Month One
Above Avalon has been in existence for one month. I would like to share some data from the first 31 days. Unique visitors is the primary metric I've been tracking, and numbers are exceeding my expectations.
Posts: 36
Unique Visitors: 16,169 (750/day normal run rate)
RSS subscribers: 896
Podcast RSS subscribers: 2,201
The amount I have learned over the past four weeks has been incredible. I'm quite happy with how my daily Apple email is going; it now has 760 subscribers. Thank you to those who have emailed or messaged me to say how they look forward to reading the email each day. I've been fortunate enough to get some great feedback and suggestions, and I always welcome additional comments.
I have much bigger plans for Above Avalon and the daily email, so stay tuned. In the meantime, if you have a coworker, friend, relative, or neighbor that may be interested in Above Avalon or my daily Apple email, I would greatly appreciate it if you spread the word. A few retweets or links go a long way as well.
Thank you to those of you that are enjoying the site each day. Your early support is greatly appreciated.
-Neil
If the Apple App Store Is a Battlefield, Jony Ive Is the Commander
The latest quarrel between Apple and developers seems to go a bit deeper than the cat-and-mouse game that has been played for the past five years. Without going into much detail (largely because I think that misses the big picture and there is debate over how justifiable some of these App Store review decisions are), the crux of the latest situation is that Apple released new APIs in iOS 8 and there now seems to be confusion and disagreement within Apple as to how these new features should be embraced.
There is a growing murmur that the latest battle is a sign of internal conflict at Apple with software engineering pinned against those in charge of App Store review. Many are pointing at comments written by Greg Gardner, creator of Launch, whose app was rejected from the App Store. He says Apple wanted to use his app as an example for rethinking how developers look at app guidelines.
“During this same conversion, I also asked specifically why Launcher was removed from the App Store after 9 days when other similar apps are still available weeks later. The answer to this question was the most interesting and informative response I had ever heard from them. They basically said that Launcher was a trailblazer in uncharted territories and that they felt that they needed to make an example of it in order to get the word out to developers that its functionality is not acceptable without them having to publish new specific guidelines. And they said that the fact that they aren’t seeing hundreds of similar apps submitted every day is proof to them that taking down Launcher was successful in this regard.
This was a pretty big revelation to me. After Launcher was rejected and the press picked up on it and started writing articles which painted Apple in a bad light, I was afraid that Apple might be mad at me. But it turns out that was actually the outcome they were looking for all along. They acted swiftly and made me the sacrificial lamb. And after that, removing other apps with similar functionality became a low priority for them.”
Instead of the App Store representing a battle between Apple and developers, I look at the skirmish as indicative of a much bigger war going on within Apple between software and hardware. The same battle ultimately costs Scott Forstall his job (internal power struggles don't help matters), transferring more responsibility to Jony Ive. I would argue that Jony Ive did not necessarily get more power from the transition as he already held more power than anyone else at Apple, as previously detailed in Steve Jobs' comments to Walter Isaacson. My theory is that Jony holds more power than Tim Cook, which makes him part of this App Store debate.
Apple's hardware and design teams are firing on all cylinders. Apple's global supply chain is unparalleled in scope and efficiency, component supplier relationships appear to have hit a stronger and more cordial tone, and nearly the entire product lineup has been updated or revised within a short timespan, with iPhone, Mac, and iPad seeing annual refreshes. In addition, Apple is now ushering a new era of personalized hardware devices. Meanwhile, Apple's software products have seen more mixed results with a buggy iOS 8 release, lingering questions surrounding Apple's ability to handle annual iOS refreshes, and software limitations starting to hold back several product's potential.
The debate is whether software is getting intentionally left behind, or if the lack of motivation and resources represents another power struggle within Apple where hardware and design are given priority, at the detriment of software. In both scenarios, I think Jony will play a vital role in the discussion (even if he is to blame), since I suspect the Apple we are seeing today is quickly transforming into Jony's vision of the Apple of tomorrow, a company focused on using design to create tangible products that possess passion. The challenge for Jony, and Apple, is figuring out a way to incorporate software and developers into this vision. One of the biggest risks Apple is facing by not being clear with the App Store, and developers, is that innovative apps aren't being made as developers decide not to spend precious resources testing App Store guidelines. Regardless of the outcome, including if a new VP-level executive is tasked with running the App Store and interacting with developers, or if there is a change in the SVP ranks, I expect Jony Ive will continue to play an important role in guiding Apple.
Developers have played a big role in getting Apple to where it is today, and will ultimately play just as big of a role in determining Apple's future success.
Thoughts on Apple's $155 Billion of Cash
Apple is relying on robust free cash flow and debt issuance to support its aggressive $130 billion capital management program. Even though Apple has $155 billion of cash, cash equivalents, and marketable securities at quarter end, the company's overall financial flexibility is limited somewhat by having approximately 90% of total cash held by foreign subsidiaries, while component purchase commitments and other obligations total $26 billion. With approximately $50 billion of expected free cash flow, I suspect Apple will issue more debt and commercial paper to increase its capital management program in 2015, while maintaining enough flexibility to invest in organic growth opportunities, including M&A. I don't view going private as a realistic option for Apple at this time given low feasibility and practicality.
Historical Analysis
Excluding the $29 billion of debt and $6 billion of commercial paper from Apple's gross cash, Apple's net cash, cash equivalents, and marketable securities stood at $120 billion at quarter end. Exhibit 1 highlights how Apple's net cash has remained relatively unchanged since the capital management program was initiated in 2012, a testament of the company's robust free cash flow.
Exhibit 1: Apple's Net Cash, Cash Equivalents, and Marketable Securities Position
Apple's domestic cash continues to decline, and now stands at $18 billion, due to the ongoing capital management program. With international sales accounting for 60% of total sales, Apple's foreign cash levels have ballooned to $137 billion, as depicted in Exhibit 2.
Exhibit 2: Apple Cash - U.S. Versus Foreign
At the same time, Apple's contractual obligations have been steadily increasing and now stand at $24 billion. Purchase commitments and other obligations include components, product tooling and manufacturing process equipment, and commitments related to advertising, R&D, Internet and telecommunications services and other obligations.
Apple launched a $10 billion share buyback program in 2012, with subsequent annual revisions to $60 billion in 2013, and $90 billion in 2014. Apple currently has $22 billion of share buyback authorization remaining. Exhibit 3 highlights Apple's share repurchase and dividend activity since 2012.
Exhibit 3: Apple Capital Management Activity
Forward Analysis: Apple's 2015 Capital Management Program
I expect the board to revise Apple's capital management program in 2015 to match the company's free cash flow, which would support an additional $40 billion of capital repatriation. I expect the share repurchase authorization to be increased by $30 billion to $120 billion, while the quarterly cash dividend is increased to $0.50/share, from $0.47/share. In order to fund the share repurchases and dividend using U.S. cash, I expect Apple to raise additional debt. In terms of total cash, Apple may reach $170 billion of gross cash, cash equivalents, and marketable securities by year-end 2015, of which approximately $50 billion would be from debt and commercial paper issuances.
