The Great Apple Music Pivot

Apple Music is the right product at the wrong price. Music subscriptions based on human curation and discovery are the future, but putting more than 30 million songs behind a paywall won't help facilitate widespread adoption. Apple Music's family plan option will give the service life, but more is needed. The free music subscription model will eventually be too difficult for Apple to ignore. By pivoting to include free music, Apple Music will then be in a much better position to put the business of music on a path to sustainability. The music industry needs its "App Store" moment, and the combination of free music, Apple's premium user base, and Apple Music's Connect would be the closest thing yet to that vision becoming a reality.  

Apple Music Ambitions

While the press has run with the Apple Music versus Spotify storyline, in reality, Apple's music ambitions are much more grandiose. Apple is once again trying to build music sustainability by selling an all-encompassing music service. There is precedent for such lofty goals as the iTunes ecosystem presented the music industry with a much needed reprieve from the rise of piracy and genuine questions of music's sustainability. Apple relied on a service that capitalized on ease of use to stoke demand for paid music downloads. Ten years later, while things may have not changed much as labels are still making short-term decisions guided by money, and there are renewed questions around music sustainability, we now live in a world where free music subscriptions are gaining momentum and acceptance.

One reason Apple is fully embracing paid music streaming and avoiding a free music steaming tier is to change the perception surrounding music's inherent value. By having consumers look at music as something worth paying for - a good with inherent value - it will be easier to get people to pay for music through other mediums in the future. A culture based on free may not bode too well when trying to sell new music initiatives and services. Take a look at the App Store for evidence of this trend. 

As Spotify has shown, when both a free and paid streaming option are available, a vast majority of users stick with free. With Apple Music, by not offering a free music subscription option, Apple is trying to increase the paid tier's value as that would be the only way to enjoy the full service being sold. There is no question that Apple Music will gain users, and I would go so far to say that it would be shocking if Apple is unable to become the largest paid music streaming service. It helps that Apple's user base is comprised of premium smartphone users that have shown the tendency to spend more on apps and other content.  However, I doubt it will be enough to move paid music streaming far beyond the segment of the population that has been paying for music all along.

The Record Labels

In today's disjointed environment where digital music industry revenue is still coming from many directions, record labels continue to spend big money on marketing and promoting their portfolio of music artists in an effort to gain mind share and exposure. The IFPI estimates that over the past five years, labels have spent $20 billion on artists and repertoire (A&R) and marketing. In this environment, free music streaming is an attractive proposition for record labels because their portfolio of artists is able to reach a much wider audience. Simply put, record labels have taken free music streaming hostage. This is one reason why the major labels put their music on YouTube, Spotify's free music tier, and even went so far as to agree to Apple's initial "no pay" stance on Apple Music's three-month free trial. Ultimately, it is this desire for exposure on the part of labels that represents Apple Music's biggest headache as charging for music is made that much more difficult when music is free elsewhere. 

Free Music Streaming

Over the past few years, free music streaming has received a bad rap. Free music subscriptions have the potential to be attractive for both music artists and fans because artists gain valuable exposure while fans have access to a vast amount of music. However, there continues to be one major problem with free music subscriptions: ad-supported free music streaming simply does not provide enough revenue for musicians. There are very few alternative monetization techniques available for the average musician unable to tour or grab sponsorships. Meanwhile, paid music subscriptions, which Apple is betting on, remains niche with no evidence of mass market appeal given the presence of free music options elsewhere. It would seem that the music industry is in quite a predicament. 

In 2014, subscription streams income accounted for 23% of the music industry's $6.85 billion of digital music revenue. However, in an alarming sign of what is to come without significant industry change, ad-supported free music stream income, despite having 2.5x the number of users, accounted for only a third of the revenue from paid music subscriptions. The math just doesn't add up for free music streaming in its current form, despite its growing popularity. That doesn't mean that free music subscriptions should go away, but rather that more needs to be done to build other ways of valuing music. 

Meanwhile, YouTube remains the most popular option to access free music, with more than 1 billion users. According to the IFPI, approximately 27% of internet users listen to music on YouTube without watching the video. Despite having upwards of 10x the number of users compared to music subscription services, YouTube and other video platforms accounted for only $650 million of digital music revenue last year, less than half of the revenue attributed to subscription services. 

One positive sign is we are still in the very early stages of the music subscription era. The vast majority of people have not used music streaming. According to the IFPI, there were only 141 million active users for music subscription services at the end of 2014, of which 41 million were paying global subscribers. For perspective, there are approximately 475 million iPhone users out in the wild. Recent user surveys from Ipsos placed paid streaming usage at 16% while free streaming stood at 35% across 13 selected markets. This suggests that there is still time to come up with new and exciting ways of  building monetization into free music streaming.

Apple Music Pricing

Apple faces an uphill battle with Apple Music pricing largely as result of the music labels. Initially, it was reported that Apple wanted to price Apple Music at $5 per month to match the amount of money people spent on music in iTunes. The labels said no. Instead, with single memberships at $10 per month, Apple Music is priced in-line with other streaming services, offering full membership for $120 per year.

