Apple's 4Q15 Earnings Preview

Apple's upcoming earnings report is set within a tumultuous market. We find ourselves in a changing environment with fears surrounding China's economy subsiding and optimism around the U.S. economy and the technology sector on the rise. Last week, large cap tech saw a resurgence as Microsoft, Amazon, and Google all reported strong 4Q earnings compared to expectations. Apple shares have traded up since bottoming at the end of August even though Wall Street continues to question iPhone sales strength. Apple's 4Q15 will provide the clearest read yet on how the global economy did this past summer as the iPhone has become the unofficial economic bellwether for China and global consumer demand.  

The following table includes my estimates for Apple's 4Q15. Where applicable, I have compared my estimates to management's guidance. 

iPhone

Investors remain nervous about iPhone sales. Upon closer examination, this nervousness has been around for close to a year, dating back to when the iPhone 6 and 6 Plus launched in September 2014. Since Apple's 4Q15 earnings reflect iPhones sales from July to September, results will primarily reflect how the iPhone 6 and 6 Plus did in China over the summer. In many ways, Apple's 4Q15 is a transitory quarter as attention will quickly move to FY2016 and iPhone 6s and 6s Plus demand. 

Exhibit 1: iPhone Unit Sales Expectation Meter (4Q15)

I remain above consensus with my 50.5M iPhone unit sales estimate. Much of my optimistic stance rests on the belief that Apple saw continued robust iPhone sales in Greater China over the summer. I am also assuming Apple experienced an average level of iPhone sales seasonality in the weeks leading up the the new iPhone launch. I consider iPhone unit sales in the range of 46M to 51M as close to my expectations. If Apple reports iPhone unit sales of closer to 40 million units, I will need to readjust my FY2016 iPhone sales view as it is likely Apple saw decelerating iPhone unit sales growth in China at a much faster pace that I expected. 

iPad and Mac

Similar to the past few quarters, the iPad and Mac will not make or break Apple's earnings report. When taking a step back from the quarterly fluctuations, Apple is still trying to find the iPad's normalized sales run rate where the pace of iPad upgraders and new customers will lead to stable growth trends. We are not there yet. The Mac continues to perform well in an environment where the laptop and desktop form factors are struggling in the face of smartphones. 

Exhibit 2: iPad and Mac Unit Sales Expectation Meters (4Q15)

Apple Watch

As we saw with Apple's 3Q15 earnings report, due to Apple not disclosing Apple Watch sales estimates, we end up with an "inside baseball" back-and-forth debate among financial analysts trying to back into Apple Watch sales estimates. Consensus seems to have settled on Apple selling 2.5 million to 3.5 million Apple Watches last quarter (I estimated Apple sold 2.6 million). At last week's WSJDLive conference, Tim Cook all but assured us that Apple will have shipped more than 2.5 million Apple Watches in 4Q15. My official Apple Watch unit sales estimate is 3 million, bringing the five month total for Apple Watch unit sales to 5.6 million. 

Guidance

Management's guidance will provide a clue as to how iPhone 6 and 6s Plus are selling. Unfortunately, Apple Watch revenue may make it more difficult to convert revenue guidance into an iPhone unit sales estimate. The debate surrounding iPhone is whether Apple can continue to grow the product category in FY2016. If revenue guidance comes in less than $75 billion, many investors will use that as evidence that Apple will struggle growing iPhone unit sales in 2016. 

Exhibit 3: Revenue and Margin Guidance Expectation Meters (for 1Q16)

Summary

Expectations surrounding Apple are much more varied heading into Tuesday's earnings report. With iPhone sales expectations more subdued this time around compared to previous quarters, it may take less for Apple to please Wall Street. I will be looking for any signs as to how management looks at the pace in bringing new customers to iPhone. While a slowdown in new user acquisition from FY2015 should be expected, the market will likely look favorably upon evidence that suggests the iPhone 6s and 6s Plus are still effective in expanding the iPhone user base at levels similar to iPhone 6 and 6 Plus. Several analysts have already given up on the iPhone 6s and 6s Plus narrative and are now focusing on iPhone 7 in late 2016. 

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Leasing Solves Apple's Cheap iPhone Dilemma

Apple is on track to sell more than 250 million iPhones over the next 12 months. When looking at overall sales share, the iPhone remains a small player, representing only 15% of overall phone shipments. However, on a profit share basis, the iPhone has rewritten the rules guiding the smartphone market, commanding upwards of 90% of the industry's profit. Even though Apple's mission has never been to sell the most of a product, there may be a way that Apple can grow iPhone's sales share rather significantly while retaining control of the smartphone industry's profits. An iPhone leasing model solves Apple's dilemma of how to address a larger portion of the smartphone market without diluting its aspirational brand and iPhone experience.  Leasing will usher in the next major phase of the smartphone industry by solving Apple's cheap iPhone dilemma.

