Previewing Apple’s 4Q22 Earnings, My Apple 4Q22 Estimates, Apple Raises Apple Music and Apple TV+ Pricing (Daily Update)

Happy Tuesday.

We will go over my updated Apple earnings model tomorrow. It's not quite ready for publication. As a reminder, with Apple reporting earnings on Thursday, here is the daily update schedule for the rest of the week:

  • Wednesday: Regular update

  • Thursday: No update

  • Friday: Special Friday update dedicated to reviewing Apple earnings


Previewing Apple’s 4Q22 Earnings

My expectation is for Apple to report OK results on Thursday. While FX, inflation, and ongoing supply chain issues will negatively impact numbers, Apple should be able to comfortably exceed the all-time FY4Q revenue record ($83B is the current record).

FY4Q presents a few challenges for Apple financial modeling and earnings analysis as results reflect demand and supply trends 1) leading up to the critical September product launches and 2) a portion of the product launches themselves. For Apple, those two periods can end up representing distinct demand environments.

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Apple FY3Q22 Earnings Recap

Two weeks ago, Apple reported a solid FY3Q22 (April to June) given the tough year-over-year compare and considerable FX headwind. In terms of good news, supply chain issues, component shortages, and COVID-related headwinds appear to have bottomed for Apple. When it comes to bad news, some parts of Apple’s business are getting hit by inflation and slowing economic growth more than others.

Here are Apple’s reported 3Q22 results versus my expectations with brief commentary for each item.

  • Revenue: $83.0 (vs. my $85.9B estimate). Results missed my estimate due to a larger than expected headwind from FX, a larger than expected supply shortage with Mac, and macro issues impacting Wearables, Home, and Accessories.

  • EPS: $1.20 (vs. my $1.25).

  • iPhone revenue: $40.7B (vs. my $39.9B). That’s a good iPhone revenue number that doesn’t raise any yellow or red flags to me.

  • Services revenue: $19.6B (vs. my $20.1B). Results missed primarily on a larger than expected headwind from FX.

  • Wearables / Home / Accessories revenue: $8.1B (vs. my $9.4B). This was a weak number which Apple attributed to a “cocktail of headwinds.”

  • Mac revenue: $7.4B (vs. my $8.9B). Apple experienced major issues with supply as the Mac was the product category impacted the most by COVID lockdowns closing factories in China.

  • iPad revenue: $7.2B (vs. my $7.6B). Apple experienced ongoing issues with iPad supply.

  • Overall gross margin: 43.3% (vs. my 43.3%)

  • Services gross margin: 71.5% (vs. my 72.0%)

  • Products (HW) gross margin: 34.5% (vs. my 34.5%)

Breaking down the $2.9B revenue miss to my estimate, there were two primary drivers:

  • $1.5B revenue miss due to Mac supply not being as good as thought.

  • $1.3B revenue miss due to weaker Wearables, Home, and Accessories.

Even though Apple missed my (elevated) expectations, the company reported a 3Q22 beat to consensus as revenue came in about $2B stronger than sell-side analysts were expecting. The beat was due to stronger iPhone revenue as most analysts were expecting something more like $36B to $38B of iPhone revenue (vs. the $40.7B reported figure). EPS came in $0.04 above consensus as Apple’s margins came in slightly better than consensus thought as well.

An Above Avalon membership is required to continue reading this article. Members can read the full article here.

The full article includes the following sections:

  • Apple’s 3Q22: The Key Numbers

  • iPhone Sales Resiliency

  • Apple Ecosystem Growth Slows

  • Reading Between the Lines of Apple’s 3Q22 Earnings Q&A With Analysts

  • Notes From Apple’s 3Q22 10-Q

  • Tracking Apple’s Paid Subscriptions

  • Apple's Share Buyback Update

  • My Revised Apple Financial Estimates

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Above Avalon Podcast Episode 159: AirPods as a Platform

Apple is turning AirPods into a platform for what comes after the App Store. AirPods will augment our environment by pushing intelligent sound. In the first episode of Season 6, Neil goes over how AirPods have evolved from an iPhone accessory into the early stages of a platform well positioned to reshape the current app paradigm for the wearables era. Additional topics include the AirPods Pro launch, AirPods Pro initial impressions, AirPods sales, examples of AirPods as a platform, and the three sources from which AirPods will derive its platform power.