At first glance, Apple Music would appear to be dead on arrival given that price. However, there are a few other variables at play that will result in Apple Music having some life. While Apple was not able to get labels to agree to lower the price for single memberships, Eddy Cue was able to get the labels to come down in price to $15 per month for the family membership. Given that up to six people can be on the same iCloud account, Apple Music's family pricing will likely be much more popular than single memberships. 

In addition, it is important to remember that Spotify has 20 million subscribers paying $10 per month for its music streaming service. Since music streaming is still in the early innings, I suspect Apple will make inroads into this market, and it would be surprising if Apple cannot get more than 20 million people to sign up. The problem is that the upside to this number is limited by not having a free music streaming option. 

Apple is aware that entering the music subscription era without a free music tier is like entering a fist fight with both hands tied behind one's back. Accordingly, Apple has made certain aspects of Apple Music accessible to everyone. In terms of marketing, Apple's messaging continues to shift the focus away from music streaming (which is mostly a commodity these days) and instead towards playing up the idea of Apple Music as one service containing various ways of listening to music, curation and discovery led by music tastemakers, and interaction with your favorite artists. Said another way, Apple is trying to build music culture instead of being just a paid music steaming service. 

Apple's Long-Term Music Plan

Apple will pivot Apple Music to embrace free music streaming. However, any early success seen with family plans will not be lost. Evidence of a vibrant ecosystem and user base would be very appealing to music labels, which would agree to have their artists and catalogues included in a free music streaming tier on Apple Music. 

Music Culture/Discovery.  Apple is investing heavily in human discovery and curation by allowing tastemakers like Zane Lowe to represent the face of Apple Music. Beats 1 is positioned as a 24/7 radio station guided by one mission: play great music. The point of such a product is to build excitement, push music discovery, and introduce passion back into music. Having a host of DJs ranging from Drake to Elton John is meant to add personality to what has increasingly been algorithm-driven playlists and radio stations. There are many questions as to how one channel broadcasted across the world is going to work, especially considering all of the different tastes represented by the guest DJs. Nevertheless, much of this focus on music culture will remain a central theme of Apple Music regardless of price and whether Apple has a free music streaming tier.  

Connect. In what may the most interesting and intriguing aspect of Apple Music, Connect has the potential to be the very early stage of a fundamentally new kind of service that the music industry has never seen. Connect is a way for artists to connect with fans by sharing content such as pictures, short clips, and exclusive material. While the service has very subtle similarities to Apple's ill-fated Ping product, management has learned its lesson that the world doesn't need another social network. 

Connect may be so significant, it can represent the music industry's "App Store" moment. Connect can become the primary medium through which artists can monetize their art beyond music. Typically, the argument has been that artists can monetize free music through merchandising and touring. While for some that may work, the much more sustainable method would simply be to create a medium by which fans can support artists directly through either subscriptions or different access tiers. In the process, the definition of a musician changes. We soon can all become musicians with a route to monetization, even if we aren't professionals. Music is the art of expressing our emotion and views on the world. To think that the only people capable of making money from music are those that go on tour and sell t-shirts is missing the much bigger point. 

In a world where all music is free, Connect can be the way that artists sell subscriptions for complete access to the process behind their art. Videos, blogs, and other exclusive content can arguably be much more valuable than the actual music itself. In such a world, discoverability and the ability to reach hundreds of millions of users is critical because to find sustainability, an artist would only need to reach a very small group of loyal fans. Instead of 20% of the population paying $120/year for all the music they want, which primarily would go to the big labels and megastars, in this new world, 100% of the population can listen to all the music they want while supporting artists that they feel a connection to.

The theme behind all of this is decentralizing power from a few labels to everyone: 

• Music will be free. As a result, music artists can reach hundreds of millions, if not billions of users.
• Artists have access to information on their fans, making it easy to set up monetization efforts.
• Artists can rely on software to monetize their brand (image and personality) primarily through subscriptions and advertisements, but also through merchandising and sponsorships.
• New talent can transition from discovery to monetization quickly without many barriers.
• The definition of “music artist” becomes boarder to emphasize a wider range of content creators.

The problem with the current music industry structure is that it is difficult, if not impossible, to accomplish many of the preceding bullet points, especially without the support of a label. However, change is in the air. A music artist no longer needs to be sponsored by a Fortune 500 company, sell out the local sports arena, or have 10 million followers on social media to find sustainability. Instead, finding one's true fans and focusing attention on those individuals can lead to sustainability. In such an environment, the most difficult bullet point remains discoverability, which is conveniently one of the underlining themes found within Apple Music. 

