The 4-Inch iPhone 6c
Rumors of a new 4-inch iPhone 6c are once again making the rounds. The idea of Apple expanding the iPhone line to include simultaneous development of three different screen sizes is intriguing because it may be the missing piece that allows Apple to reposition the iPhone line for a more sustainable future. Given current smartphone market dynamics, it would be in Apple's best interest to continue expanding the iPhone line as the product matures. Not only would an updated iPhone with a 4-inch screen appeal to a certain segment of the market, but Apple could position the new model as a way to begin differentiating the iPhone line according to it's primary distinguishing feature: screen size.
Current iPhone Line
The current iPhone line is effective in selling Apple's flagship phones (iPhone 6 and 6 Plus). Apple currently sells two-and-a-half iPhone 6 units for every iPhone 6 Plus sold. With the iPhone 5s and 5c, Apple relied on its existing strategy of taking last year's models and reducing the price by $100. Apple continues to have each price segment covered ranging from a contract-free $749 to $450. Apple's current pricing strategy is also supportive of the carrier subsidy model as the $450 differential between a 2-year contract price and contract-free price is upheld across the product line.
Current iPhone Line
iPhone Line with iPhone 6c
A new iPhone with a 4-inch screen (the "iPhone 6c") would have several longer-term implications for the iPhone line. For the first time, Apple would have three different-sized iPhone models under development (5.5-inch, 4.7-inch, and 4-inch) as the iPhone 6c would see an update from the iPhone 5s and iPhone 5c, including possibly a different design. More importantly, Apple would be able to position iPhone screen size, and not product age, as the primary pricing differentiator going forward.
Apple wouldn't reduce the iPhone 6 and 6 Plus by $100 this year, but instead sell a new iPhone 6s and iPhone 6s Plus for the same $649 and $749, respectively. The iPhone 6c would be positioned as the device for those who want to spend less money on an iPhone while the iPhone 5s would occupy the "free with carrier contract" bucket.
Expected iPhone Line with iPhone 6c - Year-End 2015
Note: Apple may change the case colors for 6s Plus, 6s, and 6c
Benefits of Selling an iPhone 6c:
- Drive consumers to iPhone 6s Plus and iPhone 6s. An iPhone 6c could be positioned to drive consumers to purchase the flagship models, the iPhone 6s and 6s Plus. After looking at the various options, including the iPhone 6c, consumers may be more willing to pay the extra $100 for the iPhone 6s. Apple relied on a similar strategy in 2013 with the iPhone 5c. While some thought the iPhone 5c would sell well, it ended up driving people into buying the more expensive iPhone 5s. This is a smart marketing decision by Apple designed to maintain the integrity of the iPhone line by getting consumers to buy the latest model, even though they may be satisfied with an older model at a lower price. Apple would benefit from earning additional revenue if consumers chose an iPhone 6s or 6s Plus over an iPhone 6c.
- Provide a good 4-inch screen experience for consumers. I suspect there is a certain segment of the population that would still prefer an iPhone with a 4-inch screen. While the larger 4.7-inch and 5.5-inch screen options would outsell an iPhone 6c, the ability to use an iPhone comfortably with one-hand, store the device in small pockets, or use the device during workouts make a 4-inch screen desirable for some consumers.
Segmenting Price (and Buyers) by Screen Size
Apple has relied on reducing the price of previous year's flagship models to address price-sensitive consumers. Such a method has been successful in maintaining an "Apple-like" experience at lower prices. However, with Apple now selling two flagship models with different screen sizes, a new strategy is needed in order to set the iPhone on a more sustainable path. If Apple sticks with it's current strategy, within three years there would be an iPhone with a 5.5-inch display selling for anywhere between $299 and $0 with a two-year contract as Apple reduces the price by $100 each year. Not only would this be confusing from a customer's point of view, but Apple may be jeopardizing the iPhone's average selling price and the important iPhone upgrade cycle as consumers decide to buy older, less expensive models.
Instead, the iPhone 6c would be the first sign that Apple is moving to a different strategy where specific screen sizes occupy set price tiers. To better view this strategy, replace each iPhone model nomenclature with its screen size. Apple now has three Phone tiers (5.5-inch, 4.7-inch, and 4-inch screens) designated for the $749, $649, and $549 price layers. This structure would remain unchanged from year to year with new models replacing the previous year's model. Meanwhile, older 4-inch screen models retain some of the old iPhone heritage of seeing price reductions over time.
iPhone Line Based on Screen Size as Primary Price Differentiator
Note: Apple will likely change iPhone case colors.
With the iPhone 6 is outselling the 6 Plus by roughly a 2.5 to 1 margin, I suspect many look at 5.5-inches as too large for an iPhone display. Taking a look at Android options, the best-selling phones also seem to come in less than that 5.5-inch range. Even in the scenario where screen sizes become a bit larger, Apple can adapt the strategy by simply relying on the concept of plus, regular (or just "iPhone"), and mini to denote three different screen sizes. The smallest screen option would then be the model to see price reductions over time.
iPhone Line Based on Screen Size as Primary Price Differentiator
Note: Apple will likely change iPhone case colors.
The "Cheap" iPhone
By segmenting the iPhone line according to screen size and shipping an iPhone 6c, Apple would eventually be in position to ship the notorious "cheap" iPhone, a two-year old iPhone with 4-inch display that sells for less than $400 contract-free. Such a device would not be sold in areas with carrier subsidies, but instead be focused on emerging markets. Even though $400 is still a premium price for a smartphone, Apple's strategy would continue to focus on slowly, but surely, lowering the iPhone's entry level price. This plan represents a much more realistic option than taking a 4-year old iPhone 6 Plus and eventually selling it for less than $400.
Apple is Getting Better at Making iPhones
Apple is likely doing a much better job at producing new iPhones at attractive margins. In the past, Apple's margin would suffer when there was a new iPhone form factor introduced, reinforcing the need to continue selling that device (with no changes) in subsequent years to recoup some margin. With manufacturing processes improving, Apple no longer has this need to continue selling the same flagship phones for years. Instead iPhone 6 and 6 Plus margins are much better to begin with and Apple can simply shift production to new models each year, while the 4-inch screen model (which Apple has already been producing for years) is the one to see price reductions over time. iPhone storage configurations are another way of Apple will be able to continue boost ASPs and margins. As the iPhone line matures, the current screen sizes will likely be around much longer than smaller iPhone screen sizes found with the iPhone 3G and 3GS, emphasizing the need for a more sustainable strategy of keeping prices stable.
Think About the Future
While the iPhone 6c is still a rumor, I'm confident that Apple management has been toying with the idea of changing its iPhone strategy in order to assure that the iPhone upgrade cycle remains robust. In addition, Apple would look to expand the iPhone line, both in terms of available models and price points. It is important to remember that there is much more to the equation than simply price. Apple could reduce the price of iPhone 6 and 6 Plus over time and its phone market share will increase. However, such a scenario may contain longer-term negatives that outweigh any near-term positives. Instead, by positioning screen size as the primary pricing differentiator, Apple is able to sell great iPhone experiences at different price layers without much in the way of collateral damage. An iPhone 6c makes a lot of sense.
