Thoughts on iPad

The iPad is at a crossroads. Introduced by Steve Jobs four years ago, the iPad has gone on to become a phenomenal success (225 million units sold bringing in $112 billion of revenue and approximately $30 billion of profit), but I suspect Apple management will alter the iPad line-up in response to wearable devices and larger-screen phones and in the process iPad’s ultimate trajectory will be more modest and niche than many expect.

 Slowing iPad Sales Momentum 

iPad sales growth has slowed dramatically from 65% year-over-year unit growth in 2013 to a 10% year-over-year unit decline last quarter. Such a contrast is startling given how promising iPad seemed in early 2013. When I first discussed my iPad concerns in 2013 (Apple had just reported a much weaker-than-expected quarter for iPad shipments), I received very strong pushback as many said iPad was fine and just suffering from varying release cycles. I knew that was not the reason for the sales weakness, but it was still hard to see why iPad sales and the overall tablet market were slowing so dramatically. Some pointed to longer upgrade cycles, which has some truth to it, but I wasn’t convinced that variable had enough explanatory power to turn 50%+ growth into sale declines within a few months as iPad was not near saturation (there are plenty of people who don’t own an iPad).  I suspect there has been a much broader ongoing trend for why iPad has been struggling to gain new users; larger-screen phones have been cannibalizing iPad sales and iPhone 6 is going to make things worse for iPad.

 A Different World

For a new product category, iPad’s sales pitch was fairly straightforward; a device that sat between your phone and PC; able to do a few tasks better than both your phone and computer. Web surfing and email were highlighted as prime examples, as well as reading ebooks. Initial sales were very strong and the iPad was off to the races. Fast-forward four years, and iPad faces a much different consumer tech landscape. 

2010 Environment

• iPhone (along with most phones) have small displays.
• MacBooks are thick, heavy, and non-retina.
• People are completely mesmerized by new apps.

2014 Environment

• Phones are much bigger (iPhone now comes in 4.7-inch and 5.5-inch display options).
• MacBooks are thin, light, and retina.
• The paid app (and even free app) ecosystem is tired and somewhat stale.

Apple now has a much harder sales pitch to make for iPad. Why buy an iPad when you could have an iPhone with a screen that doesn’t seem that much smaller than an iPad mini? Why buy an iPad when you can have a more powerful and just as easily transportable Macbook Air? The space between a phone and PC is smaller now than in 2010 primarily as the phone has become more powerful and larger. Tablets are getting squeezed.

Slowing iPad App Innovation

I can’t remember the last time I downloaded an iPad app. Curious to see how others were doing, I posed a question on Twitter, “How many iPad apps have you downloaded in the past month?” On any given question I get a decent number of responses, but this time I received a very muted reaction with a few “0” responses. Why am I not downloading iPad apps? I consider iPad app innovation to have slowed with iPhone continuing to take a disproportionately high amount of attention in the app ecosystem.  Most of my daily mobile usage now occurs on an iPhone.

Messaging: iPhone (iMessage, Facebook, Twitter)

Email: iPhone

Web surfing: iPhone (Tweetbot)

Games: Not many games, but the latest fad is usually on iPhone

Photos: iPhone

Weather: iPhone

Traffic: iPhone

Maps: iPhone

Video podcasts: iPad (for the larger screen)

I suspect one reason for suboptimal iPad app innovation has been that app developers have been too preoccupied with iPhone’s explosive usage to focus resources on iPad and if everyone is focused on iPhone, can you blame them? Of course, I’m not suggesting there is not intriguing software for iPad. Anyone in a specialized field (medicine, sports, film, music, etc.) will be able to point out apps that harness iPad’s potential, but that is niche – and even Apple’s latest iPad commercials reiterate the niche factor. However, for the average person interested in basic tasks like web surfing, email, and photos, phones are very capable devices and are consequently winning a larger share of app innovation. As I wrote after a few days with my iPad back in 2011, the device is all about apps. If I have no interest in downloading or even using iPad apps, I view that as an ominous sign for its future. My interest is moving elsewhere, namely to iPhone, and soon Apple Watch.

iPad’s Primary Use Cases

I don’t want to paint such a grim picture for iPad. Apple is still selling millions of iPads (likely around 12 million during the past three months down from the 14 million last year). How could this be if the space between phones and PCs has been shrinking over the years and there isn’t the same quality of app innovation?

