AAPL 2Q16 Earnings Expectation Meters

During Apple's 2Q16 earnings conference call, management will continue to sow a new narrative around the company. With hardware unit sales slowing across the board, management is focusing on recurring revenue streams and iOS customer transaction values. 

Exhibit 1: Above Avalon's AAPL 2Q16 Estimates

The details and rationale/methodology behind all of my estimates are available in my 2Q16 Earnings Preview available here for Above Avalon members. (Click here for more information on membership.)

Given management's revenue guidance, Apple will report its first quarterly iPhone unit sales decline. The only question remaining is, just how bad was the drop? As seen in Exhibit 2, an iPhone unit sales decline of 10% to 17% would fall within my expectation range with the center point being a 13% drop from last year. It is important to note that the iPhone SE will be a 3Q16 earnings event given the device's launch timing. 

Exhibit 2: 2Q16 iPhone Expectation Meter

The unit sales declines are expected to extend to both iPad and Mac. Given my analysis regarding recent iPad sales mix, my 9M iPad unit sales estimate implies a dramatic 27% drop in sales from last year. This is made that much more worse considering the 12.9-inch iPad Pro was released a few months ago, not to mention the iPad category had already fallen 23% last year. The iPad business has essentially been cut in half. Similar to the iPhone SE, the 9.7-inch iPad Pro will be a 3Q16 earnings event given its launch timing. As for the Mac, it is still possible Apple may just barely squeak out unit sales growth. 

Exhibit 3: 2Q16 iPad and Mac Expectation Meters

Regarding Apple Watch, Apple's pattern has been to not disclose any actual revenue or unit sales data. Instead, management has chosen to provide subtle clues or hints as to how Apple Watch has performed. It is possible we may get a broad comment as to how Watch sales have done in the new year. As shown in Exhibit 4, Apple's "Other Products" revenue line item can be converted into Apple Watch unit sales. The usual caveat is that this table assumes an Apple Watch ASP of $425 (lower than previous quarters) and that accessories revenue amounted to $1.6 billion.

Exhibit 4: 2Q16 Other Products and Apple Watch Expectation Meters

As is the case with every Apple earnings report, most investor attention and focus will be put on management's guidance for 3Q16. Expectations over the past few months had Apple's 2Q16 showing the weakest year-over-year revenue performance from an optics perspective. However, in recent weeks, there has been growing concern that Apple's 3Q16 would also show a substantial revenue decline. My expectation is for Apple to guide revenue to -5% and -11%.

Exhibit 5: 3Q16 Revenue and Gross Margin Guidance Expectation Meters

As seen by my 2Q16 AAPL earnings expectation meters, Wall Street is expecting an all-around weak earnings report from Apple. Accordingly, investors will be looking for any surprises that help shed light on how current iPhone sales have been trending following the iPhone SE launch. The $400 iPhone 5s successor may end up representing the one bright spot in an otherwise difficult stretch for Apple regarding hardware unit sales growth.

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Above Avalon members received my detailed earnings preview (available here) and will receive my exclusive earnings reaction note containing all of my thoughts and observations on Apple's results this Wednesday following Apple's earnings release. 

The Car's "iPhone" Moment

The iPhone has never stood out for its voice calling capabilities. A feature phone from 2005 is able to make just as clear of a voice call as an iPhone 6s. Instead, the iPhone went on to do something much more profound than just improve the voice call. The iPhone showed the world that there was another way to think about the phone. Fast-forward nine years, and there are questions about whether the auto industry will experience its own "iPhone" moment. Will a new product or service come along that changes our perception of a car? Is autonomous driving the technology that will ultimately change how we think about cars? Will Uber and other ridesharing companies be able to rethink personal mobility? Does Apple think it has an answer for rethinking the car? Did Elon Musk already change the car's definition with Tesla? The journey to find all of these answers begins by looking at how Apple rethought the phone with iPhone.

Rethinking the Phone

The iPhone was born from a different kind of inspiration. Instead of looking at Blackberries and Motorola RAZR, the most popular phones at the time, Apple used the iPod as an example for what it wanted to achieve with its own phone.