The Changing Smartphone Market

In the early days, the prevailing way consumers bought an iPhone was with carrier subsidies. Instead of paying the $649 up-front price for the base iPhone model, AT&T would "subsidize" $450 of the cost, which would later be indirectly recouped by charging higher monthly service fees. However, as time went on and additional carriers began selling iPhone, the subsidy model represented a declining percentage of overall iPhone sales. A growing share of iPhone buyers were now paying full price for iPhone but in return getting lower monthly service fees from their carrier. Over the past eight years, in an environment where the iPhone's full cost is either born by the consumer up front or the carrier through a subsidy and subsequent two or three year contract, the iPhone was able to grab a commanding share of the premium portion of the smartphone market (>$400) with much less success in the middle market ($200-$400).

Spurred on by competition and unsustainable growth in iPhone subsidy costs, U.S. mobile carriers began to move away from the smartphone subsidy model and are currently embracing a leasing paradigm. Consumers are now able to pay either nothing up front or a small initial payment and then pay back the rest of the iPhone across a number of months, usually 24. Since carriers are no longer on the hook to "subsidize" part of the iPhone's cost, monthly service costs have been reduced although data has continued to become more expensive over the years. 

In an effort to retain the best customers, and as a sign of the iPhone's market power, carriers have included options for iPhone users to lease a new iPhone each year by simply turning in their old iPhone. The end result is a growing number of iPhone owners that lease their iPhone, paying the same price each month, but upgrading to the newest iPhone each year. 

Apple has recently gotten involved in the mix by launching the iPhone Upgrade Program in conjunction with the iPhone 6s and 6s Plus launch. While currently only available at Apple Stores in the U.S., the program is designed for those who want a new iPhone each year with the added peace of mind provided by AppleCare+. Customers apply for a loan financed by Citizens to cover the cost of the iPhone, AppleCare+, and sales tax. After the initial payment is made, the loan holder then has to pay back the price of the iPhone and AppleCare+ in 23 equal installments. However, after the 12th payment, the loan holder can hand in his or her current iPhone at an Apple Store and then upgrade to the newest iPhone by signing up for another 24-month loan. The cycle then repeats itself until the next year. Similar to what is happening at the carriers, the iPhone Upgrade Program is creating a growing number of iPhone owners that lease iPhones which shortens the iPhone upgrade cycle, boosting iPhone sales.

While we are still early in the iPhone leasing movement, early survey results suggest there is interest in leasing programs, including Apple's iPhone Upgrade Program. Since so few iPhone sales occur in U.S. Apple Stores, any near-term impact directly related to the iPhone Upgrade Program will likely be moot. Citizens expects less than one million customers to use the iPhone Upgrade Program over the first 12 months. Longer-term trends, and more importantly, the learning experience Apple is receiving by leasing iPhones, bode well for the program. It would be surprising if Apple does not expand the program to new countries over time. 

The Cheap iPhone Is a Myth

The call for Apple to release a cheap iPhone reached a fever pitch a few years ago when Apple first entered China with China Unicom and China Telecom relationships. Even though Apple has steadily grown market share and unit sales, a certain group of analysts and pundits continue to think the only way Apple would be able to do well in China and emerging markets would be to release a "cheap" iPhone. The problem with this thesis is that there were very few strategies Apple could realistically use to sell a genuinely low cost iPhone without undermining its business.

A base model iPhone 6s retails for $649 and has an gross margin of approximately 45%. In theory, Apple could sell such a device for $350 and break even, but with a business model dependent on making money from hardware, this isn't a viable long-term solution. Another possible way to sell a cheap iPhone would be for Apple to take a base model and strip out features and components. However, upon closer examination, this is much easier said than done. The iPhone's popularity is a result of the experience obtained from using it. Accordingly, it would be very difficult to maintain that experience by selling a stripped down iPhone with lower quality cameras, screens, and processors. Even then, a stripped down iPhone would still likely sell in the $300-$400 price range, which does not address the low-end of the market.

Another option to market a cheap iPhone would be for Apple to segment screen size according to price tiers. A 4-inch iPhone "mini" could sell for a lower price than bigger-screen options. However, recent iPhone sales trends would suggest a 4-inch screen iPhone would likely become a niche device as consumer preferences are overwhelmingly moving towards larger form factors like the iPhone 6 and 6s, with a growing number of users opting for the larger screens found with the iPhone 6 Plus and 6s Plus. 

Apple would have much difficulty selling a low-cost iPhone at a price that would make it competitive in completely new market segments. The most likely scenario that many have not considered is that a cheap iPhone probably wouldn't be as popular as consensus assumes. In fact, I would go so far as to say a low-cost iPhone would likely disappoint on the sales front. The iPhone's success comes from the branding and aspirational feeling attached to the device. By selling a low-cost version of this experience, consumers would likely not value the device in the same way. 