1)      Laptop/Desktop Replacement. Many people are using iPads as their main computer, replacing old laptops or desktops. Interestingly, more people are telling me their parents and grandparents love iPad as it’s the first computer that is truly easy for them to use. In many ways, this is exactly what some saw when the iPad was unveiled – a laptop/desktop replacement. Looking ahead, however, I don’t see there being much to prevent phones from doing a better job at replacing laptops or desktops. Why buy an iPhone and iPad, when you can just buy a larger iPhone?

2)      Education. While there have been high profile cases where large school districts, and even countries, considered implementing iPad programs, success seems to be underwhelming due to logistical concerns as well as budgetary limitations. I also think a lesser discussed reason is the proliferation of larger smartphones leading many students to use their phones much more in 2014 for tasks that the iPad was initially positioned to do. There’s clearly still a market for iPad in education, but I suspect it’s much smaller and more niche than many imagined a few years ago.

3)      Enterprise. iPad in the workplace remains the unknown factor. I suspect iPad sales to the enterprise may represent a growing share of iPad sales. In this context, Apple’s recently announced partnership with IBM takes on a new light - one of offense to find use cases for iPad.

iPad Has a Future; It Just Needs Help

The iPad is a great device that needs some changes to reflect the current landscape.  

1)      Apple should stop selling the iPad mini. As a low-margin response to cheap Android tablets and given the lack of a large iPhone, the iPad mini served its purpose keeping Apple in the tablet game, but today there really aren’t many reasons to keep the iPad mini around.  Consensus seems to think Apple will add Touch ID to iPad mini later this week along with some other updates, but beyond that, unless sales trends improve (I wouldn’t expect them to), I don’t see the iPad mini staying in the line-up for too long and I think that is only for the better.  In order to keep product offerings in the same price range as iPad mini, Apple could work on lowering iPad Air pricing to approach that $299 level over time. 

2)      Introduce an iPad Pro. An iPad with a 12.9-inch retina display, new software that moves beyond just rows of app icons, and capable accessories including keyboard stands and styli. Once again, Apple’s IBM partnership comes into play.  A large iPad Pro with customized software and accessories would certainly be more interesting to enterprise users than an iPad mini with basic office utilities.

Even with a product line-up consisting of an iPad Air and iPad Pro, I would still suspect phones to eventually cannibalize the larger iPad Pro, but Apple would at least be able to get another couple of years of respectable sales out of iPad. When you add Apple Watch to the equation, the scenario where people keep their large iPhones stashed away in a backpack, purse, or satchel, while their Apple Watch handles communication and notification functions doesn’t seem too much of a stretch. Maybe now you can see why I think so highly about Apple Watch’s potential while being more pessimistic towards iPad.

iPad Was the Right Product At The Right Time

I’m convinced if Apple had to do things over, they wouldn’t change a thing.  The iPad was the right device at the right time. The past seven years in mobile has essentially boiled down to people discovering which sizes of glass they prefer in their pocket.  In 2010, it seemed like consumers would want a phone, tablet, and laptop/desktop, with the tablet eventually replacing the laptop/desktop, although many in Asia and emerging markets disagreed. As phones become larger and more powerful and wearables become more popular, I suspect consumers will be content with just a phone and wearable device. I still see a future for iPad, but it looks more like Mac instead of an all-encompassing mobile device next to iPhone and maybe that is what Apple had in mind all along. 

AAPL 1Q13 Preview; Near-Term Volatility Continuing

Revenue: $53.1 billion (AAPL guidance: $52.0 billion/Consensus: $54.5 billion) 

• I expect Apple’s revenue to increase 23% year-over-year after adjusting for the 14 weeks in 1Q12.

GM: 37.9% (AAPL guidance: 36.0%/Consensus: 38.4%)

• Apple’s margin is expected to decline sequentially from 4Q12 primarily due to the wide range of updated products. Margin remains a key near-term unknown for AAPL. Management’s 36% margin guidance is 870 basis points less than the 44.7% margin reported in 1Q12, making EPS growth difficult to achieve. I still include expanding margins throughout 2013.  Further weakness, or a shallower rebound, may result in an additional EPS growth headwind.

EPS: $12.75 (AAPL guidance: $11.75/Consensus: $13.33) 

• I expect Apple to report a 1% yoy EPS decline, when adjusting for 1Q12. While my $12.75 estimate is less than the Street’s $13.33 average, I attribute much of the variance to my lower gross margin expectation.