While Blackberry, formerly called Research in Motion, was seeing remarkable success in enterprise by selling a smartphone with a keyboard that gave each letter its own dedicated hardware key, Apple looked at such a feature as a drawback. A smartphone's dedicated hardware keyboard ended up holding back the smartphone's potential. By taking multi-touch technology originally targeted at a large screen and seeing if it could work on a smaller screen, Apple ended up changing the smartphone's trajectory by not just removing the hardware keyboard but replacing it with an alternative that helped to rethink our perception of a phone. 

Of course, the iPhone didn't just add chaos to the smartphone industry because of its hardware design. Apple's existing capabilities when it came to software turned what was a phone in our pocket into a computer. In addition, working exclusively with AT&T gave Apple the flexibility to think outside the box. Even though the strategy was not looked at as a strength in 2007, Apple's control over phone hardware and software made it possible to rethink the phone.

Cars Are Like Phones

Given the iPhone's level of success, it is has become too easy to look at everything through an iPhone lens. Taking what worked with the iPhone and then applying it to other products and industries is a recipe for disaster. However, there are a few reasons that the automobile industry is much more similar to the smartphone industry than what first meets the eye. 

Using a smartphone and sitting in a car both revolve around a relationship between the user and product. For a smartphone, this relationship is straightforward: interacting with hardware in order to utilize software. The feel, look, and sound of a smartphone matter to the user. The car contains many of these same attributes. By simply sitting in an automobile, we are taken into a different environment in which a number of our senses are driven into overload including smell, touch, sight and sound. Both a smartphone and car are capable of containing and fostering unique experiences. Accordingly, it is possible to improve or alter the product in an attempt to create a better experience.

Tesla's success can be attributed to the relationship consumers have with their Model S and the broader experience of buying and driving an electric car direct from Tesla. Uber's success is a result of the experience created by easily getting from Point A to Point B in a safe and comfortable vehicle.

Similar to how hardware and software come together to contribute to a smartphone's experience, a similar dynamic is beginning to take over the auto industry. While it is difficult to call today's car dashboard experience pleasant, products such as CarPlay help to alleviate some of the friction points while autonomous features like Tesla's AutoPilot only exemplify the significant role software and hardware have to play in the car's future.

Rethinking the Car

Since cars and smartphones share a few important characteristics, the best way to discover the car's "iPhone" moment, or a new product or service that changes the long-standing perception of a car, is to look at our relationship with the automobile. What aspect of today's modern car has the potential to fundamentally change how we perceive and think about cars? 

Internal Combustion Engine? Replacing an internal combustion engine with an electric powertrain seems like a good way to improve various aspects of an automobile. Not only are we able to help the environment, but using battery power for propulsion leads to fewer moving parts to maintain on a regular basis. However, an electric powertrain by itself doesn't rethink the car. As the Model S and X have shown, while an electric car is capable of providing a much more enjoyable driving experience than many gas-powered cars, at the end of the day, it is still a car, albeit one of the better cars on the road. The primary reason electric powertrains are being positioned for a comeback is that the price of batteries continue to fall, making electric cars much more economical. 

Human Driver? Having software control a car will certainly change how we use cars. However, people have been sitting in the back seat of cars and having someone else drive them around for a very long time. Uber and the broader taxi industry serve as prime examples for why autonomous driving doesn't fundamentally alter a car's definition. Similar to electric powertrains, autonomous driving features may lead to a better car experience, but more is needed to actually rethink the car. 

Dashboard? Many have positioned a car's dashboard as the modern day version of a Blackberry keyboard - a collection of overly complicated buttons and switches that take away from the experience of driving or simply sitting in a car. Following this thought through, some have argued that allowing our smartphone to integrate with our car's dashboard will provide the familiarity that consumers demand. Unfortunately, improving a car's dashboard does not change our perception of a car.