To listen to episode 159, go here

The complete Above Avalon podcast episode archive is available here

AirPods Are Becoming a Platform

If AirPods were magical, AirPods Pro are supernatural. Apple’s newest pair of AirPods continues to make waves with “augmented hearing” entering people’s vocabulary. However, the broader implications found with Apple’s AirPods strategy are just as impressive. Apple is quickly removing all available oxygen from the wireless headphone market, and competitors find themselves at a severe disadvantage. In just three years, AirPods have evolved from an iPhone accessory into the early stages of a platform well positioned to reshape the current app paradigm for the wearables era.

Another “Quiet” Launch

One of the more fascinating aspects found with AirPods Pro was how the product was unveiled. Instead of receiving stage time at Apple’s big product event at Steve Jobs Theater one month earlier, AirPods Pro received the press release treatment. When contemplating potential sales, AirPods Pro may end up being the best-selling Apple product that has ever been unveiled with just a press release.

The subdued unveiling given to AirPods Pro is consistent with Apple’s prior approach to AirPods. Instead of receiving the red carpet treatment as the Apple Watch did two years earlier, AirPods were unveiled to the world over the course of just five minutes at Apple’s iPhone and Apple Watch event at Bill Graham Civic Auditorium in San Francisco. In a sign of just how nonchalant Apple was with the unveiling, AirPods were positioned merely as an iPhone 7 and 7 Plus feature. The product was said to be an additional option that consumers had for handling the transition away from dedicated headphone jacks. (Remember those?)

Earlier this year, AirPods with wireless charging case was unveiled via press release as well.

AirPods Pro

It’s easy to gloss over many of the selling points found with AirPods Pro given the familiarity with AirPods. Items such as seamless pairing and the carrying case that doubles as a charging station play crucial roles in giving AirPods Pro such a high-quality and enjoyable user experience.

However, the features that have gained the most attention, and rightly so, are Active Noise Cancellation (ANC) and Transparency mode. For many people, AirPods Pro will be their first pair of ANC headphones. Those users are in for a treat as Transparency mode addresses the largest negative found with ANC headphones - the user is seemingly removed from his or her surroundings. A press and hold on one AirPod stem switches between ANC and Transparency mode. The functionality is a great example of how Apple’s engineering and design teams, through collaboration, can produce a great user experience.

Sales

In FY2019, Apple sold 35 million pairs of AirPods at an average selling price (ASP) of $162 (both are my estimates). On a revenue basis, the AirPods business is on a $6 billion per year run rate that is doubling year-over-year.

One way to put those sales numbers into context is to compare AirPods to other Apple products at the same point in time after launch. As shown in Exhibit 1, AirPods are trending similarly to iPhone sales when looking at unit sales out of the gate. After three years of sales, Apple has sold 61 million pairs of AirPods on a cumulative basis. During the first three years of sales, Apple sold 60 million iPhones.

Exhibit 1: Unit Sales out of the Gate

Apple likely crossed an important AirPods sales milestone last quarter. For the first time, Apple sold more than 10 million pairs of AirPods during a three-month stretch. While the preceding observation came from my earnings model (access to my Apple earnings model is a benefit associated with Above Avalon membership at no additional cost), the math checks out with Apple management’s commentary and clues provided on the 4Q19 earnings conference call. It’s likely that AirPods sales will exceed 10 million per quarter for the foreseeable future.

When contemplating AirPods unit sales trends going forward, too many people are stuck in a mobile mindset. Instead of seeing someone buy and use just one pair of AirPods, we may see a new kind of usage pattern develop in which a growing percentage of AirPods owners will use more than one pair of AirPods. This will help boost AirPods unit sales.

