Neil Cybart 2/16/15 Neil Cybart 2/16/15

Three Month Update

Above Avalon has been in existence for three months. I provided an update as to how things were going after the first month, so I figured an update after the first quarter would be appropriate. The primary metric I've been tracking continues to be unique visitors, and I'm quite happy with where things are heading.

Posts: 68

Unique Visitors:

Month 1: 16,528
Month 2: 25,464
Month 3: 25,324 (1,000/day normal run rate)

While there were 4-5 days that saw an unusually high amount of referral traffic from other sites, 65% of traffic is either direct or from Twitter. There have been a few other sources that have been helpful in spreading the word about the site on nearly a daily basis. Thank you.

Subscribers:

Above Avalon Twitter: 1,110
RSS: 2,253
Podcast RSS: 3,686

I started to add video into the mix and am pleased with the results. I expect to publish more videos in the future. The AAPL Orchard daily email now has 1,400 subscribers and continues to exceed my expectations.

Top Ten Most Popular Above Avalon Posts:

If you are reading this, chances are good that you contributed quite a bit to these results, so thank you. As I said during my first month update, a few retweets and link sharing make a difference. I continue to get email and messages from people who only discovered the site from hearing about it from a friend. My goal with Above Avalon is not only to understand how Apple looks at the world, but also to think differently about the world beyond Apple. My long-term goal is to have many of you join me in this journey, and so far things have exceeded my expectations. Thank you for your early support!

Neil

Neil Cybart 2/13/15 Neil Cybart 2/13/15

The Trick of Downplaying Hardware

"I don't really think that Apple was ever a hardware company, even at the beginning of time." -Tim Cook, February 2015

Tim Cook presented at the Goldman Sachs Technology and Internet Conference earlier this week to a crowd of Wall Street investors that have historically had trouble appropriately valuing hardware companies. Cook's comments on hardware/software piqued my interest. Cook reiterated that Apple has never been a hardware company but is instead all about the software. There is much more to the story with many implications on how the world sees Apple and where Apple's future lies. By putting the focus on software, Apple is purposely downplaying hardware.

Software plays a vital role in Apple's business, and there is little evidence to suggest otherwise. However, some of Tim Cook's comments would lead people to scratch their heads. For example, on one hand, Cook reiterates that it's all about the software, citing examples such as iTunes, iOS, OS X, and now services like Apple Pay. On the other hand, Cook is quick to say it's all about the experience of integrating hardware, software, and services, such as the iPod + iTunes juggernaut, iPhone, iPad, and soon Apple Watch. The two arguments don't quite mesh seamlessly as the latter requires well-designed hardware to produce the critical experience that Apple is focused on selling.

Apple is purposely downplaying hardware, which by incident is validation that hardware is a crucial piece to Apple's success. I've long felt that Jony Ive's design acumen and his creations ranging from iMac to iPod, iPhone, iPad, and now Apple Watch are responsible for where Apple is today. Why downplay hardware? They want to direct attention elsewhere.

Apple excels at producing hardware, and one can argue we are getting to the stage where Apple's supply chain is reaching such a point that competitors are simply unable to compete as Apple secures all available components and resources. By stressing software, Apple would be shifting the focus away from its hardware strength.

Another issue that I'm sure Apple is well aware of is that Wall Street and Silicon Valley simply don't understand hardware. There is a widely held view that all hardware becomes commoditized and as a result, companies with above average hardware margins and focus will see pain. GoPro, a 13-year old company now with a $6 billion market cap flew under the radar for years because of its reliance on hardware. Meanwhile, software enterprise start-ups are the envy of all. This is not to suggest that software is overrated, but that not all hardware is created equally, and it's when a single company begins to control the entire experience around that hardware that magic happens.

This dilemma leads to discussion of Apple's foray into different parts of our life including our home, health, car, and wallet, with platforms built on iOS. The situation magnificently encapsulates Apple's trick of downplaying hardware. While the focus is on software taking over our world, in reality, what is happening is the iPhone's value proposition is increasing. Software is increasing hardware's value. Of course, few will notice this and as a result hardware will continue to be underestimated, but Apple won't mind. It's not easy to downplay one's strengths, but Apple has excelled at it for years.

Neil Cybart 2/11/15 Neil Cybart 2/11/15

The Evolving Notification

Notifications play a crucial role in how we interact with technology. Just as gadgets evolve, notifications haven't remained static. As we enter the wearables era, the notification is about to undergo one of its more significant advancements in history. The Apple Watch will improve on the pager from the 1990s and position silent haptic feedback as a notification. The ability to send and receive messages via "taps" on the wrist will turn the modern notification into a communication medium. While the smartphone may have taken the notification and run a little too far with it in the wrong direction, the Apple Watch will likely put the notification on a new, more sustainable path.

Even though we now associate notifications with pop-ups on our phones and tablets, the idea of a notification has been part of our lives for a very long time. A notification is simply something that gives us information to compute. A few everyday examples have included:

1885: A steam train whistle (and smoke) alerting people of an approaching train.

1935: A raised mailbox flag indicating to the mail carrier that a letter needs to be picked up.

1975: An air siren to warn of a nearby tornado.

1995: A vibration and chime on a pager alerting the user to an incoming call.

2005: A chime alerting the user that a new AOL IM has been received on the desktop computer.

2010: A blinking light on a Blackberry indicating new email.

2015: A popup on a smartphone indicating Sam Smith won a Grammy.

2016: A double tap on the wrist from Apple Watch informing us that our significant other is leaving the store.

Taking a look at some of these notifications through the years, some of which are still common today, the smartphone's impact on notification evolution stands out. The smartphone era expanded the notification to include various types of data, including: breaking news, app updates and song recommendations. The ability to push text notifications have produced negative side effects as companies have flocked to notifications to get attention. Not only are we inundated with pop-ups, unless we manage our phone settings carefully, but even the idea of a proper notification has lost its meaning. The notification went from a useful source of information to mostly a marketing plow generating interest in apps.

Apple Watch has the potential to put the notification back on track. With the expectation that the device will be worn on the wrist for most of the day, an Apple Watch will not only add personalization and customization to notifications, but it will transform the way we think of notifications in mobile. Apple Watch will turn notifications into a new form of communication.

Notifications on Apple Watch will likely continue a few broader notification trends that have been evolving over time:

Personalization. Wearable devices promote personalization in a much more effective way than smartphones. I would expect more notification filtering, reducing the number of notifications pushed to a wearable compared to a phone. It will be very hard for a news app to be able to push breaking news to Apple Watch in the same way popups are sent to a smart phone. Whereas we may not mind getting notified on our phone whenever someone messaged us on Twitter, we may want to only be notified when certain people contact us if notifications are pushed to Apple Watch.
Customization. Having the ability to determine what kind of notification is desired (Short Look or Long Look) dependent on location or social setting (wrist raise or not) will become the norm.

I would expect the definition of a notification to once again include haptic feedback (vibration) with Apple Watch. In such an example, a simple tap on the watch face would produce a silent vibration on the recipient's wrist (assuming they are wearing Apple Watch). That tap, or a series of long and short taps, can both serve as a notification and message. In this context, the pager of the 1990s stood out. While a pager could have been worn on the waist to alert the user via vibration, the notification contained only so much information that would signal the importance of the message. The ability to communicate was still mostly one-sided. With Apple Watch, the notification can become a two-way communication medium, serving both as an indicator of an incoming message as well as the message itself. While much of this sounds similar to Morse code, one key difference is that Apple Watch users will be able to personalize the messaging, coming up with their own patterns and codes to communicate with a select group of family and friends.

Given my expectations on where notifications are headed, I have some doubts over wearable devices, such as smart rings and bracelets, that position notifications as simply an alert. If these devices are unable to provide ways to interact and respond directly to the notification, I have trouble seeing where value is created. Since most wearables require a phone, the primary reason someone would buy and wear a wearable is to remove the need to check their phone, not to serve as a reminder to check their phone.

Notifications play a vital role in our daily lives. While the smartphone may have taken the notification and run a little too far with it in the wrong direction, the Apple Watch will likely position the notification as a tool to utilize technology in a more personalized way.

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 2/10/15 Neil Cybart 2/10/15

Apple is Getting Paid to Raise Debt

Apple just raised $1.35 billion of Swiss-franc denominated debt in two tranches (0.28% and 0.74% implied yields), according to the WSJ. Apple is raising debt to fund its capital return program. In what can only be described as being at the right place at the right time, Apple is essentially getting paid to raise debt.

Apple may enter currency swaps to effectively convert Swiss Franc-denominated notes to U.S. dollar-denominated debt, which would increase the effective "cost" of the debt. Even taking this cost into consideration, Apple is in a position to earn a small profit by issuing debt. By raising debt, Apple is able to use borrowed cash to buy back AAPL shares, thereby saving on dividend expense. All else equal, and assuming an estimated $13 million after tax currency swap cost, Apple would make a profit of $1 million by raising $1 billion of debt at a 0.28% interest rate, as depicted in the table below.

Exhibit 1: How Apple Can Make a Profit by Raising Debt

Apple will have raised close to $40 billion after including today's debt issuance. It is important to recognize that the total amount of debt is spread out over various maturities ranging from 2 years to 30 years, depicted in Exhibit 2.

Exhibit 2: Apple's Long-Term Debt

By holding debt with a wide range of maturities, Apple isn't on the hook to repay the $40 billion at once. Instead, Apple will be able to use U.S. operating cash flow (or foreign cash in the event of U.S. corporate tax reform) to repay the debt as it comes due.

What is management's long-term strategy by raising debt?

Use debt to fund share buyback for what management considers to be undervalued AAPL shares.
Once AAPL shares are appropriately priced, slow the pace of buyback.
With slower buyback, U.S. operating cash flow can be used to repay debt as it comes due.
Repeat cycle with AAPL share valuation being the primary determining factor.

