Music, and early mishaps with Apple Maps.

Product Pipeline/R&D. The competitive landscape in tech is changing with the battleground centering around the body, automobile, and home. Apple is showing significant investment and interest with wearables (body) and transportation. Apple has been funneling cash into R&D at an alarming rate. In addition, Apple's M&A activity points to continued elevated awareness of Apple's limitations and weaknesses.

Operations. Ironically, one of Apple's sore spots in recent years has been Tim Cook's long-standing area of expertise. Apple has been experiencing increasingly noticeable supply chain troubles. It is becoming rare for Apple to have much, if any, supply available on product launches. While one assumes much of this is due to Apple simply meeting greater demand at launch, that is unable to explain everything. For much smaller product launches, such as that of Apple Watch, Apple has also faced severe supply issues. It has been three months since Apple Watch went on sale, and there is still a three-week wait to buy Apple Watch Series 2. Meanwhile, specialty items like Apple Pencil are pretty much out of stock for months at launch. Is this a byproduct of Apple having troubling maintaining such a large supply chain? Is it becoming harder to source components? Is Jeff Williams being stretched too thin? With all of that said, it's important to not grade Apple on a curve. The company is shipping more than 290M devices per year - not exactly a small feat.

Marketing/Storytelling. Apple has had its fair share of lows over the past six years when it comes to product marketing, both with ads and explaining new products. Cook and the inner circle have been making changes to Apple's ad campaigns, including beefing up Apple's internal teams. The recent hire of Tor Myhren as VP Marketing Communications contains much promise, and early indications do show an improvement in Apple ads. However, Apple is still struggling when it comes to telling a product's story. While Jony appears to be the one able to tell that story, the lack of desire on his part to participate in keynotes leaves this story to be told either through keynote videos or subsequent press interviews. It probably is worth pointing out that this is one area on which Steve spent quite a bit of time and attention. Apple appears to be still trying to figure out how to fill his shoes in this regard.

Culture. It's clear that Apple has changed under Cook. Power has moved to new people, which implies others have lost power. Apple is not the same little startup that it was during the iPod days. There is evidence that Cook and team are comfortable with giving Richard Howarth and the Apple Industrial Design group quite a bit of power. This implies other groups have likely lost some influence with Cook and his inner circle. The fact that Project Titan is completely separated from Apple suggests management is aware of some changes in how things are done within Apple. Titan needs more of a start-up mentality, something that may be more difficult to find within Apple itself. However, at the end of the day, the most important aspect of Apple's culture is putting the product above everything else. There is no clear evidence to suggest this ideal has disappeared or is any less important to Cook and team.

Public Face. Cook has displayed the motivation and fortitude to represent Apple to the outside world. If judging Cook strictly on his own performance, this would likely represent his strength, which is surprising given his operations and numbers background. Cook recognizes that Apple holds quite a bit of power as the most valuable company in the world and truly believes that Apple and its broader mission should follow the concept of leaving the world in a better place.

Financials. If we were grading Apple strictly by financial performance, Cook and his inner circle would get a passing grade. Apple's revenue is up 99% to $216B since 2011. Operating margins have remained steady. More than $185 billion of excess cash has been returned to shareholders through dividends and share repurchases. Apple shares are less than 10% off from their all-time highs. With all of that said, there are blemishes. It would be difficult for Cook and team to earn an "A" if going strictly by Apple financials. Apple hit a rough patch in 2016. Apple reported its first annual decline in revenue in 15 years. Management missed its revenue and operating income performance targets for 2016. In addition, AAPL shares have essentially been tracking the broader indices over the past two years. Nevertheless, it's been rare to see a public board penalize a CEO for essentially performing in-line with the overall market.

In attempt to add a bit of relative context to this subjective grading:

Product Strategy: A-
Product Pipeline/R&D: A
Operations: B-
Marketing/Storytelling: C+
Culture: B+
Public Face: A+
Financials: B

Obviously, there is room for improvement. The three weak points include: marketing/storytelling, supply issues, and finding a sustainable Wall Street narrative. While some people may penalize Cook and his inner circle for their treatment of the Mac, it would be tough to hit them over the lack of a Mac strategy driven by the Industrial Design group. (There is one although some may disagree with it). In addition, many have been quick to hit Cook for Apple being "behind" its peers when it comes to core technologies. There is not only quite a bit of subjectivity found in such a claim, but also evidence that suggests capability should not be interchanged with functionality and usefulness.

