Apple's $400 Billion Buyback Program

One of the more certain items found with Apple’s upcoming 2Q19 earnings is that the board will approve increases to the company’s share buyback authorization and the quarterly cash dividend. The two capital return initiatives continue to be polarizing topics as Apple holds more than $100 billion of excess cash on the balance sheet. A closer look at Apple’s buyback and dividend trends suggests the company’s board still has a strong incentive to increase Apple buyback authorization in a big way next week.

Capital Return Trajectory

Exhibit 1 highlights the amount of cash Apple has spent on capital return (buyback, cash dividends, and net share settlement) on an annual basis since 2012:

Exhibit 1: Apple’s Capital Return (Annual)

Prior to U.S. tax reform, Apple had been spending approximately $50 billion annually on capital return initiatives. The total was funded by a mixture of free cash flow and debt issuance. Once Apple was able to bring its foreign cash back to the U.S. at a favorable tax rate, the pace of capital return increased materially. Last year, Apple spent $90 billion on share buyback, cash dividends, and net share settlement.

Assuming Apple doesn’t spend a significant amount of its excess cash on M&A, the company has enough cash to continue spending nearly $100 billion on capital return annually for at least the next two years. Kicking off between $50 billion and $60 billion of free cash flow annually, Apple ends up utilizing approximately $40 billion to $50 billion of its excess cash on capital return initiatives each year. Over the long run, Apple’s current business footprint supports an annual capital return budget of closer to $50 billion.

Share Buyback

Next week, Apple’s board will approve the seventh consecutive increase to the company’s share buyback authorization. Here are the changes to Apple’s share buyback authorization since the program launched in 2012:

  • 2012: $10 billion buyback authorization 

  • 2013: $60 billion (increase of $50 billion)

  • 2014: $90 billion (increase of $30 billion)

  • 2015: $140 billion (increase of $50 billion) 

  • 2016: $175 billion (increase of $35 billion)

  • 2017: $210 billion (increase of $35 billion)

  • 2018: $310 billion (increase of $100 billion)

Last year, Apple’s board approved a substantial $100 billion increase in share buyback authorization. This was double the amount of the previous record increase in buyback authorization.

At the end of December, Apple had $63 billion of share repurchase authorization remaining. This is another way of saying that Apple had worked through $247 billion of its $310 billion share repurchase authorization. Assuming Apple bought back $20 billion of shares in FY2Q19 (January to March 2019), the company likely had closer to $43 billion of authorization remaining at the end of March.

When estimating the potential increase in Apple’s share buyback authorization, one has to look at the company’s intended buyback pace. Following U.S. tax reform, which opened the floodgates for Apple’s foreign cash being used to fund capital return initiatives, Apple had been on pace to buy back approximately $80 billion worth of shares annually. This elevated buyback pace was interrupted in FY1Q19 following the sudden and dramatic drop in product demand in China. In December 2018, Apple didn’t buy back any shares. However, based on Apple’s 1Q19 10-Q, it looked like Apple had begun buying back shares in January.

Assuming Apple continues to target a share buyback pace of approximately $80 billion per year, the implication is that Apple’s board will need to approve another substantial increase in share buyback authorization next week. An increase of less than $50 billion in additional share buyback authorization would imply a potential slowdown in Apple’s buyback pace. This would be a surprising move considering the significant amount of excess cash that remains on Apple’s balance sheet. In addition, management continues to reiterate its intention of reaching net cash neutral over time, which means the amount of cash on Apple’s balance sheet equals the amount of debt.

Accordingly, my expectation is that Apple’s board will approve an increase in buyback authorization in the range of $75 billion to $100 billion. This will bring Apple’s overall buyback authorization to approximately $400 billion. There isn’t much of a difference between a $75 billion and $100 billion increase in authorization. Both totals would give Apple plenty of flexibility to pursue an aggressive share buyback strategy. A $75 billion increase in authorization would provide Apple approximately $115 billion of available authorization for buyback while a $100 billion would equal more like $140 billion of available authorization. Both of those totals assume Apple repurchased $20 billion of shares in FY2Q19.

Quarterly Cash Dividend

Given how much press and attention is given to Apple’s share buyback, the company’s cash dividend story continues to fly under the radar. Apple’s board has approved six consecutive increases to the quarterly cash dividend. Next week, the company will announce its seventh consecutive increase.

Here is Apple’s dividend history since reinitiating the dividend in 2012:

  • 2012: $0.38 per share

  • 2013: $0.44 (15% increase)

  • 2014: $0.47 (8% increase)

  • 2015: $0.52 (11% increase)

  • 2016: $0.57 (10% increase)

  • 2017: $0.63 (11% increase)

  • 2018: $0.73 (16% increase)

When gauging the magnitude of the upcoming quarterly cash dividend increase, a 10% increase likely represents a floor. There are two reasons behind such an assertion:

  1. Dividend strategy. Apple follows a stable dividend policy characterized by a steady dividend payout that reflects its long-term earnings potential. Instead of dividends closely following near-term earnings swings, the two variables align when looking at long-term trends.

  2. Apple’s share buyback pace. As Apple buys back shares, the company pays out less in the way of cash dividends. This is made possible because repurchased shares are retired, reducing the number of outstanding shares. For every 100 million shares that Apple repurchases, the company saves approximately $300 million on cash dividends per year. Since reinstating the dividend, the amount of cash that Apple has spent on dividends has increased by 30% while the quarterly cash dividend has increased by 92%. As long as Apple continues to buy back significant amounts of stock, the company will be able to increase the quarterly cash dividend by 10% and not actually incur additional dividend expense.

(For an in-depth examination into Apple’s dividend strategy, check out the Above Avalon Report: Apple Dividends: A Deep Dive into Apple’s Cash Dividend Strategy. The report is available exclusively to Above Avalon members. To read the report, become a member here.)

With the preceding two variables in mind, my expectation is that Apple’s board will approve a 14% increase in Apple’s quarterly cash dividend to $0.83 per share, up from $0.73 per share.

Cash Spend

With more than $100 billion of excess cash on the balance sheet, there continues to be a vocal group advocating that Apple spend the cash on something other than capital return. However, the item that is often ignored by those advocating that Apple cut back on buyback and dividends is that management is already spending tens of billions of dollars each year funding organic growth opportunities.

In FY2018, Apple funded the following items:

After taking into account the preceding organic growth investments and expenditures, Apple was still left with approximately $50 billion of free cash flow. It is this free cash flow, in addition to the excess cash already on the balance sheet, that is funding the company’s capital return initiatives:

  • Buyback: $73.0 billion (in FY2018)

  • Cash Dividends: $13.7 billion

  • Net share settlement: $2.6 billion

  • Total: $89.3 billion

Piling additional cash into R&D simply as a means of spending excess cash doesn’t make any sense. The same philosophy applies to capex. Apple’s business model is capex light. There is no logic found in Apple moving away from this model just to spend more cash. Even if Apple doubled R&D and capex overnight, which isn’t going to happen, the company would still have tens of billions of dollars piling up on the balance sheet each year.

This leaves M&A as the only other way for Apple to spend the excess cash. While Apple is certainly in a position to fund additional M&A activity, including acquisitions with larger price tags, there is no logic in the company changing its M&A philosophy because it has excess cash. Acquisitions don’t suddenly become more rational simply because the acquirer has excess cash that it wants to remove from the balance sheet. Instead, Apple continues to look at M&A as a tool for acquiring technology and talent in order to plug crucial holes in its asset base.

Given the lack of attractive alternatives, Apple’s board still has the incentive to continue approving substantial increases to share buyback authorization and quarterly cash dividends.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 145: It's All About Curation

At Apple’s recent event at Steve Jobs Theater, the company unveiled its revamped content distribution arm. Episode 145 is dedicated to discussing Apple’s new content distribution services: Apple News+, Apple Arcade, and Apple TV+. Instead of just announcing services for consuming more content, Apple unveiled a strategy for curating content for its user base of a billion people, something that I am calling “Curation for Casual.” The discussion also goes over how curation explains Apple’s move into original content. Additional topics include a few surprises unveiled at Apple’s Services event, the history behind Apple’s video distribution strategy, the changing content consumption landscape, and Apple’s content distribution arm eventually being considered a core technology powering Apple devices.

To listen to episode 145, go here. 

The complete Above Avalon podcast episode archive is available here. 

Why Apple Is Getting Into Original Content

In what has become something of a trend, Apple uses an opening film to kick off its product unveilings. The video shown at the start of Apple’s Services event two weeks ago at Steve Jobs Theater stood out to me.

Please enjoy the opening credits to the Spring 2019 Apple Event. It's show time. Song: "Love" by Unloved https://apple.co/Unloved Learn more and sign up for updates: http://apple.co/March2019Event

Apple relied on a retro opening credits film theme to give a pretty clear hint of what was to come: a Hollywood-heavy event with nearly a third of the stage time given to celebrities talking about Apple’s upcoming video streaming service, Apple TV+.

The video served a few other functions as well. The “A Think Different Production” was telling the world that Apple was about to enter original video content in a very big way. The video was also meant to show how Apple now has a growing number of cast members (hardware, software, and services) that come together to create the film (user experience).

Event Surprises

Apple’s Services event contained a number of surprises when it came to its revamped content distribution arm:

  1. Apple is directly funding iOS game development for Apple Arcade. While third-party game developers will retain ownership of the games that will begin as Apple Arcade exclusives, Apple isn’t too far from playing in the realm of producing its own iOS gaming content.

  2. With Apple News and News+, Apple may be as close as it gets to doing original written content. Apple continues to move down the path of having its team of editors curate news and investigate reporting. The only way for Apple to move further into original written content would be to hire a team of reporters and journalists for actually reporting and breaking news. This isn’t likely to occur for a number of reasons.

  3. Apple TV+ represents Apple’s first comprehensive move into original video content. There were plenty of questions as to how Apple would position its original video content within its broader TV strategy. We know Apple TV+ will be an ad-free subscription service, the implication being that it will be some kind of paid service that lives within the Apple TV app. This app will then be available in more than 100 countries via iPhones, iPads, Macs, Apple TVs, most of the leading smart television set platforms, and Roku and Amazon Fire TV.

My full Apple Services event review is available for Above Avalon members here (major themes) and here (full notes). 

History

One of the more crucial questions found with Apple’s event involves why the company is moving into original content in the first place. The answer speaks volumes as to how the content consumption landscape has changed in just a few short years.

In order to answer the “why” behind an initiative like Apple TV+ and Apple’s move into original video content, one has to go back to the late 1990s. Apple has long held a desire to distribute content through its devices. Part of this desire is rooted in Apple’s content creation ambitions via Mac software such as iMovie. Apple introduced iMovie in 1999. As told in ‘Becoming Steve Jobs’ by Brent Schlender and Rick Tetzeli, Steve Jobs handed out Sony digital camcorders to six Apple executives for shooting and editing four-minute home movies. The clips were then shown at Macworld 2000.

Jump ahead a few years, and Apple’s iTunes empire played a major role in expanding the Apple user base and eventually setting the stage for iOS and the App Store. In 2018, Apple earned an estimated $20B of revenue from selling digital goods.

As Apple grew its content distribution arm, the thought of Apple producing its own content remained a pipe dream. While there has been a continuous stream of suggestions from analysts and pundits that Apple buy video content companies such as Disney or Time Warner (HBO), the rationale behind such acquisitions never made much sense from Apple’s perspective. The content libraries that would be purchased in a deal were already available to Apple users (and likely weren’t going away), each target company contained too much corporate baggage regarding other business segments, and there would surely be significant culture clashes.

The first signs of Apple genuinely starting to open up to the idea of original content appeared after the Beats acquisition in 2014 and Apple’s subsequent entry into music streaming with Apple Music in 2015. Jimmy Iovine looked at original video as a way to have an Apple music streaming service stand out from Spotify. In addition to various music-related video projects, including documentaries, Apple’s Beats 1 put the company firmly into original audio content territory.

Shows like ‘Carpool Karaoke’ and ‘Planet of the Apps’ served as an original video test run for Apple. The biggest takeaway was that management needed to hire outside talent and place a much larger bet on original content if it wanted to develop a coherent video strategy and stand out from the competition.

In terms of the broader video landscape, Apple’s video distribution strategy is entering a third phase:

  1. Offer video creation tools to users

  2. Offer video creation tools to users + distribute paid third-party content

  3. Offer video creation tools to users + distribute paid third-party content + distribute original video content

Too Much Content

Many people correctly predicted the slow death, or unbundling, of the large cable bundle. However, very few people projected the flood of new content from entirely new players including Netflix and Amazon. These new players are now forcing the old guard to double down on even more original content. Both Disney and WarnerMedia (formerly Time Warner) are placing big bets on ramping up original content budgets to support their respective new direct-to-consumer streaming services. Add YouTube into the mix, and it’s easy to see why Netflix says sleep is its biggest competitor. There has never been as much video content to consume than there is today. With a finite amount of time each day, there is only so much content that we can consume.

This dynamic drove recent comments from Warren Buffett, one of Apple’s largest shareholders, about how the digital entertainment space isn’t something he would be interested in competing in, although he is indirectly doing so with his $50 billion Apple stake. Here’s Buffett:

“You’ve got some very very very big players that are going to fight over those eyeballs…You have very smart people with lots of resources trying to figure out how to grab another half hour of your time. I would not want to play in that game myself.”

Buffett wasn’t alone in his stance. Many analysts and pundits looked at Apple’s event two weeks ago with bewilderment. On the surface, it seemed like Apple had simply announced new revenue-generating services to deliver even more content to its user base.