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Setting the Stage for a Larger Apple Share Buyback Program
Apple will announce an update to its capital return program next month (likely in conjunction with its 2Q15 earnings release). Earlier this week, I took a closer look at Apple's quarterly cash dividend. Turning to share buyback, I expect Apple's board to approve a $35 to $45 billion increase to the buyback program, bringing total authorization to $125 to $135 billion. With Apple stock currently trading at a 13x forward P/E multiple, management will continue to look at buyback as an appropriate way to return excess capital to shareholders. Assuming the share price remains in the current valuation range, Apple will likely continue buying back shares at a $45 billion/year pace.
Share Buyback Authorization History
Apple initiated the stock buyback in fall of 2012. In the subsequent two years, Apple's pace of buyback exceeded its own timeline. As shown in Exhibit 1, the initial $10 billion authorization had a three year horizon, but Apple had bought back $10 billion of stock within a few months. The same can be said for the year-end 2015 target for completing the $60 billion of cumulative buyback authorization announced in April 2013. Apple spent $60 billion on buyback a full year ahead of schedule.
Exhibit 1: Apple's Capital Return Program Updates
While some companies are notorious for announcing share buyback programs, only to never finish them, Apple would appear to be aggressively following its stated repurchase authorization. Management is showing confidence in the future product lineup as well as the belief that Apple's current share price remains attractive for buyback. Last year, the board announced a $30 billion increase in buyback authorization but not did provide a timeline for the buyback completion. Apple ended up buying back approximately $30 billion of shares since that time. By not providing any stated timeline for its authorization, the board may be giving management a bit more leeway to judge the proper pace of buyback given the stock valuation.
Estimating the Share Buyback Authorization Increase
Apple currently has $90 billion of cumulative buyback authorization, of which $17 billion was remaining as of December 27, 2014. For a better understanding of how much the board will increase buyback authorization, it is crucial to estimate how much cash Apple will have at its disposal for capital return.
Exhibit 2 highlights the main ingredients of cash for calendar year 2015. Even though Apple has $178 billion of total cash, only $20 billion was located in the U.S. at the start of 2015. Add in U.S. free cash flow and cash proceeds from expected debt issuances, and Apple will have approximately $75 billion of cash before taking into account share repurchases and dividends. Keep in mind, free cash flow already reflects payments made for acquisition of property, plant and equipment.
Exhibit 2: Projected Apple U.S. Cash - CY2015
Assuming Apple will spend $11 billion on share dividends, there will be approximately $65 billion of cash available for share repurchases in 2015. Since Apple entered 2015 with $17 billion of share repurchase authorization remaining, it is reasonable to assume some cash has already been used to repurchase shares in the first quarter, leaving approximately $50-$55 billion of cash for buyback. This range forms the basis for my $35-$45 billion authorization increase estimate. Apple would likely still have buyback authorization left at the end of 2015, in which case it would roll over to 2016.
There are three scenarios to look for in terms of Apple's share buyback authorization increase:
Scenario A: Increase authorization by more than $40B. An authorization increase of $40 billion or more would mean either that Apple intends to increase the pace of buyback or the board is willing to give management more leeway in determining the best time for buyback with the expectation that most of the program will occur in 2016. However, since management had indicated it would assess the capital return program each year, there may not be much sense for the board to give authorization with a 2-3 year time horizon as that would leave less room for an increase in subsequent years. Evidence would seem to support the view that the board (and management) continue to think short-term in terms of its buyback authorization.
Scenario B: Increase authorization between $30B and $40B. An authorization increase between $30 billion and $40 billion would be considered the middle ground, leading to a buyback pace similar to 2014.
Scenario C: Increase authorization by less than $30B. An authorization increase of less than $30 billion would signal that share buyback may be slowing, unless the board is preparing to authorize additional increases later in the year (unlikely). One reason this may be an unlikely scenario is that the board would want to build flexibility into the program in case of sudden stock price swings.
Exhibit 3: Apple Share Buyback Authorization Increase Scenarios
I view Scenario A and Scenario B as the most likely outcomes given the board's preference to give management a bit more share repurchase authorization in case of stock price opportunities. Given the current amount of cash in the U.S. and a slightly higher stock price valuation, a $35-$45 billion increase to Apple's share buyback authorization is the most likely outcome next month. In such a scenario, Apple's cumulative share buyback authorization may reach $135 billion.
This report was produced by Neil Cybart on March 27, 2015 and is not meant to be used as investment advice.
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Protecting Balance Sheets from Paranoia
Google made waves yesterday announcing Morgan Stanley's CFO, Ruth Porat, will be its next CFO. Many were quick to point out Twitter CFO Anthony Noto also came from Wall Street in an attempt to frame Google's hire as evidence of the ongoing battle for talent between Wall Street and Silicon Valley. Instead, Google's hire deals more with paranoia than a battle for talent. Today's tech leaders are paranoid about becoming irrelevant. Such anxiety does not bode well when contemplating more practical business affairs, such as managing a company's finances and balance sheet. Companies may find success in a structure that combines the best of Silicon Valley with Wall Street. As technology minds worry about the future, financial minds are focused on managing the present.
Technology companies are more paranoid about everything these days. Larry Page seemingly wants to get rid of his day-to-day job to focus on the next big thing. Tim Cook constantly refers to the nonstop worrying that Apple executives go through in terms of competition and what products to work on. Mark Zuckerberg is always on the lookout for the next big thing before it negatively impacts Facebook. Jeff Bezos is continuously looking for ways to keep Amazon relevant in the booming ecommerce renaissance. Paranoia isn't an inherently bad thing when coming up with strategy, however, one complication enters the equation if paranoia begins to creep into the financial aspects of the business such as cash management, capital structure, and cash flow. A certain level of sanity and rationality needs to preside in terms of a company's financial management.
While a CFO has slightly different roles depending on the company and industry, the overall job description in tech is pretty straight-forward: manage the balance sheet and capital structure, in addition to giving input on the income statement and cash flow. The product remains the pinnacle while financial management takes on a supporting role. We are seeing a new breed of tech giants sitting on cash levels that will likely have implications on the operating environment for many years, assuming the cash is well managed. Enter Wall Street. I suspect Google hired Morgan Stanley's CFO for her knowledge on how to manage $64 billion of cash, including the best ways to structure M&A deals, handle more shareholder-friendly capital management actions, and make sure the financial statements are receiving proper care and attention. Porat will likely not be involved in figuring out Google's next big computing platform, just as Apple CFO Luca Maestri isn't designing an Apple Car.
