AAPL 4Q14 Preview. Solid Quarter; Solid Outlook

Revenue: $39.8 billion (AAPL guidance: $37-40 billion range/Consensus: $39.9 billion)

• I expect Apple’s revenue to increase 6% year-over-year.

Gross Margin: 38.0% (AAPL guidance: 37-38% range)

• I expect Apple’s margin to decrease sequentially to 38.0% from 39.4% last quarter, primarily reflecting iPhone 6 shipments. Management’s margin guidance is approximately 0-100 basis points better than the 36.9% margin reported in 4Q13.

EPS: $1.32 (Consensus: $1.31)

• I expect Apple to report 11% yoy EPS growth. I am including a 6 billion share count (implying around $5 billion of buyback - similar to last quarter).

Product Unit Sales and Commentary

Macs: 5.0 million (9% yoy growth)

• Apple has reported Mac unit sales growth over the past three quarters and I expect this trend to continue with back-to-school sales and iPad fatigue (students opting for MacBooks vs. an iPad). After a difficult 2013, the Mac line-up seems to be holding its own and the idea of “Peak Mac” (Apple will never sell as many Macs as it did in 1Q12) is starting to look a bit premature. 

iPad: 12.4 million (12% yoy decline. Consensus is closer to 13 million.)

• I expect Apple to report continued Pad unit sales declines. As I previously highlighted, the iPad is in a perilous position and I don’t see last week’s iPad refresh as having much impact on the category’s trajectory.

iPod: 1.7 million (50% yoy decline)

iPhone: 36.5 million (8% yoy growth. Consensus is closer to 37-38 million.)

• iPhone launch quarters can be a wild animal. With many moving parts, including channel dynamics, sales vs. shipped differences, and the degree of delayed purchase behavior in August and early September, the actual sales number shouldn’t be judged too harshly, but instead be included with next quarter’s results to get a better idea of overall iPhone sales trends. Similar to last year, many ordered an iPhone 6 online hours after launch only to have the phone ship in October, so it’s clear that a large number of iPhone 6 (especially the Plus) launch sales will be pushed into 1Q15. My 36.5 million iPhone unit estimate assumes 7 million units of iPhone 6 and 1 million units of iPhone 6 Plus units, along with 29 million legacy iPhone units selling at roughly a 20% slower weekly sales pace than seen in 3Q14 (2.9 million).

I expect Apple’s earnings to come in close to consensus demonstrating continued EPS growth from stronger net income and a lower share count resulting from share buyback. In terms of 1Q15 guidance, I am expecting approximately $56-60 billion of revenue (consensus is around $63 billion) and 38.0-39.0% margins (which would equate to EPS of approximately $2.25, or a 9% increase from 2014). It is important to remember that weaker iPad mini sales, as a result of stronger iPhone or iPad Air sales, will actually help Apple’s financials as the iPad mini’s lower ASP and margins weighed on Apple results. 

I exclude foreign exchange impact from results given its non-operating nature. Apple is hedged against significant foreign exchange moves, but nevertheless there may be some impact flowing for the results. 

The primary Apple story over the next few months will be the iPhone 6 rollout and corresponding implications on margins (iPhone 6 Plus running with a higher margin than iPhone 6, with both models positioned stronger than iPhone 5). 

What the Beats is Going on? Thoughts on Apple Acquiring Beats

Apple is reportedly interested in acquiring Beats for $3.2 billion. 

Here’s what I’m thinking:

1) Separate the rumored deal price from the transaction.  It’s a lot of money for Apple and in many ways focusing too much on the money will make it difficult to focus on the underlining acquisition target. 

2) What is Beats?  While everyone seems to have a different answer, to me Beats is a start-up music company that is after one thing: music mind share. Think of music and Beats comes to mind, right? No? Well give it a few more years and the growing popularity of those “obnoxiously large” headphones may change things.  Co-founded by intelligent musicians (and businessmen) who “get” music, Beats knows what it is doing and more importantly what it’s after.  Headphones, stereo equipment, music streaming service, and the list goes on. Beats wants to own music. 