Management is utilizing proper capital allocation practices to not only take advantage of what they consider to be undervalued AAPL shares, but deal with excess cash weighing on Apple's cost of capital. Since $158 billion of foreign cash can not be used for share buyback or dividends, management is raising inexpensive debt as a substitute. Market observers look at this as a sign that management is confident in Apple's future and that the company won't likely require $100+ billion of cash for organic growth opportunities.

There will be a day when raising debt isn't in Apple's (and shareholders') best interest, but that day isn't today.

This report was produced by Neil Cybart on February 10, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 2/9/15 Neil Cybart 2/9/15

Thoughts on Apple's Employee Retention "Problem"

Bloomberg published a story late last week on how Tesla has been hiring Apple talent over the past few years and now has more than 150 former Apple employees on payroll. Anyone who has been tracking Tesla would be familiar with this issue considering that several current (and former) Tesla executives were former Apple employees. I think this issue says more about Tesla than it does Apple. Tesla CEO Elon Musk is a charismatic leader with a clear vision on rethinking the automobile and energy industries. Who wouldn't want to be part of that type of project?

The primary issue with roping Apple into this discussion and analyzing the company with a negative tone is that by doing so, one is comparing Apple's strategy and product roadmap to Tesla. The assumption is if 150 employees were willing to leave Apple to work at Tesla, then that must mean Apple was unable to retain talent with exciting ideas and projects. I disagree.

As we have seen over the years at Apple, there should be no expectation that talent responsible for bringing a collection of raw ideas into a finished product, such as the iPod or iPhone, will stay around until the next big thing is developed. Many people on these teams held positions and responsibilities focused on specific tasks. Instead of being shifted into another role these employees may join other companies that have their own "iPhone-like" project under development. When I hear that an Apple employee left for another company, I often look at it as a positive for the company they are joining, not necessarily a negative for Apple.

The Apple employee retention debate boils down to two questions:

Does Apple have an employee retention problem? I spent the past few days rethinking the question and concluded it may just be too loaded to answer completely. Apple's structure necessitates the need to continuously hire outside talent since Apple's mission is focused on coming up with new products. It is not reasonable to think that Apple's current employee base and skill set can fully realize Apple's mission without looking outside for help. Accordingly, the much more important question may be does Apple have an employee acquisition problem?

Apple is a somewhat routine acquirer, often hiring teams of people, or at the minimum acquiring technology, and Apple is constantly searching for new people to fill talent holes. Some of Apple's recent high-profile hires include:

Luca Maestri (CFO)
Angela Ahrendts (SVP Retail)
Kevin Lynch (VP Technology)
Dr. Michael O'Reilly (VP Medical Technology)
Paul Deneve (VP Special Projects)
Ravi Narasimhan (R&D)
Dr. Roy Raymann (R&D)
Marc Newson (Industrial Design)

As seen with some of Apple's very high profile executive hires, does Apple have an employee acquisition problem? Will most of these employees stay for the rest of their careers? Is that now a retention problem for Apple? I'm sure if Apple management had its way, some of the former Apple employees currently working at Tesla would still be at Apple. The Bloomberg piece mentioned that Apple had increased financial incentives to entice Tesla employees to join Apple. I wouldn't want to be so naive as to assume Apple management is able to retain everyone they want, but I just don't see employee retention as one of Apple's pressing issues given the company's product-centric model focused on new products in new disciplines.

Is employee retention a risk factor for Apple? Yes. Employee retention is a risk factor for any company. The mistake that I see many people make is equating "risk" with "problem." Just because something is a risk factor, there is no claim being made that it is currently a problem. In addition, employee acquisition is just as big of a risk factor for Apple, if not bigger, than employee retention.

The primary pushback I have received on this subject is that Apple's success is not dependent on high level executive hires but software engineers, and recent "issues" with Apple software and services is a sign that Apple is indeed having issues retaining this talent. It is no secret that Apple is lacking in resources, with engineering talent being one example, but there is simply not enough evidence to suggest that employee retention is the culprit of recent software "issues." Rather, Apple's focus on acquiring the next marginal customer and the corresponding pressure to ship new and exciting software features at a increasingly fast pace has produced tradeoffs with software quality taking the brunt of the fallout. I'm not convinced that having more chefs in the kitchen would necessary change the outcome.

Ultimately, a properly functioning Apple organizational structure and business model will appeal to the best and the brightest. Judging from some of Apple's recent hires, this is still the case. Once Apple ships a product and resources shift to the next big thing, a certain level of turnover should be expected within Apple ranks as materials and resources are reallocated. Finding the people needed to turn ideas into reality is Apple's biggest risk factor. Apple is expanding into new areas in which company resources had historically been underemphasized such as health, wearables, and content discovery and curation. Apple has made progress in terms of employee acquisition and retention in these areas. Given Tesla's success at appealing to those Apple employees with a desire to work on automobiles and energy projects, this issue will become much more interesting when it's time for Apple to see if there is anything they can add to the transportation and energy industries. When that time comes, the quality and excitement of the potential plans and projects will dictate how successful Apple will be with employee retention and acquisition.

Neil Cybart 2/6/15 Neil Cybart 2/6/15

Apple's New Music Strategy

Music is an awkward subject for Apple. Music streaming represents one of the rare instances of Apple losing control of one of its product's life cycle (iTunes and the move from paid downloads to streaming). In some ways, this should not be considered too big of a deal since the music business is a fraction of its former self as the product has seemingly been commoditized. In reality, it is more complicated, as Apple's future product aspirations remain aligned with content, just not in a way that most people think. Music streaming and piracy will force Apple to reluctantly pivot its music strategy. While one can harp on the fact that Apple is incredibly late to the game, there are signs that Apple has already settled on a new music strategy: curation and discoverability.

Music was the lifeline that Apple was desperately searching for in the early 2000s. Positioning a breakthrough user interface as the primary selling point, iPod and iTunes revolutionized what it meant to buy and consume music. Today, music is different. I asked a simple question on Twitter earlier this week: Where do you get your music? The answer wasn't simple: iTunes, iTunes Radio, Beats, Spotify, Bandcamp, Google Play, Amazon, Pandora, CDs, Kickstarter/PledgeMusic, Deezer, Emusic, Spinrilla, YouTube, Bleep, Boomkat, Soundcloud, Rdio, eBay, blogs, Sirius XM.

At first glance, such a situation would seem pretty bleak for Apple as music consumption is no longer tied to using iTunes. In reality, there is still a way for Apple to regain a standing with music and it involves taking a page from the iPod/iTunes playbook: software. Differentiation in music still exists through curation and discoverability, although it remains obscure and clunky. Faint elements of social can be found throughout the entire process. Ask someone why they choose Soundcloud over Spotify or iTunes and you will get an answer. While it is debatable whether that answer is easy to replicate, the point is there is an answer. People still consider there to be some level of uniqueness in terms of how they discover music. Apple's goal is to position Beats as the answer to music's software problem. Mark Gurman over at 9to5Mac reported earlier this week that Apple's plans for Beats includes an interface redesign that sits on top of Beats existing technologies and content, while reintroducing some social elements into the service.

Apple can use software to develop a music platform where curation and discoverability guide the experience; something that was always an afterthought in iTunes. Apple's entry into paid streaming may be the start of a long journey leading to artist sustainability beyond music sales, which I discussed a few months ago in my longer-term view of the music industry. While a few companies have determined that the value is in producing and owning content (music, video), Apple's success with selling devices used to consume content changes the equation. Apple is able to create more value as a gatekeeper between an overwhelming amount of content and the end user. The company owning or distributing (cable/internet providers) the product is unable to fully embrace curation due to the inherent conflict with its business model. Add in the requirement of still needing hardware to enjoy content, and a long-term content/hardware strategy is born.

There are still some questions that need to be answered. If I'm positioning the software behind the content as the value proposition, how does Apple benefit if the end product is available on competing platforms? One way would be to embrace the idea that a service available to 100s of millions of additional users on Android can be used as a way to not only guarantee proper levels of music industry support, but also market a vibrant iOS ecosystem. I have a choice: use Beats music streaming on my Android phone, or enjoy Beats music streaming in my iOS ecosystem (iPhone, Apple Watch, Mac, Apple TV). Having iTunes on Windows helped sell iPods, with a delayed benefit to Mac sales. What if a Beats app on Android helps sell the music service itself (since critical mass is important for discoverability), with iOS devices receiving the delayed benefit?

Apple isn't taking an easy path when it comes to rethinking music as some of their actions have been somewhat forced upon them by outside factors. Nevertheless, Apple remains in an interesting position to utilize their software and hardware solutions in order to remove friction from the equation. Curation and discoverability represent Apple's best shot in music.

Neil Cybart 2/5/15 Neil Cybart 2/5/15

Apple Watch: A Superb Economic Moat Years in the Making

One of the more intriguing subjects that continues to puzzle me is Apple Watch competition. I struggle coming up with companies, or even industries, that are in a position to ship a credible threat to Apple Watch. While several companies have indicated interest in entering the space, I have doubt these players know where that space is even located. Apple has been building one of the company's largest economic moats in years with Apple Watch, a device with competitive advantages created from wrapping hardware, software, apps, and services into experiences. Apple claims the Apple Watch is only the beginning, while competitors aren't even sure what is about to begin.

Repeat of the iPad?

When Apple introduced the iPad in 2010, it took the competition a number of years to even figure out what made the iPad so "magical"; the experience from using a device where software and hardware combine to make the hardware melt away. I suspect a similar situation may occur with Apple Watch, only this time the economic moat surrounding the device may be a lot wider and deeper than it ever was with iPad.

Apple Watch Competition Sources

Luxury Watch Industry. Since Apple Watch will be worn on the wrist and Apple has stressed the device's luxury and fashion tendencies, it is natural to look towards the luxury watch industry for some kind of response to Apple Watch. Soon after the device was unveiled, the attitude towards Apple Watch was one of laughter and mockery. In recent weeks, several watch manufacturers have announced plans to ship their own smartwatch, competing against a device they had brushed off only a few months prior. The primary issue with expecting much of a competitive threat from a company like Swatch or TAG Heuer is that the value proposition of a luxury watch is different than that of Apple Watch. Luxury watches rely on craftsmanship and timelessness because their utility proposition was replaced years ago by phones. With the Apple Watch returning utility to the wrist, craftsmanship shifts to include hardware and software, while timeliness melts away. When a company's primary selling point is shipping a watch that can last forever, it will be hard to compete with a luxury device that positions time-keeping as merely a feature and is intended to be replaced every few years. Ultra-luxury watch manufacturers? I doubt they will even attempt to compete with a $349 gadget for the wrist that can be worn while working out. A $10,000 Marc Newson Apple Watch collection may be another story.