In terms of Apple going private, the amount of debt that would need to be raised to make a leveraged buyout or leveraged recapitalization possible would likely be insurmountable at this time, even after considering Apple's $170 billion of expected cash by year-end 2015. In addition, with no significant Apple insider share ownership, it is unclear where the motive for going private would originate from as management has shown no prior desire for such a move, and shareholders would need to weigh the pros and cons of going private versus alternatives, including splitting the company up or spinning segments off. From a purely business standpoint, while there are benefits from going private, such as being able to manage the business easier with a long-term viewpoint, there is little evidence to suggest Apple has not been able to do that as a public company. Being public also helps in terms of accessing capital markets and paying employee compensation using stock. Similar to Dell, if Apple found itself in a situation where underperforming business segments were masking better-performing pieces, going private may make more sense, although the sheer volume of funds required would be daunting.
This report should be used to understand my views on Apple's capital management program, especially when I discuss the topic in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. This report was produced by Neil Cybart on December 9, 2014.
Apple's New iPad Ad Looked Familiar
Apple's new iPad Air 2 commercial, Change, was released yesterday.
The ad was very similar to the iPhone 5s Dreams ad released four months ago.
In each ad, Apple is stressing the user's ability to transform software and hardware into a personalized device capable of navigating the world. While a very select group of people will be installing iPads into motorcycle gas tanks, or using iPhones to check a horse's vital signs, the message isn't to make the viewer feel connected to the depicted scenes, but rather to plant the seed that these devices have the potential to be used in ways that computers have never been able to be used for before.
The interesting part about comparing the two ads is how the new iPhones are able to handle nearly all of the activities depicted in the iPad commercial. In addition, the scenes from the iPhone ad come off as more genuine because everyone will have their iPhone with them, while the iPad as a mobile device is a harder sell (Apple had roughly 60% of the activities shown in the iPad ad depict a mobile use case, which I describe as being used outside a room with four walls). Apple's latest iPad ad is just another piece of evidence that the grey area between a phone and a tablet is disappearing. One big question heading into 2015 will be if a larger iPad Pro will change this dynamic, giving the tablet more differentiated use cases versus the iPhone.
Apple's Accelerating iPhone Business; Establishing 2015 Estimates
I expect Apple's iPhone business to report accelerating growth in 2015 due to a combination of strong iOS user loyalty trends, carrier and geographic expansion, and share gains in developed markets. Following my 1Q15 iPhone sales estimate note published two weeks ago, I am establishing my quarterly iPhone unit sales estimates for the rest of 2015. Based on the initial success of iPhone 6 and 6 Plus, I expect Apple to report 25% unit growth for full-year 2015, up from 13% growth in 2014. Exhibit 1 highlights my quarterly iPhone estimates for 2015, while Exhibit 2 puts my 211 million iPhone unit estimate for 2015 in perspective with previous years.
Exhibit 1: Above Avalon iPhone Estimates
Exhibit 2: Annual iPhone Sales (fiscal year)
Topics to consider:
User Loyalty and Vibrant Upgrade Cycle. Apple has loyal iPhone users that upgrade on a regular basis, and the iPhone 6 launch looks to have successfully continued that trend. CIRP estimated that approximately 80% of U.S. consumers that bought the new iPhone 6 and 6 Plus in the first 30 days after launch were current iPhone users, up from 74% for the iPhone 5s launch in 2013. Kantar Worldpanel estimated that 86% of British iPhone buyers upgraded from an older iPhone for the three months ending October 2014. User loyalty is only one piece of the puzzle, as Apple needs a vibrant upgrade cycle to build and retain that loyalty. Apple has remained on a two year upgrade cycle built around a new form factor, with the off, or "S", years focused on refinements and component upgrades.
Additional Carriers. It may be easy to underestimate the impact from new carriers on iPhone's growth, but Apple has had a few recent high-profile additions. Apple launched the iPhone on NTT DOCOMO in 2013, and China Mobile in 2014. I estimate Apple is selling around 5-7 million iPhones a quarter through China Mobile, which would represent approximately 30% of my 2015 iPhone unit growth estimate. My declining quarterly iPhone unit growth estimates through 2015 partially reflects normalizing growth rates related to China Mobile.
In many other countries, including the U.S., Apple has been steadily working on bringing the iPhone to additional carriers, albeit much smaller than NTT DOCOMO and China Mobile. While individually each carrier may not contribute much to the bottom line, collectively they do represent a noticeable addition to iPhone's distribution channel.
Emerging Market Expansion/Further Penetration in Developed Markets. Apple expects the new iPhones to reach 119 countries by year-end, the fastest roll-out for iPhone. Apple is still in the early stages of tapping iPhone retail distribution in China, India, and Brazil. A report published last week discussed Apple's plans to expand its retail capabilities in India by opening 500 retail stores using a franchise model. In many developed countries, iPhone 6 and 6 Plus sales share is tracking ahead of iPhone 5s sales trends in 2013, suggesting Apple is capturing share from competing platforms.
Apple has a few levers to pull to maintain iPhone growth:
Upgrade Cycle. Apple has been successful in releasing iPhone features that do not over serve the market. It is in Apple's best interest to keep the iPhone upgrade cycle as short as possible by pushing the envelope with features that matter to iPhone users: screen, camera, sensors like Touch ID, and design. I would not be surprised if Apple continues to use the "S" cycle to come out with different iPhone colors, similar to the iPhone 5s.
Geographic Expansion. Apple will continue to focus on bringing the iPhone to new markets beyond just continued development in China and India. I also expect Apple to continue lowering iPhone's entry-level price, which will help drive sales in countries that do not rely on carrier-financed "subsidies" or installment plans.
Ecosystem Services. With Apple Pay, Apple is beginning to flex the iOS ecosystem by providing consumers additional value, while looking to find new lock-in mechanisms as media and content no longer increase ecosystem switching costs. Apple Pay's eventual expansion into new markets may also have a larger impact on sales in countries that were once considered outside Apple's core iPhone sales focus.
This report should be used to understand my views on Apple's 2015 iPhone sales, especially when I discuss the topic in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. Downside risks to my estimates include: iPhone supply issues and weaker-than-expected customer demand. Upside risks to my estimates include: stronger-than-expected customer demand, especially in China. This report was produced by Neil Cybart on December 8, 2014.
I publish a daily email about Apple called AAPL Orchard. Click here to subscribe.
Apple and Amazon View Failure Very Differently
Amazon CEO Jeff Bezos was the keynote speaker at the Business Insider Ignition conference a few days ago. A few of his comments about failure jumped out to me.
“It’s incredibly hard to get people to take bold bets. You need to encourage that and if you are going to take bold bets, there are going to be experiments, and if there are experiments, you don’t know ahead of time whether they are going to work. Experiments are by their very nature prone to failure, but big successes, a few big successes compensate for dozens and dozens of things that didn’t work.”