  • Not reading enough magazines or news? Subscribe to Apple News+ and get $650 worth of magazines per month for just $10 per month.

  • Not playing enough iOS games? Pay for Apple Arcade and play 100 games with no content stuck behind in-app purchases.

  • Not watching enough video content? Use the Apple TV app and watch video from your favorite sources as well as an entirely new slate of video content with Apple TV+.

Some were stumped as to how Apple could possibly compete with Netflix by just announcing a handful of original shows. Such a question demonstrated a complete misread of what Apple had actually announced on stage.

Curation for Casual

Instead of just announcing services for consuming more content, Apple unveiled a strategy for curating content for its user base of a billion people. This curation involves everything from picking out which news stories and iOS games Apple users may enjoy to taking an active role in protecting users’ content consumption habits in terms of privacy and security.

One way of describing this revised strategy is curation for the casual.

  • Apple Arcade appeals to the casual gamer who may be interested in playing a few minutes of an iOS game here or there. Such a user values Apple’s curation in terms of selecting what will be an always fresh lineup of approximately 100 titles.

  • Apple News+ is for the casual magazine reader who may not be interested in subscribing to any one particular magazine but enjoys reading an article here or there. Such a user values Apples’ curation in terms of picking out stories from hundreds of magazines.

This leaves the question: Why is Apple getting into original video content? Apple could have curated video content from third parties to those looking for a handful of interesting shows and movies.

TV+ Strategy

Heading into Apple’s event last week, my thinking was that Apple would position original video content as a way of getting people to spend time within the Apple TV app. More time spent in the Apple TV app would also likely mean more third-party video bundles being subscribed to from directly within the app. However, Apple’s very deliberate original content lineup, including the partnerships with Steven Spielberg and Oprah, told me that Apple’s original content video strategy boils down to something more.

 

Tim Cook, Oprah Winfrey, and Steven Spielberg at Apple Park.

 

Apple is using its own slate of original video content to develop a differentiated curation experience that won’t be found anywhere other than in the Apple TV app. Apple isn’t just developing shows and movies that will then be curated to its viewers. Instead, the shows themselves have already been curated. This explains Apple’s decision to bet on brands (Oprah, Spielberg, Sesame Workshop, J.J. Abrams, etc.) and star power.

Apple’s original video strategy is nothing like that held by Netflix or Hulu (quantity over quality). The strategy also ends up being quite different from Amazon’s play for third-party bundles and some original content (which has been quite bumpy). Apple appears to be taking a different path from HBO too (quality over quantity).

The Apple TV+ equation doesn’t boil down to Apple betting on either video quality or quantity. Instead, the TV+ equation is about selling video curation on a global scale. Apple’s form of curation extends to ensuring privacy and security when it comes to content consumption behavior, something that has received little to no attention up to now in the world of direct-to-consumer paid video streaming.

Turning back to the idea of users having a finite amount of time to consume video content, why is something like TV+ needed in the marketplace? The bet Apple is placing is that curation will gain value as the amount of video content available across various bundles and streaming services continues to increase. Apple’s video strategy isn’t based on grabbing as much time as possible from users. Such a battle will be a brutal one to fight. Instead, Apple is interested in offering its users a truly curated (and private) viewing experience on all their devices. No other company offers such a service.

A Core Technology

Content distribution has become commoditized. Most companies are merely interested in checking off the video streaming box on the list of platform requisites. The same can be said for music streaming, gaming, etc. Apple thinks the resulting flood of content is now opening the door for content distribution to once again turn into a competitive advantage.

It's possible that Apple’s content distribution arm, and the company’s underlying curation for casual strategy, will eventually be considered a core technology powering Apple devices. Notice how Apple News+, Apple Arcade, and Apple TV+ are not going to be available on Android smartphones.

As Apple has been working to control other core technologies powering its devices, all signs point to Apple slowly wanting to reduce its dependency on others when it comes to its content distribution arm. Apple’s move into original video content lays the groundwork for Apple to eventually move into original content in other genres as well.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 144: Checking Up on iPad

In recent years, the iPad line has undergone transformational changes. In episode 144, we look at Apple’s broader iPad strategy to add context to the newest updates involving the iPad mini and iPad Air. The episode kicks off with my thoughts on the new devices. The discussion then turns to the three sales phases that have come to define the iPad business over the years. Additional topics include Peak iPad mini, how Apple is following an iPhone / Mac hybrid approach when it comes to iPad updates, whether the iPad line is too complex or complicated, and observations on the current iPad line.

To listen to episode 144, go here. 

The complete Above Avalon podcast episode archive is available here. 

Thoughts on Apple's Revised iPad Line

In what has become something of a trend, Apple once again unveiled a few iPad strategy adjustments in March. This year’s changes include an update to the 7.9-inch iPad mini and altering the 10.5-inch iPad Pro to arrive at a lower-priced and rebranded 10.5-inch iPad Air. The best way to analyze these updates is to look at Apple’s broader iPad strategy and the significant amount of change that the product category has undergone in just the past two years.

Changes

iPad mini. The most noteworthy change to the iPad mini was that it received an update in the first place. The last time the iPad mini received an update was in September 2015. Over the subsequent three years, iPad mini sales have steadily declined and now represent a small fraction of overall iPad sales. As smartphone screen sizes increased, the market for a tablet with a 7.9-inch screen shrunk. Sales for the iPad mini won’t surpass record level put in years ago, a claim referred to as Peak iPad mini. However, there was likely still enough demand for a 7.9-inch iPad to warrant an update.

The most noticeable update to the iPad mini will be found on the performance front related to the A12 Bionic chip. The iPad mini 4 had an A8 chip. The new iPad mini also has an improved display and Apple Pencil support (1st generation). Apple maintained the $399 price for iPad mini while cutting entry-level storage in half to 64GB. In addition, Apple removed the number nomenclature, instead opting for the much simpler and cleaner “iPad mini.”

iPad Air. Apple positioned the new 10.5-inch iPad Air as the successor to the 9.7-inch iPad Air 2 that was discontinued back in early 2017. In reality, the new iPad Air is more of a 10.5-inch iPad Pro successor that had components removed in order to have a lower price. The new iPad Air retails for $499 while the 10.5-inch iPad Pro went for $649.

  • Primary addition (from the 10.5-inch iPad Pro): A12 Bionic chip

  • Primary subtractions (from the 10.5-inch iPad Pro): 12MP camera, quad speakers, ProMotion, less RAM, 4K video recording.

Another minor change includes Apple removing the 512GB capacity option.

Three Sales Phases

When looking at the broader iPad category, there have been three distinct sales phases over the years:

  1. Rocket launch

  2. Implosion

  3. Stabilization

Exhibit 1: iPad’s Three Sales Phases

Rocket launch. The iPad was Apple’s best-selling product out of the gate with 22M units sold in the first twelve months. It is going to be difficult for another Apple product to come close to achieving iPad’s early sales success. While there were likely a number of factors that came together to produce a perfect storm for iPad’s record launch, fascination with iOS on a large screen (the iPhone had a 3.5-inch screen when the iPad launched) and a thriving iOS app ecosystem provided plenty of fuel for the iPad rocket.

Implosion. iPad sales peaked at the end of 2013 at 74M unit sales on a trailing twelve months (TTM) basis. Three years later, the iPad sales runrate stood at 41M units. Three factors are behind the dramatic decline in sales: less demand for iPad mini, a longer upgrade cycle, and the broader iPad category being cannibalized by more capable iPhones.

Stabilization. The iPad business has been trending at a 44M annual unit sales run rate for the past two years. The combination of sales to new users and sales to existing users is roughly flat year-over-year. Apple’s decision to bifurcate the iPad line with more capable and powerful models at the high end and increasingly lower-priced models at the low end has played a major role in stabilizing sales. It also hasn’t hurt that the sales headwind associated with declining iPad mini demand has ended.

Current Line

The iPad line currently consists of five models and a few dozen SKUs when considering storage options and case colors.

  • iPad Pro (11-inch and 12.9-inch)

  • iPad Air (10.5-inch)

  • iPad (9.7-inch)

  • iPad mini (7.9-inch)

It may be easy to look at the five preceding models and conclude that Apple is aiming to copy the Mac line with a few “Pro” models at the top end and lower-priced models branded as “Air” and “mini” at the other end. Some may even think Apple is trying to recreate the 2x2 matrix Mac quadrant from the late 1990s in which Apple sold four Macs, two portables, and two desktops, targeting the consumer and professional markets.

However, there is one critical error in the preceding assumption.

Touch-based computing has blurred the line between consumer and professional devices. Each iPad model is used by a wide range of users. In addition to being a content consumption device, the iPad mini is utilized in various enterprise settings. Meanwhile, the 12.9-inch iPad Pro, combined with the Apple Pencil, can be either used for a wide range of content creation tasks or simply web browsing and content consumption. There isn’t one device that ultimately targets just consumer segments or enterprise use cases.

Instead, Apple’s iPad strategy seems to be following more of a hybrid approach, taking elements of both the Mac and iPhone lines.

In terms of nomenclature, there is no question that Apple is borrowing from the Mac. The MacBook Air is the best-selling and most popular Mac. The popularity is one reason why Apple decided to stick with the Air branding following last year’s update. Similarly, Apple is likely positioning the iPad Air at $499 to be one of the better-selling iPad models. Similar to the Mac mini, the iPad mini will then likely represent a smaller percentage of overall sales while handling a variety of enterprise use cases.

The strategy found with taking the 10.5-inch iPad Pro form factor and removing components and technology to lower the price and arrive at the 10.5-inch iPad Air is reminiscent of the iPhone SE strategy. The move to unveil the latest industrial design with the Pro models at the top is also something seen with the iPhone.

Borrowing from both the Mac and iPhone playbooks make sense when considering the iPad has a user base that measures in between that of Mac and iPhone. At end of the 2018, the iPhone, iPad, and Mac user bases were as follows:

Consumer Choice

One of the largest complaints facing the iPad line over the years has been the complexity and confusion in terms of the number of models available for purchase. Apple has done a few things to add clarity. Instead of keeping older models in the lineup at lower prices, management has moved to having a few new iPad models at prices ranging from $329 to $999. In addition, Apple has worked on reducing price gaps between models. The $250 price gap that had existed between the 10.5-inch iPad Pro and iPad mini 4 has been reduced to $100 with the new iPad Air and iPad mini.

  • iPad Pro (12.9-inch): $999

  • iPad Pro (11-inch): $799

  • iPad Air (10.5-inch): $499

  • iPad mini (7.9-inch): $399

  • iPad (9.7-inch): $329

There is no question that some customers use price to select the best iPad. Accordingly, the $329 iPad and $499 iPad Air will likely be strong sellers. In order for Apple to reach these lower prices, the company had to make some difficult product marketing decisions in terms of components, industrial design, and subsequently, Apple Pencil support. The non-Pro models work with Apple Pencil V1 while the Pro models are designed to work with Apple Pencil V2.

Another variable that may guide a customer’s buying decision is screen size. As with price, Apple has done a good job of covering the screen range from 7.9 inches to 12.9 inches.

  • iPad Pro 12.9-inch

  • iPad Pro 11-inch

  • iPad Air 10.5-inch

  • iPad 9.7-inch

  • iPad mini 7.9-inch

Apple continues to position the larger 9.7-inch iPad, instead of the new, smaller iPad mini, as the entry-level option. This is done because larger iPads have become vastly more popular than the iPad mini. Apple did not want to sacrifice that popularity just to have screen size correlate directly to price. In addition, the larger 9.7-inch iPad is marketed to educational institutions (special pricing brings the 9.7-inch iPad to $299).

Ready for WWDC

In recent years, the iPad line has undergone transformational changes. Apple management has not only bet on higher-priced, larger iPads with the Pro segment, but also doubled down on lower-priced iPads in an attempt to compete against Chromebooks and even hand-me-down iPhones.

From a unit sales perspective, the iPad mini’s best days are clearly behind it, and a $999 iPad Pro will likely end up representing a small fraction of overall iPad sales. However, from a hardware perspective, it’s hard to argue we aren’t looking at the strongest iPad line to date. Apple has spent the past three years expanding the iPad line in order to appeal to hundreds of millions of people.

This takes us to software - the missing link. All of the signs point to Apple getting the iPad line ready for new software features unveiled at this year’s WWDC. This week’s hardware updates cap off the first half of Apple’s two-part iPad show.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 143: Look at the Capex

For the first time in 16 years, Apple expects its capital expenditures (capex) to decline during the current fiscal year. Episode 143 is dedicated to discussing capex and how the financial metric provides a different look at how Apple is unique in comparison to its largest peers. Additional topics include defining capex, the theories behind Apple’s declining capex, the dramatic capex shift occurring among the Wall Street giants, and how capex shines light on a company’s cash-generating machine.

To listen to episode 143, go here. 

The complete Above Avalon podcast episode archive is available here. 

Apple's Declining Capex

The most surprising revelation found in Apple’s recent 10-Q and 10-K filings is related to capital expenditures (capex). For the first time in 16 years, Apple expects its capex to decline during the current fiscal year. Declining capex is made that much more intriguing for Apple considering how Amazon, Alphabet, Microsoft, and Facebook are each experiencing significant increases in capex. Analyzing Apple’s capex and the potential reasons for its decline provides a look at how the company is being managed and how Apple is unique when compared to other Wall Street giants.

Defining Capex

Capex refers to cash a company spends on buying or upgrading long-term assets in order to improve cash flow, productivity, and ultimately, value. These expenditures include both tangible and intangible items.

As depicted in financial filings, Apple’s capex includes money spent on:

  • Product tooling and manufacturing process equipment.