We saw a real-world example of this buyer aversion in 2013 when Apple unveiled the iPhone 5c. Instead of keeping the previous year's flagship phone, the iPhone 5, around and lowering the price by $100, Apple reconfigured the device by giving it a plastic shell. While the iPhone 5c did sell (I estimate approximately 40 million units were sold during its lifetime from 2013 to 2015), it was not enough to change the game. Instead, the device quickly gained the nickname "the cheap iPhone" as the device's colorful plastic shell easily signaled to people it was the cheaper iPhone version compared to that year's more expensive flagship, the iPhone 5s. It was never able to shake its cheap nomenclature. Many consumers buy iPhone for the intangibles that come with such a purchase such as being able to show it (and its high price tag) off to others. The iPhone 5c experiment is a preview of how an actual cheap iPhone would fare in the marketplace: not as well as many assume. 

The much bigger question to ask with a cheap iPhone is what is even considered "cheap"? Even though the iPhone 5c was mocked, the device still sold for a not cheap $549. A stripped down iPhone selling for $300 to $400 wouldn't classify as a cheap iPhone either, especially with other smartphone manufacturers selling product in the $150 to $200 range. The cheap iPhone may be a myth, but Apple is able to recreate many of its benefits, as well as come up with new benefits, by embracing the leasing model. 

Leasing is the Answer

A world in which iPhones are leased solves Apple's cheap iPhone dilemma. With leasing, multiple owners are able to value the same product differently. For some, there is value in being able to use the latest and greatest gadget while for others, the value is in low cost and being able to hold on to a device for a long time.

An iPhone leasing paradigm depends on a few variables including a functioning grey, or resale, market and healthy residual values. A grey market where buyers and sellers are able to transact in a low-cost, convenient, and safe manner is required for a leasing model to effectively move iPhone units from initial buyers to the next group of buyers. Since iPhones retain a good portion of their value as time goes on due to the device's build quality, popularity, and lack of lower cost models, the iPhone has high residual values. Accordingly, iPhones are able to be leased in a cost effective manner. If the iPhone did not hold on to its value well, leasing would prove to be a very expensive option as customers would end up paying most of the iPhone's retail price during the first year of ownership. As a result, the incentive to trade in an iPhone and upgrade would not be high. However, with a high residual value, an iPhone leasing model involves paying only 50% of the iPhone's retail price during the first year. In such a scenario, many would be willing to trade an iPhone in after a year for a new model since most owners currently hold on to their iPhones for two years. 

Leasing creates supply of one-year-old gently used iPhones that can be resold to new customers for less than the cost of a one-year iPhone sold by Apple. If we continue with this example for another year, leasing would create a supply of two-year old iPhones that can be resold to new customers for much less than the cost of a two-year iPhone sold by Apple. With leasing, iPhones make their way down to segments of the market that are not addressed by Apple. Even in an environment without leasing, there is a thriving grey market due to resales. Leasing would only legitimize and expand the grey market. The following chart compares new iPhone pricing at Apple to used iPhone pricing at Gazelle and eBay. Notice how used iPhone pricing currently stabilizes around $200.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

While Apple would not make money on these iPhone resales, Apple would benefit by selling new iPhones to its installed base each year. Apple would therefore be able to address a larger portion of the smartphone market while not jeopardizing its profit share. The cheap iPhone dilemma would be solved. 

The key reason someone would purchase a used iPhone that was previously leased instead of a cheaper iPhone with stripped down parts is that used iPhones retain Apple's aspirational brand characteristics. Instead of using a cheap iPhone that either looks or behaves differently than other more expensive iPhones models, used iPhones would appear and act the same as brand new iPhones. The iPhone user experience remains intact much more in a leasing paradigm. We see this play out in the automobile industry where premium brands such as Mercedes-Benz, BMW, and Audi each have vibrant leasing ecosystems where consumers can lease two to three-year-old automobiles for a much lower price rather than buy scaled-down, low-priced models that question premium car brand attributes.

Follow the iPhone

To better understand how leasing can help Apple address the low-end of the smartphone market, we can follow the path of an iPhone from original purchase to final destination a few years down the road, taking a look at the various owners and pricing along the way. 

• Step 1: A customer buys a new iPhone 6s 16GB for $649 at an Apple Store using the iPhone Upgrade Program. A two-year loan was originated to finance the cost of the iPhone and AppleCare+.  
• Step 2: At the end of the first year, the original owner returns the iPhone 6s to Apple. The original loan is then paid off. The one-year old iPhone 6s is then transferred to a third-party specializing in recycling or reselling used smartphones. The original owner leases a new iPhone from Apple with a new two-year loan. 
• Step 3: The gently used one-year-old iPhone enters the grey market and is resold to a different customer for $450. A comparative one-year-old model would sell at Apple for $550. 
• Step 4: A year later, the now two-year-old iPhone can still fetch $200 in the grey market. The second owner then decides to sell the device to someone on eBay for $200. A comparative two -year old model would sell at Apple for $450. 