Companies that don’t embrace failure, they eventually get in the desperate position where the only thing they can do is make a Hail Mary bet at the very end of their corporate existence…I don’t believe in bet the company bets. That’s when you are desperate.”
Last month, Apple SVP Design Jony Ive gave a talk at Design Museum and the topic of failure was discussed.
“I would say the priority is that we learn how to care and we learn how to fail and that we’re prepared to screw up the work that we’ve done and throw it away even if we don’t know what we’re going to do instead. When I’ve explained to people before and said ‘well we screwed this up, we parked this,’ normally I can say ‘and look what we went on to do’.
If it’s not very good we should just stop it, even if we’ve spent a lot of money trying to develop it. It’s scary, and we’ve been there on many occasions where you’ve spent this much money and I’m talking too loud to try and convince myself that it’s OK and it’s not. It’s one of the fantastic things that I feel so fortunate to work with a group of people who are very comfortable with that ‘yeah it’s not good enough we should stop doing this’ and we don’t talk about all the money we’ve just spent. Well, they might do behind my back.”
Both men accept failure and I suspect nearly every human needs to accept failure in some capacity. What is interesting is where Bezos and Jony are willing to accept those failures. For Jony and Apple, the goal is to fail behind closed doors. For Amazon, failure out in the public marketplace is thought to have little consequence and is even encouraged. For Apple, failure is actually minimized by taking bigger risks. Amazon does the exact opposite, by not taking big risks, failure is more acceptable and manageable.
I'm intrigued by Amazon's hardware strategy. While the Kindle found its niche, subsequent versions that were more akin to iPad never saw the same level of success, while every other Amazon consumer tech hardware product hasn't lived up to the hype (Amazon has never released sales numbers, but share/sales data and surveys all point to the same conclusions). For Amazon, public failure with the Fire Phone is acceptable, and even applauded, as the thought process is that things can be learned about a failure, and then future versions may have a better chance of success. Do consumer habits support such a stance? Will consumers forget about past product shortcomings, and give subsequent reiterations a fair chance? I'm not so sure.
Over the past 10 years, Apple has had very few hardware failures, with the iPod Hi-Fi speaker system standing out as maybe the biggest flop. While Apple has its fair share of hardware blemishes or minor flaws that are rectified in subsequent versions, the public has come to expect Apple's best when it comes to hardware, as most of the company's failures have been kept hidden in Jony's labs, with the public seeing only the big hardware bets. Brand equity is built in consumers' minds, while public perception and anticipation remain elevated. I suspect consumer tech hardware failures take a much bigger long-term toll on a company than Jeff Bezos would like the world to believe.
Apple's Share Repurchases Have Benefited Shareholders: Follow-Up
Since my Apple's Share Repurchases Have Benefited Shareholders by $80 Billion article was mentioned on Business Insider Deputy Editor Jay Yarow's latest podcast with Eric Jackson and Ben Thompson, titled Tim Cook's $100 Billion Mistake (44:19 mark), I thought it was appropriate to publish my response. The part of the podcast specifically related to my article had to deal with whether Apple's buyback was a waste of time and resources, akin to IBM financial engineering, and if Tim Cook is just merely trying to please shareholders.
My response: Apple's stock buyback is meant to benefit shareholders. Who else would the stock buyback be meant for? Apple is owned by its shareholders and with that ownership comes privileges such as voting in directors that are tasked with overseeing Tim Cook to make sure shareholders' interests are being considered. The stock buyback is a transfer of wealth meant to benefit shareholders (who aren't selling shares to Apple), especially when the stock being bought is considered undervalued by traditional financial valuation metrics, such as forward price/earnings and price/cash flow ratios.
It is a fact that the buyback has raised EPS per share and that each remaining share now has a higher ownership percentage (albeit very tiny) of Apple's earnings. Apple has bought back 10% of its shares, which means that for Apple to trade at the same market cap today than it did two years ago, would require 10% fewer shares needing to be bought. In terms of dividends, the remaining shareholders may now be in a better position to benefit if Apple raises its dividend purely because of fewer shares outstanding. Arguing that Tim Cook is "wasting" money by simply giving excess cash back to shareholders fails to grasp the actual debate of whether share buyback benefited shareholders. I laid out my argument for how shareholders have benefited by $80 billion, but the podcast didn't address that, instead just saying that buybacks don't benefit stocks and shareholders (with no evidence to support that claim) and that Tim Cook was trying to please shareholders, instead of taking the excess cash and buying companies, that by no means are guaranteed to fit seamlessly and effortlessly into Apple's unique structure.
CEOs and CFOs are tasked with keeping shareholders' best interests in mind. For many public companies, CEOs spend a few weeks on the road each year meeting with investors and representing the company to Wall Street. CFOs are often tasked with talking to clients throughout the year, which may end up taking up significant portions of their schedules. This is part of proper corporate governance and should be applauded, not ridiculed, or positioned as a bad decision. Management teams ultimately work for shareholders, through the board of directors, so taking a dinner with a group of investors does not mean Tim Cook is engrossed in Wall Street to the point of not having time to manage Apple.
The bigger issue with the Apple share repurchase debate comes down to unfalsifiable statements, or claims that can not be proven false, such as:
"Apple stock would be worth just as much as it is now if the buyback was not done."
One can not prove this statement false because it never happened. We don't know what Apple would look like if it hadn't bought back stock. I find the current debate to be quite funny as it essentially boils down to arguing whether Apple should alter it's strategy to spend excess cash, the same strategy responsible for giving them $150 billion of cash. Apple buys companies. Apple buys back its stock. Apple pays dividends. Despite doing all three of these things simultaneously, Apple still has $150 billion of cash that can be used to buy other companies, invest in itself, and return excess cash to shareholders. Classifying buyback as a waste with no proven benefit to shareholders, without any analysis or data to back up such a claim, takes things a bit too far.
Apple Watch's Secret Weapon
Apple Watch creates an interesting dilemma as personalized luxury, built around technology, is positioned against timelessness. There is increasing evidence that Apple Watch's personalized luxury will trump the device's lack of timelessness, which will not only impact Apple's financials, but cause a major upheaval in the traditional luxury watch market.
Starting in early 2015, Apple will sell three distinct watch collections, each positioned for a different type of buyer. Apple Watch Sport will be positioned for those with a more active lifestyle, or just looking for a less-subtle fashion accessory, while Apple Watch will be for the all-purpose, practical buyer. At the top of the price range, Apple Watch Edition will rely on refined elegance to sell to the few that truly value personalized luxury. Both the Apple Watch Sport and Apple Watch will be priced at levels that leaves timelessness out of the purchase decision, largely as a result of the device's perceived utility and value. The Apple Watch Edition raises some interesting questions though in terms of luxury, technology, and timelessness.
The luxury watch market prides itself on combining craftsmanship and timelessness to create emotion, which is then passed down from generation to generation. With a smartwatch, and its reliance on parts that will not be able to stand up against the test of time, how can luxury be a selling point? Several luxury watchmakers have given hints that they think a smartwatch's lack of timelessness guarantees traditional luxury watches will not be threatened by this new crop of wrist gadgets. I'm not so sure that logic will stand the test of time.