Product Unit Sales and Commentary

Macs: 5.2 million (flat yoy growth)

• Mac growth continues to slow as tablets and smartphones satisfy many consumers’ computing needs. I expect 10% growth in portables driven by holiday shopping to be mostly offset by nearly a 30% decline in desktop sales due to the new iMac release schedule.

iPad: 22.4 million (56% yoy growth - when adjusted for 1Q12)

• I expect Apple to report record iPad sales for 1Q13. My iPad estimate assumes approximately 8-10 million iPad minis and 12-13 million iPad 2 and fourth generation units. The iPad mini went on sale November 2 with an aggressive rollout, despite significant pent-up demand and limited supply. Apple was able to sell three million iPads in the three days following the iPad mini and fourth generation iPad launch. My estimate assumes approximately 25-35% cannibalization of the larger iPad models (1 out of 3 consumers willing to buy a larger iPad purchased an iPad mini instead). Going forward, I expect iPad mini sales to approach, if not exceed, those of the larger iPad models. 

iPod: 12.0 million (16% yoy decline)

iPhone: 47.8 million (39% yoy growth)

• Apple made significant progress in reaching supply/demand balance for iPhone 5 in the U.S. and other launch countries. My quarterly estimate is largely based on AT&T’s recent comments on October and November smartphone sales (and additional extrapolation). Historical averages for AT&T’s share of global iPhones (and assuming a slighter higher mix of international sales) would imply 40-50 million iPhone sales, which I would consider the high probability estimate range.  I then assume channel fill of at least 1 million units, which positions my estimate in the narrower 46-48 million estimate range. 

Apple has missed Wall Street consensus EPS for the past two quarters, and unless estimates come down in the following weeks, a third miss isn’t out of the question. While it is hard to point to any one factor as driving a fundamental change in Apple’s operating performance, Apple’s prior two quarters have contained a few concerning metrics, including contracting margins and declining iPad and iPhone growth.  Did the weak global economy finally catch up to Apple? Were product release cycles continuing to wreck havoc with consumer demand? 

The bear argument would label Apple’s two-year stretch from 2010-2011 as an outlier, when two new products (iPhone and iPad) produced a perfect storm for EPS explosion.  Going forward, bears would argue margins will decline further, effectively limiting EPS growth. Future products would then lack the size to move the EPS needle. 

The bull argument would focus on iPhone and iPad as product leaders in its respective industries, while a temporary margin drop is indicative of product updates and not a fundamental change in the operating landscape. Apple’s future product plans would also occupy a spot in the conversation. 

Will 1Q13 represent an AAPL inflection point? I don’t think one quarter is capable of shedding enough light to figure out where Apple stands in its long, storied history. With iPhone now entering its 6th year (iPod recently celebrated its 11th birthday), the days of 100% revenue growth may be over for the product line, but should that statement even be considered controversial? There is also evidence suggesting Apple may be looking to smooth out demand cycles by updating products more frequently, a move that may bring long-term benefits, but at short-term costs.    

While much of the recent AAPL discussion has been focused on slowing growth and falling margins, it is easy to overlook fundamentals that would be considered very strong for any Apple competitor:

• A smartphone pulling in $80 billion of revenue annually and growing at least 30%.
• A tablet pulling in $30 billion of revenue annually and growing at least 45%.

A few AAPL loyalists have recently declared another “bad” Apple quarter (where bad is judged merely by EPS) will signal a new Apple, an Apple not deserving of their attention and instead lumped in with the rest of the tech crowd.  I disagree. One quarter, especially in the midst of an obvious change in business performance (product updates and management reshuffling), is not enough to conclude the long-term Apple story has changed. If an investor wanted to run away from Apple for near-term volatility, that decision could have been made a few months ago. Continued margin volatility may produce a scenario where EPS growth can accelerate throughout the year and 2014, even with slowing product sales growth. 

AAPL’s next 3-5 years will depend on management’s ability to introduce new product categories into an ecosystem that values a set of beliefs, including two that I tried to put into words following my first days with an iPad:

That technology is too powerful of a force to enjoy without acquired perception and natural intelligence.

That product design has the power to momentarily satisfy the never-ending search for order and reason.

Walmart Discounting Apple Products: Gloom or Boom?

This past Friday, Walmart announced on its Facebook page that it was rolling back its iPhone and iPad pricing for a limited time. Within minutes, the announcement flew around tech blog circles, quickly reaching mainstream publications such as ABC and CNN.  