All of of this paranoia combined with keen sense to separate such anxiety from a company's financial management would represent a change from the past. In 2004, Microsoft's answer to holding $56 billion of cash was to issue a special one-time dividend of $32 billion, which is another way of saying they didn't know what to do with the cash and thought MSFT stock was too expensive to buy back. Today, management teams are looking at excess cash much more carefully, and in some cases, too conservatively, which is evidence for more in the way of thoughtful financial management. Instilling a sane lookout over the cash fortress will only pay dividends for years to come.
While Apple's capital return program has been well publicized, others have not participated in such shareholder-friendly alternatives, instead using cash (and stock) to continue buying the future. While there is nothing inherently wrong with such a strategy as long as value creation remains a priority, there will likely come a time when cash levels reach such a point (if that time has not already arrived) that CFOs will play a role in setting expectations and the narrative about a company's philosophy for holding excess cash.
While Google is still trying to figure out the next big thing, Facebook continues to rely on its network and reach to consolidate power and information. Meanwhile, Apple is focused on using design to create products that impact our lives and society, while Microsoft is trying to find its place in mobile. Regardless of what the next few years will bring in terms of how things shake out, those companies valuing long-term fiscal responsibility and stability are already thinking of the future. Paranoia is good for a company, until it brings on ruin. Placing safeguards in place to prevent this ruin from reaching the balance sheet is a smart move.
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Analyzing Apple's Expected Cash Dividend Increase in April
Since Apple began its capital return program in 2012, share buyback as rightfully received most of the press and attention compared to quarterly cash dividends. Apple has repurchased $73 billion of its stock, nearly three times as much as the $27 billion spent on cash dividends. However, from a signaling effect, cash dividends may do more than share buyback in portraying management's opinions and views about future business prospects.
Management included language in its financial filings that Apple intends to increase its quarterly cash dividend each year. Next month, during the annual review of the capital management program, Apple's board will likely approve an increase to Apple's quarterly cash dividend to approximately $0.50 to $0.51/share, up 8% from the current $0.47/share dividend, which would represent a 1.6% dividend yield at the current stock price. The board approved a 8% dividend increase last year. While dividends have historically signaled a maturing company with slowing growth prospects, Apple looks to be a rare exception where its financial and capital capabilities are being decoupled from a product lineup that continues to see growth and momentum.
Much of the significance underpinning Apple's buyback and dividends has been lost on market observers as the focus remains on the near-term trade, ignoring capital management's long-term signaling effect. While share buyback and dividends (both cash and stock) do not guarantee positive stock price moves in the future, market observers can use such activity as an indicator for how management views the future. By issuing a cash dividend, management is showing confidence that the business is supportive of a recurring cash expense going forward in the form of the dividend.
Exhibit 1 highlights Apple's dividend payout ratios over the past two years in addition to the expected payout ratios through 2016. A dividend payout ratio is simply the cash dividends paid each year divided by annual earnings. The lower the dividend payout, the less of a burden the dividend payment is on overall earnings (and cash flow). A high dividend payout ratio would signify that the company either doesn't see much need to hold on to its earnings, or the dividend is too high.
Exhibit 1: Apple Dividend Payout Ratio
While it is hard to come up with direct peers, if comparing Apple's 28% payout ratio to companies with similarly valuable brands like Disney (20% payout ratio) and Nike (30% payout ratio), Apple is indeed running with an in-line divided payout ratio. Interestingly, given the strong expected earnings growth in 2015, Apple's divided payout ratio is expected to decline to 20% in the near-term.
From management's point of view, it makes more sense to increase the dividend each year at a rate that smooths out earnings volatility. This strategy would imply that even though Apple is experiencing 40% EPS growth in 2015, the dividend increase would likely remain less than 10%. If the situation was flipped and Apple's earnings were declining, the expectation would be that Apple wouldn't need to cut the dividend, but instead continue maintaining an orderly, gradual increase.
Exhibit 2 takes a look at the amount of capital spent on dividend payments, which is found simply by multiplying dividends paid to shareholders by the number of shares outstanding. The data can also be found in Apple's cash flow statement. The key takeaway is that dividend expense is benefitting from Apple's aggressive share buyback program. As excess capital is spent on share buyback, Apple no longer needs to pay dividends on repurchased shares, reducing its dividend obligation. As a result, Apple is able to increase the dividend per share rate, while the total cost of the cash dividends increases at a much slower pace. This is yet another example of how current shareholders benefit from share repurchases. There is a possibility that management will take a look at this data and conclude that Apple can increase the quarterly cash dividend further, but the market has shown no expectation that such a sizable increase is required.
Exhibit 2: Apple Cash Dividends (Per Share and Total)
From an investor's point of view, cash dividends give off much more in the way of long-term management signaling when compared to share repurchases. With a dividend, management is unofficially tying the company to a long-term, recurring use of capital since any shareholder-friendly management team and board understands the negative consequences following a dividend cut. With share buyback, companies are not obligated to complete the program and have a much easier time slowing or ending the buyback without a significant market backlash. While there are few companies that purposely increase their dividends knowing they will need to be cut in the near term, there are some companies that find themselves in cyclical industries, such as energy and mining, where drastic swings in either pricing or demand may bring about the need to cut dividends. Apple's goal when setting its dividend would be to avoid this type of adverse situation where a dividend cut is required to maintain financial health during a more difficult operating environment.
The other benefit of paying a cash dividend is that Apple's investor base is expanded as some institutions only invest in dividend-paying entities. While it is hard to quantify the impact this may have had on Apple's valuation, it is clear that with a $743 billion market capitalization ($605 billion enterprise value), it would be in Apple's best interest to not exclude any large shareholder group due to specific capital return strategies.
Apple is in an interesting situation as fast-growing technology companies have traditionally not embraced paying cash dividends due to the signaling it may give concerning fewer growth opportunities. Apple management seems to be decoupling its financial philosophies concerning excess capital from a product lineup continuing to see growth. In a few weeks, Apple's board will approve an updated capital return program, including a dividend increase, that will align with management's view on Apple's long-term business prospects.
This report was produced by Neil Cybart on March 24, 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.
An Illusion in Switzerland
It's a good time to be a ultra luxury watchmaker. Consumers across the world continue to value the craftsmanship and timelessness found in engineered works of art worn on the wrist. Young professionals continue to enter the luxury watch world with open arms (and wallets) looking to wear accomplishment and success. Watchmakers remain excited about the future as consumers associate luxury watches with ideals that go beyond price, materials, and marketing.
Just like a soothing sunset can be ruined with a particular cloud cover forewarning of an upcoming storm, there are signs that the luxury watch industry is about to experience the closest thing it has ever faced to an extinction level event. Only a few luxury watchmakers, including TAG Heuer and a handful of others, have bothered to even wake up and take in the lawn furniture. Switzerland is under the spell of a widespread illusion.