With Apple Watch Edition, Apple is appealing to a small group of buyers that want luxury combined with personalization (think different bands and faces), something traditional luxury watches are unable to provide. Will there be buyers that prefer luxury over technology's inherit lack of timelessness? Looking at the cottage industry that has developed around adding personal luxury to iPhones, the answer is a resounding yes. Luxury is a feeling one receives from wearing or using a product, regardless of it's utility or lifespan. Dezeen highlighted Feld & Volk, which describes itself as "an association, consisting of artists and engineers, who create unique devices developed on the basis of iPhone and iPad." Feld & Volk disassembled the iPhone 6 to see which parts could be swapped out with more expensive counterparts. The end result is a collection of truly unique iPhones, one of which is called 'Wood', a $4,799 iPhone 6 that includes a back panel made of Karelian birch, 24K gold plated buttons, and an illuminated Apple logo made of sapphire glass. Meanwhile, another company called Brikk sells a 24K gold iPhone 6 Plus for $5,995. Vertu sells a range of Android-powered phones, with some models costing up to $20,000. While the market for these phones is quite small (Vertu has sold over 300,000 phones to date), the same can be said about Apple Watch Edition if the device is priced around the $5,000 to $8,000 range. I estimated Apple could sell a few hundred thousand watches a year from the Apple Watch Edition collection assuming a $7,500 average price, with China being the major target market.
Why would someone pay $7,500 for a watch that will not stand the test of time? The value of personalized luxury outweighs the device's short utility period. Looking at the Apple Watch Edition, I don't see the point in having the electronics be interchangeable or upgradable. An individual buying such a watch doesn't care about the device's lack of timelessness and that should keep traditional watch makers awake at night. Apple's embrace of personalized luxury has the potential to shake-up a number of industries, including the traditional luxury watch market.
iPad's Biggest Problem in Education is iPad
Apple has a storied history in the education market with a long-standing goal of transforming the way students use technology to learn. In recent months, the rise of Chromebooks and the "Cloud" and a few well-publicized iPad initiative failures have raised questions if Apple is approaching the education market with the correct strategy or if competitors' offerings are squeezing out Apple products from the classroom. I don't look at Chromebooks as competing with iPad in education and I'm rather baffled at why the education market is being labeled as a zero-sum game for computing devices. Instead, I view the iPad's biggest roadblock in education is the iPad. With a rather limited range of functionality in a strict learning environment, instead of appealing to the education mass market, iPad may be better suited serving niche learning environments where a higher-priced, specialized learning tool is desired.
Education and Technology
Unlike the consumer market, education and technology are guided by different principals including elected boards, budgets, studies, and mandates. When discussing technology adoption in education I think it is important to recognize this different structure compared to the consumer market. Even within education, there are different environments for how technology is adopted as private, parochial, and charter schools determine technology prerequisites differently than public schools. While the economy may have improved, many municipalities continue to run with very tight budgets, and education is often the largest expense line item for most cities. With such a backdrop, school districts are looking to make each technology dollar go as far as possible. Price matters in education and that dynamic can not be stressed enough. Two weeks ago, the NYC Department of Education approved Chromebooks due to two reasons: familiarity and low-price.
Chromebook Advantages
Along with price, school districts are buying Chromebooks for various reasons, including the fact that the computer serves student's needs really well. With many teachers and administrators relying on Google Apps for daily tasks such as attendance, grading, and scheduling, not to much more student-facing apps like YouTube, a Chromebook is an obvious way of utilizing Google's services and cloud infrastructure. Concerning affordability, deployability, and supportability, Chromebooks check off many prerequisites that schools are looking for to expand technology in the classroom.
iPad Disadvantages
While people love iPads, teachers and administrators have run into issues with iPads in the classroom, including logistical bottlenecks and usability. When compared to how schools use Chromebooks (sharing is a key tenet), iPads' single-user framework embraces the idea of the iPad remaining with the same student in school and at home. While this program has been adopted in smaller schools where families buy the iPad themselves, for larger school systems, this computing method is impractical, and may represent one of the biggest roadblocks for widespread iPad usage in education. Looking at iPad in the upper grades, lack of usability begins to stand out with no dedicated keyboard and lackluster curriculum offerings.
The Cloud
The argument is pretty straightforward: With everything moving to the cloud, hardware will turn into a commodity. In some ways it's simply taking a page from Christensen's 'Innovator's Dilemma'. What's missing? Brand and design. However, in education, school boards aren't looking at brand and design when considering what can be purchased to fit within a certain budget. Instead, design is largely pushed to very specific needs, such as gadgets for science labs or music halls. I suspect there will still be strong demand for differentiated, personalized hardware going forward, and the specialized education market is no different.
L.A. School District iPad Program Embodies iPad's Issues in Education
In 2013, the Los Angeles Unified School District launched a $1.3 billion technology initiative that included purchasing 605,000 iPads. Then-Superintendent John Deasy applauded the program and said the launch went smoothly. Fast forward to yesterday, and the FBI seized 20 boxes of documents related to the way the iPad bidding process was handled with accusations that Deasy rushed the iPad initiative through because he wanted to partner with Apple. As of today, the district has purchased "only" 91,000 iPads with plans on buying an additional 14,875 units, but along with laptops and 4,000 Chromebooks. What went wrong? Were Chromebooks to blame for iPad's misfortune? Not quite.
Rushed Rollout and Improper Training. Teachers complained of a rushed iPad rollout, where iPads were delivered, but the underlining curriculum was either not available or not even in existence.
iPad Misusage. Students deleted security filters exposing them to the full internet. Anecdotal evidence points to widespread misusage, including students stealing or hiding iPads in school with no proper protocol for tracking where each iPad was at all times.
In both of those cases, the iPad and any underlying infrastructure, or lack thereof, was to blame for iPad's failure. While price did play a role as well, there is little evidence of Chromebooks and laptops replacing the need for iPads altogether, but rather the iPad was simply never up to the broader initiative.
Apple's iPad Strategy in Education
Apple's biggest problem in education is iPad, not the Chromebook. In many cases, where Chromebooks are being bought in bulk, the iPad was never positioned as a viable competitor or option to begin with. A few things Apple may do to address this current dilemma include:
Embrace Niche. Not trying to be everything to everyone. Instead of shipping a product geared towards widespread education adoption, Apple would focus on what makes the iPad stand out: the seamless intersection of hardware and software. The iPad may be more appropriate for lower grades where touch has a bigger impact on learning and there seems to be a more vibrant curriculum available, while the iPad can be used for more specific uses in the higher grades such as in the sciences and arts.
Infrastructure. I think one of iPad's issues in education is the lack of support for teachers and administrators in terms of apps and device management. Whereas Chromebooks give students the bare necessities (which is all that is desired); iPad educational software, especially with higher grades in mind, has been disappointing and unable to tap iPad's potential. Apple's grand vision for interactive textbooks has flatlined due to much larger complexities beyond just iPad and Apple.