Technology Industry. If utility is returning to the wrist, technology companies would surely be in a position to come up with hardware devices controlled by software. We already see various smartwatch options being shipped today, although none have the right ingredients to truly stand out. Adding the requirement of having to wear the device adds a layer of complexity that I doubt most in Silicon Valley grasp. Fashion and design will matter more than a wearable's technological capabilities. Having a device on one's body extends that user's personality and emotion to something that will be on public display. The negative public reaction thrown at Google Glass serves as a prime example of technology lacking industrial design elements. Even then, designing a good product isn't enough. Fitbit and Jawbone bought in top designers to create their wearables, yet the devices haven't found success beyond niche markets as many question their utility and performance.

Fashion Industry. With a clear understanding of how fashion develops and morphs over time, those involved in the process of turning fabric and material into expression would be in a position to capitalize on the ability to appeal to a user's comfort level with wearables. However, the addition of technology into the discussion means that outside resources will need to be brought in to compete against Apple Watch.

Fitness Industry. The fitness industry had been one of the leading purveyors of the wearable industry. Nike exited the space in 2014, most likely in recognition of moving beyond a core competency and spending resources on not only the wrong bets, but at the wrong casino. The primary problem facing fitness companies and wearables is that fitness is niche. Appealing to fitness tracking limits the use case even further. The triathlon industry is well served by wearable gadgets from Timex and Garmin (among others), but with an addressable market numbering less than a few million, the numbers just aren't there for broader applications. Instead of pushing the idea of fitness, Apple will focus on health, a much boarder application that, in theory, applies to everyone. The biggest roadblock with health monitoring is that the concept indirectly advocates for behavioral change, including diets, routines, habits and schedules.

Entertainment Industry. Since today's culture seems to elevate celebrities and stardom, I wouldn't be surprised if there are a few attempts in Hollywood to monetize millions of Instagram followers into merchandising opportunities dealing with wearable devices that have to do more with what it says about the user than actual utility. Of course, lack of longevity would be a risk, but at that point, I doubt it would be a concern for those shipping such a product.

Other. There is always a possibility that single use-case devices could gain a solid footing, such as is the case with Disney's MagicBand, or a health-focused wrist band subsidized by insurance companies, threatening multifunctional devices like Apple Watch. Such specialized devices will not focus on the technology, design, or even utility, but rather some kind of limited, but intriguing experience. I would classify this type of idea as the true wildcard.

Partnerships and Acquisitions

The most likely source of Apple Watch competition will initially come from partnerships between the luxury watch industry and technology companies. TAG Heuer has already hinted at combining forces with a Silicon Valley firm, and it is not too much of a stretch to think of a scenario where technology companies partner with fashion houses in order to understand how to sell a wearable. Partnerships haven't exactly had the best outcomes in the past and I wouldn't expect anything to change in wearables. Partnerships are formed with the stated goal of joining forces, bringing together resources from two (or more) organizations. However, in that process of combining ideas, differing business models and organizational structures add complexity and friction that turn two companies working together to make an amazing product into two companies becoming desperate, cutting corners and making mistakes in order to stay relevant.

M&A within the current smartwatch industry is also possible as a near-term solution to appease shareholders and board of directors. Considering the deep pockets of large cap tech relative to many possible target valuations, these acquisitions would be sold as low risk/high reward, similar to how every other tech acquisition is marketed.

Apple Watch Competitive Advantages

The Apple Watch embodies Apple's philosophy of combining multiple disciplines (technology, health, arts, payments) into one experience. Competitive advantages include:

1) Engaged iPhone User Base. Apple Watch is dependent on iPhone for a few reasons, including being able to send computing requirements to a much bigger battery. Having an engaged base of more than 400 million users (most using the latest software) is an advantage Apple holds that currently no other company can match.

2) Technology. By relying on customized components, such as the Apple S1 chip, Apple will force competitors to cut corners with less attractive alternatives where the end goal is to have as few compromises as possible.

3) Efficient Supply Chain. Apple has built a supply chain that is capable of producing nearly 100 million iOS devices in a quarter. The ability to efficiently scale production of not only Apple Watch 1.0, but updates and new versions in subsequent years, is an asset that can not emphasized. Apple's ability to control various component supply, such as sapphire watch faces, could also pose a problem to competing products.

4) Vibrant Developer Ecosystem. As seen with iPhone and iPad success, developer support is crucial for ushering in personal technology with Apple Watch. While the current level of developer functionality found in WatchKit may be underwhelming to some, developer interest in the device exists with many wanting to try the device before thinking of ways to expand iOS apps to Apple Watch.

5) Apple Retail Stores. Apple's 447 retail stores provide a great opportunity for consumers to try Apple Watch in a setting managed by Apple. While 447 points of sale will pale in comparsion to the eventual network of retailers that will sell Apple Watch, the Apple retail stores serve as a starting point to get millions of Apple Watches out in the wild. The best form of marketing will be word-of-mouth and simply noticing the device being used by early adopters.

Missing Pieces

One theme when discussing possible Apple Watch competitors is that there are very few entities that hold all of the pieces needed to ship a viable product. For companies focused on luxury design, the technology aspect of the device makes it difficult to do much besides partnering with others. Technology companies likely lack the design talent to turn components into something consumers will want to be seen wearing. Apple Watch's dependency on a phone can also not be understated as any competing device won't have the same vibrant ecosystem to build on, which I suspect is an issue many in the watch industry don't quite fully comprehend.

Years in the Making

Apple has spent the past four years creating a device that deserves to take up the few square inches of wrist real estate where proper line of sight and touch accessibility can help usher in a new era of personal technology. I suspect it will take a few years for other companies to even think of the Apple Watch in this way, let alone be in a position to ship a competing product. Companies will monitor how the Apple Watch sells out of the gate to see if the device is worth responding to, only delaying attempts at competing. The Apple Watch relies not only on the latest and greatest smartphones, but design and fashion concepts that are expensive to copy and master. Being able to put all of these pieces together into a marketable product makes it clear that Apple has built quite an economic moat with Apple Watch, and the iOS ecosystem stands to be the primary beneficiary.

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 2/4/15 Neil Cybart 2/4/15

Logic Behind Apple Raising Debt Despite Holding $178 Billion of Cash

Apple raised another $6.5 billion of debt this week, bringing total debt raised to $39 billion. Why is Apple issuing debt despite holding $178 billion of cash? With approximately 89% ($158 billion) of Apple's cash held by foreign subsidiaries, management is relying on free cash flow and debt to fund share repurchases and quarterly cash dividends. Given the low interest rate environment, management is improving Apple's overall cost of capital by borrowing money for less than 1.5% (after-tax cost) in order to repurchase AAPL shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% free cash flow yield.

Current Capital Return Program

Last April, management increased the share buyback program to $90 billion from $60 billion. Along with the quarterly cash dividend, the total capital return program totaled $130 billion. Apple currently has $17 billion of share buyback authorization remaining and will undoubtedly increase the program in April, as well as raise the quarterly dividend.

Available Cash for Capital Return Program

Apple had $20 billion of cash available for capital management activities and U.S. investment needs at the end of 1Q15. After Monday's debt issuance, Apple now has more than $27 billion of cash in the U.S. If management were to use the $158 billion of cash located offshore for share buyback or dividends, Apple would be liable to pay 35% U.S. income tax on the repatriated funds. Considering that Apple is able to issue debt at a 2-3% yield with a tax break related to interest expense, it is easy to see that paying 35% tax on offshore cash is not in Apple's best interests. While there are financial techniques that allow Apple to "use" funds located in offshore subsidiaries for U.S. business purposes, the intricacies of such arrangements are for another post.

Due to Apple's global operations, approximately 40% of total free cash flow is available for capital management and routine cash needs in the U.S. If Apple were to pin its share buyback to just U.S. free cash flow, Apple's overall cash total would grow to hundreds of billions of dollars and investors may start to discount the cash (one of the primary reasons for the buyback). Instead, Apple has set a buyback pace that exceeds annual U.S. free cash flow, requiring management to raise debt (both short-term and long-term, as well as commercial paper, which is very short-term debt) to supplement free cash flow.

Apple's 1Q15 Cash Flow

A look at Apple's 1Q15 10-Q helps frame the math behind Apple issuing debt to fund share repurchases. For the three months ending December 27, 2014, Apple reported operating cash flow of $34 billion, which reflects net income and then all of the other non-cash line items that flowed through the income statement, but had no impact on cash. In terms of capital expenditures, Apple spent $3 billion on property, plant and equipment. This can be a range of items and for this exercise it really isn't that important. Subtracting the $3.2 billion from $33.7 billion, would give free cash flow (FCF) of $31 billion. A few weeks ago, I recorded a brief tutorial on free cash flow, which is a better representation of a company's underlying financial health than earnings. Keep in mind, this $30.5 billion of FCF is for the entire company. A few other calculations would suggest that approximately 40% of FCF, or $12 billion, is available in the U.S.

Moving down the cash flow statement to cash flow from financing, Apple spent $3 billion on dividends and $5 billion on share buyback in 1Q15. Proceeds from debt (the Euro denominated debt) totaled a little more than $3 billion, while Apple repaid $2 billion of commercial paper, leaving $1 billion of net debt issued. Subtracting the issued debt from dividends and share buyback cash flows leads to cash flow from financing of $7 billion, which means Apple used $7 billion of cash to cover share buybacks and dividends last quarter. Since U.S. FCF was $12 billion, Apple had enough to not only cover its capital return program, but also add to cash levels.