3) Apple is Afraid. I suspect Apple feels threatened as its mind share for music is declining. The iPod died on behalf of its older sibling, the iPhone, and following its death, the grip Apple had on music has started to slip. Think of digital music, and Pandora or Spotify may come to mind. Beats could very well be on the same path of music stardom. This past holiday shopping season, Beats headphones were everywhere (and people were buying them in droves). Walk down the street and you could tell when someone was wearing Beats. For the first time, the white EarPod was being threatened. Who knows what things would look like in a few years. Apple would be looking to change that with this acquisition. I suspect Apple is interested in buying Beats to gain music mind share.  

4) Similar Cultures. Beats and Apple share similar cultures where passion is the ultimate driver. While there would undoubtedly be segments or pieces of Beats that Apple will shutter, Beats could very easily represent a decently sized (fewer than 200 people) division within the Apple system. Sure, this would mark a departure from the way things have been, but judging from Disney’s success, sometimes you have to let the past go and embrace the future. 

5) Let’s go back to price. I think Apple is overpaying for Beats. Recent valuations pegged the music streaming service at around $100 million with the entire company worth a reportedly $1 billion last year. While additional details may come out in the coming days I suspect Apple is overpaying to avoid others from coming in and competing over price. It’s a lot of money for any company, and regardless of how much cash Apple has in its bank account, it’s still a lot of money. To me this means Apple is serious about this bet.  

6) Lots of unanswered questions.

- Will Apple actually promote the Beats brand post acquisition? Such an idea is still hard to grasp, but maybe they would have to in order to maintain a gripe on the music mind share they are acquiring.  Is the reason Beats headphones are popular because they aren’t Apple branded?  If I had to bet I would say Apple walks a thin line introducing new Apple-branded music product, while also keeping the Beats brand around.  Such an idea is still hard to swallow though…

- Will there be a Beats brain drain (employees leave) and does it even matter?

- How will this impact future Apple products? I suspect we are going to see Apple attempt a very significant push at a true music streaming service where I can have any song, when I want it (NOT RADIO), wherever I want it…and it would be free for iOS users signed up for Apple’s new mobile payment system.  

- Will this open the floodgates to additional Apple acquisitions?  If the answer is yes, then we may be entering a new era in tech M&A as the biggest tech company in existence is officially an acquirer (I don’t think this is the case though). 

Acquiring Beats would be a new type of transaction for Apple. While there are similarities to previous acquisitions, there are just as many differences and for the first time we may be seeing Apple “doing what is right” - fighting for its survival. Apple wants to own music. 

14 hour update: After plenty of Twitter discussions and thought, the only additional comments I have include:

1) Jimmy Iovine may play a big role. If the $3.2 billion price tag holds up, it becomes obvious that Apple is paying for intangibles (branding, music industry relationships) and not current products or services.   In essence, Apple would be buying the music industry - something that Apple would not be able to do organically. Iovine has been critical of iTunes and it’s possible Apple wants him to revamp iTunes and bring the service into a new era (with the full support of the music industry).  

2) Would Apple replace the iTunes brand with Beats? Is it possible for a declining consumer electronics brand (iTunes) to turn around and regain its strength? Maybe the only way for Apple to regain its grip on music is to update its branding from iTunes to Beats (among other things).  In such a case, a $3 billion price tag doesn’t seem as crazy. 

Samsung’s Crisis of Design 2.0

Samsung unveiled its second attempt at wearables, along with its latest flagship phone, earlier this week at MWC. I was not impressed and I am growing more confident that Samsung not only has another “crisis of design”, but will also soon face major headaches from competing Android OEMs.  I think we are on the verge of a new phase in mobile phone hardware: Samsung competitors will finally be able to find a footing and begin to attack the giant.  Meanwhile, I suspect Apple has already placed Samsung in the same drawer as Microsoft; irrelevant. Tim Cook and company is marching to a completely different beat.