Apple's goal in education has always been to foster new ways of learning. Over the years, as technology costs have come down and schools embraced the cloud, cheaper opportunities have ushered in more widespread technology usage in schools. Meanwhile, Apple continues to sell millions of higher-priced iPads into education annually, despite school boards trying to meet budgets, and various mandates adding layers of bureaucracy to purchasing decisions. In this context, iPad's ultimate goal in education is to provide specialized hardware and software for fostering new ways of learning, and I suspect there is a healthy market for such a product.
Apple Flash Crash Brings the Worst out of Stock News Websites
Apple stock experienced a flash crash yesterday morning, dropping 3% in one minute on extremely heavy volume. With Apple trading near all-time highs, market pundits have become increasingly eager to point out why Apple's stock dropped. CNBC ran an article yesterday titled, "Here's why Apple shares took a dive: Pros". With such a headline, I knew what I was getting myself into and I wasn't disappointed as the article contained six reasons, impressively none of which were related to each other, that explained why Apple's stock had crashed.
Reason 1: Morgan Stanley Downgrade
Daryanani got on the phone with his trading desk to find out what they were seeing. It's a common occurrence on Wall Street for sell-side analysts to periodically check-in with their trading desk to see if there is anything unusual with the incoming buy and sell orders. In reality, the traders are just reading blogs and AOL IM themselves looking for reasons a stock is up or down since they don't know either.
Reason 2: Program Selling
After getting off the phone with his traders, maybe Daryanani got some incoming calls from clients that actually knew what was going on. CNBC gives the reason one sentence.
Reason 3: Technical Analysis
People sold Apple because it crossed a random moving average.
Reason 4: Profit-Taking
Apple is down 3% in one minute and Basenese concludes that it resulted from long-term investors deciding now is the time to sell. It is just a coincidence that everyone decided to sell at exactly the same second...literally.
Reason 5: Stock Upgrade
Basenese also thinks a stock upgrade may have caused Apple's stock to crash. I assume a stock downgrade would cause Apple's stock to pop?
Reason 6: Weak Black Friday Sales
I assume this reason came in from traders with little to no knowledge about Apple or that Black Friday sales metrics were largely irrelevant because of retailers holding sales during the week leading up to Black Friday.
The CNBC article has 143 comments so I assume it accomplished its goal of attracting page views. Meanwhile, Reuters published an article yesterday about Apple's flash crash, listing one primary explantation: algorithmic and high-frequency trading.
Reason 1: Algorithmic Trading
Similar to the 2010 Flash Crash, yesterday's flash crash impacted over 300 stocks, not just Apple. The U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading (CFTC) looked into the 2010 Flash Crash and concluded that one trader initiated a sell program to sell S&P 500 futures contracts. High-frequency trading firms saw the order and started selling the contracts they had just bought from this one trader. A resulting liquidity vacuum (lack of buyers) formed and then spread into the equity markets. I suspect something along those lines impacted the stock market yesterday morning. Of course, this theory doesn't lead to the most exciting headlines and stories, so when the next flash crash occurs (and it will), I'm confident we will see new articles from the "pros" giving us six explantations for why Apple crashed.
Apple's Share Repurchases Have Benefited Shareholders by $80 Billion
With Apple having completed 75% of it's current share repurchase program, and a recent increase in chatter concerning whether share repurchases are the best use of Apple's cash, it is a good time to review Apple's share buyback program and assess its logic and success. It is important to first understand what a stock repurchase program is and how companies use buyback as a signaling mechanism when framing Apple's decision to initiate the largest capital management program in history. I estimate Apple's ongoing share repurchase program has added $80 billion of price to Apple's stock, benefitting current shareholders as the gap between Apple's stock price and value has narrowed. Despite committing to $90 billion of share repurchases and having $22 billion of buyback authorization remaining, Apple has kept all of its options open for creating additional shareholder value through funding sensible M&A and capital expenditures.
What are Share Repurchases?
A share repurchase program, often called share buyback, is the process of a company buying back its own shares either through the public market or private transactions. Share repurchases, along with cash dividends, are two of the primary ways companies can return excess cash to shareholders. The mechanism of share repurchases are not controversial; as shares are repurchased, a company's outstanding share count declines, thereby boosting each remaining share's ownership percentage. Consequently, each remaining shareholder that did not sell shares to the company would then have a higher share of earnings and cash flow. Exhibit 1 demonstrates this process as a hypothetical 10% share buyback lowers shares outstanding, while having no impact on earnings, leading to higher EPS and a higher overall ownership share for the top shareholder assuming no shares were sold. I assume it was an all-cash share buyback in a low-yielding environment with no loss of investment income.
Exhibit 1: Hypothetical Share Repurchase Program's Impact on Top Shareholder Ownership and EPS
The principal-agent dynamic underlying publicly-traded companies drives capital management decisions. Executives (agents) are hired with the goal of utilizing a company's assets in order to earn a return on shareholders' (principals) investment. The board of directors are elected by shareholders to monitor that management is considering shareholders' best interests. Management teams determine if share repurchases or dividends are appropriate when a company is sitting on excess capital, which may negatively impact financial metrics such as return on assets and equity, while the board of directors officially authorizes capital management actions.
This principal-agent relationship doesn't always work in shareholders' best interest as conflicts and differing incentives complicate matters, as seen with the recent string of corporate boardroom raiding by hedge funds. It's in this setting that Tim Cook is tasked with balancing Apple's long-term well-being with Apple shareholders' best interests in terms of excess cash on the balance sheet.
Share repurchases also have a "signaling effect", impacting how investors view a company's future. By initiating a share repurchase program, it is believed that management views its shares as undervalued and its future is bright enough to part with excess cash. Share repurchases have increased in popularity in recent years as capital gains are often taxed at lower rates than dividends, there is less risk of management teams wasting excess cash on M&A (which there are numerous examples of in the technology sector), and there are fewer side-effects from slowing or stopping buyback programs compared to dividends.
Apple's Share Repurchase Program
Apple has the largest share repurchase program in history, which stands as a testament to the company's successful products. Exhibit 2 highlights the pace at which Apple has repurchased shares. Since 2012, Apple has spent $68 billion on buyback repurchasing approximately 10% of common shares outstanding, with approximately $22 billion remaining in the current authorization.
Exhibit 2: Apple Share Repurchases - Open Market and Accelerated Share Repurchase (ASR)
Logic for Apple Share Repurchase; How Shareholders Have Benefited by $80 Billion
Using today's stock price, Apple's $68 billion of shares repurchased over the past two and a half years would be worth approximately $108 billion, or nearly 40% higher. In reality, this return is hypothetical since Apple does not benefit from previously repurchased stock rising in value, but it does help break apart the thesis that Apple has squandered money on buyback. If one was to look at the impact that Apple's buyback has had on the company's reported financials, EPS has risen approximately $0.50/share, all else equal, as depicted in Exhibit 3. Similar to Exhibit 1, I assume cash was invested in low-yielding short-term investments that did not produce significant income.