The Apple ecosystem now includes more than 1.1 billion devices and approximately 800 million users. The iPhone, iPad, and Mac installed bases have seen significant growth over the past six years. If Apple were a sandcastle, Cook has overseen quite the massive construction phase. While credit for this achievement should indeed flow to Cook and his inner circle (the four were instrumental with iPhone, iPad, and Mac), there is a much more straightforward way to judge Cook as Apple's CEO. Is the product still the most important thing at Apple? It's not by accident that the only way to answer that question is to bring Jony and the Apple Industrial Design group into the question. This leads us to the most effective way to judge Cook and his inner circle. Is Apple still a design studio with a large technology company attached to the side? In response to that question, Cook and his inner circle are doing what needs to be done in order to maintain Apple's relevancy.

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The Battle Lines in Tech are Being Redrawn

January 12, 2017 by Neil Cybart

The competitive tech landscape is changing. Some companies with proven track records in mobile will struggle while new players are poised to find success. The battle for our attention is broadening into a massive land grab for the most valuable real estate in our lives. Unlike the usual refrain found with new technologies, this new era is already upon us. In fact, it began years ago.

Old Landscape

This week marks the 10th anniversary of Apple unveiling the iPhone. While many looked at that original iPhone as just a smarter smartphone, the device set off a revolution that is still unfolding today. The iPhone kicked off two battles; one has been settled while the other is still going strong.

Contrary to popular belief, the iPhone's most formidable competitor was never Google and its Android operating system. Instead, the iPhone's success was dependent on a smartphone being able to gain power and value in a sea of laptops and desktops. Apple saw this battle coming from a mile away. Here's Steve Jobs explaining why Apple decided to use OS X to power the iPhone:

"[S]oftware on mobile phones is like baby software. It's not so powerful, and today we are going to show you a software breakthrough. Software that's at least five years ahead of what's on any other phone. Now how do we do this? Well, we start with a strong foundation: iPhone runs OS X. [big round of applause from audience] Now, why would we want to run such a sophisticated operating system on a mobile device? Well, because it's got everything we need. It's got multi-tasking. It's got the best networking. It already knows how to power manage. We've been doing this on mobile computers for years. It's got awesome security. And the right apps. It's got everything from Cocoa and the graphics, and it's got core animation built in, and it's got the audio and video that OS X is famous for. It's got all the stuff we want. And it's built right into iPhone."

Apple knew in the mid-2000s that smartphones would become more than just smart phones. It took some of Apple's competitors years to come to this realization. The smartphone not only became much smarter, but also turned into the most valuable computer in our lives. While there is still a place for laptops, desktops, and of course tablets, the smartphone's value proposition no longer needs to be explained. That battle is over.

However, the other battle kicked off by the iPhone is still ongoing and involves how we use our smartphones. Every company from Facebook, Instagram, Twitter, and Snap to Netflix and Spotify are competing against each other. All of these companies are chasing our time and attention. Time spent watching video on Facebook is time not spent watching original content on Netflix. Sharing photos on Instagram takes time away from sharing photos on Snapchat. We have a finite amount of time each day available to give to these companies. At stake is not just relevancy but all of the advertising and content dollars that are found with relevancy.

The Winners

Thanks to geographical limitations, this battle for our attention has produced two big winners:

Facebook (1.1 billion mobile daily active users)
WeChat (800 million daily active users)

Facebook and WeChat share much in common as they aren't just social networks or messaging platforms but instead curated versions of the web. There is then a long list of secondary players, including some Facebook-owned properties like Instagram and WhatsApp. Others like Snapchat and Twitter are struggling to match Facebook's users numbers but still have more than 100 million daily active users. These companies are battling each other for the advertising leftovers.

Another big winner in the fight for our attention has been Apple. In a battle between Facebook and Twitter, Apple wins as the iPhone is the common denominator. The same can be said for competition between Netflix, Hulu, Amazon Video, and YouTube. This is one reason why Apple has been so complementary over the years to Facebook, Netflix, WeChat, Twitter, Uber and pretty much every other major iOS partner. It is in Apple's best interest for there to be a vicious fight for our attention when using iPhones as the more disjointed our attention is among various apps and messaging platforms, the more power falls to the device itself. Of course, Apple wouldn't mind if we spent time using their own dedicated apps, content, and services. Judging by Apple's profit share in the smartphone industry and cumulative iPhone unit sales, competition for our attention when using iPhones has resulted in very good business for Apple over the years.

Exhibit 1: iPhone Unit Sales (Cumulative)

In the extreme case of consumers giving most of their attention to a single company like WeChat in China, Apple still has a built-in advantage of being the company responsible for not just crucial components like the screen, processor, and fingerprint sensor, but also the camera and overall design of the phone. Bear case scenarios involving iPhone sales drying up in China due to WeChat grabbing so much power haven't panned out. Last month, WeChat reported that half of its users spend 90 minutes on one its properties every day. This means that attention is still being shared among a handful of mobile properties.