  • Data centers.

  • Corporate facilities and infrastructure, including information systems hardware, software and enhancements.

  • Retail stores.

Additional capex items include acquiring intellectual property such as patents.

One way of distinguishing capex from regular operating costs (opex) is that capex benefits a company beyond the current fiscal year that the expense occurs. While opex are deducted as they are incurred, capex are one-time costs capitalized on the balance sheet with the expense spread across the lifespan of the asset. Cash spent on assets that have not been proven commercially viable fall under R&D and is expensed as incurred.

Apple Capex: By the Numbers

At the end of each fiscal year, Apple provides an expectation for the amount of capex that it will report during the upcoming year. As shown in Exhibit 1, for the first time in 16 years, Apple expects a year-over-year decline capex in FY2019. Apple’s initial expectation called for $14B of capex in 2019, down from the $16B of capex originally expected in 2018.

Exhibit 1: Apple’s Initial Expectations for Capex (Annual)

For a variety of reasons, including the difficulty associated with estimating capex, Apple’s final capex total will often differ from its initial expectations. Exhibit 2 includes Apple’s final capex reported at the end of each fiscal year. Excluding how capex came in above Apple’s initial expectations in FY2018, the trend had been for capex to come in less than initial expectations. This is why it wasn’t too surprising to see in Apple’s most recent 10-Q that management had reduced its capex expectations for 2019 even further. Apple now expects $12B of capex in 2019. Based on this revised estimate, Apple may end up reporting a nearly 30% year-over-year decline in capex.

Exhibit 2: Apple’s Reported Capex (Annual)

The amount of cash Apple spends on capex during any given fiscal year will likely differ from reported totals. Companies disclose the amount of cash spent on capex via the cash flow statement using the line item property, plant, and equipment (PP&E). Exhibit 3 reflects the amount of cash Apple spent on PP&E over the past 10 years. It is not unprecedented for Apple to report a modest year-over-year decline in PP&E. However, this doesn’t take anything away from Apple expecting a rare drop in reported capex in 2019.

Exhibit 3: Apple Payments for Property, Plant, and Equipment (PP&E)

Theories

What may be behind Apple’s expectation for capex to decline by nearly 30% in FY2019? There are a number of plausible theories.

  1. Apple is buying less tooling and manufacturing machinery. In the late 1990s, Apple began outsourcing product manufacturing to third-party contract manufacturers. The move was done in an attempt to improve the company’s balance sheet and create a leaner, nimbler, supply chain. Given Apple’s reliance on contract manufacturers, the company doesn’t own a complex web of factories around the world. However, Apple does own much of the specialized tooling and machinery found in these factories.

  2. Apple cut back the pace of retail store openings. Apple may be spending less on its brick-and-mortar retail apparatus. After an aggressive store opening strategy in China, Apple cut back on its retail footprint expansion and instead has been focusing on opening fewer, more high-profile stores.

  3. Capex headwind from elevated spend on facilities is winding down. The decline in capex may be due to Apple having already spent aggressively on various capital investments including new data centers, land purchases, and a new $5B headquarters.

  4. Apple’s initial expectations will end up being proven wrong. It is possible that Apple’s expectation that capex will decline in 2019 may simply end up proving conservative.

While there may be some logic found with each of the preceding theories, a few theories end up having more holes than others. Consider the following:

  • Retail store remodels. The declining number of store openings ignore what has been a substantial amount of resources being dedicated to store remodels around the world.

  • Lower expectations. After three months, management has already lowered its 2019 capex expectations from $14B to $12B. It is not likely that Apple is simply running with conservative capex expectations and will somehow end up reporting more than the $16.7B of capex in FY2018.

Most Logical Explanation

When taking the preceding theories into consideration, two stand out as being the most logical. As shown in Exhibit 4, despite the surge in wearables sales, the overall number of devices manufactured has remained roughly the same due to the decline in iPhone sales. This would suggest no major growth in capex due to additional tooling and machinery. In addition, Apple is coming off of a massive investment cycle for iPhone related to OLED and Face ID. Management was not exaggerating when saying the iPhone X marked a turning point for the iPhone business. This dynamic likely resulted in elevated capex in recent years which is now cooling down a bit in 2019.

At the same time, Apple management’s capex expectation for 2019 likely reflects little growth in tooling and manufacturing machinery related to a major new product category. Apple’s fiscal year ends in September, and the latest rumors claim that high volume production for Apple Glasses will be more of a FY2020 event.

Exhibit 4: Apple Device Unit Sales

Note: "Other" includes Apple Pencil, Apple TV, HomePod, and select Beats headphones. Wearables include Apple Watch, AirPods, and select Beats headphones.

Another contributing factor behind declining capex is that Apple likely finds itself facing less of a capex headwind from years of significant growth in infrastructure. As disclosed in Apple’s most recent 10-K, the company had amassed a significant amount of office space and land in recent years. As of September 29th, 2018, Apple owned 16.5M square feet and leased 24.3M square feet of building space, up 12% from the previous year. In addition, Apple acquired 2,448 acres of land in 2018 to have a total of 7,376 owned primarily in the U.S. As Apple grows into its expanded footprint, the company is likely taking a temporary breather in terms of capex on corporate facilities.

Peers

Apple’s declining capex highlights the remarkable capex shift among the Wall Street giants (Microsoft, Apple, Amazon, Alphabet, and Facebook). Exhibit 5 highlights the change in PP&E from FY2016 to FY2018 for the five giants. In 2016, Apple led the pack with nearly $13B of PP&E. The closest peer was Alphabet at $10B. Jump ahead two years, and the landscape has completely changed.

Exhibit 5: Payments for Property, Plant, and Equipment (PP&E)

Alphabet spent $25B on PP&E in 2018, nearly double the second-highest total reported by Facebook ($14B). Based on Apple management’s capex expectation, it is likely that Apple will also be surpassed by Microsoft and Amazon when it comes to PP&E in 2019. This means that in just two years, Apple would have gone from being the highest to lowest spender in terms of PP&E.

On a combined basis, the $32B increase in PP&E reported by Alphabet, Facebook, Amazon, and Microsoft between 2016 and 2018 exceeded Apple’s PP&E growth by 56x.

Change in PP&E (2016 to 2018)

  • Alphabet: $15B

  • Facebook: $9B

  • Amazon: $5B

  • Microsoft: $3B

  • Apple: $1B (rounded up)

Business Models

Business models dependent on collecting as much of our data as possible require increasing investment at unprecedented rates. This would explain the massive increases in PP&E reported by Alphabet (Google) and Facebook. Each is a services company focused on offering free, data-capturing services to as many people as possible. The business models are dependent on achieving scale in order to grab as much data as possible. 

Amazon is a retail platform company focused on getting you to buy and consume more products over time. Scale in terms of purchase volume is needed in order for the cash flow/reinvestment cycle to continue. Amazon’s data capturing investments are a bit more difficult to observe via PP&E growth given the company’s need to make other long-term investments to support its cloud business.

Apple is a design company focused on selling tools capable of fostering premium experiences. Instead of chasing scale with the goal of monetizing data or usage, Apple sells tools that management thinks people will want and are willing to pay for. For Apple, scale is considered a byproduct of a properly functioning business model.

Declining capex in any given year does not necessarily reflect Apple management underinvesting in its business. Instead, as discussed above, such declines result from Apple leveraging its existing fixed assets to generate robust free cash flow. In essence, Apple’s business model is capex light.

Ultimately, Apple's business model predisposes the company to superior free cash flow generation. The company is capable of monetizing premium experiences much more effectively and efficiently than anyone else. Free cash flow is a measure of how much cash is generated after taking into account capex and other costs associated with running the business. Apple's $62B of trailing twelve month free cash flow is $6B more than the combined free cash flow produced by Alphabet, Facebook, and Amazon during the same time period. Given how those data capturing companies find themselves needing to spend increasing amounts on capex, Apple will likely be able to maintain its significant free cash flow advantage for the foreseeable future.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 142: Rethinking the Smart Home

In one word, the smart home has been disappointing. Episode 142 is focused on why the way we think about digital homes is in need of a major reset. After going over my thoughts on the current state of the smart home, we take a closer look at Apple’s vision for the home and why the company is likely looking to revamp its broader home strategy. Additional topics include how Amazon and Google have used voice to hijack the smart home in order to push alternative visions and Apple hiring Sam Jadallah to lead its various home initiatives. We also discuss how Apple can revamp its home strategy and why the smart home path is going to be bumpy going forward.

To listen to episode 142, go here. 

The complete Above Avalon podcast episode archive is available here. 

Revamping Apple's Home Strategy

Last week, news broke that Apple had hired Sam Jadallah, a former Microsoft executive and most recently founder of a smart lock company, to lead its various home initiatives. The announcement raised a number of questions, including the most obvious: What is Apple’s home strategy? Consensus in the press is that Apple is far behind Amazon and Google in the race to control the home. I’m not so sure about that. Instead, the entire smart home genre appears to be floundering. Jadallah’s hiring points to Apple reassessing how to best get the idea of an intelligent home off the ground.

The Smart Home

Starting a few years ago, the tech industry became desperate to position the smart home as the next big thing. Much of this was due to a strong desire to find growth after smartphones and tablets. Other companies were focused on moving past Apple’s and Google’s control over the smartphone and tablet paradigm. With wearables, success has been contained to a select few companies. Meanwhile, the smart home umbrella ended up covering multiple times the number of companies, including a long list of hardware-focused start-ups.

In one word, the smart home has been disappointing. The premise underpinning smart home adoption was that one smart device purchase would lead to another and then another. In reality, that kind of behavior has not become the norm. Despite there being plenty of products available, smart home adoption remains sporadic and disjointed.

While a few product categories, like stationary speakers, have gained traction in the home, such products end up being tangential to the idea of the smart home.

Amazon is considered to be the leader in the home, at least when going by the media’s perception. The company’s acquisitions in the space certainly help push the narrative of Amazon being aggressive and forward thinking. Similarly, for Google, considered a distant second in the smart home race, its Nest acquisition provided the company a decent amount of positive coverage when it came to smart home ambitions. However, that positivity is beginning to disappear based on increasingly questionable decisions like not disclosing microphones in products. Regardless, both Alexa and Google Assistant, Amazon’s and Google’s voice assistants, respectively, have never been short of praise in the press.

Problems

A number of issues are at the root of mediocre smart home adoption. The largest issue is that the vast majority of smart home devices lack an attractive value proposition.

  • Smart doorbells with cameras have become more about providing entertainment than anything else, serving as a way to see who stole packages off the front porch.

  • Smart power plugs end up being nothing more than a way to avoid changing timers a few times during the year.

  • Smart kitchen appliances controlled by voice still make more sense in cartoons than in real-world settings.

While a handful of interesting product stories exist in the smart home realm, they are few and far between. Instead, the way smart home gadgets have embraced voice assistants has ended up being more of a distraction than anything else. In the rush to add microphones and speakers to anything and everything, the smart home’s grand vision has been muddled.

Amazon and Google have used voice to hijack the smart home in order to push alternative visions, one around e-commerce and the other around delivering information, respectively.

  • Amazon is focused on becoming the go-to place for buying stuff in the home. For Amazon, the home is an e-commerce hub. Every one of Amazon’s actions within the home has been done in pursuit of this focus.

  • Google is focused on positioning its services as front-and-center in the home. For Google, the home is an information hub. Every one of Google’s actions within the home has been done in pursuit of this focus.

While there are some value-add propositions found with improving at-home shopping and delivery and having easy access to information-rich services, both home strategies amount to collecting as much user data as possible. In addition, neither strategy takes full advantage of the most powerful and valuable screens in our lives to push the smart home forward.

Amazon Echo and Google Home marketing are notorious for never showing other computing gadgets being used in home. There are zero smartphones, tablets, or wearables to be seen. It’s as if people leave their devices by the door when entering the home, only to pick them up on the way out. Amazon and Google both want people to think stationary smart speakers controlled by voice are adequate replacements for the various screens in their lives. The reality is that the best devices for consuming and transferring information in the home have screens and are either worn on us (wearables) or always near us (smartphones). It is far more useful and practical to get the day’s weather with a quick glance and tap at the wrist than by asking a digital assistant contained in a stationary speaker.

Apple and the Home

Apple’s approach to the home is quite different than the approaches of Amazon and Google. Apple is a design company tasked with coming up with tools that enrich people’s lives. Accordingly, the home is looked at as a place to use those valuable tools.

When it comes to the smart home, Apple has been following a three-pronged strategy:

  1. Rely on HomeKit and third-party hardware to establish an ecosystem of smart home devices. These devices can be controlled and configured using the most valuable tools in our lives including iPhones, iPads, and Apple Watches.

  2. Use select third-party hardware, such as stationary speakers and television sets, as Trojan horses for Apple’s content distribution services.

  3. Remain selective when deciding to ship first-party hardware solutions for the smart home. Apple TV and HomePod are the rare smart home exceptions for Apple. Both end up being accessories for Apple users looking for the best content consumption experiences in the home. Other Apple devices for the home like the Beddit sleep monitor end up being tangential to the smart home idea.

After a slow start, Apple has seen a pickup in HomeKit adoption among third-party smart home products. However, the way expanded AirPlay 2 support has been generating greater buzz says something. With AirPlay 2, Apple uses third-party hardware as a way to spread its content distribution services.