Exhibit 3: Share Repurchase Impact on Apple's Net Income, Shares Outstanding, and EPS
Taking this additional $0.48 of EPS resulting from fewer shares outstanding and multiplying it by Apple's current 15x forward P/E multiple would result in approximately $7/share of additional stock price. However, one also needs to take into account any change in P/E multiple as a result of the buyback. Obviously, this part of the exercise is up for debate given different variables impacting valuation multiples, including higher EPS revisions resulting from iPhone strength. Apple's forward P/E multiple has expanded from 13x to 15x since the stock buyback program was put into place. Giving equal weight to buyback and iPhone strength as causing the P/E multiple to rise, another $5-$7/share of stock price can be attributed to buyback (2 (P/E multiple expansion) x $5.97 (Apple's 2014 EPS without EPS accretion resulting from buyback) x 0.5 (to reflect iPhone strength's impact on higher P/E multiple)). Said another way, the market has assigned approximately $13/share of additional price ($80 billion) to Apple's stock due to share repurchases.
Stock buyback shouldn't have much, if any, impact on Apple's value, aside from lowering the cost of capital if there have been corresponding debt issuances. However, the gap between Apple's stock price and value is closing because of the ongoing share buyback program.The marketplace went from not appropriately valuing Apple's cash to now willing to pay more for Apple's cash and additional capital management actions that may lie in the future.
While Apple's shareholders have benefited by buyback, has Apple, the company, benefited? To answer this question, one has to consider other options Apple could have taken with the $68 billion funneled into buyback.
A) Large M&A. Management could spend excess cash on a few large acquisitions. As I explained in my article "Large M&A is Not in Apple's DNA: Case Study of Why Apple Won't Buy Tesla", Apple's product success is built on collaboration and design and reinforced by Apple's organizational structure, leaving no room for large M&A. Instead, Apple continues to be an active acquirer, having bought approximately 35 smaller companies since the beginning of 2013, most of which were never made public. Apple looks at acquisitions as a way to fill talent and resource holes that could only be addressed in a timely manner by acquisition (such as Authentic and fingerprint sensor technology).
B) Dividends. Apple could issue a special one-time dividend or increase its quarterly cash dividend. Obvious drawbacks to issuing dividends include shareholder tax implications and negative signaling that management doesn't view it's stock as undervalued and worthy of share repurchases.
Instead, Tim Cook and the board are using Apple's $150 billion of cash to fund dividends and buyback, while keeping enough ammunition to create shareholder value through organic and M&A possibilities, including significant capital expenditures, which topped $11 billion in 2014 and is expected to reach $13 billion in 2015.
Stock Buyback's Long-term Implications on Apple
As I wrote in my article, "AAPL and $700 Billion", short-term stock price swings don't give much indication as to how Apple, the company, is faring due to many moving variables involved in how a stock's price is determined. While the market was concerned about Apple's iPhone business and declining margins in late 2012 and 2013, Apple was busy developing the Apple Watch. Apple's stock underperformance had little to no impact on Apple's R&D and future plans. While I will admit that a company's stock serves as an incentive mechanism for employee morale, I believe any short-term reactions tend to correct themselves overtime, limiting the long-term impact on employee morale.
Apple's stock buyback program highlights that Tim Cook and the Apple board are fostering a shareholder-friendly environment, which stands in contrast to a few tech behemoths with anti-shareholder voting structures. Despite the $68 billion spent on share repurchases since 2012, Apple still has more than $150 billion of cash, thanks in part to $29 billion of debt issuances. Ultimately, Apple's long-term buyback plans will depend on how the product pipeline materializes. It wouldn't be a stretch to assume Apple will utilize share buyback during periods of stock price underperformance and low valuation, while buyback is limited during periods of stock price greed and optimism. Given the current environment and product portfolio, as well Apple's stock valuation, Tim Cook and the board are doing the right thing buying back shares.
This report was produced by Neil Cybart on December 1, 2014.
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This week's Above Avalon podcast (Episode 4: Let's Talk about Apple Stock) discusses this article. RSS is available.
Embracing Selfie Innovation
Apple's Beats by Dre released a new ad titled 'Solo Selfie'. Take a look. I liked it.
As Abdel Ibrahim pointed out to me on Twitter, the ad was inspired by a video from Karen Cheng, uploaded to YouTube last month. Here is her 'Donut Selfie' video tutorial:
Karen earned a spot in the Beats ad and can be seen at the 0:25 mark. I found it interesting that Karen's Donut Selfie video was focused more on iPhone's camera capabilities, but instead Apple/Beats adapted the video to highlight Beats' new Solo2 headphones. The whole thing is just simply fun.
AAPL and $700 Billion
Apple just crossed the $700 billion market cap threshold. I thought it was a good time to put this event into perspective.
- What does this tell us about Apple's future? Nothing.
- What does this tell us about Apple's past? Nothing.
- What does this tell us about Apple? Nothing.
A stock's valuation is simply the value point at which the demand for a company's stock is equal to the supply of that company's stock. Any discussion around a stock's price, or any guessing as to where a stock price is headed, needs to focus on a stock's supply and demand. Luckily, analyzing a stock's supply is relatively easy.
- Determine who wants to sell their shares.
- Determine why they want to sell their shares.
- Determine at what price are they willing to sell their shares.
- Analyze the business landscape to determine if the company will need access to additional capital.
- Determine if raising more public equity would be in the company's best interest.
Once that analyses is complete, even more straight-forward analyses needs to be done to determine a stock's demand.
- Determine who wants to buy shares.
- Determine why they want to buy shares.
- Determine at what price are they willing to buy shares.
- Predict what that company's detailed capital management plans will look like for the next few years.
- Analyze the business landscape to determine if the company will decide to buy back its own shares.
- Determine if another company will be interested in buying the company's shares.
Once these eleven points have been answered or analyzed, one can then make predictions as to where a stock price is headed.
In reality, it's impossible to analyze most of these points, and I'm sure I left out a dozen more. Since investors don't like the unknown, commentators and pundits focus on developing an interesting story around why a stock is performing a certain way in an effort to remove unknowns from the equation.
The more appropriate type of analyses ignores day-to-day stock fluctuations and instead focuses on the company behind the stock. By analyzing a company, many of the above unknowns dealing with that company's stock melt away or become irrelevant.
Apple crossed the $700 billion market cap threshold and this told us just as much about Apple today that it did yesterday: nothing.
Estimating Apple's Record iPhone Sales in 1Q15
Apple will not only report record iPhone sales for the current quarter (FY 1Q15), but it may beat the previous quarterly high by as much as 30%. Several factors will combine to produce a perfect storm for strong iPhone sales growth in 1Q15. I expect iPhone 6 and 6 Plus popularity, China Mobile, and a slight addition to channel inventory will lead to Apple reporting 68M iPhone sales for the current quarter, representing 34% year-over-year (yoy) growth.