The upcoming storm is called utility, and Apple is at the front line of bringing it to the wrist. With Apple Watch, Jony Ive and company are looking to change the way we interact with technology, utilizing what some may say is the most efficient region of the body for a wearable device: the wrist. With proper line of sight and ergonomics, the wrist is arguably a better solution for a good portion of computing and communicating compared to carrying around 5-inch pieces of fragile glass in our hands and pockets.
The wrist's potential was discovered long ago as the modern day watch has been around for decades, yet we are now finding that the watch was only scratching the surface of what is possible for the wrist. Much of the luxury watchmakers' disregard for the upcoming utility storm relates to how the modern luxury watch industry has become complacent. Few watchmakers envision a world where consumers begin to look at the wrist as more than just a place for well-crafted jewelry made out of various alloys of precious metals and moving parts. Jewelry provides us a way to stand out from the crowd, be different, and show our personality, likes, and dislikes. Watchmakers are correct in assuming this type of emotion and feeling is hard to replace as price is largely removed from the equation entirely, leaving only the factors that Switzerland simply excels at: quality, care, timelessness, and prestige. The problem with this logic, however, begins to appear when considering that consumers desire only what they know. Today's wants and needs for the wrist are not good indicators for what will be in demand tomorrow. The world has never experienced personalized wearable computing.
The Apple Watch will likely change what consumers demand out of a device worn on a wrist. The convenience and ease of interacting with technology will just be too much to forgo, similar to how smartphones became the preferred phone over a device that merely handled voice calling. While nothing will change with the desire to stand out and represent one's personality to the world through objects worn on the wrist, the ability of those objects to not only monitor and record data, but simply help its wearer use technology will change the buying equation. Everyone will want utility on the wrist.
After initially dismissing Apple Watch as nothing more than a design student's class project, Jean-Claude Biver, President of the LVMH Watch Division and leader of TAG Heuer, has at least publicly shown concern that Apple may indeed be on to something with a device that puts utility on the wrist, although he continues to think the impact will be contained to the low-end, with ultra luxury watchmakers remaining relatively untouched. Swatch's co-inventor, Elmar Mock, who was responsible for positioning Swatch to address the Quartz Revolution in the 1970s, once again sees the sea change coming and describes it as nothing short of the most significant shift the watch industry has seen to date. The low-end of the watch market is worried, and rightfully so, but the ultra high-end continues to think that enough gold and craftsmanship will weather the storm.
Critics have said that luxury watchmakers have lost touch with their customers. In reality, luxury watchmakers have lost touch with themselves. Watchmakers stopped giving the wrist the imagination it deserved.
The transformation that the luxury watch industry will experience over the next few years will most likely occur much more quickly than people expect as desire can be a powerful motivator. Eventually, all watchmakers will be aware that the world has changed. By then, the first movers will have been relying on buzz and marketing to drum up support for mediocre products that may handle a few key tasks found in more complete utilitarian devices. The problem facing the luxury watch industry has been decades in the making: complacency and the illusion that the wrist would forever be a place for jewelry. The Apple Watch changes the equation by which quality will be judged. We will likely look back at this era with interest and intrigue, and wonder why luxury watch makers didn't see the upcoming storm approaching.
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Setting the Stage for Two Million Apple Watch Demos in Two Weeks
Apple's relatively nimble retail footprint will play a crucial role in selling Apple Watch. Mark Gurman over at 9to5Mac reported yesterday that Apple is planning on setting up Apple Watch demo areas where 10 customers can receive personalized 15-minute demos. I suspect a decent number of Apple Watch pre-orders will likely take advantage of Apple's offer, and get a demo/fitting, since choice and comfort are important watch elements. It is conceivable that over the two week preview period starting April 10th, including launch day, Apple will be able to give more than two million Apple Watch demos, which will not only help drive a successful product launch, but begin the process of explaining the device to hundreds of millions of customers.
The Apple Watch will launch in nine countries (a record for a new product category launch):
- US (265 Apple retail stores)
- UK (38 stores)
- Canada (29 stores)
- Australia (21 stores)
- China (18 stores)
- France (18 stores)
- Germany (14 stores)
- Japan (8 stores)
- Hong Kong (3 stores)
The only countries to have more than three Apple retail stores and not make the initial launch list are Spain, Italy, and Switzerland (no surprise there). It would seem obvious that Hong Kong's proximity to China was a much more important factor than store count. Therefore, the Apple Watch launch country list is essentially the top countries within the Apple retail network, reinforcing the idea that Apple is positioning the demo as key to selling the device.
Exhibit 1 takes a look at the number of Apple Watch demos that I estimate could be given at each Apple retail store per hour, starting at 40 for the typical small Apple store in a mall to over 150 for a hi-profile store. The various store types are based off of store footprint estimates from Gary Allen of ifostore. Gurman's report indicated each store will receive one Apple Watch demo table, with the ability to have more tables dependent on demand. I am assuming some medium/large Apple stores in mall and non-mall locations will indeed get additional demo units (reflected in the 1.5 Apple Watch demo table figure in Exhibit 1), while hi-profile stores get four tables to handle higher demand.
Exhibit 1: Theoretical Number of Apple Watch Demos by Store Type
Exhibit 2 takes the per store data from Exhibit 1 and expands it for the entire preview period across the retail footprint. It is conceivable that Apple will be able to give 22,000 Apple Watch demos per hour, leading to nearly 180,000 demos a day and over one million demos a week. Of course, school and work patterns during the week will likely result in Apple giving fewer demos than these totals, but the takeaway is Apple's built-in capacity for giving such a large number of demos. During the entire preview period from April 10th to April 24th, including launch day, Apple may be able to give upwards of two million Apple Watch demos.
Exhibit 2: Theoretical Number of Apple Watch Demos by Store Type During the Preview Period
Earlier this week, I established my Apple Watch sales expectations, including a 2.5 to 4.5 million unit sales estimate range for opening weekend. I feel more comfortable that Apple will be able to ship at least one to two million units for opening weekend as consumers will have had the opportunity to experience the watch during a demo and place an order. My estimate then assumes additional sales from in-store demos on launch day.
Many observers are underestimating the impact that a 15-minute demo will have on selling Apple Watch. Those interested in an Apple Watch will likely already own an iPhone and be familiar with the Apple ecosystem. The sales pitch will not look to answer "why Apple?" but instead focus on "here's what you can do with this watch." That message is difficult to get across in traditional advertising, so the ability to offer an in-store demo and control the entire sales message, will go a long way in selling Apple Watch to these early adopters.
The importance of a demo and the broader sales environment can also be seen from the way Apple Watch is displayed in stores compared to that of an Android Wear smartwatch (shown below). Apple's "glass-topped Apple Watch display cabinet, accessible to staff from below, via a descending, motorized flap, like the ramp at the rear of a cargo plane," as Ian Parker described it in his Jony Ive profile published last month, helps to build an experience around the device that will go a long way in nurturing desire. Simply opening retail stores is only the beginning in being able to create the right kind of atmosphere that is conducive to brand building and strong sales on a square footage basis.