The fact that Apple doesn’t sell its own television set implies that there are going to be many large, non-Apple pieces of glass being used to consume video content in the home. This explains Apple’s decision to bring AirPlay 2 support to most of the premium television sets available in the market. A similar story is found with cheap stationary speakers in the home. Apple knows people are tempted by $30 speakers in a can. A significant portion of stationary smart speaker sales can be attributed to two products during the holidays: Echo Dot and Google Home Mini. The primary use case for such speakers is music consumption. At the same time, a good portion of Echo Dot users are iPhone users. This explains Apple’s decision to make Apple Music available on Echo devices. Apple ends up leveraging its existing user relationships to push Apple Music.

Benefits and Drawbacks

One benefit found with Apple’s strategy is that the company remains focused on offering a few great experiences in the home. When it comes to delivering sound in the home, HomePod, especially when multiple HomePods are paired together, offers intelligent sound at a fraction of the cost of a high-end speaker system. Apple TV is the best way for iOS users to consume various video bundles on a large piece of glass.

However, there are also drawbacks to Apple’s home strategy. Apple is ultimately dependent on others for its smart home vision. This reality may result in lackluster device support in addition to questionable experiences in the home. Further, Apple has been facing a growing amount of backlash for saying no to certain products in the home. Some people want Apple to provide everything from the internet wired into homes and Wi-Fi routers connecting our devices to smart light bulbs controlled by digital voice assistants. This just isn’t realistic given Apple’s functional organizational structure and design-led culture.

New Hire

Apple recently hired Sam Jadallah, CEO/founder of Otto, a smart door lock company that went under before getting its $700 lock to market. According to CNBC, and apparently confirmed by Jadallah himself via Twitter, he will oversee Apple’s various home initiatives.

It would be a mistake to look at Jadallah's hire as a sign that Apple will open the floodgates and develop a wide range of smart home devices. Apple simply isn’t structured for such a scenario. Instead, Apple’s culture positions the industrial design group as the ultimate gatekeeper of the experience found with Apple devices. The implication is that Apple will remain very selective in terms of developing its own home products.

Instead, Jadallah will likely focus on coordinating Apple’s various home plays and more importantly, revamping Apple’s broader strategy for the home. This task includes coming up with tangible ways Apple’s teams can turn vision into reality. Based on Jadallah’s previous public comments regarding smart home devices and given Apple’s product philosophy, we have some clues as to what such a vision may look like. Here’s Jadallah in 2017 in a post titled “The End of the Connected Home:”

“Creating a product for the home is different than a wearable or a device that is easily replaced. Connected Home products are often installed. That installation dictates that they are reliable, durable and follow many of the rules of the products they replace. In our case, that requires a digital lock to be durable and to have design, and design options, that support the diversity of homes. Homeowners, beyond the early adopters, aren’t willing to sacrifice design, security or performance — they demand it all.

I’ll refer to Connected Home products that meet this bar as ‘Digital Home’ products. The Connected Home is far simpler — basic gadgets, obvious products with a primary value focus on connectivity. The Digital Home is the next wave of the Connected Home. Obvious products need not apply to the Digital Home, as they need to be very focused on the digital experience (connected, open, upgradeable) but also fit well into the home (designed as the home wants, not out of context design) and most importantly, be reliable, durable and classic as they are installed.”

In essence, Jadallah’s “digital home” concept describes a scenario in which design plays a much larger role in the home than what has traditionally been found in the space. It is this lack of design that has played a role in smart home products having questionable value propositions and resulted in mediocre smart home devices. With Otto, a company that reportedly was staffed with many former Apple employees, Jadallah was focused on developing a smart lock that would play in this new “digital home” era. His experience as an entrepreneur and product manager certainly fits with the idea that he will end up working closely with Apple designers on new experiences for the home.

Revamping

There are a number of ways for Apple to revamp its home strategy:

  1. Leverage existing tools in our lives (smartphones, wearables) to push the idea of a digital home forward. Should a smart home require us to use our most valuable devices less frequently? This question is going to gain importance when people begin wearing smart glasses in the home. Since we are going to literally be wearing the most valuable and powerful tools in our lives, why not take advantage of those tools to improve the home experience?

  2. Further incorporate design into the vision for the digital home. This step will involve addressing some obvious but incredibly important questions. How should humans interact with homes? How can digital home products improve our lives? Voice can’t be the only interface choice. Simply being able to unlock the front door with our voice or Watch isn’t enough.

  3. Determine where the most important experiences are found in the home and come up with ways of interconnecting those experiences. There are various genres at play within the home (entertainment, utility, health monitoring, security, etc.) How should health monitoring devices in the home communicate with devices tasked with keeping our home safe? As it stands today, there is little to no relationship or connection between experiences. Instead, everything is either funneled into a voice assistant or a framework like HomeKit.

Apple is not opposed to the idea of moving into first-party solutions for smart home gadgets. The company sells Apple TV and HomePod, after all. Instead, Apple will continue to ask the following questions: Which smart home devices are capable of fostering experiences? Which devices have a long runway when it comes to adding features and capability over time? The answers to the preceding questions will be the devices most likely to be tackled by Apple designers and engineers.

Bumpy Road

In my view, the smart home path is going to be very bumpy going forward. We are trying to compensate for the lack of homes being built from the ground up with technology truly in mind. Having homebuilders simply add voice activated gadgets in new homes falls short. Instead, the only genuine answer is to have tech companies build homes themselves. However, that isn’t on the horizon at this point.

As highlighted in the following exhibit, the home represents a crucial part of the new tech landscape. The home is a treasure trove of data, and companies are looking to grab as much of our data as possible. This explains why monitoring within the home has been all the rage. However, the home has not been the recipient of a great amount of design attention when it comes to intelligence and personalization. Instead, we have a whole lot of questionable voice-controlled devices and not much else. Hardware start-ups have been focused on adding voice control to smart home devices without a clear reason or purpose. Do consumers really want to talk to or control dozens of smart appliances installed throughout the home? Are consumers going to be OK with installing microphones throughout the home? Based on the backlash to news of Google not telling customers about a microphone being included in Nest Guard, there is a good chance we are moving to a major backlash phase against the smart home.

In recent years, the topic of “controlling” or “winning” the home has been a popular talking point. Consensus has landed on the winner in the home being the company with the most capable voice assistant as measured by the number of skills or features. This type of thinking is off the mark. Few people are using these voice skills. This explains why tens of millions of smart speakers end up being used for little more than listening to music, a development that ends up helping push forward the music streaming industry more than the smart home genre.

Instead, the winner of the home is the company that ultimately is able to grab our time and attention. This is why Apple’s vision of the home being a place where we use tools to improve our lives makes sense. If someone is dedicating most of his or her time to an iPhone while in a room full of smart home devices, which company is actually winning in that room? If an Apple Watch is continuously worn and used in a home filled with smart devices, which company is actually winning in the home? The way we think about digital homes is in need of a major reset.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 141: Viral AirPods

There’s a remarkable story found with AirPods. Nearly two years after launch, AirPods began to go viral at the end of November 2018. In December, search interest was up 500%. This is unprecedented for an Apple product. In episode 141, we take a deep dive into the AirPods phenomenon and how the product became part of culture. Additional topics include AirPods unit sales, the size of the AirPods user base, the keys to success in wearables, and thinking of wearables as battles for real estate on our wrists, ears, eyes, and body.

To listen to episode 141, go here. 

The complete Above Avalon podcast episode archive is available here. 

AirPods Have Gone Viral

Apple has a hit on its hands, or maybe we should say in its ears. AirPods have become the second best-selling Apple product out of the gate of all time. More interestingly, there are signs of AirPods now becoming a cultural phenomenon. AirPods do a superb job of demonstrating Apple’s competitive advantages with wearables, a product category that will come to define Apple for decades.

Videos and Memes

A few weeks ago, a video from “Inside Edition,” a U.S. TV newsmagazine, jumped out at me. The video, shown below, had the attention-grabbing headline “Can Your iPhone Be Turned Into a Spyphone?” The video’s focus was on the iPhone’s “Live Listen” feature, which turns an iPhone into a microphone. While the feature, designed to work with hearing aids, has been around for some time, Inside Edition’s video was focused on how AirPods can now be used to “spy” on someone. After watching the video, most viewers likely came away thinking AirPods have a built-in spy feature that Apple had secretly launched.

The video’s most up-voted comment was a reference to one of the more popular AirPods memes:

 
Screen Shot 2019-02-03 at 8.20.45 AM.png
 

The “Sorry, I can’t hear you over my AirPods” meme pokes fun at AirPods wearers for being oblivious to their surroundings. In some cases, a pair of AirPods are photoshopped on fictional characters right before something bad happens to them in a movie, as if wearing AirPods made them unaware of what was about to happen. There have been various spin-offs of the meme, with interpretations that are more subjective. Other memes have poked fun at people using AirPods as a social signal to flaunt wealth and status. These various AirPods memes took off at the end of December, just as millions of people received AirPods as presents.

Last week, another AirPods-related video caught my attention. This time, the video was posted on Twitter from Gabrielle Reilly. Her “AirPods earrings” clip is found below:

 
 


Reilly told BuzzFeed: “I absolutely refuse to lose [my AirPods]. My cat ate through two pairs of Beats Bluetooth earphones, and all my other earphones. So I got the AirPods because there was no wire for her to chew but I still needed something to connect them.” She refined the design and is now selling “Airings” for $20.

In what has become a daily occurrence, various pop culture references that poke fun at AirPods, such as the following tweet, are going viral.

 
 

Measuring Interest

While it is easy to look at AirPods memes, videos, and tweets as harmless fun or jokes, such a view misses what’s really taking place. AirPods have become part of culture. A product which the tech press declared too awkward-looking to ever go mainstream has now made headphones with wires look out of style. The various AirPods memes, videos, and tweets are byproducts of AirPods becoming incredibly popular in a very short amount of time. In essence, AirPods have gone viral.

One way of measuring the viral nature of AirPods is to look at Google Trends, which is powered by Google search data. As a general rule, Google Trends is a useful tool for gauging consumer interest in a product, especially for a relatively new product like AirPods. Compared to some of the other methodologies out there for gauging interest, like consumer surveys, analyzing the degree to which people use Google to search for something is a more reliable source.

The one caveat that is important to keep in mind with Google Trends is that if searches aren't taking place through Google, but instead on Amazon for example, that interest won't be reflected in Google Trends. For AirPods, this factor isn’t much of a concern.

As shown below, search interest for “AirPods” in the U.S. began to shoot higher this past November, nearly two years after launch. Search interest then peaked between Christmas and New Year’s. The data is indexed to 100, which denotes the maximum amount of search interest for “AirPods” during the selected time range. Indexing allows us to see how search interest levels have changed over time.

Comparing peak AirPods search interest over the three most recent holiday seasons, the juxtaposition is startling. The following are Google search interest for “AirPods” in the U.S. indexed to 100 (represents maximum search interest):

  • 2016 holiday season: 10 (AirPods search interest was 10% the volume of peak search interest).

  • 2017 holiday season: 20 (100% year-over-year growth in search interest)

  • 2018 holiday season: 100 (500% year-over-year growth in search interest)

Search volume for AirPods during the most recent holiday season was five times the search volume registered during the 2017 holiday season. Even more impressive, AirPods search interest this past December was ten times the volume registered during the December 2016 launch.

Two weeks ago, AirPods search interest (the blue line in the image below) exceeded Apple Watch search interest (the red line) for the first time.

No other Apple product has come close to this sudden surge in interest years after launch. For example, Google Trends for “iPad” in the U.S. from 2009 to 2019 is shown below. While the iPad saw a remarkable amount of interest at launch in 2010, interest levels ended up plateauing just two years later. The amount of iPad interest seen at launch was 30% the volume of peak search interest. This likely explains why iPad was like a rocket out of the gate when it came to sales, only for sales to plateau and eventually fall.

Measuring Sales

The surge in AirPods search interest isn’t just a reflection of people looking for AirPods memes and videos. The higher interest is reflective of stronger sales. According to my estimate, Apple is on track to sell approximately 40 million pairs of AirPods in 2019, representing close to 90% year-over-year growth. There are already at least 25 million people wearing AirPods. This total will likely exceed 50 million people later this year. These are massive sales and adoption figures for a two-year old product that has never received an update and rarely goes on sale for less than its $159 selling price.

The methodology and data behind my AirPods sales estimates are found in the following Above Avalon daily updates that are available for Above Avalon members here and here. (To become a member and access these daily updates, visit the membership page.)

As shown in Exhibit 1, AirPods are currently the second best-selling Apple product out of the gate in terms of unit sales, behind only iPad. An argument can be made that the iPad was an outlier and that no other Apple product will come to close to exceeding iPad unit sales.

Exhibit 1: Apple Product Unit Sales Out of the Gate

One issue found with Exhibit 1 is that quarterly unit sales are impacted by seasonality. In order to remove this seasonality, Exhibit 2 shows unit sales on a cumulative basis. While iPad’s clear sales lead is hard to miss, AirPods are the second-best selling product two years after launch, slightly ahead of iPhone at the same point after launch. On a cumulative sales basis, AirPods are outpacing Apple Watch by 40% at the same point after launch.

Exhibit 2: Apple Product Cumulative Unit Sales

Viral Factors

Despite Apple Watch selling well, there hasn’t been a similar kind of viral aspect to the product. There aren’t various Watch memes floating around Twitter. What is it about AirPods that turned the product into a pop culture viral sensation? There are likely a few factors.

  1. High Visibility. AirPods are literally hanging out of people’s ears. They are nearly impossible to miss when worn. Since the lack of wires make AirPods useful for outdoors activities including walking and running, they are bound to be seen in people’s ears while out and about. AirPods sightings have seemingly grown exponentially in recent months. Meanwhile, an Apple Watch is easily covered by long sleeves or jackets. In cold weather climates, Apple Watch visibility is reduced to indoor settings for months at a time.