At a fundamental level, the dashboard is an interface used to control a car. Simplify a car's propulsion system by replacing an internal combustion engine with an electric powertrain, and the need for a complicated dashboard is instantly reduced. Go further and add software that handles everything from autonomous driving features to cabin temperature, and the result is the Tesla Model 3. Replacing a complicated assortment of dashboard buttons with one large tablet screen marks a milestone for the car. However, a self-driving, electric car with a tablet as a dashboard does not fundamentally transform how we think about a car. It is still a box, albeit a much smarter box on wheels that gets us from Point A to Point B.  

The Car's Friction Point

If electric powertrains, autonomous driving, and software dashboards don't change how we perceive a car, it would appear that the auto industry may lack an iPhone moment in the traditional sense of the term. That is unless the answer has been literally sitting beneath our noses for decades. 

While it may seem like of one the most boring parts found in a car, the seat represents the biggest barrier to rethinking the car. If a company can rethink the car seat, our perception of a car will change, and ultimately, the entire auto industry will be impacted. The car seat is the car's version of the smartphone hardware keyboard. 

Seats play the largest role in our in-car experience. Everything from how we feel to where we are looking and what we are doing is determined by a car seat. Given these important roles, it is shocking that the car seat has seen very little change over the years, as depicted in the following pictures.

If cars are nothing more than boxes on wheels, the primary way to rethink the car is to change how we think about the "box." Similar to how the iPhone was inspired by the iPod and not the leading smartphones at the time, the best inspiration for rethinking a car's passenger compartment comes from the mobile products in our pockets and on our wrists, not the best-selling cars on the road.

Smartphones, tablets, and wearables are all about personalization. We want our iPhones and Apple Watches to be specifically suited to our personalities. Both hardware and software help accomplish that goal. With cars, the same type of personalization is nowhere to be found. The average car buyer has a finite number of options available to create an experience specifically suited to them. Once a car is delivered, future modifications and changes are pretty much nonexistent. What if there was a way we could rethink what it means to personalize our car experience? 

It all begins with the seats. By no longer thinking of seats as stationary benches facing forward, we can begin to come up with a way of creating different experiences inside a car based on our mood or merely the time of day. Of course, we have seen examples of this in the real world when it comes to the family car, such as the 2008 Dodge Caravan (pictured below).

However, there is a reason why consumers never embraced this type of setup in numbers: It was clumsy and aggravating to set up, and it was far from personalized. What if there was a way to create a certain kind of car compartment layout for one situation but then be able to switch layouts with an iPhone or even Apple Watch? Or how about creating a seating arrangement on our iPhone for one car, saving it, and then loading that same arrangement in a different car? The way we perceive a car will change. Instead of being just a box on wheels, the car will become a room on wheels. 

By relying on software to create our own unique experience and then taking that experience from car to car, we would have essentially recreated an iPhone-like experience on wheels. 

Competitive Landscape

There are very few automobile companies in a position to combine hardware and software to rethink the car seat. Ironically, the cars that have historically been the closest to delivering this kind of vision have been either large boxes on wheels like Dodge Caravans or an ultra-luxury car like a Rolls-Royce. Even then, the offerings still pale in comparison to what can truly be accomplished with software. 

Despite very high customer satisfaction rates, Tesla doesn't seem close to moving in this direction as it continues to position performance as the primary reason to buy a Tesla Model 3. In fact, the inside of a Tesla is often regarded as the vehicle's weak point. Meanwhile, the Model X internal compartment design is very conservative. This leaves Apple and Project Titan.

Project Titan

It is no secret that Apple's strength is not just hardware and software integration but the design behind the experience created from combining the two. Along those lines, while very little has been said about Apple's rumored electric car project, there are a number of clues to suggest where Apple is likely looking. Marc Newson, the newest member of Apple's industrial design team, has tried his hand at seemingly everything at least once, but one of his most well-known designs was a concept car for Ford commissioned back in 1999 (seen below with orange seats). While the car has ended up being quite a polarizing object over the years, the takeaway from his design was the importance of rethinking conventional wisdom all the way down to how we would enter or exit the car. 

In addition, a company reportedly attached to Project Titan shipped a 1957 Fiat Multipla 600 (the yellow car below) to the U.S. in 2014. Don't focus on that exact car. Instead, consider how the internal compartment would certainly mesh well with the concept of rethinking car seats and turning a box on wheels into a room on wheels. 