Apple retail was one of the key reasons that the iPad became a phenomenon. Once customers held the device, and were able to experience software that allowed the hardware to melt away, the sale was made. I have a feeling the same will occur with Apple Watch as the demo will go a long way in turning interest and curiosity into a sale.
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Apple Watch Sales Estimates (Video)
With an aggressive nine country launch into a user base of more than 400 million iPhone owners, the Apple Watch will likely represent the largest new product category launch, according to sales, in Apple's 38-year history.
Apple Watch topics discussed in this video include: opening weekend sales, 2015 and 2016 sales outlook, ASP and sales mix, and the overall impact on Apple revenue and EPS.
The full report can be found here.
Apple's Plan to Rethink Television
Television is broken. The era of smartphones and tablets continues to alter the way we consume and interact with video content. While video watching was once a sedentary behavior with little in the way of third-party distraction, video is now increasingly consumed throughout the day across multiple screens. Yesterday, the WSJ reported that Apple is looking to launch a service that repackages a certain amount of television channel programming into a more appropriate form for the mobile era. Apple has likely earned the benefit of the doubt that such a service would be worth people's time and money. However, ultimate success with rethinking television will be dependent on ignoring the mirage of simply getting television content broken out into more granular form sent over the internet. Apple will likely head in a new direction where all video creation is embraced and distributed through curation and personalization.
The primary issue concerning television isn't that there is too much content being delivered to our homes. Instead, televisions's fundamental problem is that it doesn't include the wide variety of new content born out of mobile. While our smartphones may have changed the way we consume content, the ability to record and capture almost anything in the world with little in the way of time or money commitment has changed the way content is created. Channel surfing on a large screen television has been replaced by YouTube surfing on a computer or smartphone as well as consuming video content from shared links on Twitter and Facebook. Short video clips, which at first seemed more like a gimmick, are increasingly containing more in the way of news and information than many would never have imagined. "I saw it on Vine" is increasingly becoming a more common phrase than "I saw it on CNN." Such a shift in content consumption and creation from many of the "old" players to a new breed of content companies reinforces the need for Apple (and any competing service interested in rethinking video) to start anew and build a service that combines both the old and new content creators. The strategy would be strengthened by the concepts of mobile, decentralization, and differentiation.
Source: Above Avalon
A truly revolutionary video streaming service would include all video content, relying on curation and personalization to deliver an engaging user experience.
It is reported that Apple's Plan A for rethinking television was to take a page from the iPhone playbook and work with a key partner, in this case, Comcast. In such a scenario, there would be room for both parties to win as consumers ultimately pay more for a better product. However, due to continuing setbacks and roadblocks, Apple may indeed be looking now at Plan B, a more hostile plan involving TV programmers including ABC, CBS and Fox. It is not hard to see Apple's ultimate goal to create a service that includes various "channels," or maybe a better word would be "video lengths," that provides easy access to different video content mediums. Getting the "old" players involved would be the first step on a long journey. All of this may indeed be too utopian as various parties may not want to go down the iTunes/music industry path where Apple holds too much control.
Apple's rumored scaled back TV network bundle would reportedly cost $30-$40 a month. Add this cost to Netflix's or Hulu Plus's monthly rate and a user's monthly bill is once again approaching $50 a month for what essentially comes down to traditional cable, repackaged. A whole other side of the video equation is still missing: the new players. While apps on an Apple TV may suffice for some, a suboptimal user interface and the much bigger implication on video consumption behavior stand out as barriers that would need to be overcome. Unsurprisingly, cable companies aren't as clueless as many think and are in a great position to begin increasing internet-only prices following a customer's awkward "I no longer want to pay for cable" call to customer service. In addition, companies such as Netflix and Amazon are using video content as bargaining tools to enrich their own platforms and sales pitch to consumers in an ultimate desire to buy relevancy in people's lives, no matter how small the window (or screen) may be. Walled gardens built around established social networks don't scream ease of use and interconnectivity either.
In a perfect world, I would use a streaming video content service that has had some element of curation applied, resulting in a completely new experience that would be the linchpin of dropping my cable plan. Add elements of search, discovery, and social media and this hypothetical video service would combine elements of yesterday in the form of push content such as live sports, news, and tentpole events like the Oscars and in addition have the ability to pull content from vast libraries, similar to what can be found on Hulu. Some type of classification and delivery system based on video length and subject matter represents interesting possibilities for how a smartphone user can consume a wide selection of video content. Apple's role in such a product would be to serve as a gatekeeper, providing differentiation through curation and discoverability. If this sounds similar to the music streaming strategy Apple will likely utilize, it is because they both would rely on the same themes of providing a better user experience through the way content is consumed by the end user. The entire iOS ecosystem is involved in taking advantage of streaming content services.
The most challenging barrier to overcome before seeing this new video era is related to business and economics. Combining content built on a very specific method of revenue (fees and advertisements) with new era content that may not have set parameters around monetization makes it that much more difficult to truly combine everything into a easy, digestible format. Not to mention, the sheer number of licenses and rights that would need to be obtained would make the weak of heart feel overwhelmed. Add in complexities of international expansion, and bringing services like Apple Pay to additional countries would look like a walk in the park.
An Apple streaming video service would do more to increase the value obtained from iOS devices that truly represent mobile, including iPhone and Apple Watch.
What may have initially been considered another leg on the stool, rethinking television for Apple is increasingly looking more like a much broader video service with the goal of increasing the value of the Apple ecosystem, similar to Apple Pay and Apple's upcoming music streaming service. By building additional functionality and usage into the ecosystem, Apple is continuing to go down the path of addressing key elements of our life that can be controlled, or improved, by iOS devices.
While there is no doubt that Apple has various sizes of glass in the labs, including large screens bigger than an iMac, the value from a video service may inherently be found in smaller screens and devices, including iPhone and Apple Watch. To truly rethink television, Apple needs to address the much harder task of figuring out the best way to consume content born from the modern day video renaissance.
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Establishing Apple Watch Sales Estimates: Expecting a Big Launch
With an aggressive nine country launch into a user base of more than 400 million iPhone owners, the Apple Watch will likely represent the largest new product category launch, according to sales, in Apple's 38-year history. Given my opening weekend sales expectations, the Apple Watch launch may be upwards of 12x as large as the iPad launch. I am establishing calendar year 2015 and 2016 Apple Watch unit sales estimates of 19 and 33 million, respectively.
Apple Watch is a different kind of product for Apple with 30 unique watch models curated into two collections, not including eight Edition models that will have a limited release. While I would still expect initial sales to be constrained by supply, the somewhat wide launch window (Australia, Canada, China, France, Germany, Hong Kong, Japan, the UK, and the US) suggests Apple is confident in an opening weekend unit sales number that is at least 2 million, but not likely more than 5 million. Exhibit 1 compares Apple's previous new product category launches. The Apple Watch's nine country launch stands out as an outlier.
