Previewing Apple's 4Q16 Earnings

Apple's 4Q16 earnings release is set within a dynamic environment. Expectations are on the rise. Wall Street is now calling for the iPhone to return to sales growth in 2017. In addition, there are very early signs of light at the end of the iPad sales tunnel. However, given severe iPhone and Apple Watch supply shortages following last month's product launches, 4Q16 numbers won't provide the clearest answers for judging Apple's performance improvement. Instead, a greater than usual amount of attention will be focused on management's earnings conference call and 1Q17 revenue guidance. 

4Q16 Estimates

The following exhibit contains my full 4Q16 estimates as well as expectations for 1Q17 guidance.

Exhibit 1: Apple 4Q16 Estimates

My methodology behind these estimates are available for Above Avalon members here and here. (To become a member, click here.)

iPhone

Management's revenue guidance provided this past July implied approximately 43 million iPhone unit sales in 4Q16. This number would reflect weaker iPhone 6s and 6s Plus sales in July and August, continued robust iPhone SE sales, and the initial round of iPhone 7 shipments in September. While a sales number closer to 40 million units would raise questions, Wall Street will be much more interested in management's commentary regarding 1Q17 iPhone sales. 

Exhibit 2: iPhone Expectation Meter (4Q16)

Mac and iPad

Given an outdated product line, 4Q16 Mac sales will likely be extremely weak. However, with management announcing new Macs later this week, Apple will not get penalized for weak Mac sales in 4Q16. Attention will quickly move to the future and the prospects of an updated Mac line ushering in a return to unit sales growth.

As for the iPad, 4Q16 results will be much more useful for analysis. The 9.7-inch and 12.9-inch iPad Pro represent the future of the iPad. The two devices have increased the probability of the iPad business returning to year-over-year unit sales growth in the coming year. While I continue to include year-over-year declines in unit sales in my earnings model, there is a good chance of Apple reporting the second consecutive quarter of year-over-year revenue increase for iPad. 

Exhibit 3: iPad Expectation Meter (4Q16)

Apple Watch

Similar to iPhone results, 4Q16 Apple Watch results won't tell us the complete sales picture. Very tight Apple Watch Series 2 supply will make it difficult to judge Apple Watch demand. As detailed in my recent article, "Apple Is Going After Fitbit," there is much change occurring in the Apple Watch business as management repositions the Watch given current market dynamics. 

Exhibit 4: Apple Watch Expectation Meters (4Q16) 

Guidance  

The line in the sand for management's 1Q17 revenue guidance is found at $75 billion. A guidance range that includes $75 billion will give Wall Street much confidence that Apple will return to growth in 2017. Meanwhile, a revenue guidance range closer to $71B to $73B may disappoint those expecting a significant turnaround in iPhone growth. 

Exhibit 5: 1Q17 Guidance Expectation Meters (Revenue and Gross Margin)

Above Avalon members have access to my detailed earnings preview, including the methodology behind my estimates (four parts):

1. Methodology
2. Services, iPad, Mac, Apple Watch
3. iPhone
4. Guidance

Members will also receive my exclusive earnings reaction notes containing all of my thoughts and observations on Apple's earnings. To receive these earnings reaction notes, become a member here. 

Apple's Trojan Horse into Hollywood

Apple's video content strategy is coming into focus, and the company's plans look ambitious. Management's goal is to develop its own video service to distribute original content to more than a billion Apple devices. Apple will compete with Netflix and every other video content bundle. However, there will be a twist in Apple's strategy. 

Background

While Apple has long held a desire to rethink television, there has been one missing link: content. This lack of content played a part in Apple initially positioning Apple TV as a hobby. Unattractive TV industry dynamics, including a problematic go-to-market strategy, played a much larger role. 

Over the past seven years, Apple has been trying to create some kind of video content service. In 2009, Apple thought about becoming a cable distributor. The idea was met with little interest from content companies. Apple then turned to partnerships. Time Warner Cable had shown interest in working with Apple on a new type of paid TV service. Apple also approached Comcast with a similar idea of joining forces to launch a cable package with a revolutionary, new user interface. Apple met resistance. Unlike the music industry in the early 2000s, the cable industry was still doing too well financially to look at Apple as some kind of last resort. Apple's plan to partner with distributors was dead. 

Apple's next plan involved bypassing cable distributors and going straight to content companies to deliver content over the internet. The idea was to disrupt the large cable bundle by offering a slimmed down bundle of the most popular 20 to 30 cable channels for a lower monthly price. However, there were severe disagreements over money. Content companies wanted to include more of their channels in the bundle in order to bring in more revenue. Apple knew a low price was needed to insure customer adoption. Even Disney, a company thought to be a close Apple ally, couldn't reach a deal with Apple.  