  2. New and Different. AirPods, although a successor to wired headphones, look very different without the wire. The product also stands out from other wireless headphones. In some ways, Apple designers didn’t try to hide the fact that AirPods lack wires. The product is intriguing, sparking curiosity.

  3. Social Signaling. Wearing white EarPods signaled to others that an iPod, or eventually an iPhone, was found in the wearer’s pocket. Similarly, wearing AirPods signal to others that the wearer likely has an iPhone and is able to pay $159 for a pair of wireless headphones despite a wired pair being included in the iPhone box.

Strategy

AirPods end up playing a more strategic role for Apple than just being a fun smartphone accessory. AirPods represent one half of Apple’s wearables strategy.

Success in wearables will require two ingredients:

  1. Ecosystem. A selection of tools targeting different parts of the body.

  2. Design / Fashion Expertise. Developing wearable devices that people want to wear and be seen wearing.

AirPods demonstrate Apple’s significant lead when it comes to developing a wearables ecosystem and possessing a design / fashion acumen that other companies lack.

It won’t be enough for a company to just sell a smartwatch or a pair of wireless headphones. Instead, the key to mastering wearables will be to offer an ecosystem of devices that work seamlessly together. This dynamic will require companies to have an expertise in combining hardware, software, and services, something Apple has been focused on for decades.

The winners in wearables will be companies successfully waging simultaneous battles for real estate on our wrists, ears, eyes, and body (i.e. smart clothing). As shown below, there are three key pieces of real estate that are currently up for grabs or will soon be available for grabs: wrists, ears, and eyes.

 
 

In 2015, Apple entered the wearables arena with Apple Watch. The product kicked off Apple’s attempt to grab wrist real estate. The wrist has proven incredibly useful given its line of sight for viewing information at a quick glance in addition to its ability to foster certain health monitoring capabilities. While Apple Watch is going up against traditional mechanical watches, competition ends up being much broader. Ultimately, Apple Watch is competing for a place on wrists. One of the Watch’s fiercest competitors is non-consumption, or empty wrists.

A similar dynamic is now unfolding with AirPods. The device is Apple’s attempt at grabbing ear real estate. Competitors for this real estate include both wired headphones, like EarPods, and non-consumption in the form of empty ears. Even though AirPods may be light on features today, having tens of millions of wearers today increases the probability of subsequent AirPods versions seeing strong adoption.

The battle for our eyes is on the horizon, not quite ready for prime time. A pair of smart glasses have the highest likelihood of being Apple’s next major product category.

The key to grabbing real estate on our wrists, in our ears, and in front of your eyes is selling tools that people want to wear and be seen wearing. A product’s design, defined as how we use that product, is crucial in this regard. With Apple Watch, interchangeable bands have played a crucial role in driving Watch adoption. AirPods’ elegant charging case has come to define the product’s experience.

Instead of positioning technology as a barometer for wearables success, the intersection between technology and fashion will determine which products people will want to wear throughout the day. Lessons learned from Apple Watch, and now AirPods, will give Apple an advantage when it comes to developing a pair of lightweight and unobtrusive smart glasses.

Vision

Unlike Amazon and Google, which are desperately trying to position voice as a way to leapfrog over the current smartphone/tablet paradigm, Apple is approaching things differently. Instead of betting on a voice interface that pushes some information to a stationary screen, Apple is betting on mobile screens that are home to a digital assistant. Apple is placing a bet that consumers will want the familiarity found with touch screens to transition to a future of greater AI and digital assistants. Apple Watch ends up serving as a bridge to the future. The most valuable mobile screens in our lives will increasingly be worn on the body. In addition, Apple thinks screen manipulation via fingers, hands, and eyes will remain a crucial part of the computing experience for the foreseeable future.

AirPods play a role in this vision by harnessing sound on the go. Wired headphones are an endangered species as there is no place for wires in a wearables world. While the viral nature of AirPods may subside over the coming months, especially as adoption continues to expand, the biggest takeaway from the various AirPods memes, tweets, and videos, is that wearables continue to infiltrate society. We are witnessing the early stages of the wearables era.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 140: Let's Talk Content

Some of Apple’s recent decisions regarding content distribution have sparked a debate. Is Apple embracing a new kind of strategy that elevates services at the expense of hardware? Episode 140 is dedicated to going over Apple’s content distribution strategy and how the company is looking to leverage its user base in an effort to establish one of the more formidable content distribution arms in existence. Additional topics include Apple’s history as a content distributor, how streaming is changing content consumption, misconceptions surrounding Apple’s content distribution strategy, the sudden collapse in stationary speaker buzz, Apple’s goals for its content distribution arm, and the various challenges facing the company.

To listen to episode 140, go here. 

The complete Above Avalon podcast episode archive is available here. 

Apple's Content Distribution Strategy

This past November, Amazon sent shockwaves across a number of industries by announcing Apple Music would be available on Echo devices. Earlier this month, Samsung announced Apple was bringing iTunes content to Samsung TVs. Apple also expanded AirPlay 2 support to include a wide range of high-end television sets. These announcements don’t represent some type of cultural shift away from hardware for Apple. Instead, the moves are part of Apple’s strategy to leverage its user base in an effort to establish one of the more formidable content distribution arms in existence.

Content Distribution

Apple has long held an interest in being the one to deliver content to its growing base of users and devices rather than leave content distribution to someone else. Apple’s content distribution arm delivers a variety of genres, listed below, to hundreds of millions of users and more than a billion devices.

  • Music

  • TV Shows / Movies

  • Apps

  • Podcasts

  • News

  • Magazines

  • Books

Apple has seen varying degrees of success when it comes to distributing content. With iTunes, Apple took advantage of the Mac’s low market share by getting the music industry to test a radical idea at the time: selling digital music online. iTunes ended up playing a big role in moving the music industry from albums to singles.

After years of strong growth, App Store revenue was approximately $45B in 2018. Apple has been a leader in the podcast space from the beginning. Written content distribution has proven to be trickier for Apple although the company has recently seen strong momentum when it comes to offering curated news to users in the U.S., Australia, and the U.K.

What Has Changed?

The landscape facing Apple’s content distribution arm is undergoing significant transformation.

Online streaming has taken over the music industry. The iTunes era of paid downloads is over as the idea of owning music is quickly becoming a thing of the past. Renting has become the preferred method of consuming music. The shifting landscape played a major role in Apple’s decision to buy Beats back in 2014.

According to the Recording Industry Association of America (RIAA), streaming now accounts for an astounding 75% of the U.S. music industry’s revenue. Digital downloads account for just 12%, slightly ahead of the 10% attributed to physical sales. In the U.S., approximately 50M people are paying a monthly subscription to consume as much music as they want. Globally, the total number of paid music subscriptions exceeds 200M. Apple Music has approximately 60M paying subscribers.

Turning to video, direct-to-consumer distribution has turned the industry on its head. Instead of the big cable bundle imploding, new, lower-cost video bundles such as Netflix and Hulu have exploded in popularity. These revised content bundles have the content people want to see, in addition to the distribution method that people want to use. More than 200M people pay a monthly subscription to consume video through these newer bundles. This number will continue to increase as notable names, including Disney, are about to enter the direct-to-consumer space.

One of the more interesting implications found with this new digital content landscape is how scale has been redefined. Success is no longer measured in the tens of millions of users like it was in the iTunes era. Instead, scale is measured in the hundreds of millions of users.

Spotify is the largest paid music streaming service while Netflix is the largest video streaming service. Amazon has seen the most success in the area of bundling access to content. Meanwhile, YouTube remains the behemoth in the ad-supported realm. Localized offerings in a number of emerging markets have also been able to capitalize on music and video streaming to develop compelling solutions, although few have seen success beyond their home territory.

The Strategy

Considering how Apple has approximately a billion users in its ecosystem, the company would appear to have enough customers to sustain a thriving content distribution arm. Such a strategy would involve Apple keeping its content distribution services exclusive to Apple hardware. However, upon closer examination, there is one complicating factor in such a strategy.

According to Tim Cook, there are 1.4 billion Apple devices in the wild. Given the number of Apple users, Cook’s disclosure means that at least 60% of Apple’s user base own just one Apple device. For hundreds of millions of people, the iPhone is likely that Apple device. This changes the dynamic facing Apple’s content distribution strategy.

Apple users are not monolithic when it comes to gadget buying. Instead of exclusively using Apple hardware, a majority of Apple users also own devices from other platforms such as Samsung Smart TVs and Amazon Echo speakers. Apple’s design-led culture and product development process ensure that there will always be product categories, such as TV sets and low-end stationary speakers, that Apple chooses not to play in or compete with.

With that in mind, Apple’s content strategy is as follows:

  1. Develop content distribution platforms.

  2. Give content distribution platforms the best chance of success by leveraging the user base and allowing certain content genres to be consumed on non-Apple hardware.

  3. Provide first-party hardware solutions targeting users who are looking for the best all-around Apple experience.

In summary, Apple’s user base provides the company optionality when it comes to distributing content. By not keeping some of its digital content distribution services exclusive to its own hardware, Apple reduces the risk of its users turning elsewhere for content.

Odds are good that a decent portion of Echo speaker owners also use iPhones. Given how the predominant use case found with stationary speakers is listening to music, these users may have been tempted to try Spotify or Amazon Music. By bringing Apple Music to Echo devices, Apple is able to leverage its existing customer relationships in order to improve Apple Music adoption. The same principle applies to letting Apple users send content played on an iPhone, iPad, or Mac to non-Apple speakers or television sets via AirPlay 2.

Another assumption underpinning Apple’s content strategy is that a portion of the Apple user base will gravitate towards premium content consumption experiences. Apple has the opportunity to sell these first-party solutions, such as Apple TV and HomePod, to users willing to pay for the best all-around Apple experience.

Misconceptions

There has been much confusion in the press as to Apple’s content distribution strategy.

  1. Apple is said to be deemphasizing hardware in order to grow services revenue.

  2. Apple’s decision to bring Apple Music to Echo has been compared to bringing iTunes to Zune music players.

  3. Apple is said to be no longer fully behind products like Apple TV and HomePod.

The preceding theories are off the mark.

A strategy characterized by Apple prioritizing services over hardware would revolve around Apple selling a $29 Apple TV dongle or a $29 HomePod mini speaker. Apple hardware’s function and value proposition would be altered to promote non-hardware Apple products. Neither device is likely to materialize as Apple isn’t prioritizing services over hardware. Instead, Apple is selling an Apple TV box priced at a 20% premium to a 32-inch TCL TV with Roku built-in. One HomePod goes for the same price as 12 Amazon Echo Dots or Google Home Minis.

When it comes to comparing Apple’s current strategy with that of iPod / iTunes, Apple didn’t have an ecosystem containing a billion users and 1.4 billion devices in the early-to-mid 2000s. Making iTunes available on other MP3 players, like Microsoft’s Zune, would have done little to improve iTunes or Apple’s broader ecosystem. The opposite is true today. Making certain content distribution platforms available on non-Apple hardware can help improve the service in question, which ends up adding value back to Apple hardware. In addition, Apple now has the ecosystem to not only target premium accessories to a segment of the user base, but also appeal to other users by bringing certain content distribution platforms to non-Apple hardware. A similar situation did not exist in the 2000s.

Speaking of premium accessories, Apple TV and HomePod are misunderstood products. The products are high-end accessories tasked with offering Apple users the best all-around experiences for consuming video content and listening to music, respectively. Making Apple Music or video available on other platforms does not change that dynamic. HomePod doesn’t have a weaker value proposition because Apple Music is available on a $29 Echo Dot. Apple TV is not kneecapped because AirPlay 2 support is available on a Sony TV set.

Motivation

Apple sees a massive opportunity in content distribution. There is a glaring weak point found in music and video streaming: brutal economics. Both Spotify and Netflix have business models in search of sustainability.

Spotify’s most likely path to sustainability boils down to amassing so many listeners that the balance of power begins to tilt towards Spotify and away from content providers. Either Spotify has to pay less for music, or the company will make a big move into original content.

Meanwhile, Netflix’s business model is based on a feedback loop that is consuming increasing amounts of cash. The move into original content is not proving to be a financial panacea either. Netflix clearly needs significant subscription price hikes over time, and the only way to guarantee those price hikes will stick is to continue ramping up content spending in order to sustain engagement.

Given Apple’s business model, the company doesn’t have to worry about such sustainability issues. Instead of releasing low-margin hardware that boils down to being nothing more than service conduits, Apple can use third-party hardware as Trojan horses for its own content distribution arm. This can be accomplished either by partnering with a company like Amazon to have Apple Music available on Echo devices or by expanding AirPlay 2 support to include a wide range of speakers and TV sets. AirPlay is a brilliant way of ensuring that an Apple product remains at the center of people’s lives.

Dedicated music and video streaming players will have to eventually prioritize profit and revenue. However, Apple has the luxury of not having profit be the motivating factor behind its content distribution arm. Instead, Apple is going for power. A few calculations prove this point. With Apple Music, 100M users paying an average of $7 per month would bring in $8B of revenue per year. Assuming 75% of that revenue goes back to music rights holders, Apple’s gross profit would be approximately $2B per year, or just 2% of Apple’s overall gross profit. Video streaming economics may end up being even less attractive from a cash flow perspective. Instead, Apple would be looking more at improving each service by grabbing scale and gaining influence and power in Hollywood.