Exhibit 1: Apple's Recent New Product Category Launches
Opening Weekend Sales
I am establishing a 3.5 million opening weekend sales estimate based primary on the list of launch countries and what I consider to be a realistic amount of available supply. It remains to be seen what supply will look like on launch day at Apple retail stores for those who don't preorder online. I expect many to take advantage of Apple's preview window to try out their watch selection after pre-ordering the device. Exhibit 2 highlights my expectation range for opening weekend sales with a wider expectation range of between 2.5 and 4.5 million units.
Exhibit 2: Above Avalon Estimate for Apple Watch Opening Weekend Sales (millions of units)
It is important to note that Apple may not release Watch unit sales numbers related to opening weekend or quarterly results. Management had indicated that Watch revenue would be combined with "Other Products" for reporting purposes, which includes Beats headphones and speakers, iPod sales, Apple TV, and peripherals and accessories for iPhone, iPad, Mac and iPod. There may still be a possibility that Apple discloses overall unit sales numbers if they are strong.
Unit Sales Estimates
Back in November 2014, I published my initial estimates for Apple Watch sales. Since then, I have not discovered any new information that significantly altered my view. Exhibit 3 contains my Apple Watch unit sales estimates for 2015 and 2016. It is important to note there are a number of different holding periods discussed in the press related to Apple, primarily calendar year (CY) and fiscal year (FY). Apple reports earnings according to its fiscal year.
Exhibit 3: Above Avalon Estimate for Apple Watch Unit Sales
Watch production will likely represent the biggest bottleneck for stronger initial sales. Since the Apple Watch will launch in nine countries, it would seem that Apple is confident supply would at least be large enough to support such a wide release for a first generation product. Within the nine launch countries, Apple's retail network will play a crucial role as hands-on demonstrations and previewing may be desired by a sizable portion of potential buyers. I assume the gradual rollout to other countries will take months, with the product likely to reach an iPhone-like distribution sometime in 2016.
With a target market of approximately 400 million iPhone users, I continue to view initial Apple Watch demand will be determined by a consumer's interest and passion with Apple products. Those individuals who have a long history of owning Apple products, and are interested in having the latest and greatest, will likely be first in line, while individuals who may be new to iOS and likely just getting use to their iPhone may not even consider buying an Apple Watch in the first few years. My previous note on Apple Watch sales estimate suggested that 15% of the iPhone user base (approximately 60 million) represents early adopters, the ones likely to buy the product early in the life cycle. With that in mind, 28 million unit sales during the first 12 months on the market would seem relatively plausible.
As shown in Exhibit 4, I am establishing a sales mix estimate that favors the Sport collection over the Watch collection. I relied on a combination of an opt-in Twitter survey that I conducted with early adopters, adjusted to reflect non-English speaking countries and more mainstream buyers.
Exhibit 4: Above Avalon Estimate for Apple Watch Unit Sales Mix for 2015 and 2016 (CY)
Average Selling Price (ASP) Estimates
Taking into account the sales mix, as well preferred watch face sizes and styles, Exhibit 5 highlights my estimate for Apple Watch ASP. Band revenue represents approximately 5% of Apple Watch Sport collection, while I would expect bands to represent a larger portion of Watch collection sales (8%).
Exhibit 5: Above Avalon Estimate for Apple Watch ASP
Revenue, Operating Income and EPS Estimates
Combining unit sales estimate with ASP, Apple Watch has the potential to bring in $8 billion of revenue in fiscal year 2015, which would be around 3% of Apple's total revenue. In 2016, Apple Watch has the potential of representing close to 7% of Apple's revenue. In terms of EPS, Apple Watch may represent up to $0.44/share for 2015, increasing to $1.13/share (12% of total EPS) in 2016. While the iPhone's popularity overshadows many of these strong Apple Watch estimates, one aspect to keep in mind is the Apple Watch would likely represent the second biggest product in terms of revenue and profit momentum. The iPad and Mac show no signs of similar levels of growth monetum.
Exhibit 6: Above Avalon Estimate for Apple Watch Financials (FY)
Going forward, I would label Apple Watch and iPhone as the two priorities at Apple in terms of products with both sales and structural (mobile and wearables) momentum. The ingredients are in place for a strong Apple Watch launch.
This report was produced by Neil Cybart on March 16, 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.
The MacBook Paradox
The new MacBook is quintessentially Apple. Everything from the reimagined keyboard and butterfly mechanism to the new Force Touch trackpad and reconfigured battery, the new MacBook represents Apple at its finest. Years of hardware engineering culminating in a product that literally pushes the definition of the product category it has resided in for close to a decade.
However, despite representing classic Apple, the new MacBook is inconsequential to Apple's bottom line. Even in a best case scenario, the new MacBook would struggle reaching 5% of Apple's operating income. As more portable (and cheaper) alternatives, mainly in the form of iPhone, continue to replace the need for laptops and desktops, the Mac's overall influence will continue to decline.
A paradox is formed as this product that best represents Apple (even down to the way it is introduced to the public by Phil Schiller), is increasingly playing a smaller role in Apple's future. This paradox represents one of Apple's long-term risks. If Apple is faced with supporting a growing list of still-loved, but increasingly inconsequential, legacy products, will Apple be able to completely focus on the future? The iPod turned out to be a blessing in disguise as the product line ran its natural course, peaking in 2009 and then steadily declining to an asterisk on the income statement. In the future, Apple may not be so lucky, and instead have legacy products with a much longer life cycle where sales remain too high to completely ignore, but too low to move the financial needle.
In the near-term, this risk appears to be dormant. Apple is able to effectively focus on a narrow product lineup that still fits on one of Jony's infamous design studio tables. We will continue to see innovations with the Mac and iPad, while the iPhone and Apple Watch become a bigger piece of Apple's future plans. Tim Cook and company constantly talk about being paranoid about competition. I suspect this MacBook paradox also registers with management as something to keep them up at night. The fear is that one day Apple may unknowingly find itself chained to the past, unable to completely focus on the future for too many resources are being spent maintaining products from yesterday.
There are signs that Apple is aware of, and taking steps to alleviate, this risk. Management's claim that they don't think about money when creating products is exemplified by not only the new MacBook, but also the low-margin iPad mini and the lack of a large screen iPhone until 2014. By simply focusing on making, and shipping, great products, the impact a product may have on the bottom line does not represent the main driver behind management's decisions.
One of Apple's secrets has been doing very little in order to put all of its attention and resources on a few, big things. For that to continue, Apple may need to make the tough decision to stop updating product lines earlier than would otherwise be the case. Apple may continue to be lucky and have products follow the iPhone/iPod path, where new products cannibalize old products in an orderly fashion. Navigating the MacBook paradox may one day represent a tough task for Apple, but with challenges come opportunities, and in the near-term, management will marvel at the new MacBook for a few days before moving on to the next big thing.