This left Apple in an awkward situation when it came time to unveil its updated Apple TV box in September 2015. Apple is now positioning apps as the future of TV. The logic is that consumers will rely on a number of video apps from other companies for content. While this situation will suffice in the near-term, Apple has never stopped looking for ways to set itself apart from the competition in terms of delivering content to a global audience. 

Why Video?

For a company that is all about being focused and saying "no" to most product ideas, Apple's continued interest in video content may seem strange. However, Apple is increasingly dedicating resources and attention to video content for two reasons: 

1. Content (video and music) streaming has become a must-have feature for mobile ecosystems. 
2. Changing industry dynamics has led to a new breed of content distributors getting into original content creation. 

With technology companies battling each other for our time and attention, offering video content streaming has become a crucial requirement for a vibrant mobile ecosystem. While people may be spending less time consuming content via large cable bundles, an increasing amount of time is being given to smaller content bundles, including Netflix, Sling TV, PlayStation Vue, HBO, Hulu, Amazon Video, and YouTube. 

This move to paid video streaming has altered industry dynamics. New distributors now have the customers to invest significantly in developing original video programming. Netflix is on track to deliver 600 hours of original content this year. The plan is for Netflix to increase that total to 1,000 hours in 2017. Netflix plans on spending $6 billion on content in 2017, which would be close to the $7.3 billion expected to be spent by ESPN this year. It is only a matter of time before Netflix spends more than ESPN on content. Meanwhile, Amazon is on pace to spend more than $3 billion on content this year. One consequence of this development has been a "brain drain" impacting traditional cable companies. Talent, both in front of and behind the camera, is moving to where the eyeballs (and money) are located, which is increasingly found at Netflix and Amazon.

Given these changing market dynamics, Apple in a precarious position as the company increasingly finds itself relying on competitors to provide high-quality content to Apple customers. We see how Apple has tried to avoid or diffuse this type of dependency when it comes to hardware components. The same is now happening with video content. 

Apple's Video Strategy

After years of trying to figure out TV and video content, Apple's latest video strategy marks its most ambitious plan yet. Apple will compete with Netflix, Amazon, HBO, Disney, and every other content company by moving into original video programming. The greater flexibility attached to original video programming will make it possible for Apple to distribute content around the world. Apple will produce its own shows with the goal of launching an Apple Video streaming service. However, Apple has no plans to compete with content companies along traditional terms. 

In 2014, Apple didn't buy Beats for $3 billion just as a music streaming play. Instead, Beats was Apple's content streaming play. The Beats acquisition and resulting Apple Music service will serve as the foundation for Apple's broader content strategy. We are already starting to see the early stages of this plan taking shape. 

Apple's video strategy:

1. Use Apple Music to mask original video programming ambitions. Check.
2. Expand to other types of original video programming. Check. 
3. Position Apple Music as a carrot for an "Apple Video" streaming service by offering a combined Apple content subscription including Apple Music and Apple Video. 

Notice how Apple began its original video programming strategy by creating content for Apple Music - everything from Taylor Swift's concert video to music artist interviews with Zane Lowe, head of Beats 1 radio. Apple then expanded its focus to fund Vital Signs, a six-episode scripted series about Dr. Dre. Since Apple doesn't have enough original content for its own video streaming service, the company's efforts in video are being used to push Apple Music subscriptions. Customers paying for Apple Music will also get access to Apple's original video programming (much of it related to music).

Instead of competing head-to-head with companies like Netflix and Amazon in terms of the offering a certain amount of original programming, Apple would look to bundle its original video programming into a larger Apple entertainment package that includes Apple Music. Over time, Apple could expand to include various types of licensed content including live sports, which Apple has reportedly shown some interest in from time to time.

There is a reason Apple has been so forthcoming with providing updates to the number of paying Apple Music subscribers. In addition, Apple Music executives have been doing quite a bit of press over the past year. Apple is trying to build credibility in Hollywood and boost Apple Music subscriptions. A stronger Apple Music service will give Apple a better chance of success with a streaming video service. 

Apple Studios

It will be difficult, if not impossible, for Apple to succeed with original video programming without having the right culture for such endeavors to flourish within Apple. My theory is that Eddy Cue will be given reign over a new Hollywood arm within Apple for producing content. This "Apple Studios" would produce content in house (applies to both video and music ambitions). There were many interesting things going on with Apple's exclusive with Frank Ocean a few months back. 