The discussion soon took a new direction as bloggers began to wonder if Walmart’s discounted pricing actually meant Apple was imploding; unable to sell supply due to lackluster demand.  One blogger summed up that attitude well, writing: 

"Apple has finally thrown in the towel on pretending there is a supply shortage and admitted there is simply not enough demand at the given price point, by proceeding to sell the margin flagship iPhone 5 at a third off the original price, at the bargain basement commodity expert Wal-Mart of all places….And just like that, the “niche premium” magic of the once uber-cool gizmo is gone, not to mention AAPL’s profit margins, very much as the stock price has been sensing over the past two months…”

The blog known as Reuters added additional fuel and mystery to the Apple bear argument, in their usual naive style:

"Apple has focused on high-priced, premium gadgets for many years and has strictly enforced its prices with retailers and other distributors. However, a Wal-Mart spokeswoman said on Friday that the discounts were arranged with Apple.

'We worked together with them on this,' the spokeswoman, Sarah Spencer, said. 'They are a great partner.'

Why is Walmart Discounting Apple Products? 

Third-party retailer discounts are nothing new.  Best Buy and RadioShack routinely sell entry-level iPhone 5 units for less than $199 (Best Buy is currently selling the 16 GB iPhone 5 for $149.99).  Apple’s wholesale pricing and margins remain intact as these third-party retailers eat the discount (ignoring differences between wholesale and retail prices). Similar campaigns are seen with iTunes gift card promotions, where retailers offer free iTunes gift cards when purchasing Apple products. Best Buy is also well known for promotions similar to “Buy $100 of iTunes gift cards for $75”  - where Best Buy (not Apple) is responsible for the discount.

Diving into Walmart’s latest iPhone and iPad price discount campaign sheds additional light.

1) The promotion is only valid in-store. For brick and mortar retailers, store traffic and same-store sales metrics are important. One of Walmart’s ultimate goals in discounting iPhones and iPads is having customers travel to a Walmart and make their way through the store before finally reaching the iPhones and iPads (conveniently not located near the store entrance). Walmart feels confident that it will be able to sell additional items to these customers, similar to placing milk and eggs at the back of a supermarket so that a customer has to walk through the entire store just to buy a few essentials. In addition, many consumers will narrow their holiday shopping destinations to a few stores over the next week and Walmart wouldn’t mind making that exclusive list - using discounted iPhones and iPads as the carrot for getting people into the stores.

2) The promotion is only good while supplies last.  Many consumers have flocked to Walmart’s Facebook wall to point out that quite a few Walmart locations don’t have iPhones or iPads in stock. Walmart receives good press coverage from discounting popular items, while not losing much money as product supply limits sales; sneaky, but efficient.

3) Brand awareness. By advertising discounted iPhones and iPads, Walmart is using the promotion as a marketing campaign to strengthen consumer’s association between Walmart and Apple. Many consumers don’t think of Walmart as the first place to visit for iPhones and iPads. I can only imagine how many people now have Walmart at the top of their destination list in search of that perfect Apple gift for the holidays. 

What about that little gem from Reuters indicating Apple was working with Walmart on this discount?  On the surface, it sounds somewhat damning for Apple, but in reality, it doesn’t mean much; only that Apple is okay with Walmart eating iPhone and iPad price discounts. Sounds like an iPhone and iPad boom to me. 

Anti-Apple Militia's Shifting Tactics; Attacking Apple's Cool Factor

A few years ago, I coined the phrase “anti-Apple militia” to describe the disjointed and incoherent group of SAI commenters that were not happy with Apple’s growing success. As Apple’s increasing dominance became clearer, the anti-Apple militia would desperately think of a new plan of attack,  often shifting themes within weeks. Some of my favorites were:

1) iPhone 3GS will flop because it looks just like iPhone 3G.

2) Palm Pre will crush the iPhone.

3) People don’t want a curated Apple App Store.

4) Android will crush Apple in the U.S.

5) iPad will flop because it’s just an oversized iPhone.

6) No one is buying iPhone 4 because of Antennagate.

7) No one is buying iPhone 4S because it looks like an iPhone 4. 

8) No one is buying iPhone 5 because of Maps.

Recently, I’ve seen the anti-Apple militia shift tactics and instead of attacking a specific iPhone or iPad feature, the detractors are going after the intangible; Apple’s popularity and coolness. Many anti-Apple comments are falling under the same genres, including:

"My daughter says all of her classmates are switching to Samsung and Windows phones. iPhones just aren’t cool anymore.” 

"Has anyone gone to an Apple store lately? They are empty and the only people I see are older folks. Meanwhile, Microsoft stores are packed with kids. So crowded."