In fact, Marc Newson has a pretty extensive history of turning boxes into rooms. He designed the internal compartment of a private jet interior as well as a Qantas A330. 

Add it all up, and it would look like Project Titan has the resources to spend much more time rethinking a car's interior than an electric powertrain or driving performance. 

The Car Seat Opens Doors

If a company can rethink the car seat and the kind of experience possible inside a car, our definition of a car wouldn't just change, but we would be able to fully utilize car features like electric powertrains and autonomous driving.

If a car becomes fully autonomous, what happens to the driver seat? Does it make sense for everyone to face forward when the car is moving? These types of questions don't have clear answers if the car seat isn't rethought. Instead, we are merely occupants in a box that drives itself. Bring in the topic of ridesharing and being able to "load" our individual car compartment settings for a car just about to pull up to our pickup zone, and the possibilities created by rethinking the car seat begin to materialize. While it may seem like safety regulations and state laws may curtail the possibilities in this area, rethinking the seat may actually end up improving safety inside moving cars. The main reason why car companies have not embraced new ideas for the seat is limited customer acceptance. However, instead of it being a roadblock, it should serve as an opportunity for new companies to approach the problem from a different angle. 

The car's "iPhone moment" will likely end up being an idea - thinking of cars as extensions of our homes - personalized rooms on wheels. While most think the way to build such a product is to simply add software to a car dashboard, the answer is actually found by rethinking the most important part of a car - the seat. 

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Examining Apple's Dividend Strategy

Apple's board is expected to authorize an increase in the company's quarterly cash dividend later this month in conjunction with 2Q16 earnings. Ahead of this event, I examined Apple's dividend strategy. All signs point to Apple relying on a stable dividend policy in which dividend expense follows an existing long-term growth trajectory rather than near-term earnings volatility. By finding this dividend growth trajectory, it is possible to for look subtle shifts in trajectory going forward. These shifts will provide clues as to how management views long-term business prospects and profit opportunities. 

Dividend Growth

In order to find Apple's future dividend growth trajectory, we must first take a look at the company's historical dividend growth rate. After a 17-year hiatus, Apple reinitiated its quarterly cash dividend in 2012. Since that time, Apple has paid out $42 billion ($6.84 per share) of dividends while the share price increased approximately $26. Accordingly, the dividend has been responsible for approximately 20% of an AAPL shareholder's total return.

Apple has increased its quarterly cash dividend annually beginning in 2012:

• 2012: $0.38
• 2013: $0.44 
• 2014: $0.47
• 2015: $0.52

In order to calculate Apple's historical dividend growth rate year-over-year, we take quarterly cash dividends per share and convert them into an annual total, keeping in mind that Apple increases the quarterly dividend midway through its fiscal year: 

• 2013: $1.64
• 2014: $1.82
• 2015: $1.98

We can now calculate the year-over-year growth rate for total dividends per share paid on an annual basis: 

• 2014: 11%
• 2015: 9%

Apple discloses in its financial filings that it intends to increase the quarterly dividend annually. It would appear from looking at 2014 and 2015 growth trends that Apple management is on a trajectory in which it will increase its quarterly dividend by approximately 10% each year. However, there is more to the story. 

Apple's share buyback is playing a significant role in defraying the total cost of these 10% dividend increases. As Apple buys back its shares, the number of shares outstanding is reduced. This leads to Apple paying out fewer dividends, all else equal. As long as Apple buys back shares, management will continue to have greater leverage when it comes to raising the quarterly cash dividend. Said another way, current shareholders are seeing an indirect benefit from the share buyback by receiving higher dividend payments per share.

To see how share buybacks have made it cheaper for Apple to pay higher cash dividends per share, consider the amount Apple spends on cash dividends annually:

• 2013: $10.6B
• 2014: $11.2B
• 2015: $11.6B

Since these totals exclude the impact from share counts, we can calculate the growth rate in Apple's annual dividend expense: 

• 2014: 6%
• 2015: 4%

Even though the Apple board has been increasing the quarterly cash dividend by approximately 10% over the past two years, the total growth in Apple's dividend expense has actually been only approximately 5% per year. The reduction is due to a lower share count produced by Apple's share buyback. We can now use this 5% dividend expense growth rate as the base line when plotting Apple's future dividend growth trajectory. However, we first need to measure Apple dividend sustainability.