Measuring Success

Success with Apple Music will change over time. At first, success will be judged by share of the paid music streaming market. The discussion will focus on Apple owning the "premium" music market, or those who are in a position to pay for music. Next, the discussion will focus on ecosystem strength, where the total number of users is paraded around, including those that just listen to Beats 1 and other radio channels. This is where the prospect of free music will be too hard to ignore. Meanwhile, Apple will work on expanding Apple Music's reach into other forms of music content, not to mention mind share. Apple would then introduce a new version of Connect where fans have the opportunity to buy the full experience from individual artists. All the while, the record labels will fight and drag their feet against these changes because they essentially are anti-label, giving most of the power to artists and fans. As Apple begins its new music journey, Apple Music has a future, but a few changes are needed to give the service widespread appeal and the ability to truly add sustainability back to the business of music. 

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Taylor Swift is Backing Herself Into a Corner - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts accessible to everyone, I write 10-12 stories a week about Apple sent exclusively to Above Avalon members via a daily email. The following story was sent to members on June 22nd. For more information and to sign-up, visit the membership page.

Taylor Swift is Backing Herself Into a Corner

Taylor Swift was able to capture much of the Sunday news cycle with a well-circulated Tumblr post with a passive aggressive "To Apple, Love Taylor" title. The seven paragraphs that made up the post can be summed up in three sentences:

"I'm sure you are aware that Apple Music will be offering a free 3 month trial to anyone who signs up for the service. I'm not sure you know that Apple Music will not be paying writers, producers, or artists for those three months. I find it to be shocking, disappointing, and completely unlike this historically progressive and generous company."

Eddy Cue responded within 17 hours saying via Twitter that Apple had changed its mind and will pay artists during the free trial period. Apparently, Apple will pay rights holders on per-stream basis, the details of which were not disclosed [Apple will pay 0.2 cents for each song streamed]. It would seem the rate will be less than the regular rate once the trial period ends. Regardless, the change in Apple's stance occurred very quickly. Does this mean everything is okay? Not quite.

Before I go any further, I think it's important to note that Taylor Swift knows exactly what she is doing. Beginning with her WSJ op-ed last year and her recent spat with Spotify where she removed her entire music catalog from the music streaming service, Swift has fully embraced the message that music needs to be valued appropriately. Not only does such positioning likely hold true to her beliefs, but it serves her well from a business sense.

Taylor Swift is arguably the biggest music act going today. She is one of the few that can sell out venues each night for months across the world. She has spent years developing her fan base and connects with them extremely well. Simply put, she can afford to take these kind of hard stances and use her music as a bargaining chip.  

You will quickly discover that you can't go far talking about music without discussing record labels and the complicated structure where everything is done in such a way as to position the dollar as the ultimate goal. In many ways, Taylor Swift transcends all of this talk because of the power she holds. This means that any discussion involving Taylor Swift is often much more ideological than practical as we can ignore the record label. 

At the end of the day, this Taylor Swift vs. Apple battle wasn't even about Apple. It's about valuing music. Swift previously battled Spotify. Yesterday, she called out Apple. Tomorrow, she will call out someone else. Apple is simply a symbol of what Swift is fighting for: raising awareness that the music industry is selling an art form that should be valued accordingly. 

Swift's primary argument against Apple's 3 month tier was that such a feature does not value music appropriately. If you are a music artist and you release a new album from July to September, you would have received $0 from Apple Music and the 10s of millions of people trying the service out. While simplistic in thought, basically the entire music industry would have received $0 from Apple for those three months. When you say it like that, it is hard not to agree with Swift's argument, and I suspect that is why Apple changed its tune, deciding to pay artists during the trial period. Swift wasn't the only one to raise this issue in recent days, so it is possible that Apple was at least thinking about this topic for a few days and Swift was the final straw. 

Even though Swift won this latest battle (Apple probably will face no long-term negative implications from this though), I still think Swift's long-term positioning in terms of valuing music is problematic. Swift is combining short-term goals with long-term ambitions. She is upset with any service or feature that doesn't value music correctly. She raises very valid (and convincing) arguments. However, when looking at the long-term, Swift is likely backing herself into a corner.

One theme that has developed in the music industry over the past decades, especially the last 10-15 years, is that technology is a formidable force. The music industry has not been able to figure out how to find sustainability with music streaming. There is pain in the streets. Taylor Swift, and a handful of other actors, are using what essentially boils down to aggressive negotiation tactics to force change (i.e. getting people to pay for music). In the near-term, Swift's exposure and power will increase. Her fans will like her even more. And she may very well win many battles (as she did vs. Apple).

However, look at what happened with Swift's battle with Spotify. The music streaming service's momentum in terms of user growth (the most important metric for Spotify) has shown no signs of slowing down after Swift pulled her music collection. In fact, one can argue Spotify gained exposure following Swift's very public battle with its free streaming tier. Here is where I think Swift will find some trouble. She will not be able to control technology. Even though she is the most popular music artist in the world today, that is not enough to shift what will be inevitable in terms of music and technology. She is trying to get everyone to play nicely, but no one person holds enough power to keep everyone in line. A stronger Spotify, including a more popular free streaming option, would seem to go against what Swift is advocating. 