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Marketing Implications from BuzzFeed's Apple Watch Demo Video
It is no secret that tech gadget review trends have changed over the years. What was once ruled by articles filled with jargon and specs are now led by videos that contain first impressions and interesting commentary. BuzzFeed sent two reporters to the Apple Watch event. Their demo video, which was light on detail, but heavy on emotion, was published yesterday. Unsurprisingly, many people are not happy with the video.
The official iTunes Twitter account retweeted the video to its 7 million followers. BuzzFeed did the same to its 2 million followers. The video has around 750,000 views on YouTube, so no where near viral material, but starting to reach some mainstream circles.
The BuzzFeed video talked about things that most people will think about when determining if Apple Watch is something worth buying. The two reporters discussed potential use cases in their daily lives where the watch would come in handy. There was no mention of the Digital Crown (which Apple also didn't discuss on Monday), screen specs, memory, pricing, or even the fact that the watch requires an iPhone. Instead, the video showed two Apple Watch users saying things like:
- "Already this feels amazing."
- "[Apple Watch] changes the game for messaging I think...and it's right on my wrist. That's so easy. I love that."
- "It feels very classy. It's almost kind of like vintage like old Hollywood feeling. Kind of feel like a movie start mixed with an astronaut."
- "I like that when you turn [your wrist], the face comes up."
- "I think it's going to change the way we talk to each other."
After watching the BuzzFeed demo, the viewer would understand that Apple Watch is a product that is clearly different than just an iPhone on your wrist, with many different features. Interestingly, that is the exact message Apple was going after. Accordingly, some people weren't too happy with the BuzzFeed demo and started to question its authenticity.
AdAge asked Apple about the BuzzFeed video and whether it was a paid advertisement (it wasn't), and then goes into a discussion on how Apple never did something like this under Steve Jobs. Yes, they actually said that. Joshua Topolsky, a media editor at Bloomberg, was not pleased with the video, publicly calling the whole ordeal "embarrassing". The YouTube comment section for the BuzzFeed video was filled with negative reaction asking if the video was some kind of marketing job from Apple. People are still uncomfortable with where tech gadget reviews are headed.
The goal in product reviews is to recognize that viewers have an endless amount of information and resources at their disposal and are merely looking for things that can't be learned from visiting websites, namely emotion and real-world experiences. Giving viewers that in a well-edited video, filled with personality, like what BuzzFeed did, will be popular going forward. For additional evidence, look at all of the people Meerkating in the Apple demo event. The primary point in doing that was to connect with viewers and give an inside look at the room and some initial early impressions of the products. I doubt a livestream where someone is just running off spec after spec would be as interesting to watch as someone casually chatting away about how the Apple Watch may fit in their life, and just happening to let 100 people look on over Meerkat.
The Verge's Apple Watch demo video (200,000 views on YouTube) was obviously different than BuzzFeed's video because The Verge has a different reader base, with specific needs and values.
The contrast between the BuzzFeed and The Verge demo videos are noteworthy, demonstrating the much bigger trend in technology: personalization. While there is still demand for videos that go into a gadget's specs, the momentum is clearly found with videos that simply discuss the emotion behind the product and if it is something worth people's time to learn more about. Gadgets are becoming extensions of ourselves and that is only intensified with wearables. While some may be interested in the assumptions included in stated battery life claims, many more will be mesmerized by an animated Mickey Mouse watch face.
Incidentally, Apple has been placing emotion ahead of tech specs in its marketing campaigns for a long time. We saw this once again at Monday's keynote where the takeaway message was to drum up interest in the Watch and not focus on specifications or even how the Digital Crown works. This makes the Apple online store that much more important as a source of information, in addition to brick-and-mortar retail establishments. Taking a look at Apple's recent retail hires, it would seem that Apple is betting its retail arm will become more crucial to the overall business as time goes on. Apple is also introducing a new type of watch preview system at its retail stores where the goal is to educate customers on Apple Watch.
Tech sites will have a very difficult time adopting a model where emotion is the primary focus of their gadget reviews. If The Verge tried to do an Apple Watch demo like BuzzFeed, their users would rise up in revolt and the reviewer would probably be dismissed (or told to correct the video).
Tech reviewers like Marques Brownlee, who is already somewhat of a YouTube sensation with 2.3 million subscribers, are resonating with viewers because they represent the hybrid between The Verge and BuzzFeed (while also being purely video based). Brownlee's high-quality videos are concise, filled with relevant information and personality. I suspect a good portion of Brownlee's viewers are also tech site readers. Apple's "Spring forward" keynote was Brownlee's first Apple event. His MacBook video demo from the Apple event has 650,000 views on YouTube in one day.
As technology becomes more personal, emotion will need to play a bigger role in explaining how a particular device can fit into someone's life. While some felt uncomfortable with the BuzzFeed video and its lack of detail, there are many others that genuinely got something out of it and will now take time to research the product. The gadget review continues to evolve and personalized gadgets like Apple Watch are only accelerating the process.
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The New Apple: Embracing Personalized Technology with a Luxury Twist
While it may seem like we have everything figured out about mobile with the iPhone form factor now cemented in our daily lives, in reality, we are in the early stages of the current mobile renaissance. Consumers are still trying to figure out what sizes of glass should be carried in our pockets or worn on our bodies. Despite all of these changes, there is one theme that has remained unwavering: technology is becoming more personalized. With Apple Watch, Apple is placing a big bet that a device for the wrist is the next progression of personalized technology, which inherently adds an element of luxury and fashion to the mix. Yesterday's Apple Watch keynote wasn't perfect, but management took the opportunity to tweak its marketing message a bit with the goal of positioning the Apple Watch as the newest, most personal device in the iOS product portfolio. The Apple Watch has the potential to be positioned as the primary interface for mobile computing.
Unchartered Territory
If there was one moment of the Apple's "Spring forward" keynote that should stand out it occurred at the 52-minute mark. Up to that point, the presentation was classic Apple. After a little bit of Apple TV news, Jeff Williams introduced a new health research platform that came across as something only Apple would be able to do, and Phil Schiller was up on stage, gleefully explaining why the new MacBook was the best Mac ever imagined. For the first 52 minutes of the event, Apple was at its best, and it showed. When the discussion turned to Apple Watch, Tim Cook and Kevin Lynch spent the next 42 minutes talking about all of the things Apple Watch can do, but the presentation lacked the same level of cohesiveness that was found in the beginning slides. Cook awkwardly worked through the Christy Turlington Burns storyline, which gave off a bad late-night TV talk show vibe. One could sense that the Apple Watch and all of the inherent fashion and luxury surrounding the product is new territory for Apple, and it may very well be more of a "learn as you go" mantra when it comes time to explain the device to the world.