New Landscape

Change is in the air. While the fight for our attention and relevancy is not over, advancements in hardware and data collection are leading to tech battle lines being redrawn. While the smartphone is the most valuable computer in our lives today, a new crop of devices are popping up. A land grab is unfolding as companies go after the most valuable real estate in our lives: our cars, homes, and even bodies.

Screen Shot 2017-01-12 at 2.01.42 PM.png

There are three key variables guiding this redrawn competitive map:

Monitoring. Simply grabbing our attention while we use hand-held computers is no longer enough. Instead, value has begun to flow to devices and software that can monitor significant portions of our day. The end goal is capturing more of our data.
Intelligence. As devices collect a growing amount of our data, there will be a stronger need for these devices to learn from this data and then provide feedback to the user. Buzzwords like "machine learning" and "artificial intelligence" are now paraded around to describe this variable. In reality, a much simpler way of describing this trend is that computers will have to become smarter.
Personalization. In what may be the most underappreciated trend in tech today, new manufacturing techniques are allowing hardware personalization like we have never seen before. This will become critical as the line between technology and fashion becomes blurry.

New Battleground

The best way of mapping this new competitive landscape is to look at the new battleground.

Body. While smartphones continue to gain value in our lives, the form factor doesn't lend itself to being a great monitoring device. As software continues to invade the healthcare industry, the need for biometrics monitoring will increase. Advancements in terms of what can be captured using noninvasive sensors have already led to a new range of small computers that can be worn throughout the day and night.

Automobile. We have been using boxes on wheels to get us from Point A to Point B for the past 100 years. The extent to which these boxes can be customized after purchase has involved folding down a seat or two. In addition, car utilization associated with car ownership is abysmal. The combination of electric powertrains, ridesharing, and autonomous driving represent the change that is needed for massive innovation to occur in the auto industry. Once these technologies and services become a reality (we are still waiting for autonomous driving), new design and manufacturing ideas will render boxes on wheels into smart rooms on wheels. This will have major implications not only on how we travel, but also on what takes place inside automobiles.

Home. The smart home has been forecasted for decades. Ironically, much of what is now taking place in the category isn't too different from the utopian picture of us talking to our appliances. We are currently seeing a wave of what will likely turn out to be transitory products in the form of stand-alone microphones and speakers, such as Amazon Echo and Google Home, that use voice assistants to control what is still a very manageable number of smart home items. Over time, as the number of smart home items increase, new control methods and interfaces will need to be developed.

Key Considerations

If the new tech battleground is expanding to the body, home, and car, each one of those realms seems to be a logical area for voice to gain quite a bit of power. At the same time, there are ongoing questions as to the role screens and cameras will hold in our lives.

Voice. The current buzzword in tech is voice. The major theme from this year's CES dealt with hardware companies announcing their support for Amazon's voice assistant, Alexa. The plan is to put Alexa in anything that contains a microphone and speaker. Everything from large-screen TVs to cars is on the table. This has led to a narrative centering on "voice first" and "voice only" interfaces. Instead of relying on screens to gather and consume data, we will instead simply talk to a digital assistant using microphones worn on our bodies or situated throughout our homes and cars. In a world without screens, the tech landscape would be turned on its head.

There are a number of glaring issues with the idea of voice as an interface. The biggest problem is that voice is simply not a great conduit for sharing and consuming large amounts of data. A simple weather query demonstrates this limitation. While a quick question about the current temperature to Alexa or Siri will lead to a straightforward answer, it becomes much harder to rely on voice to get the forecasted hourly temperature change throughout the day. This information can be easily consumed via a screen in a few seconds. Another example is found with consuming news. Using voice to stay informed of current news, also known as radio, will produce an experience inferior to a quick swipe through one's Twitter timeline or Facebook news feed.

Many are using voice in 2017 in a very transitory way, as a stepping-stone to something much more sustainable and valuable. No wonder one of the most popular uses for Amazon Echo is setting kitchen timers - something easily done with a smartphone.

Instead of voice replacing our screens or becoming the only way we interact with our computers, voice will become a way we interact with our proactive assistant. However, the smarter this assistant becomes, the less talking will take place.

Why ask about the weather when a proactive assistant will know the best time to feed us the information we want to know?
Why ask about the day's top news when a proactive assistant can curate and then deliver stories to our nearest screen when it thinks it is the most convenient time?
Why use voice to turn on or off our smart home devices when home automation is a much better alternative?