Look at how Kid Rock turned out in his opposition to paid downloads on iTunes. Technology, and the world, passed him over. The same will happen with Swift if she doesn't change her tune (which I think she will) over time, concerning how music should ultimately be valued. 

Swift wants people to value music appropriately. Apple does too. Swift thinks the best way of doing that is to pay for music. I'm not sure Apple feels the same way long-term. Technology likely has other plans in mind (and I suspect Apple does too) in terms of how one can monetize music to ensure sustainability. Free music streaming isn't going away, regardless of how much Taylor Swift hates it.

In addition to the preceding story, Above Avalon members also received the following stories this past week:

• Apple Stock Buyback Primer (seven chapters)
• Apple's Cash Dilemma (Why Not Just Pay the Tax?) 
• One Drawback of Holding $194 Billion of Cash
• The Symbolism Behind the Gold iPhone
• Google's Early Approach to Take On Apple Watch
• Calculating Apple Watch Band Profit
• Just Doing What's Right (Tim Cook and Eddy Cue edition)
• Improving iOS 9 Adoption is High Priority at Apple

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Wall Street Starting to Doubt Apple Watch - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts accessible to everyone, I write 10-12 articles a week about Apple sent exclusively to Above Avalon members via a daily email. The following article was sent to members on June 17th. Please visit the membership page for more information and to sign-up.

Wall Street Starting to Doubt Apple Watch 

One by one, sell-side analysts are starting to turn cold on Apple Watch, a product released seven weeks ago. Yesterday, Pacific Crest analyst Andy Hargreaves published a note saying his confidence in Apple Watch is declining as interest appears to be higher in the iPod than Apple Watch, judging by Google Trends, and something needs to be done or else Apple will struggle meeting Watch expectations. Here's Hargreaves:

"Initial Apple Watch demand has been very strong and our most recent checks suggest Apple remains well positioned to produce enough units to meet or exceed our FQ3 unit estimate of 5.5 million and our F2015 unit estimate of 11 million. However, reviews of the device have been mixed, the fashion angle appears to be leaning a bit too much toward "calculator watch," and general consumer interest as measured by search volume is below the iPod (with an "o")...All of this suggests a dramatic increase in functionality is likely needed to grow unit sales and meet current expectations for F2016 unit volumes. Given Apple's developer community, this is clearly possible. However, our confidence is declining, which suggests risk to our F2016 unit estimate of 24 million is increasing."

I will comment on his Watch sales estimates shortly, but it's important to note what he is arguing: once early adopters buy the Watch, evidence in the form of Google Trends would suggest sales will slow. The focus isn't so much on Apple Watch sales for the current quarter or even next (those will probably be fine), but the follow-through as we move away from launch. Basically, the question being raised is will normal people buy the Watch?

Hargreaves is not the first analyst to raise Watch concerns. On Apple's last earnings quarter, Toni Sacconaghi of Sanford Bernstein took issue with Tim Cook's attitude and tone when discussing Apple Watch. Here's Sacconaghi:

"I just wanted to revisit the watch. Tim, I think you've said, when you were talking about your new products, you said we're 'very happy with the reception' and in response to a previous answer, you said, 'relative to demand, it's hard to gauge with no product in the stores.' I would say relative to other product launches, where your commentary around demand was characterized by superlative after superlative, that assessment feels very modest." 

Tim responded, "I'm thrilled with it, Tony, so I don't want you to read anything I'm saying any way other than that. So I'm not sure how to say that any clearer than that." Sacconaghi recently visited with Tim Cook and Luca Maestri and once again he made note of their demeanor, saying their tone was "confident, though not ebullient."

All of this doubt should be expected as Apple chose not to disclose Apple Watch sales. That decision was likely not taken too lightly at Apple HQ. If management announced opening weekend sales, a can of worms would be opened where people would expect such disclosure at every turn and any slight deviation would be marked as a negative. Take a look at iPad to see what being aware that unit sales are declining year-over-year can do to a product's perception.

However, by not releasing sales numbers, doubt and worry are allowed to build as there is no concrete evidence to refute an analyst's analysis. Instead, some are left resorting to analyzing management's tone when talking about the Watch.

I suspect one of the driving reasons that led management to keep Apple Watch sales under wraps is that given the current environment, Apple doesn't need to release Watch sales numbers. With the iPhone selling so well and representing a large portion of operating income, I can see Apple looking at that and saying that there wouldn't be much benefit from releasing Watch sales numbers. When you are selling 50 million iPhones a quarter, announcing four million Apple Watch sales may be lost on many market observers. In addition, the less Watch disclosure, the harder it would be for competitors to respond.

The very little amount of data that we do have on Watch sales (primarily from Slice Intelligence, but also Apple revenue guidance for the current quarter) would suggest that Apple Watch sales look solid (4M so far), although the adoption rate may be a bit weaker than that of the initial iPad in 2010. Said another way, the Watch may indeed take a bit longer to catch on with people compared to how the world seemed to accept the iPad over night. Did Apple expect this and feel it was prudent to not release sales early on? It's possible. In a way, Apple would be somewhat hedging its bet just a bit.