While Apple had enough FCF to satsify its capital management initiatives last quarter, Apple's holiday quarter is historically the largest quarter from a revenue and profit viewpoint with declining cash flow levels for the rest of the fiscal year. In addition, Apple's capital management pace is much more robust than $5 to 7 billion a quarter. Apple's accelerated share repurchase program meant that Apple prepaid $9 billion in 4Q14 for shares repurchased in 1Q15. Going forward, Apple is more likely to be on a $10-$12 billion quarterly pace for share buyback and dividends, which would require additional debt issuance.

Math Behind Issuing Debt to Fund Share Buyback

Running with a hypothetical example using the $6.5 billion of debt issued this week, as seen in Exhibit 1, Apple could take the additional capital, buy back 54 million shares, save on dividend expense, and essentially end up paying a net of $46 million per annum to borrow $6.5 billion.

Exhibit 1: Hypothetical Apple Scenario for Issuing Debt to Fund Share Buyback

Apple's $39 billion of long-term debt has a 2.0% average effective interest rate. Taking into account that interest payments are tax deductible, Apple is effectively paying 1.3% per annum to borrow cash. With shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% FCF yield, taking excess capital to buy back stock is a cost effective way of improving Apple's cost of capital. I wouldn't expect any significant change to this strategy in the near-term as long as interest rates stay low and Apple's business prospects look promising.

Neil Cybart 2/3/15 Neil Cybart 2/3/15

Apple Doesn't Sell Phones

In the eight years since Apple introduced the iPhone, traditional business and industry analysis has failed miserably at predicting Apple's approach to technology. Ben Thompson, writing at Stratechery, articulated three reasons why tech observers misunderstand Apple. I think the heart of the issue was briefly touched upon by his third point dealing with Apple's stated goal of making great products. Apple has actually been playing a completely different game than everyone else for years. Apple has been successful at building iPhone momentum in the face of what seems to be insurmountable obstacles because Apple doesn't sell phones, but rather experiences. The best selling experience is called iPhone.

Apple is a company built in such a way as to be a product-driven organization. When trying to define Apple's products, a somewhat savvy observer would answer: hardware, software, apps and services. In reality, Apple is selling much more than tangibles. The combination of those elements into one device creates emotion. Apple's primary products are experiences. From videotaping themselves unboxing new Apple products to vividly recalling the day they bought their first iPhone at an Apple store, people crave experiences, and Apple has been focused on selling such a product for years.

An iPhone represents something different to each of the 400 million current users. For some, it is a remarkable symbol of design, while for others it embodies hard work and accomplishment. It may also just be a device used to take pictures and send Snaps on Snapchat. Regardless of what the device represents, the experience of using an iPhone on a daily basis for years creates a bond. It is that bond that Apple is focused on nurturing and maintaining over time. A bond that is so strong that 9 out of 10 iPhone buyers decide to buy another iPhone. A look at other companies selling handsets would show a completely different paradigm. Samsung is so removed from the consumer, management wasn't even aware that people weren't buying the latest flagship Galaxy phone until the mobile carriers complained of unsold inventory.

Once the iPhone is thought of as an experience and not a phone, the mobile industry begins to look very different, and much of the mystery surrounding Apple's decisions fade away.

Competition. Apple's biggest competitor in the phone industry is the previous year's iPhone. The implications of this are significant, helping to frame why Apple never seems to follow industry protocol or respond directly to competitors. As an Apple competitor, this strategy is hard to counter because Apple is always one step ahead, as shown with Samsung's current lack of direction in mobile.

Two other examples of this strategy were Apple's AuthenTec acquisition and the decision to hold off on large screen iPhones. Apple turned fingerprint scanning from a gimmick feature into an enjoyable experience and competitors have so far been unable to find an answer. Meanwhile, Apple SVP of design Jony Ive's decision to hold off on larger screens for the iPhone was Apple's attempt at getting it right, instead of being first. Apple had plenty of experience with larger screens since the iPhone was born from the concept that eventually became the iPad. Jony Ive waited in order to make sure the experience was just right. Judging by Samsung's recent struggles, being the first to market a feature or idea, such as large screens, doesn't guarantee success.

Since the previous iPhone represents the competition to beat, Apple doesn't get distracted by features on competing phones that amount to little more than smoke and mirrors, as seen with most of Samsung's features, and pretty much the entire Amazon Fire Phone feature list.

Addressable Market. Following Apple's record 193 million iPhones sold in 2014, it would be easy to rely on smartphone shipment data to figure out iPhone's remaining addressable market in the premium Android space. In reality, that strategy is prone to error as it fails to describe how Apple views the landscape. Apple wants to sell experiences to as many people as possible. Take a look at Apple's renewed product strategy and it's clear that Apple isn't content on just selling these experiences to a certain segment of the population. Apple comes up with new products with the goal of appealing to all consumers, not specific tiers or layers of a market.

Price. Many consumers face price obstacles when wanting to buy an Apple experience. However, Apple has shown that roadblocks are meant to be overcome. Apple doesn't look at low prices as motivation to come up with an inferior experience, instead Apple positions the ultimate iPhone experience as an aspirational goal, while reducing the cost of older iPhones (which at their time were the best experiences on the market). By reducing older iPhone prices, Apple is able to accomplish the goal of selling a great experience at a lower cost, while keeping a different, newer experience as something to desire. Apple has also shown the ability to address price in different ways other than just selling older experiences at a lower price. Apple's iPad mini continues to sell relatively well, with very strong satisfaction rates, and has proved to be quite an attractive proposition for those who want to experience iOS for much less than the cost of an iPhone.

Apple Retail. In the context of selling experiences, Apple's retail plans take on a much more strategic importance and is the primary reason why I look at the retail stores as a key competitive advantage for Apple. A look at Apple's current retail push into China would suggest that management is focused on selling the iPhone experience, not just a merely a phone. Many people go to flagship Apple stores, which some have described as museums, just to visit and take in the environment, a rather remarkable feat when other retailers struggle to even get attention.

Apple knows what kind of experiences it wants to sell years ahead of time. Features, components, and designs included in Apple's current product lineup are often included as groundwork for what is to come. By recognizing that Apple's primary products are experiences, management's strategy in terms of pricing, marketing, and product direction begin to make more sense. Of course, selling experiences is much harder than selling hardware gadgets or software. Even Apple has failed to deliver a great experience from time to time. The key is to do less and concentrate all available resources on building few, but very meaningful, experiences. As long as Apple doesn't just sell a phone, the iPhone will see continued success.

Neil Cybart 1/30/15 Neil Cybart 1/30/15

Luck or Vision

Following Apple's earnings release earlier this week, there seems to be a rather twisted and intellectually dishonest argument gaining steam that Apple is becoming a risker company simply because the iPhone is so successful. Bernstein analyst Toni Sacconaghi did a great job at summing up this prevailing attitude with the following quote given to The New York Times:

“There’s always the risk of another paradigm shift. Who knows what that might be, but Apple is living and dying by the iPhone. It’s a great franchise until it isn’t.”

According to Sacconaghi, it sure sounds like Apple is lucky that the iPhone has been so successful and Tim Cook should be concerned that his luck can run out overnight. Another paradigm shift may come along and make the iPhone irrelevant, with only Apple feeling the brunt of this shift. Sacconaghi has a $135 target price and Outperform rating for Apple, so his quote isn't so much a bad stock call turning into sour grapes. Instead, his comment symbolizes the confusion that exists in the marketplace concerning Apple.

Has Apple's successes over the past 15 years been due to sheer luck or effective vision? One way of answering this question is to analyze a company that was actually lucky: Blackberry. The company was able to take initial successes in mobile technology and turn it into a $83 billion market cap as little competition and unwavering enterprise support drove years of strong growth and success. However, a quick look at the product portfolio would tell a different story. Compare a Blackberry phone from 2004 with one from 2010 to see what luck looks like. Even after Apple introduced the iPhone and then eventually the App Store, Blackberry shrugged it off, showing little understanding of its market and customer base. Missing a feature here and there can be costly, but manageable. However, missing an entire era can be lethal. Blackberry's luck had run out.

Meanwhile, compare the iPhone 6 and 6 Plus to the original iPhone. Apple's focus is on making great products with often the only limiting factors being of a technological nature. Every other year Apple has focused on not only changing the iPhone's form factor for the sake of change, but to improve the user experience. As screens have become bigger, battery life has gotten better, and devices have gotten thinner. Apple has then used the "S" cycle off years to introduce updated components to the iPhone, and in the case of iPhone 5S, new features like TouchID.

Jony Ive, Apple SVP of design, back in October at a Vanity Fair event, discussed how Apple had iPhone prototypes that included large screens in an effort to see what would make the best product. In the end, design challenges pushed off large screens for a few years. Today Apple is shipping iPhones with larger screens and Apple continues to see 15-20% of iPhone buyers come from other smartphone platforms. Just as an Apple critic can claim Apple may have dragged their feet a year or two too long to introduce larger iPhones in response to competitors, the discussion can be quickly turned around to reflect how Apple added a fingerprint sensor to iPhone in 2013, a feature that was considered a gimmick up to that point. Apple has also been very successful in understanding its next marginal iPhone buyer and not shipping phones with features that over serve the market. If this type of forward-thinking is simply luck packaged in a pretty box, then most of Apple's peers wish Tim Cook would share some of that luck.

Despite reporting a record quarter, Apple still has risk factors. Apple includes these risk factors in its 10-Q and 10-K filings. One risk factor in its 10-Q filed earlier this week seemed to apply to this luck versus vision discussion:

“The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. The Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. ”

Management is pretty clear on why it thinks it has been successful. Not only does Apple simply ship new products every year, but Apple:

designs hardware
develops operating systems
creates numerous software applications
introduces new services
invests in R&D
registers for patents and copyrights

Apple's biggest risk isn't that the iPhone makes up 60% of revenue, but rather failing in any of the preceding bullet points. Claiming that Apple is too dependent on iPhone implies that Apple got to where it is by luck. I don't think that is genuine criticism. Instead, Apple got to where it is today by executing on its vision. Failure to stand by that vision represents Apple's biggest risk factor.