Apple Studios would sit uniquely within Apple's organizational structure. As seen in the following chart, Apple Studios would be an entity positioned in such a way as to contain a certain level of independency within Apple. However, Apple Studios wouldn't be completely cut out of Apple.

Apple's primary objective in creating a distinct Hollywood arm is to avoid culture clashes. For example, not long after Apple bought Beats, there were reportedly issues as the two companies did things very differently. Two years later, we still see some of these differences when it comes to how Jimmy Iovine wants to run Apple Music. This same type of situation will undoubtedly rise as Apple pushes deeper into original video programming. Decision making needs to be revised to better suit content development. Apple's strict level of secrecy will need to be rethought. Simply put, Apple's Hollywood Arm will need to approach problems differently than the rest of Apple. This would explain why Apple Studios would be given greater independency.

What About Acquiring Netflix?

Given Apple's growing video content ambitions and desire to build a video streaming service, a natural question to ask is, would it just be easier for Apple to acquire Netflix? With one swoop, Apple would own the most popular paid video streaming service in the world. 

The best way to analyze the rationale for Apple acquiring Netflix would be to take a step back and ask a few, key questions. 

• Would Apple strengthen its product line by owning Netflix?
• Would Netflix plug a hole in Apple resources and talent when it comes to video content streaming?
• Would acquiring Netflix help accelerate Apple's existing video strategy? 
• Are there unintended consequences associated with acquiring Netflix?

Turning to the first question, acquiring Netflix would not strengthen Apple's product line as Apple customers already have access to Netflix content. Given Netflix's business model of making its content available to as many people as possible, the odds of Netflix no longer being available on Apple devices is very low. In fact, Netflix has an incentive to continue making it extremely easy for Apple customers to access and consume its content. In a scenario where another company acquires Netflix, I'm skeptical the situation would change as the new buyer would likely want to continue to support iOS users. Apple wouldn't need to acquire Netflix in order to guarantee Apple customers will enjoy Netflix content. 

When it comes to Apple acquiring Netflix as a technology play, there are more effective and efficient ways of acquiring streaming capabilities than having to buy Netflix and its 3,500 employees.

There would be some positives associated with acquiring Netflix. In terms of talent, acquiring Netflix would give Apple key personnel with deep knowledge of the streaming industry. In addition, acquiring Netflix would instantly give Apple the lead in paid video streaming. However, there are unintended consequences associated with the deal that would likely offset these gains. One of the biggest is culture shock. Netflix and Apple are not alike. Netflix is increasingly being run by media talent fleeing traditional content companies (remember that brain drain?) while Apple is run by industrial designers. This is why Apple building its own Hollywood arm within Apple has a higher chance of success over time.  

Add it all up, and there just isn't much rationale for Apple to acquire Netflix. Notice how price hasn't even entered the discussion. There are many reasons other than a high price tag that make Netflix a poor acquisition target for Apple. A Netflix acquisition would inevitably boil down to two things: branding and revenue plays. Neither are strong reasons for Apple to pursue an acquisition.  

The Big Picture

Apple is not getting into video content to boost its services revenue. Instead, video and music streaming will be positioned as ways to increase the value found in using Apple hardware.

Apple sees itself as the company best able to bridge the gap between Hollywood and Silicon Valley - a technology company with a range of devices and a loyal base of more than 700 million premium users that values high quality content. In addition to scouting programming ideas on its own, Apple will take a few pages from its Apple Music playbook to embrace, and potentially partner with, existing content companies on original programming ideas if the right opportunities arise. Hollywood isn't Apple's enemy. 

When comparing Netflix and Apple Music paid subscribers, it becomes clear why using Apple Music as a type of incubator for Apple's video streaming service ends up being such an interesting twist. By using original video content to boost Apple Music, Apple already has nearly 20M paying viewers accessing that video content. This compares to Netflix's 83M user count - not bad for a 16-month-old paid streaming service. As the amount of additional video content increases, Apple hopes this will further increase Apple Music subscriptions, thereby improving its video chances. Apple's $3 billion Beats acquisition was a Trojan horse into Hollywood. 

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Apple Is Going After Fitbit

Fitbit is being underestimated. While Wall Street continues to show little interest in the wearables company, Fitbit is on track to quietly sell more than 25 million wrist devices in 2016. Not only has Apple taken notice of Fitbit's sales success, but Apple Watch is being put on a fitness detour to better compete against Fitbit. There is only one genuine battle for the wrist, and it is between Fitbit and Apple Watch. 