Let's not forget, Apple has been big about disclosing sales numbers if they are strong. That's why I think this decision may be related to iPhone strength. Apple would have decided they weren't going to break out Watch sales numbers months ago. I suspect this is not a decision based on opening weekend sales strength or weakness. 

Ultimately, Wall Street is all about expectations. Back in November 2014, my very first Watch sales estimate was for 20-30 million units to be sold in the first 12 months on the market. In March 2015, I fine-tuned my estimate to 28 million units in the first 12 months on the market. These numbers are important because they help frame how I look at the Watch and what would be "disappointing" results or "strong" numbers. Every analyst is different, and that is important to take into account when they issue research notes discussing the Watch. Looking back at Hargreaves' note, his 12-month Watch sales estimate looks to be pretty similar to mine across the board, so he's not overly optimistic or pessimistic.

If analysts' main concern is around Apple Watch sales in 2016, I have a feeling we may need to get used to this Apple Watch doubt. We are in the very early innings of this game, and there is no evidence yet to suggest the Watch has struck out.

In addition to the preceding article, Above Avalon members also received the following articles this past week:

• The Genius Move Behind the Phil Schiller Interview 
• How to Discover Apple Watch Sales 
• Apple is Playing Offense, not Defense 
• New Productivity Features Hint at iPad's Future
• Fitbit Prices IPO Above Expectations 
• Cablevision CEO Sees Cable Bundle Dying 
• Apple's New Search APIs 
• Apple Retail Store Renovations  
• Apple Hiring News Editors
• Apple Correctly Killed Plans for Beats Wifi Speakers 

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Apple's Cash Dilemma

With approximately $200 billion of cash on the balance sheet, Apple's financial strength has never been stronger. However, Apple has a growing dilemma on its hands concerning its cash and capital return program. Apple is unable to keep the pace of share buybacks and dividends in-line with its foreign cash generation.  As a result, excess cash that is not needed to run Apple's business continues to build on the balance sheet. While labeling a company with $200 billion of cash as having a cash dilemma seems like hyperbole, Apple's valuation metrics will likely be negatively impacted in the coming years if Apple is unable to return this excess cash to shareholders. 

Apple's Total Cash Continues to Increase

Apple currently has $194 billion of cash, cash equivalents, and marketable securities. Not only is this a record in terms of cash held by a single company, but it represents approximately 10% of all cash held on corporate balance sheets. Given Apple's business model, it does not need all of this cash to run its business. With an enterprise value of $583 billion, Apple would theoretically be able to repurchase 30% of itself using the cash on its balance sheet. In reality, things are much more complicated as most of this cash is not able to be used for share buyback because it is held offshore and would be liable for additional tax if returned to the U.S.

Exhibit 1: Apple's Total Cash, Cash Equivalents and Marketable Securities  

Most of Apple's Cash is Held Offshore

Apple's foreign cash continues to comprise a growing portion of Apple's overall cash. In the eight years since the iPhone was released, Apple's foreign cash has grown to $171 billion from $7 billion and now accounts for 89% of Apple's total cash, up from 44% in 2007. With approximately 70% of annual revenue coming from outside the U.S., Apple's foreign cash will continue to grow at a much faster pace than its U.S. cash. Apple has been content with keeping foreign cash offshore in order to avoid paying additional tax if it was brought back to the U.S. 

Exhibit 2: Apple's Total Cash, Cash Equivalents and Marketable Securities (Foreign vs. U.S.)

Apple has been using some of its foreign cash for organic growth initiatives, including component procurement, international retail and facility expansion, and clean energy initiatives. Even after all of these expenses, cash generation continues to exceed what management needs to run the business.  

This past quarter, Apple sold more iPhones in China than in the U.S. for the first time. Rather than this being an isolated event, China will only become a bigger piece of the iPhone sales pie given social-economic trends and an untapped market of more than 600 million phone users. The end result is Apple's foreign cash generation will continue to vastly outpace U.S. cash generation.

Apple's U.S. Cash is Being Depleted

With foreign cash being kept offshore, Apple is forced to use its U.S. cash to fund the capital return program. As a result, Apple has a more "modest" $22 billion of cash available in the U.S., which reflects the impact of more than $40 billion of debt issuance over the past three years. Without issuing debt, Apple would only be able to rely on U.S. free cash flow generation of approximately $20-$25 billion a year to fund buyback and dividends. It is important to remember that Apple needs a certain level of available cash in the U.S. to take care of routine business expenses, not to mention have cash on hand to take advantage of M&A opportunities. It is not prudent to allow this cash total to fall too low, and management has shown the willingness to slow share buybacks instead of depleting U.S. cash reserves.

Exhibit 3: Apple's Cash, Cash Equivalents and Marketable Securities (U.S.)