Neil Cybart 1/29/15 Neil Cybart 1/29/15

Jeff Williams: Apple CEO Material

One thing became abundantly clear after analyzing Apple's recent earnings report: Jeff Williams is doing a phenomenal job. As senior vice president of Operations, Williams is tasked with making sure the Apple machine is well-oiled and in tip-top shape, not only capable of producing more than 100 million iOS devices in a quarter, but building flexibility into the system to handle annual hardware updates that would make most hardware companies quiver with fear. I considered Jeff Williams as Tim Cook's successor before Cook finished his first day as CEO, and I feel even more confident about that today. Regardless of what the future brings, people need to start watching Jeff Williams because he is executing at levels that few are able to achieve.

A look at Jeff Williams' background would quickly bring up a comparsion to Tim Cook. Both Williams and Cook earned an MBA from Duke, spent time working at IBM, and joined Apple in 1998. Cook was Apple's Chief Operating Officer (a position Apple never filled once Cook was promoted to CEO), while Williams was vice president of Operations, seeing a promotion to SVP after Antennagate. Fortune called Williams: "Tim Cook's Tim Cook."

Williams is in charge of Apple's immense supply chain and production process. More granular duties include overseeing Apple's relationships with suppliers, like Foxconn, and negotiating supplier contracts that are so large, the broader tech industry is often crippled as a result (HP TouchPad comes to mind). Williams also oversees product quality across the company.

I don't think there are many people that would object to the notion that Jeff Williams is CEO material. From being able to work through problems to motivating others, there probably aren't many hardware companies that would pass up the opportunity to be led by Williams. Why is Jeff Williams Apple CEO material?

1) Values Collaboration. Apple is run by committee comprised of a small group of top Apple executives. This structure has been around for years, with the primary objective of fostering collaboration between groups and departments. If a new iPhone is to be announced in a few weeks, having the entire company (via SVPs) focused on that product can lead to better results. I view this type of structure as supportive of someone with Tim Cook's personality and management style; characteristics that Williams share. Listening to varying viewpoints and guiding direction, while focusing on more typical CEO-like duties, such as building company culture and representing the company to the public, would match a operations-minded individual focused on day-to-day operations much better than a product person thinking of the next big thing.

2) Understands Products. Running Apple's operations leads to copious amounts of time with products and trying to think of ways to source, collect, and then assemble components into finished goods. To do this while maintaining excruciatingly difficult quality standards makes the job that much tougher. Products are very important to Apple and Williams is likely the most qualified candidate in this area.

3) Embraces Details. One of the key differences between Apple and other companies is the degree to which executives are involved with the details at Apple. It reportedly was the reason Mark Papermaster's tenure was cut short at Apple, and most likely represents the biggest hurdle for outside talent embracing the Apple philosophy. Having led worldwide operations for iPod and iPhone for years, Williams is well-trained and accustomed to focusing on details, while not losing perceptive of the big picture.

Judging by Apple's financials, as well as Apple's ability to attract top hires from various industries, Tim Cook is successfully leading Apple. Looking over the next 5-10 years, keen Apple observers can begin to see where Apple is headed, and there is no reason why anyone other than Tim Cook (and Jony Ive) will lead Apple in that direction. As a public company, good corporate governance would require Apple's board to have a CEO succession plan in place for obvious reasons. I suspect that Jeff Williams is indeed on that list. While the board would also look outside Apple, on behalf of shareholders, just to leave no stone unturned, I have low confidence that someone without a few years of Apple experience will see much success leading Apple.

While there are literally thousands of people that contributed to Apple's very strong holiday quarter, Jeff Williams stood out as executing at the highest level for driving such strong unit production growth without sacrificing quality. With the Apple Watch launch approaching, I'm sure Williams will continue to play a key role in overseeing the process of turning a collection of components into a finished product . Williams' stock is on the rise inside Apple.

Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.

Neil Cybart 1/29/15 Neil Cybart 1/29/15

Video - Reviewing Apple's 1Q15 Earnings

I published a short video about Apple's strong 1Q15 results. You can take a look at the full report here.

A review of Apple's strong 1Q15 earnings report. For more info: http://www.aboveavalon.com/notes/2015/1/28/apples-record-earnings-waiting-to-get-large-iphones-right-paid-off To subscribe to the daily Apple email: http://www.aboveavalon.com/subscribe/ Twitter: https://twitter.com/neilcybart

Neil Cybart 1/28/15 Neil Cybart 1/28/15

Apple's Record Earnings

Apple was firing on all cylinders last quarter, reporting:

74M iPhones
21M iPads
5.5M Macs
$75B of total revenue
$24B of operating income
500M visitors to Apple retail stores (physical and online)

Listening to management's earnings conference call, two questions stood out. One was what many analysts were thinking: "How is it possible that a company can report such strong numbers?" The other was one that a few asked Tim Cook: "Is this sustainable?" The second question on sustainability is maybe the most important question to ask, not only for the stock, but for Apple and the iOS ecosystem. Are we at some type of peak or is this a new era at Apple? I contemplated these questions for a few hours last night. I ended up looking at Apple's product philosophy for the answer.

How Is This Possible?

Jony Ive, SVP of Design at Apple, gave a talk at the Vanity Fair New Establishment Summit in San Francisco this past October. It was a wide-ranging discussion (and I highly recommend taking a look). The question of why Apple moved back to curved edges for larger iPhones was brought up. Here was Jony's response:

“Many years ago, we made prototypes of phones with bigger screens. We made notebooks with bigger screens; it was a concept that we were familiar with. There were interesting features having a bigger screen, but the end result was a really lousy product because they were big and clunky like lots of the competitive phones are still…And we thought there is a danger you are seduced by a feature at the expense of making a great product. And so years ago we realized well this is going to be important that we have larger screens, but we needed to do a lot of things to make that larger screen yield a really competitive product.

It was very important to making [a phone with bigger screen] comfortable and actually feeling less wide than in reality it was.”

Instead of shipping an iPhone with a large screen years ago just to be the first to cross an item off the feature list, Apple took a type of tick-tock approach with incremental step ups in screen size every two years, holding off on the 4.7-inch and larger screens until late 2014. The decision to wait paid off as Apple not only beat 1Q15 consensus on record iPhone sales, but reported the highest level of quarterly operating income in corporate history. The combination of pent-up demand for bigger iPhones and Apple's supply chain prowess, led to 75M iPhones being sold (up 46% year/year), well above expectations of close to 65M units, and even my 69M estimate. Heading into the quarter, the primary risk to the iPhone number was inadequate supply. Instead, having the best supply chain in the industry, under the leadership of Jeff Williams, allowed Apple to increase iPhone production to such a level as to sell the device in 130 countries within three months of launch.

The iPhone 6 and 6 Plus are increasingly looking like game changers in the smartphone industry, an industry that some declared set in stone with the iPhone destined to the top 10-15% share. iPhone unit sale growth was up 44% in the U.S. last quarter, with even stronger growth elsewhere, including 100% growth in China, Brazil, and Singapore. Countries where critics thought the iPhone would do poorly are ending up representing very attractive opportunities for Apple.

Is This Sustainable?

The iPhone is now supported by 375 carriers, representing 72% of the mobile phone subscriber base. In a rather remarkable display of Apple's growing size and power, it would likely require an additional 10M iPhones just to get iPhone channel inventory within the 5-7 week target range set by management. Tim Cook mentioned that the Android switcher rate is the highest it has been in the three previous years (likely around 15-20%) and the number of customers new to iPhone is greater with iPhone 6 and 6 Plus than any other iPhone launch. These data points serve to frame the heart of the argument surrounding iPhone sales sustainability. Having 20% of iPhone buyers come from competing platforms may be the most important figure to be taken out of Apple's earnings conference call. The iPhone 6 and 6 Plus remove the biggest feature difference that had developed in the phone market: screen size. Looking ahead, Apple will target the 100s of millions of consumers that bought Android smartphones over the past few years and will soon be looking for a new smartphone. Tim Cook also disclosed that approximately 10-15% of the iPhone user base upgraded to iPhone 6 and 6 Plus, implying the iPhone user base stands at 400-420M. Considering the average iPhone user holds onto their phones for 2-3 years, Apple expects continued momentum from iPhone upgrades through 2015.

1Q15 Highlights

Apple reported record revenues of $75 billion, up 30% from 1Q14, which is remarkable on a number of fronts, including the large revenue base Apple had to work off from, the overall global economic picture where any growth is considered good growth, and FX trends that have weighed on results from other multinational companies. With the Apple Watch launching in April (3Q15), Apple is on track to report 25% revenue growth for full-year 2015.

Apple's gross margin, once considered the most important piece of the puzzle to AAPL investors, continues to move higher as the iPhone makes up a larger portion of the overall business. Apple's current operating margin is approximately 41%, excluding FX impact, up from a low of 37% in 2012. Not only is Apple growing revenue by 30%, but margins are moving higher.

Management's 2Q15 guidance looks strong with revenue of $52-$55B ($55.8B expectation) and gross margins of 38.5%-39.5% (39.4% expectation), despite a 500 basis point impact on revenue and 100 basis point impact on margin from FX movements. The Chinese New Year will likely bring continued momentum for Apple product sales in 2Q15.

Exhibit 1 includes all of the major line items from Apple's income statement, compared to 1Q14 results and Above Avalon's expectations. Interestingly, research and development expense continues to remain elevated, rising 43% year-over-year to $1.9B last quarter.

Exhibit 1: Apple 1Q15 Results Compared to 1Q14 and Above Avalon Expectations

Exhibit 2 highlights Apple's product sales in 1Q15 versus 1Q14 and Above Avalon's expectations. Strong iPhone unit sales and ASP (thanks to the iPhone 6 Plus and reconfigured storage tiers) more than offset weakness in iPad and relatively in-line Mac results.