The smarter a computer becomes, the less we should need to talk with that computer. The future of voice will include a whole lot more listening than talking.

Screens. A bet that screens will retain value in the future will likely end up being a very good bet. Screens provide something that voice will never be able to offer: a visual window into the world. While the look and feel of screens as well as how we use screens in our lives will change, we will continue to use screens for a very long time to consume images, video, and even text.

Cameras. One of the biggest revolutions to take place during the smartphone era has involved the camera. There is a very high likelihood that the camera found in your current smartphone is the best camera you have ever owned in your life. This has produced a situation in which photos and video are no longer just about memory capture. They have become a primary form of communication. Instead of voice wiping this medium away, there is a much higher likelihood that additional cameras and screens will enter our lives. Cameras will be the smart eyes that make self-driving cars possible. Cameras will make it possible for augmented reality to be consumed on our iPhones. Cameras will begin to be found in many devices, some of which will come as a surprise.

Apple's Roadmap

Apple has done extremely well in the current tech landscape. The company has sold more than a billion iPhones and grew its iPhone installed base by a hundred million users in 2015 and 2016. Since unveiling the iPhone, Apple's stock price is up 800%. As the competitive maps are redrawn, Apple will face new opportunities and challenges. New competitors are going to enter the arena while surprising partnerships will likely jolt the space.

Body. Apple's best chance of success will be found with the body. Apple excels at creating devices that require a deep integration of breakthrough hardware design and software. Wearables closely fit the bill. In addition, the manufacturing experience Apple has spent more than a decade building will help the company tremendously when it comes to producing increasingly smaller and more personal devices that fit into our lives. Apple is already on track to sell 30M wearable devices this year when combining Apple Watch and AirPods sales. In addition, Apple's stance on privacy has the potential to become a much more important topic in a world where devices are monitoring and collecting an increasing amount of our data, including sensitive biometric data.

When it comes to competition for the body, Nike and Under Armour should not be ignored. While Nike was correct in getting out of the wrist wearables space years ago, the environment is going to change as the gap between technology and fashion shrinks. Nike's adaptive lacing technology may seem like a gimmick today, but it is a sign of Nike embracing technology in a much more direct way. We already see Nike and Apple partner with Apple Watch Nike+. This will likely grow into a much broader partnership between Apple and Nike that spans a number of products. Meanwhile, the legacy watch and fashion industries are going to face extinction-level competition.

The other realm of competition will come from the same companies currently competing for our attention on smartphones. Spectacles are the beginning of a much broader push by Snap that will eventually lead to the company selling augmented reality glasses. Facebook has indicated similar interest in placing screens on our faces. These devices will represent a prime example of how screens and cameras will continue to a play a pivotal role in our lives for a very long time. Will Apple be able to recreate the iOS platform for glasses? The company benefits from the fight for our attention on smartphones, and creating an environment in which there is a new battle in front of our eyes may be even more attractive. (Jony Ive and the rest of Apple's Industrial Design group are going to first need to solve the many issues found with wearing computers on the face.)

Automobile. When it comes to rethinking the car, some of the major themes found in the smartphone market are going to reappear. Today's cars are boxes on wheels. Tomorrow's cars are going to be smart rooms on wheels. There may be an opportunity for the car industry to experience its very own "iPhone" moment. Tesla's current offerings don't represent this earth-shaking change.

As it does with the smartphone industry, value is going to flow to the companies that control both auto hardware and software. Autonomous driving and the machine learning powering these cars will require both significant hardware and software advancements. In addition, passenger compartments are going to become prime real estate for lots of data consumption (music, video, etc.). The fact that these smart rooms on wheels will be surrounded by lots of screens (i.e. windows and windshields) should give us clues as to how important augmented reality will become in the auto space.

Apple has many of the ingredients to go very far in the car industry although the company is also missing some crucial technologies. My suspicion is that Project Titan's change in strategy is geared to first fill some of these technology gaps before proceeding with automobile hardware. Meanwhile, ridesharing and different ownership models will increase a car's utilization rate by almost 20x. This will have a major impact on the cost of travel. However, at the end of the day, design and manufacturing will be the two most important variables to watch in the auto space - two of Apple's biggest strengths. There is simply too much at stake for Apple (or any major tech company for that matter) to not have a comprehensive strategy for the automobile as cars turn into smart rooms on wheels.

Home. This is where Apple has the least attractive position. Given Apple's culture and functional organizational structure, one should not expect Apple to move down the path of selling various smart devices for the home. Selling niche hardware that will be owned for long periods of time without upgrading doesn't exactly sound too attractive of a business for a hardware maker either. Apple's answer to get around the lack of Apple-branded hardware is HomeKit and the Home app: Rely on third-party device manufacturers to come up with smart devices that can be controlled via iOS and Siri.