Above Avalon Accuracy
Over the past two and a half years, I have published seven AAPL earnings previews that included iPhone estimates, with an average error of 500 basis points, as depicted in Exhibit 1. For the four most recent earnings reports, my average iPhone estimate error was 275 basis points.
Exhibit 1. Above Avalon Historical iPhone Estimates
Management Commentary
Tim Cook categorized iPhone demand as "staggering and geographically broad-based, markedly higher in every single country where we've launched compared to the iPhone 5s a year ago." Apple is unsure when iPhone demand and supply will be in equilibrium. Despite being on sale for only 12 days, iPhone 6 and 6 Plus contributed to 17% iPhone unit sale growth yoy in the U.S., 20% growth in Western Europe, 32% unit sell-through growth in Greater China despite no iPhone launch in China, greater than 50% growth in Latin America and the Middle East, and greater than 100% growth in Central and Eastern Europe. Apple sells the iPhone in over 200,000 locations and expects to bring the new iPhones to more than 115 countries by the end of the year.
Breakdown of 68M iPhone Estimate
I estimate Apple will sell 68M iPhones in 1Q15. Exhibit 2 compares 1Q iPhone sales for the past three years as well as channel inventory information.
Exhibit 2. Apple iPhone Quarterly Data Matrix
Using Apple's observed global Phone growth rates during FY4Q14 as a proxy for supply, I added 10.2M to the 51M iPhones Apple sold in 1Q14 to reflect 20% yoy growth in overall iPhone strength. I added 5M units to reflect China Mobile's impact on overall sales, which would not be reflected in 1Q14 results. Finally, I added 2M units to reflect an increase in channel inventory to get Apple within its previous 4-6 week channel inventory target range (management increased the range to 5-7 weeks). The resulting 68.2M iPhones sold estimate implies 34% yoy growth, which would be the strongest quarterly growth in over two years.
This report should be used to understand where I stand on iPhone 1Q15 sales, especially when I discuss the item in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. Downside risks to my estimates include: iPhone supply issues and weaker-than-expected customer demand. Upside risks to my estimates include: Stronger-than-expected customer demand, especially in China. This report was produced by Neil Cybart on November 25, 2014.
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Luxury Watch Industry Planning to Use Lawsuits to Delay Smartwatch Era
I don't think the next couple of years will be fun for luxury watchmakers. Instead of thinking of their customers and innovating, TorrentFreak is reporting that luxury watchmakers are forming a type of consortium to send cease and desist notices to people giving away free knock-off watch face downloads for smartwatches. While a company has a right and obligation to protect its trademarks, I find it quite amusing that high-end watchmakers think sending cease and desist letters is going to hold off the tsunami that is about to hit them over the coming years as smartwatches go mainstream.
Jean-Claude Biver, CEO of Swiss luxury watchmaker Hublot, did a great job at describing the paradox facing high-end watchmakers and the coming smartwatch era when he said, "[a] smartwatch is very difficult for [Hublot] because it is contradictory... Luxury is supposed to be eternal... How do you justify a $2,000 smart watch whose technology will become obsolete in two years?"
In four months, Apple will not only begin selling a luxury smartwatch that will cost well over $2,000, but also a mass market $349 smartwatch that could sell in the 10s of millions of units annually. Apple Watch will combine luxury with personalization and technology; something that current luxury watchmakers are incapable of doing.
I just don't see a place for a luxury "dumb" watch in a luxury "smart" watch world.
Samsung's Issues Look Weirder by the Day
The WSJ is reporting ($) that Samsung is considering a significant management shake-up to address slumping Galaxy S5 sales and an overall deteriorating mobile device outlook.
I have the following thoughts/questions:
- The WSJ, citing sources, reported that Samsung management mistakes and errors contributed to a significant Galaxy S5 inventory buildup "forcing Samsung to increase marketing expenditures to unload the devices". That line sounded odd to me given that Samsung had just come off of a record year for marketing costs, spending $14B in 2013, nearly 14x more than Apple on a dollar basis. Considering most of Samsung's 2013 phone sales involved some portion of this marketing/carrier promotion, were continued 2014 phone promotions actually a result of management incorrectly estimating demand or did Samsung simply carry-over some of these now dependent promotion practices from 2013 to maintain sales momentum?
- The article says 12M Galaxy S5 smartphones were "sold to consumers" in the first three months following launch. That figure seemed low to me, especially when I think back to prior WSJ articles, around the time the Galaxy S5 launched, discussing Samsung's bullish prospects and sales figures. After a few minutes of searching, I found($) the WSJ's "Samsung Says New Galaxy S5 Is Off to Strong Start" article in which Samsung Mobile Chief J.K. Shin was interviewed. He said sales of the Galaxy S5 were 11 million in the first month, outselling the Galaxy S4 by a million. Shin went on to say S5 sales were "much stronger than the Galaxy S4". How did the number of Galaxy S5 phones go from 11 million for the first month of sales to 12 million for the first three months? I assume it once again comes down to the "ship" vs. "sold" dynamic, where Samsung's sell-through sales were much weaker than units shipped to carriers, but that doesn't give me much comfort as Shin even went out of his way and commented that S5 sales were much stronger than S4. I am left wondering if Shin was lying or if this is a case of Samsung losing touch with reality and not even having data as to how their phones were selling.
- Galaxy S5 sales were down 50% in China versus Galaxy S4 during the first six months of sales, while the U.S. was the only major market where S5 sales were better than S4. Low-end Chinese smartphone competitors are impacting Samsung much more than third-tier phone vendors in the U.S., where Samsung faces slightly less competitive pressure on the low-end and subsidies mask some of the price differential. I suspect promotions are still playing quite an active role in the U.S. as well.
All of this stands in stark contrast to Apple's iPhone strategy where product sell-through numbers don't diverge much from shipped figures, especially when Apple is experiencing a supply/demand imbalance, and if there is a difference, Apple will clearly indicate the change in the earnings conference call. Apple's now notorious relationship with carriers, which include sometimes aggressive iPhone sales benchmarks and contracts, compare to Samsung's reliance on carriers for data about its products and markets. With Samsung overshooting Galaxy S5 demand by 40%, either management misread the market incorrectly or other opportunities and products served as a distraction. Given all of the turmoil, it's fair to start wondering if Samsung's response to the Apple Watch, if there will be one, is delayed or at least put on hold as a result of the company's mobile struggles.
Assessing Apple Watch's Primary Risk
Last week I published my Apple Watch sales projections. Some of the feedback I received dealt with how I can be confident that Apple Watch won't have build-quality issues or other performance problems. Taking into account Apple's product-focused structure and the way risk is mitigated, I think a more appropriate criticism would be to question Apple Watch's biggest risk: consumer acceptance.
Apple's Risk Mitigation
Much of Apple’s recent success can be explained by the company's organizational structure mitigating internal risk, such as lack of attention or motivation, and ineffective collaboration, leaving only external risk embodied by consumer demand. I went into this phenomenon in greater detail in my article, “Making Big Beats and Controlling Risk – How Apple Succeeds." Apple's structure allows decision makers (upper management) to come in contact with everything that is shipped to consumers and, more importantly, everyone who is in charge of the product (designers, marketers, engineers). Within the past four years, Apple's executive team has seen nearly 50% turnover, including a new CEO, and yet Apple is still functioning, showcasing how this process is built to last beyond its current operators.