Exhibit 2: Apple 1Q15 Results Compared to 1Q14 and Above Avalon Expectations

Additional Themes

iPad Is Finding It's Purpose. Tim Cook essentially gave guidance for the iPad in 2015 by saying he did not expect much change in iPad sales momentum. During the quarter, the company shipped 21.4M iPads, beating my 19.5M estimate, but down from 26.0M last year. iPad continues to find its proper role within the Apple ecosystem. Tim Cook announced 12 additional MobileFirst iOS apps related to the IBM partnership will be released this quarter, which will go along with the 10 apps recently released. Apple is increasingly positioning enterprise as a key market for iPad, which makes a rumored iPad Pro geared towards content creators that much more interesting. First-time buyer rates for iPad remain high with upwards of 50% of iPad sales going to new customers, including a 70% first-time buyer rate in China. iPad ASP continued to decline suggesting that the iPad mini is replacing the iPod touch as the popular entry-level price iOS device. Overall, there wasn't much in the iPad results to suggest any significant changes in my expectations.

All Eyes Are on China. In what may be the clearest signal of Apple's bullishness on China, Tim Cook mentioned Apple will have 40 stores in China by mid-2016, implying 50% store count growth in a little over a year. We are already seeing the beginning roll-out of this renewed retail focus in China with new stores in Hangzhou and Chongqing. In terms of the Apple online store (now over 350 cities), online revenues in China last quarter were more than the sum of the previous five years. Apple's recent high-profile hires from Burberry (Angela Ahrendts and Chester Chipperfield) would certainly make sense if considering China's importance to Apple and considering Burberry is in the midst of a similar retail expansion program in China.

Jeff Williams Performing at Highest Level. Apple's SVP of Operations Jeff Williams continues to position himself to be Tim Cook's successor as Apple CEO. While I don't expect any change at the top for many years, Williams is only 50 years old (Cook is 53 years old), and quarterly results like the one Apple just reported show that Williams is executing at the highest levels imaginable.

Apple's Retail Weapon. It is rather remarkable how Apple is doubling down on its retail efforts (including physical stores), while peers are either scaling back or staying out of the mix. Apple's investments in its retail operations (447 total stores, 182 of which are outside the U.S.) may be one of the most important bets the company has taken over the past 15 years. Looking ahead at the upcoming Apple Watch, having hundreds of retail locations with trained staff represents a significant competitive advantage for Apple.

Cash and Capital Management. Apple has $178 billion ($31/share) of cash and marketable securities, up $23 billion from last quarter. Apple currently has $33 billion of long-term debt and $4 billion of commercial paper (short-term debt). Management repurchased 53M shares last quarter for between $5-$6 billion (roughly in-line with expectations). Apple has approximately $16B of share buyback authorization remaining and will likely increase the buyback program, along with raising the quarterly cash dividend, in April.

Valuation: Investors Searching for Earnings Sustainability. Apple is currently trading at a 16x trailing P/E and a 12x forward P/E. Obviously, such valuation metrics (as well as more granular metrics such as price/free cash flow) would suggest the shares are undervalued given the company's growth metrics, but that has been the case for years. It is much more important to focus on investor's comfort level around Apple's EPS growth and sustainability. Unfortunately, as a consequence of the industry it operates in, Apple's earnings and growth are looked at with more skepticism than peers growing at a much slower rate. Looking ahead, the Street seems to be expecting continued strong iPhone demand and a decent Apple Watch launch. What will make investors feel more comfortable with earnings sustainability? Diversification, additional service revenue, and more clarity on how Apple product users treat ecosystem paid upgrades, such as iCloud storage). In the meantime, management will likely continue to be in the market buying back AAPL shares.

Looking Ahead

Apple is likely entering a new round of revenue growth on the heels of continued follow-through strength of iPhone 6 and 6 Plus in 2015, as well as the impact from Apple Watch revenue beginning in 3Q15, as shown in Exhibit 3.

Exhibit 3: Apple TTM Revenue (Blue = Reported, Grey = Estimated)

Apple's decision to wait to sell iPhones with large screens until the product was ready will likely go down as a turning point for iPhone. Market share gains will help position the iOS ecosystem to benefit from new services such as Apple Pay, and eventually music streaming, video, health, home, car, and other endeavors. Management often reiterates that Apple is a product company. Record 1Q15 earnings demonstrated that commitment.

This report was produced by Neil Cybart on January 28, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 1/26/15 Neil Cybart 1/26/15

Video - Apple 1Q15 Earnings Preview

I published a short video of my Apple earnings preview. You can take a look at the full report here.

Neil Cybart 1/23/15 Neil Cybart 1/23/15

The Battle for Mindshare

Microsoft surprised us earlier this week when a Windows 10 event geared toward the press turned into a full demonstration of the company's augmented reality computing platform. Judging by headlines, those in attendance were impressed.

The Verge: "Up close with the HoloLens, Microsoft's most intriguing product in years"
The New Yorker: "HoloLens: Microsoft Finally Does Something Interesting"
Business Insider: "I Just Tried Microsoft's Remarkable Holographic Headset - Here's What It's Like"
Fast Company: "Hands on with Microsoft's HoloLens: Windows in its most daring and unexpected form"
The New York Times: "Microsoft HoloLens: A Sensational Vision of the PC's Future"

Microsoft was after one thing by revealing Windows Holographic and HoloLens: relevancy. In that regard, the event was a success. To be part of the conversation and debate over the future of computing was more valuable than anything else announced during the presentation. The Verge produced a good 4 minute video of the event, and it only took 25 seconds before the discussion turned towards HoloLens. The most popular video on Microsoft's YouTube channel was the HoloLens introduction with 7 million views, 100x more views than the Windows 10 highlight video. Not only has Microsoft been using this tactic for years (from the CES keynote playbook), but it is becoming a trend across the tech industry as there seems to be uneasiness over what will be the next big thing.

Mindshare represents accomplishment in consumer technology. Google's success in search turned the company name into a verb describing the act of searching the web or simply looking for information. Instagram's name became synonymous with uploading and sharing photos. Amazon spent years buying competitors in an effort to stay financially on top of the growing e-commerce mindshare game. Apple's iPod, iPad, and to an extent, iPhone, became household names used interchangeably with competing products from the same gadget category. However, like most things, mindshare evolves over time. The ideas of search and e-commerce are changing in a mobile world. Digital music trends are shifting, as seen with Apple buying Beats.

We are now at a point where the giants are looking to take the next big step, but instead of figuring it out when no one is looking, many of them have resorted to using a megaphone to announce their intention loudly and clearly regarding where they are stepping and why they are on the right path. Does the next "big thing" deal with virtual reality, augmented reality, Internet of Things, or all of them? The current debate doesn't even seem to be about the technology, but rather about the players and who will lead the way. Larger companies are battling to remain part of the conversation and to demonstrate that relevancy hasn't been stolen by smaller, more nimble companies. Does fighting for mindshare with early prototypes and ideas that aren't quite ready for prime time take the place of execution, intuition, and design when it comes to success? In the race for mindshare, many companies seem to be forgetting where the finish line is located.

Neil Cybart 1/23/15 Neil Cybart 1/23/15

1Q15 Apple Earnings Preview

Apple will likely report strong 1Q15 earnings on Tuesday. The iPhone 6 and 6 Plus have resonated with consumers across the world and will help propel iPhone unit shipments to a record quarterly high. Partially offsetting some of the iPhone strength is continued weak iPad shipments as the product finds a more steady sales run-rate. The strong dollar is serving as a headwind and will likely impact 2Q15 guidance, although Apple's foreign exchange hedging program will mitigate some of the negative impact. The combination of continued share repurchases, an updated product lineup, and additional revenue from Apple Watch, will likely result in Apple reporting 20%-30% EPS growth in 2015.

Exhibit 1: Above Avalon's AAPL 1Q15 and 2Q15 Estimates

Screen Shot 2015-01-23 at 9.31.32 AM.png

Things to Consider

Revenue and Margin Guidance. I will be looking for clues as to how the iPhone 6 and 6 Plus are expected to sell January through March, and if the Apple Watch will launch in March. Keep in mind, the strong dollar may impact revenue and margin guidance a bit, so the conference call may be required to get the full picture. Any negative impact from foreign exchange will likely be backed out and considered non-operating.
Management Commentary on iPhone. Any insights as to upgrade versus new user trends for iPhone, as well as China sales will help in terms of modeling.
iPhone ASP. With additional moving parts in the iPhone line (storage capacity mix shift and two current iPhone models), the iPhone ASP is likely to see an increase ($660 estimate, up from $637 last year). Any significant change from $660 would likely change my forward revenue estimates.
iPad Sales and ASP. Unit sales are expected to be down year-over-year for iPad, but is there any evidence of stabilization in sales trends? Would a lower than expected ASP suggest the iPad mini is more popular than expected?
Share Buyback. Was there any change in share buyback momentum during the quarter ($5 billion/quarter estimate)?

Revenue and EPS

I am calling for a slight revenue beat to both consensus and guidance on strong iPhone 6 and 6 Plus sales. Working through an above consensus revenue expectation and 38.5% margin estimate (in-line with guidance), I am expecting Apple to report EPS of $2.62, slightly higher than consensus of $2.59.

Exhibit 2: Apple Revenue and EPS Expectations

Guidance

My current 2Q15 estimate includes $56B of revenue and 39.4% gross margin. If management guides to $50B-$53B of revenue, I would't expect much change to my forward estimates. Anything under $50B of revenue and I would likely need to lower my iPhone estimates. If the Apple Watch is launched at the end of March, then guidance will likely reflect the corresponding $1-$2 billion of additional revenue.

Product Unit Sales

Even though I provide unit sales estimates for modeling purposes, it is more appropriate to consider ranges when looking at quarterly product unit sales. Exhibit 3 details my iPhone, iPad, and Mac unit sales expectation meters. My estimate is highlighted in white, while the grey area represents unit sales that would be close enough to my estimate to not elicit much of a surprise. Anything in green would be much stronger than expected, while red would indicate weaker than expected.