1) The Galaxy Fit looks awful. A curved AMOLED touch screen with a huge piece of plastic on its underside attached to a Modern Glam (plastic) watch strap.  I’m having a hard time seeing what is so “beautiful” or “pretty” about Samsung’s new fitness device, to quote a few easily amused tech bloggers. The company’s business model is not dependent on good design and few would suggest otherwise, but I struggle to understand how people can look at the Galaxy Fit and be even mildly impressed by such a horrendous product. One tech blog went so far as to say the Galaxy Fit is a “smartly designed fitness band”.  It’s a piece of curved glass set on top of a bunch of plastic with an extremely awkward user experience and interface.  Smartly designed?

 2) Samsung Galaxy S5.  Samsung’s flagship phone now comes in gold and has a fingerprint scanner. While the joke would typically stop there and many would say “copying a good artist is a pretty good strategy”, Samsung didn’t even copy well.  The gold color is the wrong shade of gold (Modern Glam gold?) and the fingerprint scanner doesn’t work.   I really don’t think I need to say much more about Samsung’s new flagship phone. I suspect Samsung will unveil the real Galaxy S5 this May?  Interestingly, Apple was very quiet this week versus last year’s PR push leading up to the Galaxy S4 launch.  I wonder why…

3) Samsung is a fish out of water without new Apple inspiration.  Samsung is struggling.  The easy smart phone growth achieved by simply shipping an alternative to iPhone (bigger screen) is drying up and with no clear path to additional revenue or earnings growth, the company amusingly jumped into wearables. The Galaxy Gear was downright disgusting, while the Galaxy Fit isn’t far behind. Samsung likes to throw around the “we give consumers what they want” meme and I am left wondering who was asking for something like the Galaxy Gear or Galaxy Fit?   Samsung is throwing a lot of poop against the wall and desperately hoping something sticks. While some may label such a business strategy as acceptable, I have my doubts that consumers are going to stand by a company that is willing to ship products that merely represent different batches of wall poop.

4) Samsung’s credibility is taking a hit. Last year I noticed a few of my acquaintances made the switch from iPhone to Samsung.  The usual reason given for such a move involved wanting a change or simply being bored by iPhone.  Interestingly, on follow-up discussions in recent weeks, these switchers are now regretting their move away from iPhone due to Samsung’s plastic and subpar build quality.  More than a few people on Twitter tell me the same thing about friends or family being disappointed with their Samsung phones. The amount of negative feedback caught me by surprise.  Interestingly, only a few hours after introducing the Galaxy S5, Samsung rumor blogs were talking about a new Samsung phone coming out in May that actually wasn’t made of cheap plastic. Have we reached a point where even Samsung realizes the “not an iPhone”  plastic gold Urban Glam option probably isn’t going to do much in terms of winning converts from competing platforms?  Consumers are starting to notice what Samsung is actually shipping and the grumblings are getting louder.

5) Samsung competitors are foaming at the mouth.  The long-standing joke is that the best Android phones available in the market (never a phone made by Samsung) don’t sell well because no one cares about anything other than Apple and Samsung.  I think that may change. After this week, I am becoming confident that consumers are going to stop being passive and begin seeking out alternatives to Samsung in the form of HTC, Sony, Nokia, Lenovo, or countless of other Asian OEMs, all of which are making significant progress in shipping attractive phones at attractive prices (I would include Nexus, but Tony needs to help Google rework distribution). In terms of hardware specs, most of these phones are already at parity and with several Samsung competitors now focusing on hardware design; consumers will simply have fewer reasons to instantly turn to Samsung. Whereas in the past, Samsung might have been the default choice for Android, I suspect that lead will start to slip. In addition, Samsung recently announced that they will reduce their advertising and marketing budget as mobile phone profits decline (not exactly the best timing for such a move). While smaller mobile hardware companies individually lack the ability to compete against Samsung, and just the thought of going up against Samsung can scare many executives into a cold chill, I think each competitor can take a bite out of the giant which can collectively create serious damage. To succeed against Samsung: 1) Focus on branding 2) Save or raise as much capital as you can and throw it into marketing 3) Narrow your distribution focus 4) Figure out why someone should buy your phone. The challenge is significant and Samsung will not stand still, but 2014 is the year. Wait any longer and limited resources may not allow another fight in the future.  