On Apple’s 4Q19 earnings conference call, Tim Cook was asked about the potential upgrade trajectory for AirPods. Cook commented that he thought current AirPods owners would be in the market for AirPods Pro to “have a pair for the times that they need noise cancellation.” The clear implication found in Cook’s comment was that Apple expects some AirPods owners to use multiple pairs of AirPods with differing levels of functionality.

After just three years of sales, we are already starting to see the early stages of this trend develop with people upgrading their AirPods but keeping their old pair as a backup.

In an unscientific poll conducted via Twitter poll through my account, 30% of respondents said they use more than one pair of AirPods. Interestingly, 41% of people who said they purchased a pair of AirPods with wireless charging case claim to still be using their older pair of AirPods as well. It helps that AirPods last years before poor battery life takes its toll. My initial pair of AirPods from 2016 are still used daily. It's early, but it looks like people using more than one pair of AirPods is a thing.

Platform Building

The current app paradigm primarily consists of downloading an app to our smartphone, tablet, smartwatch, smart TV, or laptop / desktop. We then interact with the app to “pull” information and context at a time of our choosing. App notifications are not very smart and instead represent mostly useless distractions more than anything else.

The Apple Watch was the first device to genuinely begin questioning the current app paradigm. The Siri watch face on Apple Watch is all about providing the wearer glanceable amounts of information, data, and context in the form of cards chosen by a digital assistant. These cards are personalized to the wearer based on the time of day and schedule. In essence, we are moving away from pulling data from various apps to receiving a curated feed of data that is dynamic - always changing and tailored to our needs.

Apple is turning AirPods into the second platform built for what comes after the App Store. Instead of being about pushed snippets of information and data via a digital voice assistant, something that will likely remain ideal for mobile screens, AirPods will be all about augmenting our environment by pushing intelligent sound.

AirPods Pro wearers are able to experience the early days of this dynamic with Transparency mode. Switching between Transparency mode and ANC is equivalent to augmenting our environment. We are receiving two different experiences despite being in the same location.

This dynamic could be extended so that a simple tap of an AirPod or a quick voice command can take us to a different location via sound. Utilizing HomePods as sound receivers, an AirPods wearer would be able to “move” from the kitchen to family room. A quick tap of one AirPods, or Siri voice command could bring the wearer from the family room to kitchen to answer a family member’s question or simply to be “in” the room.

App developers would be able to take part in this revolution by building experiences that further augment people’s hearing. “Apps” would amount to tools capable of adding context to our hearing. Fitness can be rethought by adjusting the AirPods wearer’s hearing during workouts and exercise based on his or her activity. As an example, AirPods music playbook can be adjusted based on the users’ heart rate obtained by an Apple Watch. Such adjustment would amount to the AirPods wearer being “removed” from his or her environment when close to reaching a maximum heart rate during a run or track workout. Of course, such health tracking and monitoring may one day be brought directly to AirPods in subsequent editions.

Another example involves utilizing AirPods to deliver different sound experiences to different people despite being in the same location and looking at the same thing. As an example, a single presentation shown in a school or office setting can end up delivering a dozen different experiences to those in attendance.

Platform Power

AirPods will derive its platform power from three sources:

  • Technology advantage

  • Design focus

  • Massive adoption

Apple is pulling away from the competition when it comes to building mini computers worn on the body. AirPods are computers for the ears. Years of learning how to manufacture 2.1 billion iPhones and iPads is now helping Apple to build nearly 70 million wearable devices per year.

This technology prowess and manufacturing acumen goes to waste if people don’t actually want to be seen wearing the devices. Apple’s success at redefining luxury, combined with the company’s design-led culture, gives the company a large advantage in the area of understanding what people will want to wear on the body.

The final source of platform power will come from massive adoption. There are currently 45 million people wearing AirPods. At the current rate, more than 100 million people will be wearing AirPods at some point in 2021. As to how Apple is able to see such strong AirPods adoption, Apple is busy removing all available oxygen from the wireless headphone market.

The company is utilizing a masterful combination of price and features to establish multiple beachheads in the market.