Exhibit 3: Apple Product Unit Sales Expectation Meters (1Q15)

One way to think of Exhibit 3 is that my thoughts about iPhone, iPad, Mac would need to be adjusted if actual product sales fell in the green or red zones. If the results fall in the grey zone, than my current expectations are mostly intact.

iPhone

Nearly every data point and customer survey over the past three months have supported the view that iPhone 6 and 6 Plus are selling quite well with lack of supply being the biggest risk to 1Q15 sales estimates. My 68.9M iPhone unit estimate suggests 35% year-over-year growth. There are still supply and demand imbalances in certain countries, which would suggest the number Apple reports on Tuesday will simply represent the amount of iPhones that were able to be shipped. The implication of this is that any iPhone shipment number (no matter how low) will likely be given a pass as investors focus on the next quarter. There has been no significant change to my iPhone estimate since November. I take the 51M iPhones sold in 1Q14 and apply 20% sell-through growth (matching Apple's stated growth trends in 4Q14). I then add 5M unit to reflect China Mobile and 2M for channel inventory build.

iPad

I am expecting weak iPad sales of 19.5M, representing a 25% year-over-year decline in unit shipments as the product continues to find its place within the Apple ecosystem. Earlier this week, I discussed how Apple is likely repositioning the iPad in relation to the iPhone and Mac, which ultimately suggest we are in the process of finding iPad's normalized sales run-rate. My iPad estimate reflects a combination of analyzing Fiksu iPad model share trends (U.S. and Europe focus) from September to December, in addition to a 1.5M channel build estimate.

Mac

All indications point to another solid quarter for Mac with IDC and Gartner suggesting 5-6.5 million units as a likely sales estimate. Mac sales may be continuing to bounce back as iPad sales cool, suggesting MacBook Air models remain a popular purchase.

Services/Other Products

Given Apple's revised reporting segments, my expectations for Services (iTunes/software/services and Apple Pay) is $4.8 billion, while I am modeling $2.3 billion for Other Products (iPod, Beats headphones and speakers, Apple TV, and peripherals and accessories for iPhone, iPad, Mac, and iPod).

Valuation

Apple is currently trading at a 17x trailing twelve month (TTM) P/E. Exhibit 4 shows that Apple has traded within a trailing P/E range of 12-18x (using year-end data) since the U.S. financial crisis. While Apple's P/E remains at a discount to the overall S&P 500, the gap has been closing. Using my 2015 and 2016 estimates, Apple's forward P/E currently stands at 13.4x for 2015 and 10.9x for 2016, which suggest there is some market pessimism that Apple will be able to meet my estimates (likely due to questions surrounding iPhone 6s sales in late 2015 and 2016 and Apple Watch sales).

Exhibit 4: Historical P/E (TTM)

Exhibit 5 includes different valuation scenarios assuming various 2015 EPS estimates. My $8.50 estimate column is highlighted in yellow.

Exhibit 5: AAPL Valuation Matrix

In terms of valuation, the iPhone continues to be the primary focus for Apple investors, while the Apple Watch remains a wildcard as expectations target 15-20M unit sales in the first 12 months.

This report was produced by Neil Cybart on January 23, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 1/20/15 Neil Cybart 1/20/15

Apple's Plan for iPad in an iPhone World

The iPad was introduced five years ago when iPhones were smaller and MacBooks were larger. Apple was able to market the iPad's larger screen as a reason to not only own a smartphone and PC, but also a tablet. In the past, Apple positioned products in separate silos geared for a particular buyer. Apple has begun taking a new direction where each device is merely a piece of the bigger puzzle in which a customer chooses products based on their personality and lifestyle. The change has significant implications not only for iPad, but also for how Apple looks at future product iterations, including wearables. The iPad was crowned the future of computing. In reality, iOS is the future of computing. The iPad is now positioned to take a supporting role to iPhone as Apple expands the iOS ecosystem.

iPad in 2010

When the iPad was introduced, many were unsure if a new product category was needed between a phone and a laptop. In very simple and plain language, Steve Jobs listed seven tasks that can be handled better with a device that sits between an iPhone and MacBook.

Exhibit 1: iPad Use Cases in 2010

The expectation was for people to buy both a smartphone and a tablet, and that's exactly what happened for the first few years. Sales of the iPad over the first four years on the market exceeded iPhone's initial sales during the same period. With a 3.5-inch screen, the iPhone simply was unable to beat the iPad in terms of browsing the web, checking emails, viewing photos, watching video, and reading ebooks. Meanwhile, MacBooks lacked the magical multi-touch interface and apps that came with the iPhone and iPad.

iPad in 2015

Five years later, are there still things that iPad is better at than the iPhone and Mac? While I can look at Exhibit 1 and update that list, what has happened since 2010 is people have developed different habits and lifestyles around their gadgets. For some, an iPhone 6 Plus handles email better than an iPad, while others still prefer a larger iPad Air. Over the past few months, I've been thinking of a way to describe the iPad, and I think the product has become a bit awkward when considered as a stand alone product category independent of iPhone and the Mac. When considered as part of iOS, the iPad would appear to be simply finding its place (which may very well be at a lower sales rate). Apple sold 68 million iPads last year and while sales momentum has disappeared in recent quarters, Apple is still expected to sell 50-60 million units in FY2015.

Four-Quadrant Product Grid Drawbacks

The notorious Apple four-quadrant product grid introduced by Steve Jobs in 1998 has been well publicized and discussed. As depicted in Exhibit 2, to simplify the product line and realign focus, Steve wanted a product in each of the four boxes, representing different target markets.

Exhibit 2: Apple Four-Quadrant Product Grid (1998)

The same kind of product analysis no longer works.

1) Apps have blurred the distinction between the consumer and professional columns.

2) Screen size and mobility have replaced desktop and laptop as the primary differentiator. There is no longer a one size fits all description for what screen size is geared for a particular segment. Small-screen iPhones have infiltrated enterprise and education, while MacBooks can be found in consumer and enterprise.

Exhibit 3 was what many would have come up with analyzing Apple's current product line, and in such a grid, having iPad by itself in the upper left corner exposes the product to incomplete analysis because the product is no longer targeted to only one type of buyer or customer.

Exhibit 3: Faulty Apple Product Analysis Four-Quadrant Product Grid (2014)

Apple's New Personalization Product Analysis

Instead of product quadrants, a new type of analysis is needed to measure Apple's long-term objective and strategy. In Exhibit 4, I highlight how Apple views its current product line where screen size and mobility are the primary differences between products. Now each device can appeal to consumers in various segments of the market from education to enterprise to content creation and content consumption. Personalization is becoming a much bigger factor. In this table, the iPad's role is to serve as a placeholder for those who want technology with a slightly bigger screen than an iPhone or someone who wants a more simple and interactive device than a MacBook. While some may enjoy the iPad, there will be others that have no use for such a device.

Exhibit 4: Apple Personalization Product Analysis

Exhibit 5 depicts what I would call an Apple Product Screen Personalization analysis, which includes unit sales estimates for every major Apple product ranked according to screen size. Over time, while the peaks may shift left or right, I think the general shape will remain true as the iPhone remains the top seller and other devices fall in line.

Exhibit 5: Apple Product Screen Personalization Analysis (2015)

The primary takeaway from Exhibit 5 is that future product innovation will largely be based on Apple continuing to ship a product line that appeals to different lifestyles. The iPad is merely a part of the Apple product lineup designed to appeal to lifestyles where a touchscreen ranging from 7 to 12 inches makes sense. Looking at quarterly unit sales by total iOS devices may make more sense than looking at iPad sales down 25%, but iPhone up 35%.

Over time I would expect Apple to continue to refine screen sizes. For now, it would seem like consensus has landed on 4.7 inches for iPhone and 9.6 inches for iPad. In the future, the phone may continue to get bigger, which will force Apple to push a larger iPad Pro more, so the line in Exhibit 5 will shift to the right a bit, but the overall iOS product line stays intact. The Apple Watch at the far left may also see some interesting sales trends, causing another peak at that part of the line.

Apple visualized this analysis in a slide from the iPad keynote this past October, shown in Exhibit 6.

Exhibit 6: Apple Product Screen Personalization Visualized (2014)

Here is Tim Cook describing the keynote slide from Exhibit 6:

“This is the strongest line-up of products that Apple has ever had. And we believe that each one of these play a very important role. People need different types of technology for the way they live their lives. We all do different things.

In fact, many of us and many of our customers use more than one of our products every day. Sometimes you want to sit at your desk in front of a huge beautiful immersive screen, packed with powerful technology. And we’ve made that much better today with the Retina 5K screen for iMac.

Sometimes you want to take that powerful technology with you wherever you go, and we’ve made our notebooks even better this year with MacBook Air and MacBook Pro.

Sometimes you want to be close to your content, touching it and we’ve made that experience even better today with the iPad Air 2, more powerful and incredibly thin.

Sometimes you want to hold that powerful technology in the palm of your hand and there’s no better thing for your hand than the iPhone 6 and iPhone 6 Plus.

And soon, you can wear that powerful technology right on your wrist...

They are designed to be incredible products individually but they are also designed to work together seamlessly.”

Apple has moved beyond product grids and quadrants as the combination of hardware and software have created a vibrant device ecosystem suited for various lifestyles.

iPad's Role Going Forward; Time to Reset Expectations

The iPad will likely be repositioned to appeal to consumers looking for that larger iOS companion device that may make video better to watch, Twitter easier to use, or ebooks more relaxing to read. In addition, a new iPad Pro would be geared toward content creators that may be unsatisfied with the Mac's capabilities. Accordingly, I suspect sales will likely reflect this new status. I don't view the iPad as on a trajectory to outsell iPhone, but at the same time, there will likely be buyers that need a computing device that is bigger than an iPhone with a 5.5-inch screen, but more nimble than a MacBook.

I see two factors serving as the primary buying variables going forward across the Apple product lineup: screen size and price.

Screen Size

We are still in the phase of figuring out which size of glass we want to carry in our pockets or hold in our laps in bed. I would expect continuing shifts in trends, especially once the Apple Watch goes on sale and consumers interact with a small screen on the wrist.