Bonus - iWatch Implications from Galaxy Fit. The iWatch will not look like the Galaxy Fit and the iWatch will certainly not operate like the Galaxy Fit. The best way to think about this would be envisioning a small table in Jony’s design lab with various iWatch prototypes. The Galaxy Fit version (simple rectangular curved piece of glass positioned on a plastic watch strap) would be instantly cast off as a no, if it even would be positioned as a possible prototype in the first place.  I highly doubt the iWatch will include a strap/buckle or a thick piece of bulging glass. The device won’t depend on an awkward user experience where you have to rotate your head and arm just to look at the device. In summary: Look at the Galaxy Fit and you now know what the iWatch won’t be.

Marketing a Smaller iPad

Marketing is an art, not a science. We were fortunate to see this art first-hand on January 27, 2010 as Apple unveiled the iPad. Technological and engineering marvels aside, Apple faced the daunting task of marketing a disruptive product that had to grow into its role of replacing the modern-day PC. Jump ahead 33 months and it appears Apple has had some initial success, selling 84 million iPads. Within weeks, the world will see Apple’s second test marketing iPad, but this time it will be a new form factor, a smaller iPad.
 
Marketing; Portraying the Product
 
The most important aspect of marketing is the product; the look, feel, and sound (fortunately iPad’s smell and taste aren’t a major factor in this discussion). Apple eloquently marketed the iPad as a sexy device that could do a few things extremely well, all the while feeling great in your hand. The consumer was left focusing on iPad’s strengths, and not its short-comings, or mysteries, such as if its weight becomes an issue after extended use. In subsequent years, Apple began the task of marketing the iPad as a device capable of content creation, in an effort to begin cementing its path to replacing the modern-day PC. When unveiling a smaller iPad (7.85-inch screen) in October, Apple will be given 60 minutes to tell a story; why a smaller iPad should exist.
 
Apple may take two paths:
 
1)      Positioning a smaller iPad as a replacement to the current 9.7-inch iPad. Apple’s presentation will include all of the features a smaller iPad could do well, such as web surfing, content consumption and creation, but in a smaller form factor and at a lower price point. Consumers will have to decide between a small or large iPad.
2)      Positioning a smaller iPad as a companion to the current 9.7-inch iPad. Apple’s story will include the few things a smaller iPad could do extremely well, such as content consumption, in a more convenient form factor for extended passive use, such as reading or watching movies. Consumers will understand the differences between a small and large iPad and come away from the event wanting both, not one or the other.
 
Apple will most likely choose the second path, positioning the smaller iPad as a companion device to the current iPad line-up, and in doing so will not only sell a lot of small iPads, but keep the large 9.7-inch iPad as the powerhouse in the tablet market.
 
The Tablet Story
 
On January 27, 2010, Apple could have unveiled an iPad with a 7-inch screen, or 8 inches, or maybe even 12 inches, but settled on 9.7 inches. Apple knew there would be plenty of television commercials marketing iPad, but the biggest marketing ploy would be the product itself, a device capable of eventually replacing the modern-day PC as the primary form of computing. Apple wanted (or needed) consumers to begin thinking of an iPad as a possible laptop replacement from the start. The “iPad as your new laptop” thought didn’t need to be completely formed on Day 1, or even by Year 3, but Apple needed to plant the seed on Day 1 and a 9.7-inch device was an easier sell than a smaller 7-inch device.
 
Fast forward a few years, and the tablet market is now flooded with smaller 7-inch tablets. Besides not being given an adequate reason for their existence, consumers are confused by these 7-inch tablets labeled as a “full tablet” despite failing in comparison to a laptop’s immense feature list.  
 
So why should Apple introduce a smaller 7.85-inch tablet now? It is time because the 9.7-inch iPad is a success.
 