AirPods Pro do not replace AirPods in the product line. Apple is instead embracing a strategy of expanding the product line according to functionality. AirPods Pro represent the expansion of the AirPods line into a higher-end segment that places value with ANC. The end result is that Apple now has three different AirPods model, each targeting a different price segment of the wireless headphone market. It is certainly reasonable to expect Apple to continue pushing this strategy in the coming years so that we see a pair of AirPods go for as low as $99 and as high as $500.

We see similar product strategies with the iPad and Mac lines. With these, Apple sells a range of flagship products with varying degrees of functionality, and of course, price.

There are some unique attributes seen in Apple’s campaign to remove oxygen from the wireless headphone market. Unlike what they did with the iPhone or iPad playbook, Apple didn’t launch AirPods at one price and then begin to lower pricing once all of the profit had been sucked from that initial market segment. Instead, Apple has been doing the opposite. Apple unveiled AirPods at a very aggressive $159 price, which sent shockwaves across the industry as the competition was priced closer to $300. Three years later, competitors are still struggling to match AirPods' $159 entry-level price.

Something Big

This AirPods evolution into a platform does not come as a surprise. Here was the opening paragraph from my initial Above Avalon article on AirPods shortly after being unveiled in September 2016:

“AirPods will turn out to be one of the more strategically important hardware products Apple has released this decade. However, you would never know it judging from the way Apple unveiled the device last week. I suspect that was intentional. While the press remains focused on the short-term debate surrounding the iPhone's lack of a 3.5mm headphone jack, few have realized that Apple just unveiled its second wearables platform.”

Three years later and that paragraph still rings true. AirPods have turned into a cultural phenomenon while dedicated headphone jacks on smartphones have become relics. Meanwhile, Apple’s wearables train continues to gain momentum as the company grabs real estate on our wrists and in our ears by bringing a new level of personal computing to the masses.

Listen to the corresponding Above Avalon podcast episode for this article here.

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 152: Let's Talk Wearables

Apple is the undisputed leader in wearables, and they are pulling away from the competition. In Episode 152, Neil discusses how Apple’s wearables business can be thought of as a train gaining momentum. Competitors face declining odds of being able to stop the train. Additional topics include Apple’s wearables performance in 3Q19, wearables as a percent of overall Apple gadget unit sales, Apple wearables revenue, the factors behind Apple’s wearables success, and why wearables represent a paradigm shift in computing.

To listen to episode 152, go here

The complete Above Avalon podcast episode archive is available here

Apple Deserves More Credit for Wearables

The wearables era at Apple began years ago. However, Wall Street and Silicon Valley are only now slowly starting to pay attention to what Apple has been building. Apple is the undisputed leader in wearables, and they are pulling away from the competition. Given how Apple’s wearables strength continues to be underestimated, the company deserves more credit for what it has achieved and where it is headed.

The Data

A takeaway from Apple’s recent 3Q19 earnings was that we are witnessing the wearables era continue to unfold at Apple. Segmenting Apple’s quarterly revenue growth into product categories is one way of highlighting wearables momentum. Both an accurate financial model and close following of Apple clues over the past four years are required to accurately estimate Apple Watch and AirPods unit sales and average selling prices (ASPs). Therefore, this exercise has not been practiced by many.

The preceding totals represent the change in revenue from 3Q18 to 3Q19.

Apple Revenue Growth Drivers (3Q19)

  1. Services: $1.5 billion

  2. Wearables: $1.2 billion

  3. Home / Accessories: $0.6 billion

  4. Mac: $0.6 billion

  5. iPad: $0.4 billion

Note: These totals do not represent revenue totals but instead the change in revenue between 3Q18 and 3Q19.

The revelation from the preceding data is riveting. Wearables nearly exceeded Services in 3Q19 as Apple’s top revenue growth generator when looking at absolute dollars. Consensus was not expecting this to occur as Services was positioned as Apple’s growth engine. It is clear that consensus spent too much time on the Services highway and ended up missing the exit for wearables.

In taking a closer look at wearables revenue growth, it becomes evident that Apple is benefiting from both higher ASPs for Apple Watch and AirPods as well as continued strong unit sales growth. For AirPods, unit sales growth is nothing short of spectacular at 80%.