Goals

Here are some of Apple’s specific goals for its content distribution arm:

Apple Music

  1. Grab enough users to position Apple Music as a legitimate alternative to Spotify and Amazon Music. From Apple’s perspective, scale in music distribution has gone from being a liability during the iTunes era to being the key to success with Apple Music. The decision to bring Apple Music to Echo speakers is a clear attempt to limit Amazon Music and Spotify adoption, especially among Apple users.

  2. Work more closely with the labels. By positioning Apple Music as an alternative to Spotify for the music labels, Apple is in a position to gain back the incredible amount of power it once had with the iTunes empire.

  3. Capitalize on the changing way music is consumed by investing in better A&R capabilities. Playlists are gaining power in the realm of talent discovery. Capitalizing on improved ways to find new talent stands to improve Apple Music playlists and Apple’s relationships with music rights holders.

Apple Video

  1. Convince third-party content creators to embrace the TV app. The key metric to watch in video streaming will be engagement. Accordingly, to have people spend an increasing amount of time in the TV app, Apple will look to establish a platform from which users can access various video bundles. This strategy resembles more of Amazon’s video playbook instead of Netflix’s. The idea underpinning this strategy is that video streaming won’t be a winner-take-all market, or even a winner-takes-most market.

  2. Use original content to elevate the TV app. Since one form of differentiation in video streaming is great storytelling, Apple has been focused on developing its own slate of original programming. One thing Apple can do to stand out from Amazon is make its initial slate of original programming free for TV app users. The idea behind such a move is to get people using the TV app, which will then increase the odds of people singing up and paying for third-party video bundles through the TV app.

Bundling. There is an opportunity for Apple to bundle various content genres into one monthly payment. Music and video make the most sense for a bundle although news and magazines are doable as well.

Experiences. Apple is one of the few companies to have a diverse content distribution arm in addition to more than a billion customers and devices. This gives the company a unique advantage when it comes to fostering customer relationships. In addition, Apple can offer premium experiences to those in the Apple ecosystem by having its content distribution arm work seamlessly with entirely new hardware form factors.

Challenges

Apple faces various challenges in its pursuit of establishing one of the more formidable content distribution arms in existence. The most difficult task is found with video streaming. There is about to be a brutal war in video streaming as a handful of companies with deep pockets begin to compete with Netflix. We haven’t yet seen genuine competition in the paid video streaming space. In a scenario where there are only one or two all-powerful streaming services, Apple will find itself at a bigger disadvantage. On the flip side, greater competition could prove to be a benefit to Apple if it means other streaming services will want to work with the company and its TV app.

With music, Apple appears to be going back to basics and fighting for every user whether it’s through bundling deals with mobile carriers or keeping existing users as users. It appears to be working. Apple is proving to be a formidable challenger to Spotify despite many having already declared Spotify to be untouchable years ago. In addition, by maintaining good relationships with a handful of labels, Apple has access to tens of millions of songs. The entire dynamic is easier for Apple to manage.

In terms of written content, Apple is in a good position when it comes to relying on human curation to surface content. However, there are questions regarding scalability and just how effective Apple can be in convincing publishers to get behind such efforts.

Big Picture

It is not too late for Apple to compete effectively in music and video streaming. Meanwhile, the turmoil found in distributing and consuming written content through traditional social media vehicles is still in the early innings. This will give Apple its best chance of finally cracking written content distribution.

Despite slowing unit sales, the iPhone continues to fuel growth in the user base. Meanwhile, wearables are boosting the number of Apple devices in the installed base. Not only are these positive developments when it comes to strengthening the Apple ecosystem, but they also increase the number of people in a position to rely on Apple for content.

With a pair of smart glasses not quite ready to be unveiled, now is the time for Apple to dedicate precious time and resources to strengthening its content distribution arm.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 139: Thinking About Apple in 2019

January is a great time to embrace the unknown rather than come up with predictions for the next 12 months. Episode 139 is dedicated to going over my fifth installment of Apple questions as the new year kicks off. We discuss 56 questions facing Apple in 2019. Topics include everything from big picture themes to detailed questions about Apple’s product strategy. Additional topics include Apple’s financial picture, management changes, emerging markets headwinds, R&D, and capital expenditures.

To listen to episode 139, go here. 

The complete Above Avalon podcast episode archive is available here. 

Apple Questions in 2019

Last year was a busy one for Apple, and all indications point to 2019 being another busy year. Earlier this month, Apple announced a rare negative revision to its quarterly revenue guidance due to an unforeseen sales drop in China. The news was quickly followed by announcements from the leading TV set manufacturers that Apple was extending AirPlay 2 support to smart TVs. In addition, Samsung announced Apple was bringing an iTunes app to Samsung Smart TVs. The moves are part of Apple’s long-standing ambition to strengthen its content distribution arm.

January is a great time to embrace the unknown rather than come up with Apple predictions for the next 12 months. Accordingly, this is my fifth installment of Apple questions as a new year kicks off.

Previous year’s questions are found here:

Here are my questions for Apple in 2019:

Big Picture

  • Major Themes. What will be the major themes for Apple in 2019? Apple unveiled an aggressive hardware strategy in 2018 with updates to every major product category. Apple Watch and iPad Pro saw especially strong hardware updates. A case can be made that Apple used 2018 to release powerful, new hardware that is now in a position to take advantage of new software and services that will be launched in 2019.

  • New Products. Will Apple unveil a completely new product? While Apple will likely release a number of updates to existing product categories, the best candidate for an entirely new product in 2019 is found with wearables (a pair of Apple-branded, over-the-ear headphones). New content distribution services are also likely in the pipeline.

  • Health Initiatives. What does Apple have in plan for health in 2019? With COO Jeff Williams leading Apple’s health initiative, management continues to position health as one of Apple’s more important long-term plays. According to Tim Cook, Apple’s “greatest contribution to mankind” will be about health. While the claim may come off as hyperbole, there aren’t many tools more important than those helping to improve one’s health. The major themes in Apple’s health strategy include adding health sensors to wearables, positioning the iPhone as a health data depository, investigating primary care, and hiring medical professionals to work on entirely new ideas and concepts.

iPhone

  • New Models. How many new iPhones will Apple unveil in 2019? Last year marked the first time that Apple unveiled three new flagship iPhones at the same time. This added much complexity to the iPhone business. Reports point to Apple will once again unveiling three new iPhones later this year.

  • New Features. What will be the top features for this year’s new iPhones? The AR era is coming to smartphones, albeit at a slower pace than many expected. A safe bet is to look for upgrades to the device’s brain (processor) and eyes (cameras). Face ID improvements are also likely in the pipeline given how Face ID works in both horizontal and vertical positions with iPad Pro.

  • Differentiation. Will Apple add greater differentiation between iPhone models? Apple positioned screen size as the only differentiator between the $999 5.8-inch iPhone XS and $1,099 6.5-inch XS Max. A few, relatively minor items differentiate the iPhone XS from the $749 6.1-inch iPhone XR. Greater differentiation could play a role in pushing iPhone demand in a particular direction, say to the largest, most powerful model.

  • Screen Size. Is Apple working on a new, smaller iPhone? While the smartphone market has likely moved beyond the 4-inch iPhone SE, there may still be enough demand for an all-screen device, with Face ID, that comes in a smaller foot print than the iPhone XS.

  • Naming. Will Apple stick with the iPhone X nomenclature for its newest iPhones? While the “Max” branding works for Apple’s largest iPhone to date, the effectiveness found with “XS” and “XR” are more up for debate. A good argument can be made for Apple to stay away from a Roman numeral naming scheme. However, as long as Apple maintains an annual iPhone update cadence, it makes sense for Apple to rely on naming to differentiate new iPhones from older models.

  • Gauging Demand. How will Apple approach iPhone demand forecasting in 2019? One item that outsiders did not fully contemplate was the level of difficulty found in estimating demand for three different flagship iPhones. Not only did Apple management have to estimate overall demand for iPhone, which is incredibly difficult to do on its own, but the sales mix also had to be estimated. While much has been written about waning iPhone demand in 2019, demand fundamentals outside of China look healthier than consensus assumes.

  • Pricing. Will Apple maintain its current iPhone pricing strategy? While it may be easy to think lower pricing will lead to stronger iPhone demand, there are additional factors to consider. The growing gray market for iPhone is satisfying demand at the low end. This gives Apple more freedom to be aggressive at the high end. At the same time, Apple has likely been increasing pricing to compensate for including additional technology in flagship iPhones.

  • iOS 13. What will be the tentpole features in iOS 13? With iOS 12 being focused on performance and stability, iOS 13 will likely contain cosmetic and UI changes. Changes to the iOS home screen would not come as a shock, especially given the way iPhone usage has been changing with increased importance given to digital assistances.

Apple Watch

  • New Models. How many new Apple Watches will Apple unveil in 2019? Last year, Apple discontinued the Watch Edition, a possible sign of Watch demand gravitating towards the lower-priced aluminum version.

  • Watch Bands. Will Apple continue to position Watch bands as the primary price differentiator between Watch models? Instead of using Watch case materials as a huge differentiator, Watch bands make more sense to appeal to the wide range of Watch wearers. Apple currently sells Watch bands ranging from a $49 Sport Band and Sport Loop to a $539 Hermès.

  • New Features. What will be the tentpole features in this year’s new Apple Watches and watchOS 6? After a rethinking of most of the Watch’s hardware last year, this year’s features will likely be focused more on internal changes, possibly related to expanded health monitoring.

  • Watch Faces. Should we expect Apple to rethink Watch faces? The app paradigm found on iPhone doesn’t extend to the wrist. Instead, Watch faces, including how complications are arranged on the face, play a big role in how we get information on our wrist.

  • Pricing. Will Apple continue to run with higher Watch pricing? Management raised Watch pricing by $70 to $100 moving from Series 3 to Series 4. At the same time, Apple increased entry-level Watch pricing by $30.

AirPods

  • Update. Will Apple unveil an updated pair of AirPods in 2019? Based on unit sales, AirPods is the second best-selling Apple product of all time, behind only iPad. The product has seen incredible sales momentum despite not being updated in two years. An update to the AirPods charging case to support wireless charging has long been rumored. In addition, rumors of an AirPods update involving additional capabilities have been floating around. Given how the product has gained iconic status almost overnight, major cosmetic changes aren’t likely.

iPad

  • iPad mini. Is Apple going to update the iPad mini? Peak iPad mini occurred years ago as larger smartphones permanently reduced the market for a small iPad. However, if management believes an updated iPad mini can generate a few million unit sales per year, such a product may receive the green light.

  • 9.7-inch iPad. What will happen to the low-end 9.7-inch iPad? Apple has been aggressive in cutting entry-level 9.7-inch iPad pricing. In addition, the 9.7-inch iPad has been the model used to target educational settings. Judging by iPhone ASP, the 9.7-inch iPad has been a success.

  • iOS 13. Will the iPad Pro be a beneficiary of iOS 13? Given strong iPad Pro hardware updates in 2018, positioning future iOS versions to take advantage of that more powerful hardware seems inevitable. The debate is found with how best Apple can add greater capability to iPad.

Mac

  • Mac Pro. What will be the new Mac Pro’s design language? Based on previous management commentary, a modular machine is in the works. However, there are still questions regarding what such a design actually entails.

  • Standalone Apple Display. How will Apple position its upcoming standalone display? With a new Mac mini announced last year, Apple is likely going to target a display to a relatively small niche of the Mac installed base.

  • macOS. How will Apple’s efforts to make it easier for iOS developers to bring their apps to macOS impact the Mac’s overall narrative?

  • ARM-based MacBook. Will there be additional clues of a Mac powered by Apple chips being in the pipeline? Much of the intrigue found with taking frameworks from UIKit and bringing them to MacOS involves implications the move will have on an entry-level Mac powered by Apple chips.

Home Accessories

  • Apple TV. Will Apple expand Apple TV partnerships to include additional cable providers? The Charter partnership (50M homes) is one of the more interesting news items for Apple TV from 2018.

  • HomePod. Is Apple planning a HomePod update in 2019? As Apple continues to roll out its stationary speaker to additional countries, a good argument can be made that Apple will skip a HomePod update this year.

  • Marketing. Will Apple market Apple TV and HomePod any differently given its focus on strengthening the content distribution arm? With AirPlay 2 extended to smart TVs and speakers, there are still important roles for Apple TV and HomePod to play in the Apple ecosystem. Each device ultimately provides the best Apple experiences available to those interested in smart TVs and stationary smart speakers.

Content Distribution

  • Apple Music. What is the next chapter for Apple Music? Judging by M&A activity, such as the Platoon acquisition, Apple has been busy developing some of Apple Music’s behind-the-scenes pieces. One such focus is working more closely with labels by having a more powerful A&R platform. Apple has also been increasingly focused on growing the number of paid users by betting on partnerships and making the service available on as many devices as possible.

  • Apple Video. When will Apple launch its original video content initiative? There has been a constant stream of reports pointing to Apple developing a portfolio of original TV shows, movies, documentaries, and children’s programming. A few months ago, reports pegged Apple as making its original batch of content free to Apple’s TV app. However, a paid video streaming service, accessible to users on non-Apple devices, seems likely.

  • Apple News Availability. Will Apple make Apple News available beyond Australia, the U.K., and the U.S.? The primary reason for the painstakingly-slow rollout is likely found with difficulty in scaling Apple News’ human curation.

  • Paid News. Will Apple launch a paid tier to Apple News? Apple’s Texture acquisition certainly raised the odds of Apple expanding the paid magazine subscription model to include news.