A Smaller iPad; Companion to the Current iPad
 
The iPad is now well established as a successful tablet and cornerstone to Apple’s product line-up. While many have fallen in love with iPad, the device does have some minor drawbacks, namely form factor for extended use and price. The device tends to feel heavy in hand after extended use, such as reading or movie watching, while the $499 entry price is still unattainable for a large swath of the population, including education and business, leaving wiggle room for competitors to try something at the bottom-end of the price ladder. Are these two factors (heavy form factor and price) enough for Apple to introduce a smaller iPad?
 
In October, Apple will address the space between an iPhone and a 9.7-inch iPad and most likely market a 7.85-inch iPad as a companion to the 9.7-inch iPad. Books, movies, TV shows, podcasts, and games will be shown as more enjoyable given a smaller iPad form factor. Apple will need to walk a delicate line though positioning a smaller iPad as the best way to consume content, as many will continue to enjoy content on their large iPads (as well as on their iPhones).

More importantly, Apple needs to portray a small iPad not as a 9.7-inch iPad replacement, but as an iPad companion. If consumers begin to think of a smaller 7 to 8 inch device-great at content consumption but not so great at other aspects-as an iPad replacement, the effort of positioning iPad as the disruptive force will be in jeopardy since wide-spread adoption would come under pressure and laptops would continue to appear superior to the average 7-inch tablet.
 
For those who would buy a smaller iPad due to price, proper marketing will position the smaller iPad as a gateway drug to a larger iPad. If a consumer enjoys content on a small iPad, the thought of not only consuming the same content, but also creating content on a larger iPad will only be enhanced.
 
Other Musings
 
Price. If given three $5 casino chips and told to guess the small iPad’s price, the $199, $249, and $299 squares would be occupied with a chip. If given one $15 casino chip, the $249 price point would be occupied. Not only is the product itself a form of marketing, but a device’s price can say a lot. Priced too low, a small iPad may have a hard time losing the “just a content consumption” tagline, while priced too high and the small iPad becomes an iPad competitor as consumers assume the two devices must be similar in compatibility. A $249 price point would be the best of both worlds; a device $150 less expensive than the entry-level iPad 2, but still more expensive than other 7-inch tablets.
 
Future iPads. One could replace any mention of “small iPad” in this piece with “larger iPad” and the same overall thesis would apply. A larger iPad (greater than 9.7 inches) for content creators (movie makers, artists, designers, etc.) would certainly make an interesting proposition.
 
iPod touch. The updated 5th generation iPod touch (and all of its amazing features) is sold for just $299, which could very well be more expensive than a 7.8-inch iPad. Apple is positioning the iPod touch as that powerful guard, awake all night, preventing any Trojan horse from causing havoc.
 
Product Quality. It says a lot that throughout this entire discussion, the idea of Apple selling a small iPad with superior quality and craftsmanship is simply assumed to occur.  Anything else would be a disappointment. High expectations can be both a blessing and curse.

Microsoft’s Interesting Week

 
With WWDC winding down in San Francisco and chatter concerning next week’s Google I/O picking up, few would have expected this week to be dominated by Microsoft news. Late Monday evening, after the East Coast had largely gone to sleep, at an event that was oddly so secretive that the press was not made aware of the venue until a few hours prior to start time, Microsoft announced its revamped Surface tablet and I felt somewhat duped. A team of executives got on stage in Los Angeles and put on a scripted show, only I was led to think it was reality. Microsoft faces an uphill battle and while consumers are now talking about the company and Surface, I have little confidence that Microsoft’s ultimate destiny was altered this week.
 
 
Surface Event Lacked Direction and Message, but Microsoft Accomplished Goal
 
At Apple’s iPad unveiling in 2010, Steve carefully crafted his sales pitch to show why the iPad should exist and be worthy of consumer’s precious dollars (pundits still questioned iPad’s purpose for the weeks, months, and years following the event). On Monday, Microsoft lacked a similar sales pitch, instead relying on teleprompters, and hobbling through failed demos, in an attempt to show that the lights were still on in Redmond. Microsoft’s event actually reminded me of HP’s TouchPad event in early 2011, where HP showed a general lack of direction and enthusiasm for the device. Reading off of teleprompters can really kill the passion. It has been four days since the Surface was unveiled, and with more questions than answers, I think Microsoft’s primary goal was accomplished; being mentioned in tablet (and phone) discussions between WWDC and Google I/O.
 