In this timeline, a $649 iPhone was able to be "bought" by three customers over the span of three years for a collective $1,299. The difference in prices helps facilitate the grey market transactions. A larger and more robust leasing paradigm would make this process much more efficient and legitimate, similar to how leasing used cars pretty much involves the same process and players as leasing a new car. Over time, used iPhones would be able to be purchased or leased at many of the same locations where new iPhones could be purchased. 

One consequence of additional iPhone supply entering the grey market as a result of additional iPhone leasing is that resale prices may fall in order to match demand. However, there appears to be significant room for prices to fall without impacting the leasing paradigm, as displayed in the following chart. The black dashed line represents the point where iPhone resale values could fall to in order to still work with Apple's iPhone Upgrade Program.

Notes: Pricing is for entry-level storage. Gazelle and eBay prices are for unlocked models.

Financial Impact

Apple currently has an iPhone installed base of approximately 500 million users. When taking into consideration hand-me-downs and the resale market, the total number of iPhone users exceeds 500 million. If we were to assume leasing will be the only method by which iPhones will be purchased in the future, than theoretically, Apple would sell 500 million iPhones a year (every iPhone user would simply lease a new iPhone every year). A 500 million iPhone annual sales rate would be 98% higher than the current 253 million sales that I expect Apple to sell over the next 12 months. 

In reality, we are still in the very early innings of the iPhone leasing model, and not everyone will want to lease their iPhone. However, running with conservative estimates of 20-25% adoption rates for iPhone leasing over time, it does not take much to begin seeing a tangible benefit to Apple's iPhone sales. At 20% adoption, Apple would sell an additional 50 million iPhones a year. Said another way, if 100 million iPhone users leased their iPhones each year, Apple would see a 50 million unit boost to unit sales each year. The other benefit from leasing would be that used iPhones would help expand the iPhone user base benefitting the iOS ecosystem which may come in handy as Apple continues to push on content deals (Apple Music, Apple Video in 2016) and services such as Apple Pay. 

With iPhone leasing at 20% adoption, it is conceivable for iPhone's smartphone sales share to increase by 4-5% to 20% without even needing an entry-level low-cost iPhone to boost sales.  

iPhone Leasing Momentum

Ultimately, the only reason leasing iPhones makes sense in the first place is that the iPhone is becoming the primary computing device for hundreds of millions of people. There is a significant need and desire to use the newest iPhone each year. This would be a new type of hardware paradigm compared to previous computer technology eras where consumers bought and then held on to gadgets for years. Another reason an iPhone leasing model works is that consumers have noticed Apple's iPhone development cycle and the company's ability to ship new iPhone features each year. Mediocre annual iPhone upgrades would likely make leasing a much harder sell as consumers would decide just to hold on to their new iPhone for a few years, a much cheaper alternative than leasing. Ultimately, leasing changes the smartphone game by expanding Apple's addressable market and solving the company's cheap iPhone dilemma. 

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Apple Uses Good Design to Marginalize Industries

What makes a great product? 

How can one product change an entire industry?

One of Apple's most significant accomplishments has been a dedication to design that borders on the line of obsessiveness. As people decipher the driving factors behind what makes a product like the iPod, iPhone, and iPad so successful, it is crucial to recognize how a product's design has the potential not just to alter industries, but go so far as to marginalize them. The iPhone relegated the mobile phone to a single app. Apple Watch is being positioned to turn the modern Watch industry on its head. Apple's ambitions with the automobile will be nothing short of a transformational shift in how we think and use automobiles. When a company places only a few big design bets every few years, the resulting bets need to be huge, and Apple positions good design as the guiding light with all of its bets. 

What is Good Design?

Apple has thrust the topic of design into today's society. There is more cultural awareness of design than ever before. While this may sound like a good thing, the definition of design has seemingly expanded along with its growing popularity. The end result is growing confusion as to what design even means. Apple has always positioned design as a guiding principle even though consumer demand for such design is still a recent phenomenon. The world needed to see what the lack of design in the PC market looked like before craving Apple products born from the rebirth of the design-led process in the late 1990s.

With good design, a product is able to tell the world something about the person who created it. Good design is born during the product development stage when a fragile idea is allowed to advance and mature without compromises. So much of the corporate world is built in such a way as to stifle good design. The end result is that we are left with industries that play a crucial role in our lives but are susceptible to being altered by products that are created with additional care and intuition. The difficult part is looking at these legacy industries in a way that allows one to discover how they can be improved. While a handful of companies may realize the pieces to the puzzle for unlocking good design, there are even fewer companies that actually possess those pieces. An Apple led by Jony Ive is currently one of those companies, and Apple's $200 billion of cash is one tangible piece of evidence that Apple has possessed these pieces for years. 