  • Apple’s Distribution Arm. How will Apple continue to expand its content distribution arm? As mentioned up above, Apple’s decision to extend AirPlay 2 support to smart TVs can play a beneficial role when it comes to Apple’s streaming video initiative. At the same time, bringing Apple Music to Echo devices and expanding AirPlay 2 to various stationary speakers bodes well for Apple Music. A stronger content distribution arm ends up improving Apple’s digital content offerings, which ultimately adds value to Apple hardware.

Services

  • Apple Maps. How fast will Apple roll out Apple Maps 2.0? Apple had a somewhat quiet launch of its enhanced mapping service in mid-2018 with a rollout limited to northern California.

  • iCloud. Will Apple adjust or modify its free and paid iCloud tiers? Apple currently offers 5GB of iCloud storage for free. There are three paid tiers: 50GB, 200GB, and 2TB for $0.99, $2.99, and $9.99 per month, respectively.

  • Apple Pay. What are Apple’s plans for improving Apple Pay adoption among U.S. retailers?

Siri

  • Watch Face. How will Apple push Siri forward as a visual digital assistant? The Siri Watch face continues to be one of Apple’s most intriguing features.

  • Shortcuts. How will Apple push Siri Shortcuts forward? The technology and design philosophy behind Shortcuts say a lot about how Apple thinks about a digital voice assistant. Shortcuts are likely only being used by a small fraction of the installed base.

Capital Management

  • Share Buyback. Will there be any change to Apple’s share buyback pace in 2019? Following the passage of U.S. tax reform, Apple began to utilize its foreign cash to fund share buyback. In FY2018, Apple spent $73B on share repurchases, although the buyback pace was closer to $80B per year by the end of the year.

  • Cash Dividends. How much will Apple increase its quarterly cash dividend? Apple has telegraphed that it will increase the cash dividend each year. Apple follows a stable dividend policy in which management targets a consistent dividend growth rate that does not follow the cynical nature of business. For more information on Apple’s dividend strategy, the Above Avalon Report, “Apple and Dividends: A Deep Dive into Apple’s Cash Dividend Strategy” is a 4,000-word deep dive into Apple’s dividend strategy (available here exclusively for Above Avalon members).

Financial

  • Quarterly Guidance. Will Apple alter its financial guidance strategy after issuing a rare negative revision to 1Q19 revenue guidance? In an environment with increased volatility based on economic conditions in emerging markets, Apple has the option of adjusting the way it provides guidance.

  • Financial Disclosure. Will management refine its financial disclosure strategy in 2019?

Management

  • Turnover. Will there be any turnover within Apple’s executive team? There was no turnover in 2018. Given Apple’s upcoming product pipeline, there is no obvious candidate within the SVP ranks when it comes to retirement or departures.

  • New Hires. Will Tim Cook and his inner circle expand the executive team? There are currently 12 members officially on Apple’s executive team. Last year, Apple expanded the team by one with John Giannandrea being promoted to SVP of Machine Learning and AI Strategy. For more information on Apple’s leadership structure, the Above Avalon Report, “Apple’s Leadership Structure Under Tim Cook and Jony Ive” is a 5,000-word deep dive into Apple’s leadership structure (available here exclusively for Above Avalon members).

Industrial Design Group

Emerging Markets

  • China. How will Apple respond to slowing economic growth in China? During the financial crisis of 2008 and 2009, Apple was a fraction of its current size, with the iPhone having just launched and the iPad still being developed.

  • U.S. / China Trade Tensions. Will Apple approach U.S. / China trade tensions differently in 2019? In what may not be a surprising development, Cook has remained characteristically upbeat about U.S. / China reaching some kind of deal or compromise.

  • Pricing. Will Apple continue to raise product pricing outside the U.S. to compensate for FX? The stronger dollar has been impacting demand for Apple products outside the U.S. as management has been raising prices.

  • India. What initiatives does Apple have in store to improve its positioning in India? Apple is being priced out of the market and there is no obvious near-term solution. In 2018, India was responsible for just $2B of Apple’s revenue, which officially positions India, when it comes to revenue, as a rounding error for Apple.

R&D / Future Products

  • Apple Glasses. Will there be any signs of Apple getting closer to a Glasses unveiling? Based on M&A trends, odds of Apple holding a Glasses unveiling go up in 2020 and 2021.

  • Project Titan. What will be the major developments related to Titan in 2019? Last year, there were a number of notable news items regarding Titan, a catch basin for Apple’s transpiration R&D initiatives. Apple is reportedly working with Volkswagen on self-driving vans for Apple employees. There were also reports of a few notable hires, including Doug Field, hinting of Apple’s ongoing interest in auto hardware and proceeding with its plans to have a much larger test fleet of autonomous cars.

  • AirPower. Will Apple launch AirPower in 2019? In an uncharacteristic move, Apple did not provide a comment pertaining to missing AirPower’s launch deadline, which was assumed to be sometime in the first half of 2018. The lack of announcement points more to ongoing development efforts versus a complete project cancellation.

Capital Expenditures / M&A

  • Manufacturing / Supply Chain. Will Apple unveil any significant changes to its manufacturing and supply chain apparatus? After a few years of little publicity, rising U.S. / China trade tensions have put Apple’s contract manufacturers and supply chain in the spotlight. Questions regarding Apple’s need to diversify out of China have been on the rise.

  • U.S. Expansion. Is Apple planning additional U.S. expansion in terms of additional facilities and real estate? Apple’s recent announcement about building a new campus near its current Austin, Texas campus led some to think Apple may still announce another campus in the U.S. In addition, Apple continues to own and lease manufacturing space in Silicon Valley.

  • M&A. Which companies will Apple buy in 2019? The question is difficult to answer as Apple tends to buy small, relatively unknown companies for technology and talent. Over the past few years, Apple has bought approximately ten companies annually.

  • Retail. Will Apple announce any major new retail initiatives? Apple has been focused on expanding Today at Apple sessions around the world, in addition to remodeling older stores. The number of new store openings has slowed with the focus centering high-profile locations in the world’s largest cities.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 138: iPhone Pessimism Gone Too Far

There will come a time when the iPhone business is in big trouble. However, that day has not arrived quite yet. Episode 138 is focused on how the sheer level of pessimism facing iPhone hit an inflection point in 2018. Things have simply become too negative. The discussion begins with the iPhone’s impact on Apple financials. We then dissect iPhone hysteria to see how pessimism has changed and centered on a new type of narrative. Additional topics include demand for $999+ iPhones, the gray market, genuine risks and concerns facing iPhone, how the iPhone business is changing, and why wearables have to be part of the iPhone discussion.

To listen to episode 138, go here. 

The complete Above Avalon podcast episode archive is available here. 

iPhone Hysteria

With 2018 quickly coming to a close, a look back at the past 12 months leads to an interesting observation regarding Apple. On one hand, the company had a remarkably strong year when it came to pushing the Apple ecosystem forward. Every major product category was updated, with especially strong updates to Apple Watch and iPad Pro. iOS 12 experienced a successful launch, followed by strong adoption.

However, Apple had an awful year when it came to perception and media coverage. The first half of the year was all about iPhone X demand coming in weaker-than-expected. The past two months have been focused almost entirely on weak demand for iPhone XR, XS, and XS Max.

We are in the midst of an iPhone hysteria phase that has reached an inflection point. Attention is being given to data points that are not good indicators of the underlying strength of the iPhone business. Meanwhile, little to no attention is being given to the items that are genuine risks and concerns facing iPhone. We are now starting to see this hysteria and pessimism spill into how the rest of Apple’s business is perceived.

The iPhone Matters

If there is one widely-held opinion about the iPhone, it would be that the product still matters to Apple. The iPhone is directly responsible for 60% of Apple’s revenue and 65% of Apple’s gross profit. However, those percentages ignore the role the iPhone plays in driving Services and wearables revenue.

According to my estimates, approximately 80% of Apple’s Services business is in some way tied to the iPhone. Revenue drivers such as the App Store, iCloud, licensing, and AppleCare are closely tied to either iPhone sales or the broader iPhone installed base. With wearables, Apple Watch still requires an iPhone to set up. Taking into account the preceding items, the iPhone is responsible for more like 75% of Apple revenue and 85% of gross profit.

Dissecting iPhone Pessimism

The difference in opinion when it comes to iPhone is found with how best to analyze the business. In addition, there is disagreement as to Apple’s iPhone pricing strategy and where the iPhone fits within Apple’s broader product strategy.

There was quite a bit of iPhone pessimism in 2018. Pundits, analysts, and reporters concentrated on a specific narrative. Instead of focusing on the usual risk factors given for iPhone, such as competition from Android manufacturers or lower profit margins, attention was given to the lack of unit sales growth and higher pricing. Apple’s decision to no longer disclose iPhone, iPad, and Mac unit sales only added fuel to the fire.

The following quotes were pulled from articles published since Apple reported 4Q18 earnings last month.

WSJ:

“[Apple’s 4Q18 earnings] offered affirmation for two main pillars of Apple’s current strategy: promoting its software-and-services business and raising prices on its flagship iPhones to compensate for slower growth in unit sales.”

Bloomberg:

“The iPhone maker is transitioning from a business driven by the number of devices it ships into one that leans on pricier products and more sales of software and services to drive revenue.”

Business Insider:

“As Apple also alluded to this year when it decided to no longer announce unit sales in its earnings reports, growth across its most popular product lines, like the iPhone, is beginning to slow down. Price hikes help compensate for less business.”

On the surface, the preceding quotes may sound rational. Raising iPhone prices to offset slowing unit sales may pass the smell test for casual observers. Arguing that Apple is promoting services to offset slowing hardware sales probably won’t raise many eyebrows.

However, each quote shows a fundamental misunderstanding of Apple’s business model and the rationale behind management’s decision to push higher iPhone prices.

The common thread found in each quote is that slowing iPhone sales have led Apple management to desperately seek out revenue growth elsewhere. As a result, Apple is said to be making questionable product and strategy decisions. Higher iPhone prices are positioned as nothing more than an attempt to squeeze more money from existing iPhone users. Some people are going so far as to draw a parallel between Apple’s current iPhone pricing strategy and the company’s disastrous Mac strategy from the 1990s, which played a role in nearly bankrupting the company.

Meanwhile, Apple services are positioned as nothing more than a lever Apple is pulling to squeeze extra money from iPhone users. How Apple uses services to add value to its hardware and become a stronger content distributor is given little to no attention.

Things are Overdone

The sheer level of pessimism facing iPhone has hit an inflection point. Things have simply become too negative. The infatuation with quarterly iPhone unit sales is leading many observers to reach incorrect assumptions about business fundamentals.

Quarterly unit sales data have been telling us less about the iPhone business for years. Here were annual iPhone sales over the past four years:

  • 2015: 231M units

  • 2016: 212M

  • 2017: 217M

  • 2018: 218M

Given how iPhone unit sales have gone nowhere for years, things may not look too great on the surface. However, dive deeper, and iPhone business fundamentals look completely different.

Despite a lack of iPhone unit sales growth since 2015, Apple has added nearly 300M people to the iPhone installed base during the same time period, including 80M in 2018 alone. Strong growth in the iPhone installed base has been completely hidden by flat unit sales trends. Given high loyalty and satisfaction within the installed base, these users will very likely upgrade to a new iPhone at some point in the future. In addition, these users are more likely to subscribe to and pay for various Apple services and even purchase additional Apple products including Apple Watch and AirPods.

Despite declining iPhone unit sales over the past four years, Apple has generated approximately $250B of gross profit from iPhone sales during the same time period. A portion of this profit is funding Apple’s R&D initiatives, including the products designed to eventually take value away from iPhone. Apple is also plowing some of this profit into M&A and capital expenditures such as new stores and data centers. The remaining cash is going to fund Apple’s capital return program.

iPhone pricing was one of the more controversial topics over the past year. While consensus continues to view Apple’s march to higher pricing as a mistake directly responsible for unit sales weakness, few are taking into account the impact of the iPhone gray market. The gray market is handling a growing amount of iPhone demand at the low end. This development is giving Apple the freedom to become more aggressive at the high end. In addition, iPhone trade-in values remain robust, reducing the actual cost of iPhone ownership. A very good argument can be made that the iPhone, even at $1,000, is underpriced when considering the role it plays in nearly a billion lives.

When it comes to gauging demand for higher-priced iPhones, Apple has sold approximately 75M iPhones priced at $999 or higher over the past year. The idea of Apple selling 75M computers starting at $1,000 each in just 12 months would have been unimaginable as recently as a year ago.

Genuine Risks and Concerns

The problem with iPhone hysteria is that due to infatuation with unit sales and higher pricing, genuine concerns and risks facing the iPhone are ignored. Attention is being placed on the wrong items.

There are three genuine concerns found with the iPhone business.

  1. Users switching from iPhone to Android.

  2. Users leaving the Apple ecosystem.

  3. Simpler, non-Apple devices handling use cases formerly given to iPhone.

None of those concerns can be monitored by simply looking at iPhone unit sales or ASP trends. Despite reporting flat to negative iPhone unit sales, Apple is still bringing new users into the installed base. This gives us confidence that the first concern is being kept in check. Strong loyalty and high satisfaction end up playing much larger roles in determining the health of the iPhone business than the quarterly fluctuation in iPhone unit sales.

Meanwhile, strong sales momentum found with Apple wearables and services, along with steady iPad and Mac sales, tell us that the Apple ecosystem continues to gain strength. This will have an impact when it comes to users deciding which smartphone to buy when it’s time to upgrade. Declining iPhone unit sales trends simply aren’t useful for determining if users are moving away from Apple.

However, the biggest risk facing iPhone is the inevitable competition from simpler, more personal devices. These devices will eventually be positioned as smartphone alternatives, handling some tasks formerly given to the iPhone.