Dividend Sustainability

In order to judge how sustainable it is for Apple to increase its dividend expense by 5% each year, we need to look at Apple's dividend payout ratio. As the name implies, a dividend payout ratio shows the percentage of a company's total net income that is paid to shareholders in the form of cash dividends.  

Apple's dividend payout ratio (dividends / net income) has been trending down:

• 2013: 29%
• 2014: 28%
• 2015: 21%

The declining dividend payout ratio is a sign of improving dividend sustainability because it suggests Apple has remained conservative with its dividend growth policy even in the face of strong earnings growth. When compared to industry averages, Apple's 21% dividend payout ratio is only marginally higher. This is a byproduct of Apple following a stable dividend policy in which the company strives to maintain a certain level of consistency when it comes to dividend expense growth. Even though Apple saw a boost in earnings in 2014 and 2015, management will likely follow its existing strategy of running with a modest 5% increase in dividend expense. There are a few reasons to do this with the main one being that investors value predictability. Apple avoids having to make sudden dividend swings in the future, including cutting the dividend when earnings slow. 

The primary takeaway is that future Apple cash dividends will not be determined solely by the company's earnings. Instead, Apple dividends will be based on a stable growth policy in which management targets a consistent dividend growth rate that does not follow the cyclical nature of its business. By selecting a dividend that appears to be well within their capability of paying, management is indicating they are comfortable increasing their dividend expense by 5% each year. Going forward, management can use the dividend payout ratio as a periodic check to make sure that the company is not playing it too safe with its dividend or vice versa, putting itself in financial distress. 

Charting Apple's Dividend Trajectory

Since we now have a sustainable, dividend expense growth rate in hand, it is time to plot Apple's future dividend trajectory. We assume Apple maintains its 5% growth rate in dividend expense going forward (represented by the blue line in Exhibits 1 and 2) because of Apple's stable growth dividend policy. In addition, two other dividend expense growth scenarios are plotted in Exhibits 1 and 2, including a more robust 10% growth trajectory (green line) and a weaker 2% growth trajectory (red line).

Exhibit 1: Apple Dividend Expense Trajectory ($ billions)

Exhibit 2: Apple Quarterly Cash Dividend Trajectory (Per Share)

Assuming Apple increases its dividend expense by 5% each year and the current pace of share buyback is maintained, we now have five years of expected dividend expense:

• 2016E: $12.2B
• 2017E: $12.8B
• 2018E: $13.4B
• 2019E: $14.1B
• 2020E: $14.8B

Converting these totals into quarterly dividends per share (keeping in mind share buyback will lower the share count as time goes on), we arrive at: 

• 2016E: $0.58
• 2017E: $0.63
• 2018E: $0.69
• 2019E: $0.75
• 2020E: $0.82

This would suggest that when Apple announces a dividend increase later this month, my expectation is for a 12% increase to $0.58 per share per quarter. When converting these quarterly dividends into annual totals, we get: 

• 2016E: $2.20
• 2017E: $2.42
• 2018E: $2.64
• 2019E: $2.88
• 2020E: $3.14

Trajectory Shifts

Of course, a company's dividend strategy does not operate in a vacuum. If the business environment changes, management will need to reassess whether or not the change will result in a permanent increase or decrease in industry attractiveness and profitability. A weaker outlook may lead management to cut its dividend growth trajectory in order to conserve operating income. Vice versa, a stronger outlook could give management room to increase its dividend which would benefit current shareholders, including Apple employees. 

This is where we can use Apple's likely dividend growth trajectory to our advantage by monitoring whether or not management veers off its current course (blue line). Exhibit 3 highlights how a shift in dividend growth can be either classified as a positive trend (green shaded area) or negative trend (red shaded area).