For many companies the concept of mitigating internal risk and leaving the consumer as the biggest unknown variable is underappreciated, since such an action positions a company to rely on marketing and storytelling to sell a well-designed product. The iPad is a prime example of this strategy as Apple's marketing team was tasked with addressing the last remaining risk factor: customer demand. Consumers needed to hold and play with the device in order to understand its magic and eventually find a need for it in their lives. If the device wasn't ready to ship due to hardware or software issues, Apple would have delayed the launch. On the other hand, Apple Maps is a good example of when the Apple Machine isn't well-oiled and risk is kept internally with nasty politics possibly getting in the way of Apple's product-focused strategy.
Apple Watch's Risk
Apple Watch's biggest risk is consumer acceptance, not poor material design or bad software. Will consumers envision an Apple Watch fitting in their daily schedule? Over the past few weeks I've laid out several use cases that I think make a compelling argument for how the Apple Watch can function alongside an iPhone, all of which invoke the same theme: breaking the "problem" into more granular tasks, with the more complicated and power-hungry steps kept to iPhone, while Apple Watch tackles the finishing touches. Apple's primary job to address consumer demand risk is to focus on marketing, showcasing Apple Watch in various settings outside the tech world and installing Apple Watch demo units throughout the Apple retail distribution network, allowing consumers to wear and test the product.
Word-of-mouth marketing is another variable that is left largely out of Apple's control. With an addressable market numbering in the 10s of millions of iOS users, these early Apple Watch adopters will play a role in determining what kind of adoption rate the Apple Watch experiences in its first few years on the market. If internal risk factors are mitigated during the product development cycle, a well-engineered device is created with consumer demand left as the biggest risk.
Estimating Subscribers for a Revamped Beats Music Streaming Service
With three publications reporting Apple is looking to bundle Beats Music into iOS in 2015, it's prudent to start thinking about the size of an Apple music streaming service.
U.S. Market Opportunity
A Beats Music streaming service bundled into a future iOS update has the potential of being the largest paid subscription music service in the U.S. assuming Apple adopts a free ad-supported tier as well as a $5/month or $60/year paid tier. I reach this hypothesis by taking iTunes Radio adoption and growing it to account for a much better streaming Beats service (using the current product as a base). Exhibit 1 includes my estimates for U.S. paid and total subscribers as well as my rationale behind the estimates marked in red.
Exhibit 1: Beats Music Streaming Sub Potential - U.S.
Global Market (Including U.S.) Opportunity
One of the big unknowns is if Beats Music will eventually have the same global footprint as Spotify. Assuming Beats Music is bundled in iOS and is available in many countries, I suspect Apple's music streaming service could be bigger than Spotify. I reach this hypothesis by using Spotify's global to U.S. paid subscriber ratio and assuming Beats carries a more U.S.-centric focus, detailed in Exhibit 2.
Exhibit 2: Beats Music Streaming Sub Potential - Global.
Running further with revenue assumptions would quickly reveal that a Beats Music streaming service bundled into a future iOS update would not have a significant impact on Apple's income statement. Nevertheless the potential of Apple holding off competitors and remaining on top of the music relevancy chart has the potential of being much more valuable.
Interesting iPhone/Sapphire Tidbit from the WSJ
Event: Information about Apple's sapphire usage was tucked within the WSJ's fascinating look into the troubled Apple and GT Advanced Technologies sapphire deal. - Link ($)
From the WSJ:
"Apple consumes one-fourth of the world’s supply of sapphire to cover the iPhone’s camera lens and fingerprint reader. Early last year, the company began looking for a much larger supply, to cover the iPhone’s screen."
Apple's intention with sapphire and the iPhone is becoming clearer: With sapphire already being used for the iPhone camera lens and fingerprint reader, and now the iPad fingerprint reader, Apple needed a significant amount of sapphire supply to come onto the market if it wanted to use the material for iPhone screens. Sapphire's biggest benefit is being scratch resistance, as seen in this video, while negatives include weight and cost (which Apple looked to alleviate by having GT innovate in terms of production). Due to the combination of managerial mishaps at GT and changing Apple requests, the sapphire being produced did not meet Apple's strict standards.
From all indications Apple is still interested in using sapphire for iPhone screens (would have served as a nice upgrade feature for the more expensive 6 Plus), but for now any near-term plans seem to be on hold. There is no reason to assume Apple is facing a sapphire supply issue for Apple Watch (the Apple Watch and Apple Watch Edition collections use sapphire crystal) considering GT was geared towards sapphire for iPhone screens. I estimate Apple will sell approximately 30 million Apple Watch and Apple Watch Edition collection units over the first two years on the market (out of a total 60 million Apple Watch units). The sapphire supply needed for 30 million Apple Watch screens over the next two years pales in comparsion to the approximate 400 million iPhones that will be sold during the same time period.
iPhone 6 vs. iPhone 6 Plus Sales Update
With the new iPhones on the market for a little over two months, I'm able to make some initial comments as to how the iPhone 6 is selling in comparsion to the iPhone 6 Plus.
What the data says: The iPhone 6 was initially outselling the iPhone 6 Plus by approximately 6 to 1 at launch, but over the last nine weeks as iPhone 6 Plus supply has ramped up and the new iPhones launched in China, the iPhone 6 is now outselling the Plus by approximately 3 to 1 according to Mixpanel and Fiksu. Tech analyst Ben Bajarin reported Baidu/Umeng data suggests a similar breakdown between iPhone models in China.
What the data doesn't say: We still don't know how iPhone demand/supply imbalance is impacting consumer purchasing decisions. Are consumers choosing the model that is in stock in-stores or with a shorter wait time online? In the Apple U.S. online store, the 16GB iPhone 6 Plus ships in 7-10 business days while the 16GB iPhone 6 ships in 5-7 business days.
Looking ahead: I wouldn't be surprised if the iPhone 6 to iPhone 6 Plus ratio trends towards 2.5 to 1 suggesting approximately 70% of consumers are choosing iPhone 6 and 30% are choosing iPhone 6 Plus. Why? The iPhone 6 Plus may represent a good compromise for consumers deciding between a phone and tablet. I can envision a scenario where some consumers not interested in the latest tech gadget actually prefer the iPhone 6 Plus because it is easier to read text and watch video on compared to the iPhone 6. Offsetting this trend, the Plus' higher price tag may make the iPhone 6 a more popular choice for parents buying phones for their children or budget-conscious customers that don't want an iPhone 5s or 5c.
Apple Impact: The iPhone 6 Plus has a higher margin than the iPhone 6 which should help Apple's financials. I still view iPad cannibalization at the hands of iPhone 6 Plus as a long-term positive for Apple given the higher iPhone margin and the customer remaining in the iOS ecosystem.