Software Represents Additional Design Tools

Software allows good design to posses a different dimension. Similar to how a new paint color added to one's palette can result in a completely different picture, software allows a designer to add something to a product and to accomplish what would otherwise be impossible. It's not that software should be looked at as completing good design, but it provides a set of additional tools to interpret the world. Software makes it possible for us to interact with products in new ways that once seemed unimaginable. 

Turning Phones into Computers

When Apple executives began to seriously consider entering the cellphone industry, the motive was clear: come up with a phone that people want to use. Even though the iPhone is only eight years old, the world was a much different place in the mid-2000s. The cellphone industry was being built on a paradigm where phones were used to dial a long list of numbers in order to speak to someone. Innovation came in the form of a better keyboard; each button moved from having three letters to having its own letter. The world accepted these products with open arms because we were able to send and receive email when away from our computer. 

A cellphone's keyboard was quickly turning into a limiting factor, a feature that was holding back the device's potential. Few saw this taking place, especially the phone industry leaders. Even more remarkable was the untapped potential for the phone form factor: a device that could be small and light enough to be carried around with us all day. 

The iPhone ended up representing a simple question: Is there something better than a physical phone keyboard? The iPhone's design represented the answer. By removing the keyboard, a smartphone's potential was unleashed. Of course, those industry leaders clearly invested in the old paradigm not only did not understand the appeal of not having a keyboard, but also lacked an understanding of the potential now created by removing the keyboard as a limiting factor.  

The iPhone's design doesn't just stop with the lack of a physical keyboard. Everything from hardware design elements like physical volume button placement to software features like pinch-to-zoom told us something about who created the device. The iPhone stressed intuitiveness above all else, and this goal ended up positioning the iPhone a good five years ahead of the competition. The iPhone was one product that was able to upend not just the mobile phone market, but the entire computer industry. 

The iPad's Magic

The iPhone was a byproduct of research and development originally geared for a larger tablet device. With lessons learned from iPhone development, Apple returned to what ended up being unveiled to the world only three years after the iPhone: the iPad. 

The iPad has since had a storied history, despite tallying only five years. It came out of the gate as the fastest selling consumer gadget in history, (Apple sold 19 million iPads in the first year on the market) but the device is now experiencing waning sales momentum as the entire tablet market has shown structural issues. 

When the iPad was first introduced to the world, many called it a big iPod touch in an effort to discredit Apple's design foray into the tablet market. In reality, the iPad's greatness resided in it being "just" a big iPod touch. The device's intuitiveness was nothing short of earthshaking. The iPad's recent sales struggle isn't so much an indication that multi-touch computing has hit a saturation point or is being replaced by another computing paradigm. Instead, consumers are still experimenting with multi-touch screen form factors. For many people, a larger iPhone is a more optimal form factor than an iPad. Accordingly, we are left with a situation where smaller iPads are seeing weakening sales momentum while Apple moves faster at the high-end of the market. This is likely just the start of where the iPad is headed. Ultimately, the iPad was a computer designed to have the hardware melt away during use, leaving the software as the primary user interface. Apple's quest to make the most personal computers came to fruition. 

Apple Watch's Mission

Good design was used to question a cellphone's keyboard, unleashing the device's functionality. Similarly, the Apple Watch is given a mission to redefine utility on the wrist. As both Jony Ive and Marc Newson have mentioned publicly, Apple Watch wasn't born out of disgust with the modern wristwatch. There was something else at play, and the Watch's design gives us clues about this driving motivation and why Apple Watch represents a pivotal turning point in the watch industry.

Apple Watch design represents a simple question: can a device worn on the wrist include additional utility? Giving Apple Watch a rectangular watch face, something that was steadfast from early in the Watch development process, emphasizes the device's purpose to display text in the most space-efficient manner possible. The Apple Watch's design does not imply that the device is trying to be a mini iPhone, but instead a device that is meant to take certain tasks once destined for the iPhone (checking the time, receiving notifications, tracking health and fitness) and display information in a location with proper line of sight to the wearer. Haptic feedback serves to replace line of sight for some users as well as create another form of notification. 

Design is also found in the Apple Watch bands, demonstrating that the Watch is a fashion accessory worn on one's body and on display to the world. In a way, watch bands can be thought of as a form of software. It is perhaps fitting that with the Hermès partnership, Apple introduced leather watch bands in addition to software specifically designed for the Hermès collection. 

The end result, and one that we find ourselves in the early innings of, is a watch industry coping with the prospects of adding additional utility on the wrist. The Apple Watch draws into question how timelessness and craftsmanship should enter the buying equation (both are now largely marginalized in their current form). While some still think certain segments of the luxury watch market will be able to ignore the smartwatch movement, the aggressive moves Apple is making in the fields of traditional luxury, including the Hermès partnership, should serve as an indicator that few watch makers will be able to avoid the future brought on by software on the wrist. 