As an example, if Apple reports dividend expense between $12.8 and $14.0 billion in FY2017, then it would fall in the green positive trend area and indicate that Apple management has increased its dividend expectations. If dividend expense is between $12.0 and $12.8 billion, then Apple reduced its dividend expectations. Apple could certainly report dividend expense that is above and below even the shaded regions, which would obviously indicate somewhat major shifts in management attitudes toward Apple's prospects. 

Exhibit 3: Apple Dividend Expense Trajectories

Dividends Matter

Wall Street understands that Apple's earnings are volatile. It is rational to assume that over time, there will be earnings peaks and troughs depending on Apple's current product line at any given moment. Given this volatility, Apple's dividend strategy is aimed at adding a bit of continuity and predictability to the mix. This is just another reason why it is in Apple's best interest to maintain a steady dividend growth rate that can survive the ups and downs of Apple's product line.

While paying a small $0.58 per share quarterly dividend may not seem like a big deal, if Apple grows its dividend expense by 5% each year and continues to buy back shares, Apple will pay nearly $3.15 of dividends per share annually by 2020. At Apple's current stock price, this would equate to a very attractive 2.8% dividend yield. If we assume Apple maintains its current 1.9% yield, Apple's stock price would trade at $165 per share. These two examples show the power behind a dividend, even if it experiences modest growth from year to year. Apple dividends are going to matter much more than many people think.

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Apple Watch's Future Will Include Smart Watch Bands

Expectations surrounding Apple Watch continue to decline. Given slowing sales growth at some of the leading wrist wearable companies, including Fitbit, there is a feeling that the wrist wearable category has been one giant head fake, a fad that just doesn't contain much potential beyond tech enthusiasts. This view not only ignores reality given the number of Apple Watches sold to date, but also fails to understand the path wrist wearables will follow. The Apple Watch's future will not be found just with better Watch cases updated on an annual schedule like an iPhone. Instead, Apple Watch bands deserve more attention going forward as they begin to incorporate technology and gain additional importance for wearable computing. A smarter Watch band will play a crucial role in Apple Watch's future as a personal technology device.

Apple Watch's First Year

Apple sold approximately 10 million Apple Watches during the first eight months on the market, placing the Watch as the second best-selling new product category in Apple's history. For perspective, Apple sold 15 million iPads during its first three quarters on the market. The majority of Watch sales occurred in the U.S., and the lowest-priced Watch Sport collection, which was responsible for a majority of the sales, had seen significant customer interest around the holidays given Best Buy and Target sales promotions. In terms of Watch bands, the Sport Band has proven to be the clear choice with consumers. 

The Apple Watch has undergone an expectations reset over the past year. The device was initially positioned as a mini iPhone on one's wrist. The expectation was that we would use a series of apps positioned in a honeycomb pattern on a small piece of glass worn on our wrist to get through our day. After only a few weeks of use, it became clear that this vision was not going to be the primary use case for most people. The introduction of watchOS 2 in September didn't change the trajectory. 

Apple contributed to these initial Watch expectations in the way they unveiled the device in September 2014 and yet again in March 2015. While Apple's positioning of the Watch as a great way to display small amounts of text and information was on point, management's broader focus on third-party apps hasn't materialized. While some may attribute lackluster developer interest as the primary reason app usage has trended differently than expected, the much bigger reason was that Apple likely tried overselling the Watch. In reality, consumers saw value in a few simple daily tasks like receiving notifications from their favorite apps. Instead of involving searching and then interacting with apps like we would on an iPhone, the Watch required a new, much simpler way of interacting with apps.

The Watch's future is not found by simply taking the way we use our iPhone and putting it on a smaller screen on our wrist. Instead, the Watch will gradually handle tasks we used to give to our iPhones. We already see this taking place in terms of sending and receiving messages and paying for things in stores. In addition, the Watch is beginning to handle new tasks like tracking our health. The commonality among all of these tasks is the need for evolutionary updates and improvements in order for Apple Watch to be positioned to handle many more tasks as time progresses.