The Dilemma

Apple's cash dilemma is straight-forward: Apple is generating cash internationally at a much faster rate than it is able to spend on stock repurchases and cash dividends in the U.S. As China continues to make up a larger portion of Apple's product sales, boosting total free cash flow, management is facing some limits as to the amount of available funds used for stock buyback and dividends. The following exhibit shows how the amount of free cash flow (red line) is expected to outpace the amount of cash spent on buyback and dividends (blue line) in the coming years. China is increasingly causing the red line to slope upward as time goes on while the blue line is being pinned as the U.S. is becoming a smaller piece of the overall cash generation pie. In an ideal world, there would no gap between the red and blue lines as most of Apple's free cash flow would be spent on buyback and dividends. 

Exhibit 4: Apple's Cash Dilemma

Apple's Options

Management does not have many available options at its disposable for solving its cash dilemma. 

• Lobby for U.S. Tax Law Changes/Holiday. The preferred option would be returning cash currently held offshore back to the U.S. in an environment with a lower tax rate (15% or less), or during a special tax holiday similar to 2004. Obviously, Apple would want a rate in the single-digits, but Washington politics may make any change to tax policy a long shot. If the tax rate was lowered, Apple would be able to bring back $140-$150 billion of foreign cash and then buy back up to 20% of itself in relative short-order through a public tender offer. At a forward price/earnings ratio of 12x and a free cash flow yield of 6%, Apple management likely views AAPL's current valuation as attractive for such a tender offer. 
• Continue Issuing Debt to Fund Capital Return. Apple is currently using a combination of debt and U.S. free cash flow to fund share buyback and dividends. As Apple's foreign cash grows, Apple can continue to borrow additional debt. However, Apple's cash dilemma will not be solved as foreign cash generation will still likely outpace the rate of capital return even after considering a realistic amount of debt issuance each year. Eventually, Apple would be holding $400-$500 billion of cash, almost all of it offshore, and $150 billion of debt, all of which would have been spent on the capital return program. Apple would then need to manage its debt obligations, only straining its U.S. cash needs even more. Management may begin to cool to the idea of issuing significant amounts of debt if interest rates rise or if Apple's business slows, further making this option somewhat unsustainable in the long run. 
• Do Nothing. Management could also slow debt issuance and simply spend less on share buyback. This option would be taken with balance sheet preservation in mind. If Apple slowed all buyback activity, both U.S. and foreign cash would increase and Apple would likely reach $400 billion of total cash in relative short-order. The risk to this option is Wall Street's reaction to Apple sitting on too much excess capital, a scenario that had begun to play out in 2011-2012, and some can argue, is still playing out today. 

How is Holding too Much Cash a Dilemma?

Apple's market valuation is obtained in the marketplace at a price where AAPL buyers and sellers are willing to trade shares to each other. If there is greater demand for shares at a certain price, the price will rise until demand and supply are in equilibrium. Investors buying Apple shares are interested in owning a piece of the company's assets used to generate cash in the future. Since a company's value is obtained by discounting future cash flows and excess cash is not involved in future cash generation, the market is forced to include the cash in its Apple valuation. The end result is there is a high likelihood of either Apple's cash being valued incorrectly, or much more likely, Apple's underlying business being valued at a discount. This is the fundamental logic behind those that have been pushing Apple to use its excess cash to buy back more stock. 

Unless foreign cash is brought back to the U.S. in order to boost the magnitude of share buyback, Apple's excess cash will continue to grow, and the valuation metric that the market is giving Apple will continue to be suppressed. This is one likely reason why Apple is trading at a 12x forward P/E multiple. Apple CFO Luca Maestri has quite the dilemma on his hands.  

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Apple Is Playing Offense at WWDC

Apple is on the offensive. This is not a company content with standing by and letting Google, Facebook, Spotify and a handful of other third-parties take over critical elements of the user experience of approximately 500 million iPhone users. Instead of just swinging a sword and trying to compete with everyone indiscriminately, Apple is carefully positioning its resources and the overall iOS platform to stress value propositions at which Apple has historically excelled. These include personalization, emotion, and privacy. WWDC highlights how battles are being chosen meticulously as Apple's mission is clear: reducing its dependency on others. With the News app, Apple is trying to change users' habits in terms of how they get content. Apple Music is a test in how successful Apple will be once again in not just getting customers to pay for something that is free elsewhere, but rethinking the music industry. Siri and Spotlight are being positioned as Apple's method for rethinking search. Instead of sitting back and letting third-parties have all the fun, Apple wants more. 

The Chess Game Heading into WWDC

Apple had the wind at its back headed into this year's WWDC. The iPhone 6 and 6 Plus have resonated with consumers across the world, especially in China, leading to more than 40% unit growth year-to-date in 2015. One metric that Tim Cook has reiterated on recent earnings conference calls is the Android switcher rate, or the percent of iPhone sales that can be attributed to former Android users. Recent Kantar data and Above Avalon estimates would suggest that approximately 20-25% of iPhone sales in 2015 have come from customers new to iOS, which totals to nearly 25-30 million users entering the iOS ecosystem for the first time. 