It's Fitbit vs. Apple Watch

There was much unknown surrounding wrist wearables when Apple unveiled Apple Watch in September 2014. One of the biggest mysteries dealt with competition. There were at least six potential sources for Apple Watch competition: 

• Luxury watch industry
• Technology industry
• Fashion industry
• Health and Fitness industry
• Entertainment industry
• Other (health insurance industry, etc.)

Over the past two years, we have received some answers as to how these potential competition sources have panned out. It would be an understatement to say that there were a few surprises. 

• Luxury watch industry: After a year of denial, a handful of luxury watchmakers have embraced the idea of connected watches. None have sold in volume.  
• Technology industry: Android Wear is irrelevant. Microsoft just canned its Band wearable product. Samsung and its Tizen platform are barely on the map. 
• Fashion industry: Nonfactor. 
• Health and Fitness industry: Fitbit is on track to sell nearly 25M devices in 2016. Garmin and other fitness endurance companies remain niche players. 
• Entertainment industry: Nonfactor.
• Other: Nonfactor. 

While many thought the battle for the wrist would be between Apple and the Swiss watch industry, in reality, there was barely a skirmish. When ranked according to revenue, Apple was the second best-selling watch brand in 2015 despite having only eight months of sales. On a unit sales basis, Apple has already become the best-selling watch brand. After only a few months, Apple Watch's impact on the Swiss watch industry was being felt. (Evidence of deteriorating Swiss watch industry operating conditions is available here, here, and here.)

The only legitimate Apple Watch competition ended up coming from the health and fitness industry. Fitbit is the only wearables company outselling Apple Watch in terms of unit sales. When combined, Fitbit and Apple Watch represent nearly 40 percent of all wrist wearable devices sold in 2016 year-to-date. This means that there is a 40 percent chance that a consumer looking for additional utility on the wrist will end up buying either a Fitbit or Apple Watch. 

Fitbit Results

Fitbit Co-Founder and CEO James Park, along with Co-Founder and CTO Eric Friedman, have turned Fitbit from a company selling simple activity trackers into a household name synonymous with health and fitness tracking. After going through the Fitbit Force recall in 2014 when adhesives were found to cause severe skin rashes, Fitbit management has gone on to execute extremely well in terms of product, marketing, and distribution. Fitbit devices are available in 54,000 retail stores in 64 countries. 

In terms of unit sales, Fitbit's revenue guidance implies the company is on track to sell 26 million devices in 2016. On a cumulative basis, Fitbit has sold nearly 55 million health and fitness trackers. As seen in Exhibit 1, Fitbit has seen iPod-like sales growth in recent years. Fitbit average selling price (ASP) trends have increased to approximately $100. 

Exhibit 1: Fitbit Unit Sales (annual)

Fitbit's product strategy has been one of diversification. As shown in Exhibit 2, the company continues to build on its core activity-tracking capabilities in order to expand the product line. Devices like the Blaze smartwatch are designed to appeal to consumers wanting more utility on the wrist. In addition, Fitbit has been investing in software and services in order to expand into other mobile realms. Judging by recent M&A, the Fitbit product pipeline likely includes many more health-focused initiatives as well as broader computing features such as a mobile payments offering.

Exhibit 2: Fitbit's Expanding Product Line

There have been a few warning signs circling around Fitbit. Sales growth is slowing. In 2015, Fitbit grew unit sales at 96 percent. The company will be lucky to see greater than 25 percent growth this year. Another issue that has plagued the company is the rate at which Fitbit customers stop using their devices. The data suggests that nearly one in three people buying a Fitbit will stop using it within nine months. This is high and has been the source of much skepticism around health and fitness trackers. In addition, there have been questions around some of Fitbit's technology, such as the accuracy found with its heart rate monitors. Despite all of these issues, Fitbit currently has an active installed base of approximately 20 million, which is more than the number of Apple Watches sold to date. 

Apple Watch Results

In some ways, Apple Watch performed much better than Fitbit out of the gate. Since April 2015, Apple has sold 16 million Apple Watches. Not only is that a much faster sales ramp than Fitbit, but it also places the Apple Watch as the third best-selling Apple product post-launch, behind iPad and iPhone. On a revenue basis, Apple is on track to report $4.2 billion of Apple Watch revenue in 2016, $1.5 billion more than Fitbit. I previously valued the Apple Watch business at $10 billion. 

Exhibit 3: Apple Product Sales Post-Launch

While these Apple Watch numbers are unequivocally strong for a new product, upon closer examination there have been a few developments worth monitoring. Apple Watch sales growth slowed heading into summer 2016. While there are a handful of possible explanations for the slowdown, including the lack of new models and purchases being pushed to the holiday quarter, Fitbit did not see a similar drop in sales. At the same time, Apple Watch ASP has been declining as Apple pushes through price cuts while Fitbit's ASP has been increasing as the company sells higher-priced devices. 