Apple Watch Bands

While Apple Watch app usage has trended differently than Apple initially positioned, watch bands were one aspect of the Watch that Apple seemed to get right from the beginning. The wide variety of available Watch bands has contributed significantly to Apple Watch's success. As it is a personal device worn all day, every day, the ability to add personality to one's Watch with different bands has proven popular. Tim Cook recently pointed out that one third of Apple Watch owners regularly change their Watch bands. This amounts to more than three million people buying at least $150 million of what amounts to an Apple Watch fashion accessory. While this may pale in comparison to revenue from Apple's other products, early trends contain much promise. 

As a sign that Apple expects Watch bands to play a crucial role in Apple Watch's future, Apple had a new range of Watch bands ready for sale only five months after launching Apple Watch. At the same time, the Hermès partnership was announced, positioning luxury leather bands as the centerpiece of a new Watch collection. Last month, Apple unveiled additional Watch bands for its "Spring collection." The motivation behind these moves was clear: New Watch bands add a sense of freshness to the product category. A new phenomena developed and instead of buying different Watches from more than one collection, consumers were buying multiple Watch bands and switching them on and off depending on the occasion. It was difficult to miss Jony Ive coordinating his Watch band selection with whatever he was wearing at various Apple keynotes and events. There was something with Watch bands that caught consumers' attention much more than even the Watch cases themselves.   

My Experience

Over the past 12 months, my Apple Watch experience has reflected many of these larger themes that sum up Apple's entry into the wrist wearable category. The Watch's value proposition has revolved around three primary items for me: notifications, timekeeping and fashion. 

1. Notifications. Apple positioned sending and receiving notifications as a key Apple Watch attribute from the start and with only a few exceptions, this has largely proven true. There is value and convenience in being able to easily see iMessages, incoming phone calls, tweets, and other short reminders without having to retrieve my 5.5-inch iPhone 6s Plus from a pocket or nearby room. 
2. Timekeeping. Even though it sounds comical, I use my Apple Watch for timekeeping. As there is convenience found with receiving notifications on my wrist, there is value in not needing to find my iPhone to see the time. However, as a sign that Apple Watch is something more than just a watch, I never used my traditional watch to tell time. This may be attributed to the fact that I prefer Apple Watch faces over a traditional watch face.  
3. Fashion. There is no question that the only reason I wear my Apple Watch every day is because of the Sport band. There is value in forgetting I am actually wearing the Watch thanks to the Sport band's comfort and design. Watch bands play an important role in positioning Apple Watch not just as a personal technology device, but also as a fashion accessory. This was the primary reason I previously wore a traditional watch - not because of its usefulness, but to simply put something on my bare wrist. 

When combined, these three use cases help show not only how effective the first edition Apple Watch has been in serving as an iPhone accessory, but also where Apple can push to bring the device to the next level. One obvious next step involves looking beyond just the Watch case and instead, thinking about my entire wrist. 

It's All About Wrist Real Estate

After looking at my three primary Watch use cases, a few things stood out to me. I enjoy having some type of display on my wrist that is capable of showing me more than just the time. Simple plastic wrist bands or pieces of smart jewelry not having the capability to display text, pictures, and yes, even emoji, don't represent the future of wearable computing. Instead, these devices will forever remain accessories to other screens in our lives. 

The need for some type of display with a clear line of sight means Apple Watch's rectangular display sitting on top of the wrist will remain for the foreseeable future with periodic updates that include faster processors, improved sensors, and evolutionary design changes. I think the Apple Watch case is still a bit thick. The eventual inclusion of GPS and cellular connection will likely represent significant shifts in trajectory for Apple Watch adoption.

Expectations currently point to the first major Apple Watch case revision being unveiled in September. However, instead of looking at these periodic Watch case changes as the extent of Apple Watch's future, there is actually more potential found with Apple Watch bands.

Success for wrist computing involves taking the finite amount of real estate on our wrists and using it to make technology more personal. This doesn't mean just taking technology and putting it closer to our bodies, but rather it means using a device's design to introduce new capabilities. Wearables make it possible to extract additional power from technology without having it take over our lives. One example is paying for an item in a store by using Apple Pay with just an arm swing and double press of a button. Another is turning a gentle tap on the wrist into a form of communication. This quest for making technology more personal has been Apple's singular mission over its 40-year history. 