The Big Question
 
The Surface discussion can be reduced to one question:  Is the Surface a proof of concept device meant to spur OEMs into action or is the Surface a sign that Microsoft is entering the tablet hardware space in response to changing market dynamics? It is easier for one to assume that Microsoft intends for OEMs to remain in the game, announcing the Surface as a means to drum up support and give OEMs confidence that there is interest for devices running Windows. However, if MSFT is looking to change strategies and develop the entire Surface device alone, I will give Steve Ballmer a pat on the back as that is one daunting move given the sheer difficulty in manufacturing desirable hardware.
 
Prototyping
 
The lack of available Surface devices for journalists to play with (unattended) and horrid onstage demos leads to me think that the Surface is very far from a shippable state. While working prototypes are common place in Silicon Valley, it is incorrect to assume mass production is only a few short months away as the task of figuring out how to turn a prototype into a mass-produced product at a particular price point (not discussed by Microsoft) by a specific deadline (also not discussed by Microsoft) may end up being just as difficult as building the original prototype.
 
Hardware Delicacy
 
Tablet hardware is tricky.  From my initial iPad 2 review:   “After a few minutes of using iPad 2, I found myself forgetting that I was using iPad 2. My entire thought process was given to the app that I was using.  While iPad looks and feels amazing, the iPad dissolves away when in use, exactly how Apple planned it. Remove the intermediary and let users interact directly with innovation.  I don’t care what is or isn’t inside iPad 2, as long as iPad 2 has the ability to run the highest quality apps possible.”  After 15 months, I am unsure if the iPad’s software or hardware is more intriguing. Apple, a company built on the seamless integration of software and hardware, spent years mastering the art of making iPads. Does Microsoft, a company built on software, have the capabilities of designing and producing an intriguing tablet offering in a few months? While some point to Xbox and Zune as examples of Microsoft’s hardware success, the world is now a different place with substantially higher barriers of entry for hardware makers. HP, a company built on hardware, was forced to manufacture the TouchPad with parts deemed unworthy of the iPad since Apple had procured all available resources through long-term contracts.  Meanwhile, PC OEMs are seeing their sales decline as their designs are falling flat with changing consumer preferences.  I enjoy iPad because the hardware melts away.  Is Microsoft capable of beating Windows OEMs and produce tablet hardware that is truly revolutionary, but still let app interaction resonate? Daunting would be an understatement.
 
Expectations
 
Microsoft faces an uphill battle with tablets, regardless if they intend OEMs to help out or they go it alone. The most likely scenario is that Microsoft will try to have one’s cake and eat it too; bring the Surface to market while keeping OEMs in the loop about broadening the Windows mobile platform. Microsoft will likely face an increasing number of manufacturing difficulties leading to certain things being left out, or altered, in order to stay near competitive prices.  I would look at HP TouchPad and RIMM PlayBook hardware and price points as goals that Microsoft will try to meet, let alone beat (the TouchPad and PlayBook failed in the marketplace). I expect subpar Surface hardware, wrong price points, and limited distribution to become major headwinds for Microsoft. In order to beat iPad 2’s $399 price point, the Surface needs to come in at least $100 lower given Apple’s superior brand – a price I don’t think Microsoft will be able to meet without reporting huge losses. Instead, Microsoft will talk up the increased functionality of Surface (to validate a higher price) and the message will go in one ear and out the other as consumers realize laptops already fill that spot of the market. The Surface’s software, which many have continued to give praise for, will probably be up to Microsoft’s standards, however hardware limitations may spoil the treat, and as the iPad demonstrates (along with every other tablet), hardware cannot be ignored, regardless of how great the software is. Microsoft faces an uphill battle. Arriving at the baseball game in the 4th inning can make winning the game somewhat of a challenge.