On paper, the strategy makes sense. Unfortunately, reality is quite a bit different. Expecting consumers to go out and buy lots of smart home devices at prices that are in some cases 10x more than those of their non-smart alternatives doesn't bode well for the smart home going mainstream any time soon. This is why Apple expects this process to proceed gradually, with consumers buying a few smart items in the beginning and then slowly building their collections over time. This is why predictions of Amazon and "voice only" interfaces ruling the home seem immature. It is simply way too early. When it comes to the home, value is going to eventually flow to automation, an element that Apple seems to be betting big on with its Home app. However, the hardware piece of the equation just isn't there.

The TV industry remains a mess with no clear winner when it comes to video streaming, and the home may end up in a similar state. In some ways, Apple's Home app is similar to its TV app. Both strategies contain holes.

After the iPhone

Everyone wants to know what will come after the iPhone. This is likely the wrong way of thinking about the future tech landscape. The new tech battle lines being redrawn don't assume there will be a "new iPhone." The iPhone will likely remain a very valuable device in our lives for many years, and companies are still going to be fighting for our attention when using smartphones. However, value has begun to flow to those companies able to place hardware and software in the most important parts of our lives: our bodies, cars, and homes.

The unknown found in this new competitive landscape concerns just how much autonomy these new devices will have. (Hint: It's much more than people think.) Instead of seeing wearables remain as iPhone accessories, we are going to see smartwatches, wireless headphones, and maybe even smart glasses gain independency. Instead of cars being controlled by our iPhone, cars will become like our iPhones.

The iPhone has had a major impact on society because it redefined a computer. For the first time, we had a computer that could fit in our pocket. We are quickly moving to the point of having many new computers on our bodies, on our roads, and in our homes.

Apple Questions for 2017

January 05, 2017 by Neil Cybart

I don't see any value in coming up with tech predictions at the beginning of a calendar year. Predictions are nothing more than an attempt to add a bit of manufactured clarity to what is ultimately a lot of unknown. Instead, January is a great time to embrace that unknown. One easy way of doing this is to come up with a list of questions for the new year. This not only helps guide our analysis in the coming months, but also proves incredibly useful for navigating Silicon Valley and Wall Street.

My first set of Apple questions was published in January 2015 (available here), followed by the second installment in January 2016 (available here). My thoughts and observations on Apple's 2016 are available here.

Here are my Apple questions for 2017:

iPhone

New iPhones. How many new iPhone models will Apple unveil in 2017? For the first time, Apple is in a position to potentially unveil three different iPhone screen sizes simultaneously. Significant design changes are on the table for at least one model as well. This should not be treated lightly as it will test Apple's supply chain and demand forecasting.
New Features. What will be the key new features found with the new iPhones? Traditionally, Apple has positioned three or four new features as the primary selling points. These are often a combination of hardware and software features. With the iPhone 7, Apple unveiled a list of 10 features although one could boil the list down to four primary features: Jet Black, the camera, stereo speakers, and wireless (AirPods).
OLED Displays. How will the rumored OLED display shortage hamper Apple's iPhone strategy in 2017? It's been hard to miss stories about the looming shortage of OLED displays. Meanwhile, the long-standing rumor about the iPhone line has been that Apple wants to transition to OLED due to the potential benefit on battery life in addition to OLED producing better picture quality.
iPhone Plus. Will Apple continue to differentiate the iPhone Plus model from the rest of the iPhone line? In 2016, the iPhone 7 Plus received a dual-camera system. It is not unreasonable for Apple to eventually give the largest-screen iPhone a completely different design than its smaller siblings.
iPhone SE. What are Apple's plans for the iPhone SE? The $399 4-inch iPhone SE was the sleeper hit of 2016. While the product may not garner many headlines, the iPhone SE has played a major role in returning the iPhone line to unit sales growth. The combination of a smaller form factor and low price has been appealing to many customers (both existing iPhone users and new users).
Pricing. How will Apple price its new iPhone lineup? Apple wasn't shy in passing along higher component costs found with the iPhone 7 Plus. At the same time, Apple is currently milking the iPhone when it comes to positioning the device as a new user magnet. This involves continuing the multi-year trend of gradually lowering iPhone pricing.
New User Growth Trends. Will Apple see a slowdown in iPhone new user growth in 2017? While the iPhone's contribution to Apple financials cannot be overstated, the product plays an even more important role for Apple. The iPhone is Apple's single most effective tool for expanding the user base. In 2016, the iPhone installed base grew by more than 100M users. This is on top of the iPhone seeing 100M new customers in 2015. (The math behind these figures is available here.) A vast majority of these users are new to the Apple ecosystem. No other Apple product comes close to having these new user numbers.
Upgrade Cycle. The iPhone upgrade cycle has been slowing as iPhone users hold on to their devices for a longer stretch of time. How will the new iPhones impact the upgrade cycle heading into 2018?