Marginalizing the Auto Industry By Looking Inside

With the automobile, Apple will once again look to position good design to marginalize a legacy auto industry that is more than 100 years old and has played a defining role in how we live our lives. The modern day automobile is not intuitive. Drivers need to learn to operate an automobile. Passengers have to conform to a car's existing seating arrangement with only marginal modification. Software has the potential to change all of these limitations. 

While Tesla has become a pioneer in electric vehicles and BMW continues to slowly build momentum in the space, both companies have not actually altered the automobile's fundamental purpose. Nowhere is this seen more than inside the Tesla Model X and BMW i3. While the dashboards have seen a change, in Tesla's case most of the dials and knobs having simply been converted into software and placed on a large tablet. There is much room for improvement. 

The way we think about automobiles today will be different than how we look at the automobile in the future. Good design is powerful enough to alter our prevailing attitudes and views of a product. Simply put, we are being held back by our prevailing attitudes of what an automobile is. With Apple Car, Apple would reposition the car as a connected room on wheels. The car interior is being held back by both legacy automobile design and the lack of software. Take into account how software holds the potential to add magic to a user's iPhone or iPad, and the same can apply to the experience in a car. We are still stuck in the era of trying to improve the smartphone keyboard when it's time to drop the keyboard altogether. This would mark a significant departure for an auto industry that has rode the combustible engine to the end of the road. 

Good Design Is All About Taking Risks

The one recurring theme found with all of Apple's products unveiled over the past 15 years is they were all high-risk. The iPod, iPhone, and iPad were all bets that the consumer would place value in doing something in a different way. The Apple Watch is a bet that people want additional utility on the wrist. Project Titan will be positioned as nothing short of a bet-the-company play in the automobile industry. Failure would be measured not only in billions of dollars, but more importantly, in time. 

Good design contains risk, the same risk that legacy companies did not want to take to move their industries forward. 

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Apple Watch Is Being Severely Underestimated

The Apple Watch continues to show incredible promise although much of it is being masked behind an iPhone lens. Unrealistic expectations positioning Apple Watch as the next iPhone in terms of sales and popularity have now resulted in many people ignoring positive Apple Watch developments. When analyzing geographic and retail distribution expansion, product and market strategy, and the competitive landscape, it is clear that the Apple Watch is not just being severely underestimated but has quickly become one of the best-selling wearable devices.

Apple Watch Expectations Pendulum

With Apple Watch representing Apple's newest product category since the iPad in 2010 and the first genuine new product developed during the Tim Cook and Jony Ive era at Apple, the product launch received quite a bit of attention. Apple helped build the excitement as the Apple Watch debut in September 2014 was billed as one of the bigger Apple product keynotes in recent history, even beating the iPad's unveiling in 2010. Expectations were set high. In reality, these expectations were too high. The Apple Watch was being thought of as the next iPhone, a device that would quickly surpass the device we already carried with us all day, every day. Many compared the Apple Watch keynote to the iPhone keynote, looking for the device's three key features. For iPhone, it was a telephone, communication device, and iPod. Apple obliged with most of these requests, as they followed a similar playbook with Apple Watch, labeling the device as a communications and health & fitness device as well as a timepiece. Once again, expectations were likely mispositioned. 

If Apple Watch expectations were a pendulum, right before the Apple Watch was launched, the weight on the end of the string was pulled all the way back to "the next iPhone" as expectations were quite high. However, in the weeks following launch, the overall feel towards the product took on a completely different tone. There was increased attention given to posts discussing how the Apple Watch was just a toy and not ready for prime time. One post went as far as being just a GIF of Apple Watch being thrown on top of a bunch of leftover and old chargers in a desk drawer. The word "flop" was being passed around with increased frequency. Sticking with the pendulum theme, Apple Watch expectations had quickly moved to the completely opposite end of its trajectory, now classified as a flop. Five months have since passed Apple Watch's launch and after looking at sales, usage patterns, and customer satisfaction surveys, it would appear that the Apple Watch is neither the next new iPhone (at least not in the near-term) or a flop. Instead, it is a fun and cool product with much promise and intrigue. The pendulum will eventually come to rest between both extremes. 