The iOS platform has hit critical mass; it is large enough to sustain app innovation and developer interest. Nearly every major third-party consumer-facing technology company, including Google, Apple's primary competitor, have all but guaranteed support for the iOS platform, a noteworthy reversal from years of doubt and cynicism from those who warned Apple's smartphone 10% market share may eventually be outmatched by Android's massive reach. The problem with that logic turned out to be that Apple actually has 70%+ market share in the premium smartphone market which includes those who are very likely to use apps and services.

On top of that, Google and Facebook have business models that depend on obtaining data at scale, and Apple's highly engaged users are a prime target. It would be difficult, if not impossible, for Google and Facebook to ignore 500 million iPhone users. 

Given the current environment, one would assume Apple is feeling pretty good. Executives could push out an iOS refinement update, watch iPhone sales roll in, and coast along until WWDC 2016. In reality, Apple is more nervous now than ever before. 

This nervousness is not born from weakness, but rather strength. Apple is nervous about the unknown, the low probability event, the Black Swan that we can't even imagine. It is with this nervousness that Apple positioned certain new OS X and iOS 9 features as preemptive moves on the hypothetical chess board. 

Apple wants to be in a position where it can counter the scenario of Google, Facebook, or another powerful third-party taking over such a large amount of the user experience that Apple's relationship with the user is harmed. People are spending an increasing amount of time on social networks while music streaming is taking over. Even though both of these activities are not directly hurting Apple's financials, it's clear management wants to be better positioned to respond to each trend. 

While there are very few, if any, credible competitors that can truly ship software, services, and hardware at scale, it would be theoretically possible for a company to take user engagement on iOS and try to leverage it into a new direction using their own differentiated hardware. If Apple can position itself more strategically as a counter to third-party offerings, reducing its dependency on others, Apple could be in a better position to maintain the user experience and battle third-party apps and services in the future.

Fighting for Your Attention 

Although Apple may be seeing success in terms of smartphone sales, a fierce battle has been occurring for our attention once we turn on our gadgets.  Press and hold the iPhone home button and the battleground emerges: our home screen.  Software and services companies are each angling for our attention. Tech pundits often say Facebook's greatest threat is Google. Instead, Facebook's greatest threat is our short attention span. Services that largely do similar things are increasingly fighting for mind share in the areas of messaging, email, photo storage, and entertainment. When considering that a service can benefit from a network effect, the battle is only intensified as the apps and services with the most users achieve the best quality, thereby making it that much easier to attract new users. 

Whereas hardware manufacturers measure success by the 10s of millions of users, for software, success is now measured in 100s of millions. As more people spend more time on smartphones, the battle for our attention is only intensifying. It is for this reason that iOS is such an attractive proposition for companies craving reach and scale amongst premium users. 

In the early days of the iPhone, it was common to see a smartphone with lots of apps, each possessing a specific duty or job role. I created separate folders for social apps and news. Today, I still open my social app folder every day, but now my news folder has become irrelevant as I get most of my news from Twitter. This type of fierce competition for my attention is still playing out in area of social platforms and media brands, but it's clear that given the finite amount of attention, there will be winners and losers.  

With a suite of over 20 apps, Apple has relied on its vertical integration of shipping hardware, apps and services. In 2012, Apple jumped into maps. In 2014 Apple launched its health, fitness, and payments initiatives. And at this week's WWDC, Apple launched new News and Music apps, with rumors of a video service arriving sometime later this year or 2016. All of these services share one purpose: controlling our time and experience. They are meant to represent tasks or things that we do each day and to which Apple can add differentiation. One should not expect Apple to try to be the answer to everything, such as entering social media or other services that are inherently less fundamental to Apple's product line-up.

News

Apple's News app isn't so much a competitive jab at Facebook, but instead a hook for grabbing people's attention. Apple's description of the new app is quite clear: "News conveniently collects all the stories you want to read, from top news sources, based on topics you're most interested in - so you no longer need to move from app to app to stay informed." With News, Apple is trying to keep our attention just a little bit longer. Take a look at Facebook's Instant Articles and Snapchat's Discover to see what the war over attention is leading to. Technology companies are trying to shift commoditized news into a differentiated service meant to keep you within their properties.

This type of attention-holding strategy isn't new. In brick-and-mortar retail, Walmart includes various stores within its stores, such as vision centers, fast food restaurants, and medical clinics in an effort to get you inside a Walmart.  Similarly, Facebook wants people to spend more time within its apps by offering additional services, like news.

I don't view Apple as necessarily trying to rethink news or put other companies out of business. Instead, it is looked at as a tool to enrich the iOS platform while maintaining a closer relationship with the user. 