Apple Watch

New Apple Watches. Will Apple unveil new Apple Watches in 2017? Given the product's unique attributes, one cannot assume that Apple will follow an annual cadence with Apple Watch updates. However, September is a logical time for updates given the device's propensity to be gifted at the holidays. In addition, Apple's expansion of the Apple Watch line into Series 1 and Series 2 opens the door for a number of different options when it comes to updating the Watch line.
New Features. How will Apple push the Apple Watch forward? Given the product's smaller supply chain footprint, especially in comparison to iPhone and iPad, there has been a noticeable lack of leaks surrounding potential new Apple Watch features. Logical choices include better battery life and faster processors.
Watch Bands. What kind of new Apple Watch bands will Apple unveil? Watch bands play a crucial role in Apple Watch adoption. New colors, materials, and collections seem likely at some point this year.
watchOS 4. Which new features will anchor watchOS 4? New Watch faces and complications are high on the list. In addition, further refinements to the user interface would go a long way.
Marketing. How will Apple Watch marketing evolve? We have seen Apple take Apple Watch messaging from a mini iPhone on your wrist to a health & fitness device that can do other things. This change gives Apple a much more effective strategy for competing against Fitbit. While the health & fitness focus may suffice in the near term, it's not a long-term marketing strategy as it will ultimately sell Apple Watch short.
Price Cuts. Will Apple lower Apple Watch's entry-level price? The company has been aggressive when it comes to Apple Watch pricing. In just 17 months on the market, Apple Watch's entry-level price went from $349 to $269. This past holiday shopping season, Apple Watch Series 1 was available for $199 thanks to Black Friday promotions in the U.S.
New Partnerships. Will Apple unveil new partnerships for Apple Watch? In 2015, Apple kicked off its Hermès partnership. Instead of announcing another traditional luxury partnership in 2016, Apple unveiled a significant tie-up with Nike for Apple Watch Nike+. Each partnership contains much intrigue with Apple not holding anything back in supporting its Watch partners.
Financial Disclosures. When will Apple begin to disclose additional details about Apple Watch sales? The company already provides clues as to how Watch sales are trending. At a certain point, the benefits associated with releasing quarterly unit sales data will outweigh the drawbacks.

AirPods

New AirPods. Does Apple plan on updating AirPods in 2017? AirPods aren't just a pair of wireless headphones. They are Apple's second wearables product. September would seem to be the most logical time for a revised version given its proximity to the holiday shopping season.

Mac

New Mac Desktops. Does Apple plan on updating Mac desktops in 2017? Due to a number of reasons, Apple has been updating the Mac line in a piecemeal way. In 2015, Apple unveiled a 12-inch MacBook that gave major clues as to Apple's design strategy for Mac portables. Seventeen months later, Apple unveiled the new MacBook Pro with Touch Bar, which unsurprisingly shared much of the design language found in the 12-inch MacBook. We have not yet seen Apple's plans for the Mac desktop.
Mac Pro and Mac mini. What is going to happen with the Mac Pro and Mac mini? A Mac mini increasingly looks out of place given its heritage as a product designed for enticing Windows users to Mac. Meanwhile, the Mac Pro may still interest the Apple Industrial Design group for no other reason than lessons learned from its unique manufacturing process.
iMac. Where is the iMac's place within Apple's ecosystem? Management has provided a few clues suggesting that the iMac will continue to receive attention and resources. This may alleviate some concerns held by current iMac users worried about the lack of future updates. However, it's difficult to shake the theory that there may be something greater in store for the iMac. Are we moving to a point at which Apple will look at the iMac as the only Mac desktop? This would certainly create a firestorm within some parts of the Mac community.
MacBook Pro Pricing. Will Apple reduce pricing for the new MacBook Pro in 2017?

iPad

New iPads. Will Apple unveil new iPads in 2017? As with the Mac line, Apple has been updating the iPad line in a piecemeal way. Apple unveiled a 12.9-inch iPad Pro in September 2015, and this was followed by a 9.7-inch iPad Pro in March 2016. The current iPad line feels incomplete as only two of the five models that make up the line are new.
iPad mini. What are Apple's plans for the 7.9-inch iPad form factor? Even though we have seen Peak iPad Mini, Apple is still selling more than 10M 7.9-inch iPads every year. There would be demand for an updated model.
New Apple Pencil. The Apple Pencil was released in November 2015. Should we expect an updated Apple Pencil in 2017? Will the iPhone receive Apple Pencil support?