The Fitness Detour

Apple's strategy with the Apple Watch has seen significant changes in just 17 months on the market. The company's initial goal for Apple Watch was to redefine a smartwatch as a fashionable piece of luxury. Apple went so far as to have exclusive showings in the days leading up to the launch, and the star of the show was Apple Watch and the assortment of Watch bands. 

As seen with last month's launch of Apple Watch Series 2, Apple has taken a decidedly different route with Apple Watch. (My initial Apple Watch Series 2 impressions are available here.) Fitness and health are being given a much greater focus. The three main selling features found in Series 2 were framed around fitness activities:

• GPS: For runners.
• Water resistant: For swimmers.
• Better display: For outdoor activities.

Apple is taking a fitness detour with Apple Watch Series 2, placing a bet that the best and most effective way to sell the next 15 million Apple Watches will be to position the device as a health and fitness monitor. Some of this changed strategy is due to the current state of wearables in 2016. Consumers are embracing the idea of using wrist devices to monitor tasks like miles walked or calories burned. In addition, Apple is indirectly admitting that some of the mini-iPhone on the wrist product marketing for Apple Watch was off the mark and not quite resonating with the average consumer. 

A Formidable Competitor

Consensus has never viewed Fitbit and Apple as rivals. Fitbit is often described as a low-end hardware manufacturer that will eventually run out of time or be pushed out of the wearables market by either a premium player like Apple or low-cost competition. Apple and Fitbit have also been operating at pretty different ASP ranges with Apple Watch closer to $400 and Fitbit at less than $100. 

Consensus is wrong.

Fitbit and Apple are not only rivals in the wearables space, but Fitbit's progress in terms of product and brand development is not being fully appreciated. Fitbit is becoming a force within the wearables space, and Apple is left with no other choice than to respond. As a sign of how the two companies are increasingly going after the same buyer, there is a very high likelihood of an Apple Watch Series 1 model selling for $199 this holiday season after retailer promotions, the same price as a Fitbit Blaze smartwatch and $50 less than a Fitbit Surge.  

The Fitbit/Apple Watch situation is no longer akin to the MP3/iPod era during the early 2000s. Despite going up against a number of less expensive MP3 players, the iPod did just fine due to a much better user experience. Many consumers eventually bought an iPod after first trying a lower-cost alternative. This scenario may not happen in health and fitness wearables. Fitbit is iterating much faster than people were expecting. In addition, Fitbit is grabbing both market and mind share. Fitbit ASPs are increasing, and the company is leveraging a strong balance sheet by investing in R&D in addition to M&A. 

There is evidence that Fitbit is succeeding where Apple Watch has been coming up short. One chart demonstrates this scenario and explains why Apple is likely going after Fitbit. Exhibit 4 compares quarterly Fitbit unit sales to Apple Watch unit sales (the blue line). The increase in the Fitbit to Apple Watch unit sales ratio from 4Q15 to 2Q16 denotes a slowdown in Apple Watch sales when compared to Fitbit. The same trend is seen when comparing Fitbit revenue to Apple Watch revenue (the red line). Fitbit did not see the same kind of slowdown in sales this past spring. Exhibit 4 assumes Apple sees an increase in sales due to the Apple Watch Series 1 and Series 2 launch. 

Exhibit 4: Fitbit vs. Apple Watch Ratios (Unit Sales and Revenue)

The Goal

Apple's goal in going after Fitbit is simple: Prevent Fitbit from gaining additional ground in health and fitness tracking. Apple doesn't need to compete with Fitbit on price, but rather on feature set and ease of use. This is one area in which Fitbit has had an advantage by starting simple and then expanding outwards. Apple took the opposite approach with Apple Watch with the third-party app experiment.

In some ways, Fitbit has seen success by keeping it simple and not overselling wrist wearables. Apple appears to be taking notes. Assuming Fitbit continues to see growth in 2017, the company will soon be approaching 30 million unit sales per year. With an ASP of around $100, Fitbit would be on track to sell at least 5 million to 10 million devices that retail for more than $150. That is Apple Watch territory.

Adding Fitbit and Apple Watch sales to date, the two companies have sold 80 million devices. There will be 1.4 billion smartphones sold in 2016. Succeeding with fitness tracking today will increase the odds of winning with health monitoring tomorrow. There are very few things that will end up having more of a mass market appeal than wearables capable of health monitoring (Don't forget about AirPods.) This is why Apple is willing to take a fitness detour in its battle for the wrist.  

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