Massive Launch for First Generation Product

The Apple Watch launch was unlike recent new Apple product launches. There were no lines outside Apple Stores, carrier stores weren't selling Apple Watch models, and there was much mystery as to how to sell such a personal device with so many different options. Some even wondered if Apple would be able to find a way to sell Apple Watch in the same setting that it used to sell desktops, laptops, tablets, and smartphones. With the launch now in the rearview mirror, we have a much clearer picture of the issues Apple faced leading up to the first Apple Watch sale. While all new Apple products suffer from supply issues at launch, Apple Watch supply was much more limited than most realized. Some blamed Angela Ahrendts for a "botched" Apple Watch retail launch while others even looked at Jeff Williams as holding some responsibility for confusion surrounding Apple Watch availability. The WSJ went on to report that faulty taptic engines in some Apple Watches led to Apple not being able to sell a certain percentage of assembled units, leaving the company with not enough stock to have the device available for in-store purchase. What had been billed as the largest Apple product launch in years seemed to miss the mark.

However, when Apple reported earnings at the end of July, a different picture began to appear. Even though Apple Watch revenue and unit sales were not disclosed, one is able to back into a fair estimate of such metrics using an accurate financial earnings model. Apple likely shipped 2.6 million Apple Watches from launch to the end of June. Taking into account that many of these shipments were ordered at or close to launch, we are then able to paint a picture as to what kind of launch the Apple Watch really had.

Apple likely sold around two million Apple Watches at or close to launch. On an absolute basis, this would classify as the biggest product launch in Apple's history despite there being no long lines. In the preceding weeks after launch, Apple Watch supply then improved rather dramatically. Apple just had completed its quietest record-breaking product launch in its history. When comparing the first quarter of Apple Watch unit sales to previous flagship products, the Apple Watch and iPad are closely ranked. The iPad had a few extra weeks of sales in its first quarter on the market, which distorts the numbers a bit. Regardless of timing, Apple sold more Apple Watches than either iPhones and iPods during the first three months on the market. 

Geographic and Retail Point of Sale Expansion

With Apple Watch supply improving dramatically beginning in June, Apple has been expanding Apple Watch distribution at an unprecedented rate. From both a geographic and retail point of sale perspective, the Apple Watch is now available at many more locations across the world. While this doesn't necessarily suggest that Apple Watch demand has dramatically improved since launch, it does tell us that many more potential consumers are in a position to be introduced to Apple Watch. From Apple's perspective, the hardest part of selling Apple Watch is getting it in front of customers to try out and purchase. The more options and alternatives at the consumer's fingertips, the better.  The Watch can now be bought not only at Apple Stores, but also at select third-party electronics stores in a few countries, including Best Buy in the U.S. A few mobile carriers have begun to sell the device, and we are now seeing the first big box retailers sell Apple Watch. It would appear the goal is to build out the Watch's retail availability in order to have a successful holiday shopping season beginning in November. The following two exhibits highlight the expanded geographic expansion for Apple Watch as well as the additional retail locations in the U.S.

Product Strategy & Marketing

There have been some subtle changes in the way Apple has been marketing and selling Apple Watch. One way of quantifying some of this difference is to look at changes seen with Apple's Watch mini site. While Apple is still relying on a few major use cases for why someone may want to buy an Apple Watch, there is much more attention given on some of the intangibles attached to the device. Watch bands and different watch cases are now emphasized as a way to demonstrate not only how the device is making technology more personal, but also how there is the ability to personalize the watch's appearance in many more ways than there was even at launch. 

Apple's Apple Watch page - April 24, 2015 (Watch launch):

Apple's Apple Watch page - October 5, 2015

There is much more focus on some of the Apple Watch intangibles and different looks. 

It is telling that after only a few months on the market, Apple released a plethora of new Apple Watch Sport Band options, along with Gold and Rose Gold Sport Watch case colors. Having used Apple Watch since launch, I am confident in describing the band as both the Apple Watch's most important aspect and most intriguing element going forward. 

Apple Watch bands hold the potential of easily turning one Apple Watch into a number of different watches. While the technology and components found in one Apple Watch case may not change, buying a new watch band could lead to the feeling of owning a completely new watch. This is an intriguing aspect to the device considering how the watch bands do not contain any technology. Surveys indicate around 30-40% of Apple Watch buyers will likely buy more than one band, demonstrating some of the financial and marketing appeal of highlighting various bands available for sale. 

When thinking about the future direction for some of the Apple Watch's design and features, it is likely that we will see much more change with watch bands compared to watch cases. Considering that some Apple Watch owners will have multiple watch bands, with some costing hundreds of dollars, it is not likely that Apple will frequently change the Watch case in such a way as to no longer work with previous watch bands. This may suggest that we will see more innovation found with the Apple Watch bands themselves, including options that contain sensors and technological components within the bands themselves. In the long run, it is not crazy to envision certain types of bands being sold where the entire band is one, long flexible display able to show certain notifications or alerts to the user. 