Apple TV

Original Content. Will Apple push further into original content programming? We will soon get a look at "Vital Signs," Apple's first scripted TV series as well as "Planet of the Apps," Apple's unscripted reality TV show.

iOS

Redesign. What does Apple have in store for iOS 11? This question could arguably turn into an entire post on its own. Given Apple's direction with the iPhone, an iOS redesign is high on the list. The traditional home screen and rows of apps are dated. In addition, an iPhone with the home button built into the screen requires iOS changes. We already saw some of these changes with iOS 10 with the greater emphasis on swiping left, right, up, and down instead of going back and forth to the home button. There is much more that Apple can do along those lines to have iOS 11 build off of iOS 10.

Apple Music

Paid User Trends. What is a realistic year-end goal for Apple Music paid users? Apple grew Apple Music by approximately 10M paid users in 2016. This would suggest that 35M to 40M paid users is an attainable year-end goal for Apple Music.
Pricing. Will Apple reduce Apple Music pricing to drive stronger customer adoption?
Music Exclusives. We know Apple will continue to bet on music exclusives. How will Apple double-down on music exclusives?
Tidal. What is going to happen to Tidal? Jimmy Iovine has been very careful to paint a rosy picture of the relationship between Apple Music and Jay-Z. However, Iovine is then quick to argue there will be consolidation in the music streaming space. Notice how Tidal, and not Spotify, received a spot on this year's questions list. Apple Music's success is increasingly becoming decoupled from Spotify's path forward (an IPO or sale).

Services

Apple Maps. How will Apple improve Apple Maps? We are getting to the point where Apple Maps is legitimately great in certain parts of the world compared to its competition. In the U.S. Northeast, Apple Maps is a winner. In other parts of the world, it's another story. Nevertheless, Apple has made much progress with Apple Maps and the incentive is there for ongoing improvement given maps' importance to Apple's transportation initiatives.
Apple Pay. How will Apple work to improve Apple Pay acceptance in the U.S.? Outside the U.S., Apple Pay is seeing quite a bit of success. However, the U.S. is proving more difficult from the perspective of getting retailers to support Apple Pay. This has had a negative impact on customer adoption.
Messages. What new features will Apple bring to Messages? Apple Pay support is coming eventually. Picture and video filters are other items worth considering.
Siri. Needless to say, Siri will be a popular talking point in 2017. What does Apple have in store for SiriKit? Greater third-party support via Siri APIs would be high on the list. In iOS 10, the Siri API works with just six types of applications. Regardless of the progress made with Siri, I have a strong feeling that a certain segment of the Apple user base will remain incredibly disappointed with Siri's capability in 2017.

Project Titan

Autonomous Driving. After a strategy shift in 2016, what kind of progress will take place within Project Titan in 2017? Reports have positioned 2017 as a critical year for Apple's autonomous driving R&D efforts.
Hardware Hires. Will there be new clues regarding Apple's ongoing interest in automobile hardware? A few months after Titan hit some speed bumps, Apple poached Alexander Hitzinger, a Porsche technical director responsible for the Porsche 919 hybrid. Hitzinger easily qualifies as one of Apple's most accomplished and talented hardware hires from the auto industry.
Bob Mansfield. A hardware guru, with a proven track record of success, is leading Apple's car development project. It's difficult not to come up with a long list of questions about that dynamic.

Washington and Wall Street

U.S. Tax Reform. When will we see U.S. corporate tax reform? While this question is seemingly put forth every year, odds of some kind of progress in 2017 are at their highest in years.
U.S. Manufacturing. How will Apple respond to calls to bring more manufacturing to the U.S.? Upon closer examination, there is little chance of Foxconn and other Apple assemblers bringing high volume production to the U.S. any time soon.
Wall Street Narrative. Apple still doesn't have an effective narrative on Wall Street. Will management find a sustainable narrative for Apple on Wall Street?
Buyback. How will Apple approach its buyback program in 2017? For the past few years, Apple CFO Luca Maestri has been overseeing a buyback program operating at its limits. Having the vast majority of its cash offshore hasn't helped Apple's capital management program. Apple can only raise so much debt to fund its dividend and buyback activity. Corporate tax reform, including changes to how offshore cash and earnings are taxed, will have a major impact on Apple's buyback (and dividend) strategy.