While there are early signs of iPhone users being content with their current iPhone, as seen with the slowing upgrade rate, Apple appears to have expected such a development given the company’s focus on wearables. Apple Watch is rapidly becoming an iPhone alternative, handling a growing number of use cases formerly given to iPhone in addition to possessing entirely new use cases. This development means products like Apple Watch need to be part of the iPhone discussion. In reality, few people are even talking about Apple’s wearables platform.

The Road Ahead

It is certainly possible, maybe even likely at this point, that Apple will report a decline in iPhone unit sales in 2019. (Above Avalon members have access to my Apple earnings model, including my iPhone estimates.) Demand for flagship iPhones may indeed be coming in weaker than Apple management expected. (Forecasting iPhone demand is incredibly difficult.) However, such developments do not mean that the iPhone business is imploding or even in dire straits.

There are changes taking place in the iPhone business. The business is maturing. However, the largest change is something unable to be seen by just looking at unit sales or ASP. In recent years, the iPhone’s role within the Apple universe has been evolving.

In the beginning, the iPhone was the vessel for introducing Apple to nearly a billion users. While the iPod was Apple’s first genius mass-market item, the iPhone redefined the definition of mass-market for Apple. Years of mobile carrier expansion, which served as a natural tailwind for iPhone unit sales, ended back in 2015. The iPhone business is not going back to that high growth era.

While the iPhone remains the most effective tool for bringing new users into the Apple ecosystem, something that will continue even if unit sales decline in any given year, the iPhone is now becoming a stepping stone in getting Apple’s wearables platform off the ground. The Apple Watch still requires an iPhone to set up. It won’t be surprising if Apple’s upcoming smart glasses require an iPhone to set up. It’s not that the iPhone is the hub and wearable devices are the spokes of an Apple "wheel.” Instead, the iPhone is being used to promote more personal devices that will one day surpass the iPhone in terms of utility and value.

There will come a time when the iPhone business is in big trouble. One day, the value we place on wearable devices, such as AR glasses and smartwatches, will surpass the value we give to smartphones. However, that day has not arrived quite yet.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 137: A Cheaper Buyback

Given the magnitude of its buyback program, excess cash position, and free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil. Episode 137 is focused on how Apple can leverage its buyback program to take advantage of stock market dislocations. The discussion begins with my thoughts on the recent weakness in AAPL shares. We then look back at previous AAPL stock downturns to find a few similarities and takeaways. The discussion turns to Apple’s share buyback and the impact a change in stock price has on Apple’s buyback activity. Additional topics include Apple buyback scenarios, valuation, and the irrationality found in comparing a company’s stock price to its underlying health.

To listen to episode 137, go here. 

The complete Above Avalon podcast episode archive is available here. 

Leveraging Apple's Share Buyback

AAPL has had a rough two months. The shares are down nearly 20% from all-time highs, shedding $275 billion of market cap in eight weeks. Unprecedented does a good job of describing the fall’s magnitude and speed.

Apple’s dramatic stock price drop is now leading to a surge in pessimism towards the company. An increasing number of Apple management’s actions are being questioned while criticism is being thrown at various Apple products. In reality, most of this criticism is nothing more than a byproduct of a declining stock price. This has happened before, and a closer examination of previous stock price drops suggest Apple management will use the lower AAPL share price to its advantage by leveraging its share buyback program.

Why Is AAPL Down?

Surfing through Twitter over the long Thanksgiving weekend led to some Apple-related observations. There was no shortage of reasons being passed around for why the company’s stock price was in free fall:

  • Apparently, no one is buying the newest iPhones because they are too expensive.

  • Management must want to hide something really bad by no longer disclosing unit sales data.

  • Apple’s fortunes in China continue to sour.

In essence, there was a surge in fear, doubt, uncertainty, and overreaction.

People love to come up with reasons for why a particular stock or market index is up or down on any given day. Much of this is due to the human desire to add clarity to what is an inherently unknown process. Unfortunately, the only way to figure out why Apple’s stock price dropped more than 20% would be to poll every market participant as to why he or she sold or bought shares. Obviously, this isn’t feasible.

We know a few developments took place in recent weeks:

  1. Apple provided slightly weaker-than-expected 1Q19 revenue guidance and cautious commentary. Management cited uncertainty around supply for some of the new products, slowing demand in emerging markets (India, Turkey, Brazil, and Russia), and foreign currency headwinds.

  2. Apple announced it would no longer provide unit sales data, which came as a shock to Wall Street, who as a collective body relied on unit sales as a financial crutch. While consensus has been negative on the move, management’s decision makes sense given how unit sales have been telling us less about business fundamentals over time.

  3. Apple EPS estimates are being revised lower. While every analyst is guided by different motivations, many have cited Apple’s 1Q19 guidance and weaker demand for flagship iPhones as driving their lower estimates. Over the past month, FY2019 EPS estimates have been cut by 2% although many analysts have yet to update numbers. My FY2019 EPS estimate was cut by 7% due to a higher tax rate going forward and lower revenue attributed to a number of product categories. Above Avalon members have access to my current earnings model here.

  4. The broader stock market has been in disarray. The four largest companies saw nearly $800 billion of market cap wiped away in less than two months. On a combined basis, Apple and Amazon saw more than $500 billion in market cap evaporate.

While some market participants may have been swayed by one or more of the preceding developments, others may have been guided by unrelated matters. Accordingly, the most accurate explanation for why Apple shares lost $275 billion in market cap is because Apple shares were down. Selling pressure begets more selling pressure.

We’ve Heard This Song Before

Apple’s stock price has never been immune from rough patches. Prior to 2018, the most recent downturn occurred in 2015 and 2016. Over the course of a year, the stock traded down 30% from an adjusted $124 to $87. There was even a two-month span from November 2015 to January 2016 in which shares fell nearly 20%, reminiscent of AAPL’s recent downturn.

The 2015 and 2016 stock price decline was set within an environment of slowing iPhone sales. In November 2015, Apple provided weak 1Q16 revenue guidance. The implication was that iPhone unit sales growth would soon evaporate despite Apple having just reported 37% unit sales growth in FY2015. Wall Street quickly turned its attention to 2Q16 guidance to determine if iPhone sales weakness would be temporary or a longer-term trend.

Three months later, Apple’s 2Q16 guidance not only implied even weaker iPhone sales, but also an overall year-over-year decline in revenue. Many market observers became concerned about the long-term health of the iPhone business. Analysts fumbled over each other in a rush to cut estimates. AAPL shares ended up bottoming three months later and then went on to see two years of gains totaling 150%. Apple added $600 billion of market cap during this time period as its forward P/E multiple increased from less than 10x to 15x.

Apple went through an even steeper stock price decline in 2012 and 2013 when shares fell 37% from an adjusted $69 to $44. However, the circumstances around that decline were quite a bit different. Apple’s gross margins were evaporating due to the iPad mini launch. Apple’s revenue growth then began to slow as iPad sales imploded. There were also genuine fears in the marketplace that the iPhone would lose at the hands of Android smartphone manufacturers. In summary, the worry was that Apple’s long-term gross margin picture would deteriorate, resulting in less profits and cash flow.

Looking back at previous AAPL downturns, a few takeaways become apparent:

  1. Expectations reset. AAPL shares faced an earnings expectations reset. Either gross margin projections were dialed back or the company’s revenue growth projections were cut. Both changes had a negative impact on earnings expectations.

  2. Negative sentiment. The broader narrative around Apple had turned remarkably negative. In 2012 and 2013 it was about competition driving lower margins while in 2015 and 2016, it was based more on a slowing iPhone upgrade cycle.

  3. Bottoming process. AAPL shares put in a trough once market commenters and analysts stopped trying to call a bottom and instead assumed the stock would keep falling. In essence, once people stopping paying attention to AAPL and expectations had been reset, the shares were in a better position to begin outperforming.

It shouldn’t come as a surprise that the most recent AAPL stock price move is taking place during an earnings expectation reset. Analysts are cutting estimates due Apple’s 1Q19 revenue guidance and fears of slowing iPhone sales although it is debatable if overall iPhone demand is actually that much different from that of previous quarters. In my view, fears of an iPhone demand implosion are off-the-mark.

Similar to previous stock price downturns, AAPL stock weakness is also leading to a rise in criticism facing the company. Some people are convinced that Apple is getting greedy by charging higher prices for iPhones, iPads, and Apple Watches. Gross margin data, which Apple will break out between Services and hardware for the first time, will shine much light on the issue. My expectation is that margin data would show higher product prices are primarily to reflect the additional technology included in the latest flagships. Add in worries about slowing emerging markets growth and the U.S. / China trade tension boogeyman, and the result is a toxic brew of Apple revenue growth concerns.

The Buyback Wild Factor

Instead of going on the PR offense to calm fears about business and product demand, Apple management is in a prime position to stay quiet and take advantage of AAPL share weakness. Given the lower stock price, Apple can leverage its share buyback program to repurchase additional shares for the same amount of cash.

Apple began buying back shares at the end of 2012. Over the span of six years, Apple has spent $239 billion buying back 2.1 billion shares at an average price of $115 per share. As seen in Exhibit 1, Apple’s total number of shares outstanding has been on a steady decline and is now 25% below peak levels. This is another way of saying Apple has repurchased 25% of itself over the past six years.

Exhibit 1: Apple Shares Outstanding

Breaking out Apple’s buyback by quarter, it’s easy to see management’s decision to ramp its buyback pace following U.S. tax reform. Apple no longer has an excess cash dilemma with cash “stuck” in foreign subsidiaries.

Exhibit 2: Apple Share Buyback ($)

As Apple’s stock price increased, it took much more cash to repurchase the same number of shares. In essence, the share buyback became more expensive. For example, Apple repurchased 92 million shares via open market transactions last quarter to the tune of $19 billion. This total ended up being a little more than double the number of shares repurchased in 2Q16 (41M) via open market transactions, for which Apple spent just $4 billion on open market repurchases. Apple paid an average of $210 per share with its repurchase activity last quarter versus $98 in 2Q16.

Apple is currently spending $20B on buyback per quarter. As shown in Exhibit 3, assuming AAPL shares remain near $180, Apple will be able to buy back 330M additional shares over the next two years versus if Apple shares were trading at $230+. An additional 330M shares amounts to buying back seven percent of the company in just two years. This exercise assumes Apple spends the same $20B per quarter.

Exhibit 3: A Cheaper Apple Stock Buyback

If Apple shares trade down to $160, management would be in a position to buy back nine percent of the company in two years. This amounts to 30% more than what can be repurchased at $180, assuming the same $20B is spent on buyback every quarter.

For every $10 price drop in AAPL shares, management can repurchase an additional one percent of the company over two years, assuming Apple spends the same $20B per quarter on buyback. This produces an interesting dynamic as it is in Apple management’s best interest, from the perspective of the share buyback, for AAPL shares to decline in price.

Valuing Apple

Share buyback is not created equal. For some companies, buying back shares is a mistake and nothing more than a ploy to distract shareholders from mismanagement. For other companies, share buyback is a very attractive way to return excess cash to shareholders.

From Apple management’s perspective, as long as AAPL shares trade at an appropriate valuation, the buyback is an attractive way to return excess cash to shareholders. Apple is generating more than $50 billion of free cash flow per year, all of which can be returned to shareholders. Free cash flow is the cash left over after investing in the business and organic growth opportunities. Given Apple’s balance sheet, the company has about $125 billion of excess cash that can be returned to shareholders. Combining the excess cash with free cash flow generation, Apple is in a position to continue the current $20B of buyback per quarter for the foreseeable future.

The key ingredient required for Apple to properly leverage its share buyback is maintaining the buyback pace even in the face of market volatility and dislocation. This is where Apple management has a significant advantage over the market.

Tim Cook and Jony Ive are overseeing a design company tasked with coming up with tools for people. Given how Apple is a toolmaker, the market has had a very difficult time valuing the company’s future cash flows. Revenue and profits are the result of a successful product strategy built on intense collaboration and focus. Once a product ships, the Apple machine keeps churning, pushing out iteration after iteration in a process that is hard for competitors to match.

A consequence of this product strategy is that at any given moment, by just looking at the products Apple is currently selling, one is seeing only a snapshot of the Apple machine. Most of Apple’s long-term value is found with the process used to come up with future products. The market is not in a good position to value this process.

During periods of severe market dislocation, Apple’s market value can swing by hundreds of billions of dollars. For example, Apple’s enterprise value is currently $750 billion, down from $975 billion at the beginning of October. Apple management has an advantage when it comes to determining whether Apple shares are under or overvalued given the unannounced product pipeline. In addition, management is in a good position to judge how effective the Apple machine is in coming up with new ideas for future growth.

By capitalizing on the market’s worry, anxiety, and unease, Apple management can leverage the share buyback program to buy additional shares when Apple shares come under pressure. Given the magnitude of the buyback program and Apple’s free cash flow generation, no other public company is in as good of a position as Apple to benefit from stock market turmoil.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Above Avalon Podcast Episode 136: The Unit Sales Crutch

The most surprising part of Apple’s 4Q18 results wasn’t found with the numbers or even guidance. Instead, by announcing unit sales data would no longer be provided starting in 1Q19, management dropped a bomb on Wall Street. Episode 136 is focused on discussing Apple’s decision to move beyond unit sales. We go over how unit sales became a crutch for financial analysts. The discussion then turns to management’s new blueprint for how it wants Wall Street to judge Apple. Additional topics include Apple revenue and gross margin trends, Wall Street narratives, and Apple as a toolmaker.

To listen to episode 136, go here. 

The complete Above Avalon podcast episode archive is available here.