The risk in the strategy is that many users still have to go to Facebook, regardless of reading news. Going back to the Walmart analogy, it would be the equivalent of having to go to Walmart regardless of which medical clinic you visited. Chances are good you will end at the clinic inside Walmart rather than going across town to the stand-alone clinic. At the end of the day, the easiest path usually wins. It is for this reason that I think caution needs to be held before assuming News will be a runaway hit. Instead, I look at it as Apple moving a piece on the chess board, trying to gain a better competitive position in the future. 

Apple Music 

Apple's ambitions in music are underestimated. As Eddy Cue and Jimmy Iovine have made it very clear, Apple Music is not about music streaming, but rather a new music ecosystem meant to offer listeners across the world (100+ countries at launch) a place to not only access music, but become part of something bigger, interacting with musicians and receiving recommendations. Eddy Cue and Jimmy Iovine don't say it, but Apple Music is inherently built to keep your attention rather than just engage you in the physical act of listening to music. Technically speaking, Apple is now getting into content creation with its 24/7 radio station, Beats 1, as Zane Lowe will have a music show that contains interviews and other content. 

Connect, which will serve as a venue for musicians to connect with their fans, while distinct enough from the Ping disaster, contains just enough social media to make people begin wondering if there may be a bit more that meets the eye, where Connect can become a musician's first stop for sharing content. It is important to point out that despite Apple introducing new features that undoubtedly chase people's attention, the company is not being hostile to third-parties. Connect allows sharing through Facebook and Twitter. 

Apple Music is competing with the free streaming services of the world, including YouTube. While Apple may have indeed gotten people to pay for music once around (iTunes), it will be challenging for Apple to completely rethink the music industry without a free, ad-supported streaming option. Nevertheless, Apple is going to give it a try, positioning service and a new culture-defining internet radio option, as reasons customers will be willing to give Apple Music their attention and pay for something that can be gotten for free in the next app over.

Siri and Spotlight

We saw hints of Apple's ambitions in search last year, but this year's WWDC all but confirmed that Apple is quickly looking to distance itself from Google search.  

Apple's intentions on reducing its dependence on third-parties is not just limited to apps and software. All of Apple's new announcements related to an improved Siri and Spotlight, not to mention a new search API, are meant to have us move past Google dependence. In the process, Apple is able to build on its relationship with the user and not necessarily collect troves of data. Apple feels very confident that it doesn't need all of your data to produce "magic" as Phil Schiller described it. In reality, what Apple is suggesting is that it can produce an enjoyable environment that doesn't let technology overwhelm the user, yet still position the iPhone as a personal assistant. Apple calls it "intelligence," which is appropriately quite different from the connotations surrounding Google's "machine-learning" initiatives. 

Pushing Forward with iPad and Apple Watch Software

Apple’s mission hasn’t changed from its founding in the 1970s. As Jony Ive put it at the Condé Nast International Luxury Conference this past April, Apple has always been about making technology more personal. The primary way Apple will be able to continue going down that path is if they control our time and attention by selling gadgets filled with apps and services that we increasingly use to navigate the world. 

Nowhere is this strategy more apparent than Apple’s current product line-up, pieces of glass ranging from the Apple Watch to the iMac. At every stage in between, each product possesses a different function or role. This is the primary reason why Tim Cook hasn’t sounded the alarm about the iPad despite the product losing all of its sales momentum. For Apple, the iPad still has a role in the world. It’s just that a greater number of people are able to get their jobs done using iPhones and Macs. At WWDC, Apple all but assured us that a larger 12.9-inch iPad Plus will be released in the future with Split View, Slide Over, and picture-in-picture video. An iPad Plus isn't meant to turn around the iPad line, but instead serve a particular set of needs that can be answered with a multi-touch Force Touch-enabled large display. Some of Apple's products are simply more popular than others, based on screen size and mobility. Success isn't determined by the number of unit sales, but instead how effective a product is in addressing a particular set of problems. 

From Apple’s perspective, positioning the iPhone as a computer in our pocket is central to controlling our time because of how we are able to bring the iPhone mostly everywhere we go. Taking things further, in a quest to control even more of our time, what better way than to sell a computer that is literally on us?  The Apple Watch is Apple's first personalized piece of technology that can be worn. The outlook for native apps able to tap into much of the advanced components found in the Watch only validates Tim Cook's claim that the wrist is indeed a very interesting place. The day is still early with wearables, but Apple isn't waiting to push the envelope on what can be done on the wrist.    

WWDC 2016 and Beyond 

When considering Apple’s future, take a look at your daily calendar and at the activities that take up significant portions of your day. Anything from sleeping, watching TV, and commuting to and from work likely represent areas of interest for Apple. Of course, management is quite selective and as Tim Cook mentioned last year, executives actually spend most of their day debating what not to do. Apple is built on a model of placing very few big bets that can change the world, not lots of little bets very likely to fail but not likely to have much long-lasting impact. Apple's offensive strategy was on display at this year's WWDC including additional Siri capability, new and updated apps meant to hold user's attention, and a new Music platform positioned to regain music mindshare. Such tactical maneuvering is indicative that Apple is not pausing despite its improved market positioning when compared to Android. Apple is playing offense. 

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