Management

Turnover. Will there be any executive turnover in 2017? There hasn't been much movement within Apple's upper ranks in recent years.
M&A. Will Apple continue to adjust its M&A strategy in 2017? Even though Apple continues to rely on M&A for filling holes in its asset base, there have been signs of change taking place in terms of Apple's investment philosophy. The company is willing to be a bit less secretive in order to get better access to newer technologies. The $1B investment in Didi and allowing AI researchers to publish are two examples. We already see signs of this revamped M&A strategy in 2017 as Apple just confirmed it will invest $1B into SoftBank's tech fund.

Apple Industrial Design (ID)

For the first time, I am giving ID its own dedicated question category. Given the sheer amount of power given to ID within Apple, it only seems fitting.

Jony Ive. Simply put, will we get any surprises from Jony in the new year? It's safe to say Jony will continue to make some people uneasy in 2017. For 2016, the Apple design book certainly counts as a surprise. The completion of Apple Campus 2 this year may represent a major news event involving Jony given his immense contribution to the project.
Marc Newson. Will we get any clues as to Marc Newson's role within Apple? I continue to think Marc Newson's involvement within Apple is being underestimated. Newson played a critical role with Apple Watch development and has experience with various product categories, including jewelry and cars, as well as a range of materials.
Departures. Will we see any departures from the close-knit group of industrial designers in 2017? Danny Coster, who was considered one of the most senior members of the team, left Apple last year to help GoPro find a future. While one departure is not necessarily a sign of concern, it is something worth noting. Additional departures would clearly reveal changes are taking place within Apple Industrial Design.

Wildcards

New iPhone Nomenclature. Will Apple change its iPhone naming strategy? As the iPhone upgrade cycle gets longer, it makes that much less sense for Apple to stick with its current iPhone nomenclature. I will admit there is quite a bit of risk found with altering naming for such an iconic and popular product. However, that is usually the exact scenario that requires a name change. We are likely moving to the point where we simply refer to iPhones as "iPhone mini," "iPhone," and "iPhone Plus."
An iOS-powered MacBook. When are we going to see an ARM-based MacBook powered by an iOS variant? Given Apple's unusual Mac updating schedule, 2017 seems off the table for a release. Nevertheless, we may receive additional clues during the year that such a product is coming down the pipeline. It is becoming not a question of if, but of when.
Foxconn. What should we expect from Foxconn in 2017? Apple's relationship with Foxconn is becoming more intriguing by the day. Foxconn has become Apple's most important business partner.
New Products. What are the leading candidates for brand new Apple products in 2017? For 2015, I positioned an "Apple Pen" as a likely product in the R&D labs. That same year, Apple unveiled the Apple Pencil. Last year, I positioned a ring and "wireless EarPods" as the leading candidates for a brand-new Apple product. We got AirPods in December 2016. For 2017, a brand new health-focused product, possibly working alongside an Apple Watch, and a ring worn on your finger stand out as possible new products. Wearables are increasingly becoming a focal point for Apple's industrial design group.
Other Products. There is a somewhat large bucket of rumored products (hardware, software, and services) in the Apple labs. We can include various AR, VR, wearables, stand-alone speakers, etc. Will any of these see daylight in 2017?

AirPods Kick off Apple's Battle for Our Ears

December 22, 2016 by Neil Cybart

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.

Exhibit A: The Jony Ive Promotion
Exhibit B: Jony Ive Is Making People Uneasy

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.

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.
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

December 15, 2016 by Neil Cybart

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)

Screen Shot 2016-12-15 at 12.14.39 PM.png

The Players

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

Apple
Garmin
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.

The sales gap between smartwatches and fitness & health trackers will shrink.
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

December 06, 2016 by Neil Cybart

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.

Screen Shot 2016-12-03 at 2.42.09 PM.png

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.

Screen Shot 2016-11-29 at 4.53.58 PM.png

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

November 17, 2016 by Neil Cybart

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.

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.

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Above Avalon Turns Two

November 10, 2016 by Neil Cybart

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

November 04, 2016 by Neil Cybart

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

October 24, 2016 by Neil Cybart

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):

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

October 20, 2016 by Neil Cybart

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:

Content (video and music) streaming has become a must-have feature for mobile ecosystems.
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:

Use Apple Music to mask original video programming ambitions. Check.
Expand to other types of original video programming. Check.
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

October 06, 2016 by Neil Cybart

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)

Screen Shot 2016-10-05 at 4.18.10 PM.png

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

September 28, 2016 by Neil Cybart

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.

Screen Shot 2016-09-26 at 8.02.08 PM.png

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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