Competitors

Despite much attention being put on the current watch industry as being the source of a true Apple Watch competitor, early indication would position Fitbit as Apple's most significant rival in the wearable market. Not only does Fitbit have a much better retail distribution than most watchmakers, including even Apple Watch (for now), but the combination of low prices and customer awareness gives Fitbit some advantages over Apple in the beginning. While Apple Watch and Fitbit wearables are not exactly direct competitors when looking at prices and feature sets, there is evidence that many consumers consider them to be rivals. I would go even further to say that many look at Apple Watch and Fitbit as the two primary pioneers in the wearable space, even though there were others before them. The following chart highlights Fitbit's annual unit sales, including 11 million units shipped in 2014. The company already shipped eight million devices in the first six months of 2015. The upcoming U.S. holiday quarter will be crucial for Fitbit. 

There continues to be many questions as to the long-lasting effect wearables will have on health and fitness. Early indication would show that there is an element of interest in health and fitness wearables beginning to wear off after a certain time leading to customers discarding or no longer wearing the device. It is likely that fitness will remain a niche use case while there continues to be potential for health to be positioned as a long-term use case for a wearable device. There is evidence that future Apple Watch models will improve on the device's health applications. 

Apple Watch Sales Estimates

Expanded Apple Watch distribution bodes well for improving Apple Watch sales momentum as more consumers are exposed to the device, not to mention that Apple is building the Apple Watch retail channel. While it may not be reasonable to expect continuously improving Apple Watch sales on a month-to-month basis, the upcoming holiday season (beginning in November for many countries and including February for China) will be crucial when expecting improving Apple Watch sales numbers. The following are my Apple Watch unit sales estimates for the next four quarters. 

• 3Q15: 3M units (reported)
• 4Q15: 3M units (increased retail distribution)
• 1Q16: 5M units (holiday quarter)
• 2Q16: 3M units (Chinese New Year)
• 3Q16: 3M units

During the first 12 months on the market, I expect Apple Watch sales to approach 15 million units. When comparing this sales number to the total iPhone installed base, Apple Watch adoption would be approximately three percent. Fifteen million Apple Watch sales in the first 12 months on market would beat iPod and iPhone in terms of initial sales. The following exhibit highlights my trajectory for Apple Watch unit sales in the coming years. 

Apple Watch sales trends also demonstrate some of the device's drawbacks. Apple Watch has to be paired with an iPhone. This requirement limits the target market for Watch to current iPhone owners. Even though there are more than 500 million iPhone users in the world, that is a smaller number than the number of people in a position to buy the iPad when it hit the market in 2010. In a rather remarkable sign of iPad's initial sales success, Apple sold 19 million iPads in the first 12 months on the market, which would be 4-5 million more than my Watch sales expectations for the same time period. 

Additional Questions

A "cheap" Apple Watch. One question that may take time to answer is how the Apple Watch demand curve looks when plotted against price. Much of Apple Watch's appeal may originate around the fact that it is a premium mass-market luxury object with a starting price of $349. Would a lower-priced collection priced around $200 be a panacea for the product category or would we see something similar to the iPhone 5c phenomenon where the device was never able to shake its "cheap" nomenclature when sold alongside more expensive alternatives? 

Retail Strategy. It is clear that Apple has been experimenting with the strategy used to sell Apple Watch. After a few months of sales, early trends would suggest that the way people buy Apple Watch Sport at Target will likely be quite a bit different than buying Apple Watch Hermès or Apple Watch Edition. When Best Buy began selling Apple Watch, the company reported much stronger than expected sales. The interesting part is that Best Buy was selling just a few models from the Apple Watch collection with only a few stores even having them on display. Most of these sales were Apple Watch Sport models and done on Best Buy's website. This would suggest that consumers look at the Apple Watch Sport as more like an iPod, iPhone, or iPad, a device that may not necessarily need the personal attention of trying it on. 

Meanwhile, someone buying Apple Watch Hermès will likely want a more personal touch during the buying process. Apple's answer to this seems to be to segment Apple Watch collections to certain retail locations. Apple Watch Hermès is available at 70 locations worldwide while Apple Watch Sport is now sold in thousands of retail locations. When it comes to Apple Stores and selling Apple Watch, we will likely continue to see change in the coming years as Apple figures out what works best for selling various models of the same product, each with different intangibles that enter the buying process. 

Don't Underestimate Apple Watch

The Apple Watch contains too much promise and potential to question it's long-term viability as a product category. It is becoming clear that the device was dealt a bad hand when it comes to early expectations, being compared too much to its very successful siblings - the iPhone and iPad. However, when looking at all of the various data points, estimates, and trends, it becomes clear that the Apple Watch is doing much better than it seems. We are living in an iPhone world with Apple expected to sell more than 250 million iPhones over the next 12 months. The iPhone 6s and 6s Plus position the iPhone that much closer to becoming someone's sole computer. In such a world, the Apple Watch likely has a role in handling some of the more simple tasks that were once given to iPhones, in addition to being given an expanding list of use cases that revolve around identity, monitoring, and personality. In a world moving towards more personal technology, Apple Watch has a place. It's time to stop underestimating Apple Watch.

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