In terms of wrist real estate, as shown in the picture below, the Apple Watch Sport band takes up nearly four times as much wrist area as a Watch case.

The M/L Apple Watch Sport band takes up four times as much area on the wrist as the Watch case. 

Obviously, this ratio will change depending on the user, but the primary point is that simply utilizing the top of our wrist is not optimal for wrist wearables. While the top part of the wrist is ideal for viewing data, the rest of our wrist can still be used for other purposes.

Including additional sensors, battery volume, and other components directly into Watch bands will better utilize wrist real estate. Instead of having the Watch case be the only "smart" piece, Apple will likely begin selling Watch bands that go much further than just representing pieces of fashion. The fact that thinner Watch cases would seem to stand at odds with the need for additional battery space and the eventual inclusion of GPS and cellular connection may further stand as motivation for pushing certain components into Watch bands.

We likely got a glimpse of this future when looking at the New Yorker's profile of Jony Ive which mentioned that he admitted much of Apple's Watch R&D was focused on the bands and not the rectangular Watch case. 

There are a number of ways Apple could incorporate technology into Watch bands, including even a modular approach, which Apple has patented. One real-world example of this type of setup is consumers' ability to swap out Watch bands for ones with built-in battery, extending the Watch's usability. The user would then be able to further refine the band, adding or removing links containing extra battery. The same can be done for health-related bands containing certain sensors that require a cuff-like product to work properly. This is where Apple could theoretically apply for FDA approval for specific Watch bands marketed to treat or diagnose various diseases and conditions. In this scenario, Apple would avoid putting the entire Apple Watch through the FDA approval process. 

Sales and Price Implications

The addition of smart Watch bands will have major implications for Apple Watch financials. One likely scenario is that customers will use Watch cases for an extended period of time. Meanwhile, smart Watch bands would be positioned as items worth upgrading more frequently. In fact, Apple has already begun positioning Watch bands as something worth purchasing multiple times a year based on the season.

This would suggest that the number of Apple Watch users would be a much more important metric to track than the number of Apple Watches sold. As the number of Apple Watch users increase, the addressable market for various smart Watch bands will expand. In a few years, selling a $199 smart Watch band into an Apple Watch installed base of 30 to 40 million users will lead to much success even if a small fraction of Watch owners buy the band.   

In terms of pricing, instead of highlighting three Watch collections based on Watch case materials (aluminum, stainless steel, gold), Apple could position Watch bands as the primary pricing variable. It appears Apple is already moving in this direction based on their new Watch interactive gallery available on Apple's website (shown below) where there isn't much distinction between the Sport and Watch collections. 

Apple's New Apple Watch Interactive Gallery.

Product Implications

While a rectangular piece of glass sitting on the top of the wrist is an adequate way to to display data today, the Watch band itself will likely one day be able to display data. Over time, Apple Watch could be nothing more than a smart wrist band with a flexible AMOLED display containing a mix of personal technology and fashion. As with its Hermès partnership, Apple could work with existing luxury companies to build Watch bands that contain precious metals and minerals. If watch manufacturers were already concerned about Apple Watch, the move away from dedicated watch cases and to flexible bands capable of displaying information would represent even greater anxiety.

A Hybrid Approach

It is easy to think of Apple Watch case development in terms of iPhone and iPad. Each year, or in the case of iPad, approximately every 18 months, Apple releases an evolutionary update containing various amounts of hardware and software improvements. However, the iPod may end up serving as a better example for how Apple Watch bands will evolve. Comparing the very first iPod released in 2001 to today's iPod touch conveys the message that the product saw not only incremental design changes, but also fundamental shifts in feature sets based on new technology. This would suggest Apple Watch will likely take the hybrid approach. Watch cases will retain much of their familiarity and see more evolutionary changes while Watch bands will become much smarter over time and capable of eventually replacing even Watch cases. While the Apple Watch continues to be underestimated, Watch bands rather than Watch cases will prove to possess the larger amount of surprise. 

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