"I was at the market yesterday, and some kid came up to me and couldn’t stop asking about my kick-ass Samsung phone. Youth just aren’t interested in the Phone anymore."

I think one of the main catalysts for this new attack campaign was Samsung’s ads that mocked people waiting in-line for the iPhone 5, including the scene of a son holding a spot in line for his parents. Samsung is going after one of Apple’s largest competitive advantages: it’s coolness. I look at these shifting attack tactics as desperation.  If using the battlefield analogy, Samsung and the anti-Apple militia are firing all remaining ammunition in the general direction of the enemy hoping something will stop the advance.

In reality:

1) Kids can’t get enough of iPhones and iPads (literally - parents are often not willing to buy new iPhones for their children until at least 8-9th grade).

2) College students continue to embrace Apple products at an alarming rate. 

3) Apple stores are more packed now than ever, with some complaining about how loud the stores have become.  Will the anti-Apple militia soon proclaim “no one goes to Apple stores because they’re too loud”?

4) Despite much broader product roll-outs, including massive pre-order allotments, people are still lining up for new Apple products.

Apple competitors see the writing on the wall. Not only is Apple continuing to broaden its reach across the world, including advances into enterprise and education, but it’s coolness factor is actually expanding.  As for the surveys and guesstimates showing Apple’s market share is getting trounced in China and markets where Apple has a weaker presence;  a true battle is one where both sides are present.

AAPL 4Q12 Estimate

Revenue: $36.2 billion (AAPL guidance: $34.0 billion/Consensus: $36.2 billion) 

• I expect iPad and iPhone to represent approximately 69% of Apple’s quarterly revenue.  

GM: 40.8% (AAPL guidance: 38.5%/Consensus: 40.4%)

• Apple’s margin will likely decline sequentially from 3Q12 due to the iPhone 5 and continued iPad 2 sales. A key question facing AAPL in the near-term is the margin run rate. In 2011, Apple reported a 40.5% gross margin, which increased to approximately 44% in 2012. Looking at 2013, I expect margins to decline a few hundred basis points to 42% related to the iPad mini and ongoing costs related to the iPhone’s new form factor.

EPS: $8.95 (AAPL guidance: $7.65/Consensus: $8.85) 

• I expect Apple to report 27% yoy EPS growth.  Interestingly, my $8.95 estimate is close to the Street’s $8.85 average, with 17 analysts projecting EPS higher than my $8.95. I attribute my low estimate to weaker iPhone sales, a lower iPhone average selling price (ASP), and a lower overall margin.

Product Unit Sales and Commentary

Macs: 5.5 million (12% yoy growth)

• Mac growth is slowing as tablets and smartphones satisfy many consumers’ computing needs. I expect double-digit growth in portables, driven by back-to-school purchases, to be partially offset by a modest decline in desktop sales due to stale models.

iPad: 18.4 million (65% yoy growth)

• I expect Apple to report record iPad sales for 4Q12. My iPad estimate assumes approximately 1.5 million iPads sold per week (including iPad 2 sales), which compares to the approximate 1.4 million weekly run rate last quarter. Supply/demand is in balance. Anecdotally, iPad 2 sales in education and business appear robust following the price cut, while lower component and manufacturing pricing should help limit drastic margin compression.

iPod: 6.1 million (8% yoy decline)

iPhone: 24.8 million (45% yoy growth)

• My estimate reflects 7 million iPhone 5 units and approximately 18 million iPhone 4S units (and to a lesser extent iPhone 4 and 3GS). Apple is currently suffering from a supply/demand imbalance for iPhone 5, which will limit sales in the near-term (including 1Q13). Other unknowns include the iPhone 4S sales run-rate prior to the iPhone 5 introduction and iPhone 4S popularity following the price drop. My 18 million iPhone 4S estimate reflects the impact from consumers delaying iPhone purchases ahead of the iPhone 5 release.  I am including a declining ASP due to robust iPhone 4S sales following the price drop (an observation partially derived from Verizon’s earnings which showed strong non-iPhone 5 sales, which I attribute to the price drop).  

When Apple releases earnings on October 25, investors will focus on product ASPs and margin. Publicized iPhone 5 supply shortages and iPad mini rumors should go a long way in explaining any moderate misses in iPhone and iPad unit sales, respectively. Nevertheless, any evidence of continued margin weakness and declining ASP in iPad and iPhone may push observers to reduce forward earnings, which have a high sensitivity to margins. A 100 basis point change in margin corresponds to a 3% change in Apple quarterly EPS.