Speaking of unit sales, one out of five gadgets that Apple sells is now a wearables device. Exhibit 1 highlights the growing share that wearables represent when looking at overall Apple device unit sales.

Exhibit 1: Wearables Share of Apple Device Unit Sales

Exhibit 2 depicts wearables’ growing share of gadget sales relative to Apple’s other product categories. Apple is currently selling approximately 70M wearable devices per year. This includes 30 million Apple Watches and more than 30 million AirPods.

Exhibit 2: Apple Gadget Unit Sales

On a revenue basis, Apple’s wearables business is now at a $16 billion annual run rate growing at 55% to 60%. At the current pace, wearables will surpass both the iPad and Mac near the end of 2020 to become the third largest product category behind iPhone and Services when looking at revenue.

The Wearables Train

One way of thinking about Apple’s wearables business is that it’s a train gaining momentum. Competitors face declining odds of being able to stop the train.

The Apple wearables train is boosted by three items that no other company has the luxury of utilizing or leveraging:

  1. A massive installed base of iPhone users (925M globally).

  2. Core competencies and a company culture built on making technology more personal, intuitive, and easy to use.

  3. A thriving platform of multiple wearables products.

Apple is leveraging its ecosystem of users and devices to give its wearables business an ideal launching pad for success. While there are handful of companies with more than a billion users, no other company has an ecosystem of a billion users and nearly 1.5 billion devices (nearly 90% of which are running the latest software). The lack of a self-sustaining ecosystem is one of the primary factors driving Fitbit’s gradual fade into irrelevancy. This limitation manifests itself in new products like the Fitbit Versa smartwatch failing to catch the needed traction. 

Design, or the lack thereof, is proving to be another high barrier for many companies to get over in terms of wearables. Silicon Valley continues to focus too much on technology and not enough on design, or how we actually use technology. Google’s ineptitude when it comes to wearables is partially due to the company not having a clue as to how to get people to wear wearable devices. Management thought consumers would want to wear Pixel earbuds because the devices had real-time translation. In reality, consumers don’t want to be seen in public wearing wireless headphones that don’t reflect aspiration and coolness. A keen understanding of how to play in the luxury and fashion realms while simultaneously appealing to the mass market is tricky.

Flying Under the Radar

In assessing why Apple’s wearables business has received so little attention to date, one doesn’t have to look much further than the iPhone. Preoccupation with trying to find a singular product capable of replacing iPhone made it difficult for many to see how a platform of wearable devices is the answer for what can eventually serve as a viable iPhone alternative.

A cellular Apple Watch paired with AirPods is already able to handle a number of tasks currently given to the iPhone. Add a pair of smart glasses to the mix, and mobile devices like the iPhone and iPad stand to lose even more use cases.

It doesn’t help that new Apple products are also graded on a curve next to iPhone. If a new product is unable to move Apple’s financial meter out of the gate, the product is looked at as a flop, toy, or mere iPhone accessory. 

Guardrails

For competitors, the bad news is that there is evidence that Apple is still applying some breaks to its wearables train. In some ways, Apple is holding things back. An iPhone is still required to set up an Apple Watch. A truly independent Apple Watch that doesn’t require an iPhone would grow the device’s addressable market by three times overnight. 

In addition, Apple currently only offers wearables devices for two pieces of real estate on the body: our wrists and ears. A compelling argument can be made that the most prized piece of wearables real estate, our eyes, remains untapped. 

Looking Ahead

We are witnessing wearables usher in a paradigm shift when it comes to how we use and interact with technology. Apple deserves more credit for not only choosing to ride the wearables wave, but also playing a crucial role in getting wearables off the ground.

Apple is well on its way to having Apple Watch and AirPods installed bases of 100M people each. The company is more than half way there with Apple Watch and is quickly approaching the same level with AirPods despite the product being sold for half the time.

Apple also finds itself in the midst of a major investment phase to expand its wearables platform. There is an opportunity to bring more utility, in addition to clearer vision, to the eyes in the form of smart glasses. Such a product would be a precursor to a pair of AR glasses.

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.