Price

As depicted in Exhibit 7, Apple now sells five iPad models at five prices, which isn't exactly the easiest thing to decipher when buying. Why is Apple doing this? The iPad does a great job at addressing price umbrellas.

Exhibit 7: Apple's Current iPad Line - This Is Getting a Bit Awkward (2014)

By selling older iPad models for $249-$399, Apple is appealing to those consumers that value price over certain features or components. Apple doesn't want competitors to ship capable devices that may undermine some of these smaller iOS screens. The iPhone "subsidy" in many countries complicates this a bit for the iPhone line since there are already phones being sold for free (but with a monthly fee or a subsidy). As smaller devices continue to outsell Macs by multiples, I would expect this trend of Apple relying on iPad to address the low-end of the market to continue, and eventually the same strategy may spread to Apple Watch in a few years. Meanwhile, the MacBook and iMac lines don't have the same type of price umbrellas given that iPhones and iPads address the lower-end of the market.

Currently, the $199 iPod touch is likely selling around 1-2M units a quarter. Combined with the 2-3M older iPad minis, Apple is selling around 20M iOS devices a year, or roughly 8% of total iOS devices, for less than $300.

Software Moves to Middle

One likely theme going forward is that software differences between iOS and Mac will continue to move to the middle, which will call for some new and different things where the iPad meets the MacBook. What works great on an iPhone will likely not work great on a laptop, so a solution that takes the best of both worlds may be needed in that big tablet/small laptop area. Incidentally, Apple is rumored to have a new iPad and a new MacBook Air in the pipeline, so that intersection would appear to be an exciting one in 2015.

Next Marginal Apple Product Buyer

Even though the probability is that Apple's next marginal buyer into iOS is likely an iPhone buyer from Greater China (looking at current sales), from Apple's perspective, it doesn't matter if a new user enters iOS by buying an iPhone 6, iPad mini, iPhone 6 Plus, or iPad Air. Devices have matured to such a degree and are now positioned in such a way that consumers don't need to buy 3-4 Apple products. While certain products are more universal such as iPhone, others are more personal, such as iPad. Accordingly, the shift to a more personalized product line based on screen size and mobility would suggest there will be continued effort and innovation across the product line, despite some products selling at a fraction of others. For iPad, the spotlight may continue to dim a bit, especially when compared to iPhone, as the product finds its place within the Apple ecosystem.

This report was produced by Neil Cybart on January 20, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 1/18/15 Neil Cybart 1/18/15

Apple Rethinking the Pen: Initial Thoughts on 'Apple Pen'

Apple analyst Ming-Chi Kuo is out with a new report suggesting Apple will launch a stylus in a few months alongside a new, larger 12.9-inch "iPad Pro." Judging by the sheer volume (over 30+) of patents for a stylus going back to the iPad launch, I don't think the question has ever been about whether or not Apple has been working on such a device, but instead if Apple would ever release such a product. Would a stylus receive one of Apple's rare "yes" votes and make it to the marketplace?

A quick glance at Apple's patents for what I call the "Apple Pen" would suggest that such a device is not simply a stylus used to draw on an iPad, but a comprehensive solution for reinventing the modern-day writing instrument. Apple would be reinventing the pen. The use cases are broad and extensive:

Enterprise. There are many situations in the corporate world in which a keyboard is not appropriate for taking notes. Whether it is used during a formal board meeting or a quick brainstorming session, a laptop often hinders discussion and interaction. In that same vein, an iPad doesn't offer any additional benefits and very often makes it even harder to record notes or thoughts. Instead, paper and pen continue to be utilized (or third-party styli with iPads) because it is much easier to record notes and thoughts in free-form on paper or a tablet. An Apple Pen would find a nice fit in this type of setting. Additionally, if the Apple Pen can be used to capture information such as distance, shape, texture, and angles, the implications expand into many different industries such as industrial and into various commercial settings from Fortune 500 companies to independently owned and operated businesses.
Education. Obvious implications for an Apple Pen would include taking notes, but deeper applications involve content creation in the arts and sciences including math, chemistry, physics, and biology, where a keyboard (or finger) is less effective than a fine point writing instrument. As Chromebooks gain ground in education, a touch-screen device with an accompanying smart pen would stand out as adding to the classroom not only utility, but also new forms of creativity and imagination.
Consumer. Imagine tasks for which a pen and paper are still used such as creating shopping lists and writing letters. In each of these cases, a smart pen can increase utility.

I still have more questions than answers regarding an Apple Pen. How much would an Apple Pen cost? Would the device be initially compatible with just an iPad Pro in order to boost sales of the device, or would the smart pen work with any iOS device? How many functions would such a device include in the first version?

I see an Apple Pen being positioned not only to replace the modern-day pen, but also to serve as a new way to gather and input data. I can see an Apple Pen eventually work without the need for even an iPad or iPhone as a screen isn't necessary to capture data. As sales of third-market devices show, there is already demand for a stylus. An Apple Pen would eventually be positioned as a device that we can't imagine living without. In reference to competing products that came with a stylus, Steve Jobs once said, "if you see a stylus, they blew it." He was right. An Apple Pen wouldn't be a stylus. It would be a data collector and interpreter that just happens to take quick notes and drawings on a screen.

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.

Neil Cybart 1/16/15 Neil Cybart 1/16/15

Apple Pay Enrollment Trends

Bank of America reported yesterday that 800,000 of its customers had registered with Apple Pay. Since Bank of America is the second largest bank in the U.S. according to assets (third in terms of deposits), this new data point suggests early Apple Pay enrollment trends look strong. I estimate 10-15% of iPhone 6 and 6 Plus owners in the U.S. (2-3 million people) have registered cards with Apple Pay.

Exhibit 1 highlights the top ten banks in the U.S., ranked by total assets. Total deposits are also included to get a better idea of customer base rank. The top four banks clearly have a larger asset footprint than peers, representing 40% of deposits in the U.S. Most of the larger banks in the U.S. now support Apple Pay.

Exhibit 1: Largest U.S. Banks - Total Assets

Screen Shot 2015-01-16 at 2.11.26 PM.png

Exhibit 2 highlights the top banks in the U.S. according to branch footprint, which shows some slight reshuffling in rank from Exhibit 1, although the top players still support Apple Pay.

Exhibit 2: Largest U.S. Banks - Retail Branches

In order to reach Apple Pay enrollment estimates, I added the roughly 15 million iPhone 6 and 6 Plus units sold globally in 4Q14 to the expected 50 million iPhone 6 and 6 Plus units sold in 1Q15 (Apple is still selling iPhone 5s and 5c), implying Apple has sold around 65 million iPhone 6 and 6 units globally, with approximately 35% attributed to the U.S, or 23 million units. Running with that number, Exhibit 3 highlights three possible Apple Pay enrollment scenarios predicated on the percentage of total iPhone 6 and 6 Plus users represented by Bank of America.

Exhibit 3: Apple Pay Enrollment Estimates

Screen Shot 2015-01-16 at 2.02.22 PM.png

Running with a conservative estimate of the percent of Apple Pay users Bank of America (50M total banking customers) represents, Apple Pay enrollment rates in the U.S. would stand at 8%. If using aggressive metrics, Apple Pay enrollment would be 16%. I estimate 10-15% of iPhone 6 and 6 Plus owners in the U.S. have registered with Apple Pay. As a reminder, this does not mean that 10-15% of iPhone 6 and 6 Plus owners are using the service at retailers or within apps. Having users add cards to Apple Pay is the first major hurdle Apple has to overcome to get Apple Pay usage off the ground. By adding a card (even if it's already included in iTunes), users demonstrate trust in Apple and the Apple Pay service. In the coming months, Apple's focus in the U.S. will continue to be on adding banks (close to 90% of card credit transaction volume is supported by Apple Pay) and additional retailers. International expansion is also expected in the coming months with reports indicating Britain and Canada as possible targets for the next Apple Pay rollout. It is still early, but Apple Pay enrollment trends in the U.S. look strong.

Neil Cybart 1/14/15 Neil Cybart 1/14/15

Apple Watch Isn't a Luxury Watch

Many people are trying to analyze Apple Watch with the assumption that the device is just another luxury watch only with additional customization and features. I think this type of thinking misses the big picture. An Apple Watch will be just as much a watch as an iPhone is a phone.

Last week, I discussed how I thought Apple will sell Apple Watch by positioning it as a watch with customizable faces and bands. By keeping the message simple, anxiety and uneasiness will be removed from the buying decision. Most consumers, even if they don't wear a watch, understand what a watch is and what it does. However, the comparsion of Apple Watch to a luxury watch needs to stop there as once a user begins to rely on Apple Watch for communication, health and fitness tracking, and mobile payments, the idea that it is just another luxury watch will no longer apply.

The Apple Watch and its strengths shouldn't be compared to luxury watches, and more importantly, luxury watch strengths. Timelessness, or lack thereof, seems to be at the top of the list of lingering questions about Apple Watch. If a luxury watch can last the test of time and be passed down from generation to generation, how would Apple Watch compete? Who would pay thousands of dollars for a device that won't stand the test of time? Timelessness won't matter for Apple Watch since the Apple Watch isn't a luxury watch. Instead, Apple Watch is a mobile computing facilitator worn on the wrist. The users will have just as much motive and desire to pass the device down to children or family as they would with an iPhone or iPad. By discussing price in context of luxury watches, I suspect many are jumping to the conclusion that the only reason someone will pay thousands of dollars for an Apple Watch is to wear it forever as a status symbol. Instead, people will pay thousands of dollars in order to have the opportunity to buy an Apple product that can be worn. The desire to upgrade to a newer, more advanced version in the future will likely be just as strong as it is with iPhone.

Apple understands its user base very well and correctly sees that there is a market for very high-end tech gadgets. This buyer takes an iPhone and its lack of personalization, puts thousands of dollars into the device to truly make it his or her own, and then will eventually upgrade to a newer iPhone just like everyone else. The Apple Watch Edition collection is Apple's first attempt at addressing this segment of the market.

Just as with fashion, technology evolves. The Apple Watch isn't a luxury watch, but rather a fashionable communication facilitator worn on the wrist.

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.