Less Details, More Insight
A prime example of Apple still playing around with how Apple Watch should be marketed was how Apple chose to bypass any mention of the Digital Crown. Back in September, Tim Cook literally introduced the Apple Watch to the world as a device dependent on a breakthough user interface based around the Digital Crown. The Apple Watch borrowed much heritage from a classic watch crown but altered its functionality to essentially be the "pinch and zoom" of the Apple Watch. Jony Ive was quoted in the press about all of the painstaking effort put into coming up with the Digital Crown. Yesterday, the only reference to the Digital Crown was said in passing by Kevin Lynch who mentioned "crown" a few random times during his demo. Such a change in marketing didn't quite stop there as Apple seemingly avoided discussing much of the mechanism dealing with Apple Watch buttons, menus, and swipes. There was also little to no discussion around the device specifications, similar to what Phil Schiller had just finished doing with the MacBook. The Watch is different, and Apple treated it accordingly.
Not coincidentally, reviewers' initial thoughts about the device after 15 minutes of demo time seem to center around the watch feeling a bit complicated to use. There may be a learning curve involved with Apple Watch, and management decided to spend less time talking about those details and more time talking up apps and things that would increase someone's interest in the device. The strategy would seemingly involve Apple Retail to help get people comfortable with the new user interface. Apple did announce there will be an opportunity to preview Apple Watch at Apple Retail stores, which will likely involve a quick overview of the device. We have experienced very few breakthrough user interfaces since the mouse, so maybe our sense of perspective and expectations for ease of use is a bit skewed by the sheer intuitiveness of multi-touch?
Bringing iOS to the Wrist
Some criticism that was thrown towards Apple after the first Apple Watch event in September was that there wasn't a clear reason given for why someone should buy an Apple Watch. Even after yesterday's keynote, there likely were many disappointed pundits awaiting Apple's clear bullet by bullet list for why the Apple Watch is worthy of someone's wrist. In reality, however, Apple explained in not so clear language why Apple Watch makes sense: it brings technology much closer to the user. Similar to the way the iPhone and iPad seemed magical next to laptops and desktops, having a device that is on the wrist, a location with superior line of sight and proximity to the face, may bring new ways of using technology.
Apple could have explained the device a bit better in context of the full product lineup, as shown below. If one was to go back to Apple's previous keynotes, Tim Cook eloquently explained the following slide that was in yesterday's presentation.
Exhibit 1: Apple's Current Primary Product Lineup
Instead of relying on antiquated consumer/professional product matrixes, Apple's product strategy can be described by a personalization analysis, included in Exhibit 2. It is clear where the Watch fits into the mix.
Exhibit 2: Apple Personalization Product Analysis
In terms of selling the Apple Watch to consumers, Apple, as expected, relied on a soft sell approach by merely listing various apps that I would suspect were heavily favored and used by Apple employees that got to test the device over the past few months. While some may have poked fun at the thought of using Instagram on a watch, one would hope Apple obtained valuable input from employees indicating photos on a wrist had some intriguing value to them.
The overarching theme of Kevin Lynch's Apple Watch demo was about iPhone substitution. While many of the Watch app demos fell a bit flat due to the personalized nature of both the app and the device, a close listen to Kevin Lynch's dialogue would be very revealing. If audience members closed their eyes, it would have sounded like Lynch was talking about a new iPhone. Not only did he discuss things that were known to be watch-focus activities, like notifications and messaging, but nearly every app discussed was a popular app on iPhone. Lynch made his ultimate rationale for owning an Apple Watch clear when he said he would want to leave the phone by the door and just use the watch around the house. I suspect there are very few people who really think of Apple Watch as this versatile.
Personalization Allows Luxury
As personalization permeates through mobile technology, one of the more interesting consequences is how luxury is inherently intertwined in the discussion. Since Apple Watch is a device meant to be worn, Apple was correct in assuming people would want the device to represent their personalities and styles. Apple is selling Apple Watch to everyone from high school students to senior executives with a keen fashion sense (although some still seem opposed to Apple's fashion sense). As the level of exclusivity increases, an item is able to display more characteristics of luxury, as shown in Exhibit 3. Moving along the independent axis, supply begins to decline, an often necessary ingredient in luxury markets. Compare a flagship iPhone model that ships hundreds of millions of units per year to a personalized Apple Watch Edition with limited supply. The iPhone will simply not contain the same potential as the Apple Watch to be regarded as a luxury item. Critics would point out that there is plenty of emotion that enters the equation when analyzing and referring to something as luxury. Nevertheless, the general idea behind Exhibit 3 still stands.
Exhibit 3: Exclusivity vs. Luxury
The interesting aspect of Apple embracing luxury is that Apple inherently has the ability to add even more personalization in the form of software, but it may be best to assume the luxury markets treat that with some level of doubt. While the first version of Apple Watch may not push the boundaries of what is possible with customized technology, future reiterations, including various other devices, would certainly beg the question of what the limit is to Apple's luxury motives. Exhibit 4 shows the various Watch collections graphed according to price. It is easy to see that at least on paper, Apple is relying on scarcity ("exclusivity" sounds better for marketing) in order to drive prices higher.
Exhibit 4: Apple Watch Prices by Collection
Threading the Luxury Needle
One of Apple's primary goals yesterday was to transition to a premium mass-market luxury brand. Even though Apple has mastered the art of selling mass-market goods at premium prices, catering to a luxury clientele comes with new risks, including alienating core users who may be turned off by management's focus on the high-end at the detriment of the "low-end." Apple handled the transition well by offering clear distinctions between the three tiers (aluminum for Sport, stainless-steel for Watch, and 18K gold for Edition). Tim Cook's presentation of the Edition pricing (no stated pricing on a slide and no video depicting the gold) suggested there will be a very clear difference, or segmentation, between how the Edition is sold compared to the other two tiers. There will likely be very few instances of $349 Apple Watch Sports being sold next to $17,000 Apple Watch Editions.
Pricing Looks Right; Sales Potential Remains Elevated
Apple is selling the Sport and Watch collections for a reasonably fair price with premium mass-market in mind. The Edition pricing reflects not only the 18k gold but also artificial scarcity with limited production. The initial target market for Apple Watch is approximately 400 million iPhone users. If one were to simply look at iPhone 6 and 6 Plus users as a closer barometer of likely Apple Watch purchasers, the market is now greater than 100 million users. It is important to remember that many consumers do not buy the first version of a product for a multitude of reasons. Therefore, most people will not buy Apple Watch in 2015, or even 2016. With that in mind, I still feel confident in my estimate of 17 million units sold in 2015 with another 35 million units sold in 2016. If looking at sales in terms of months of market, for the first 12 months on the market, Apple will likely sell around 25 million Apple Watches. Beyond 24 months, sales may be a bit more difficult to forecast as it is unclear what the Watch upgrade cycle looks like. Apple has indicated the battery can be swapped out, and some of Jony's recent comments would suggest there may be a scenario where the watch face doesn't change much from year to year.
Expanding the Personal Experience
The primary takeaway from Apple's keynote yesterday was that the iOS product family is expanding as a watch takes up the spot of the most personal device Apple has ever made. The watch holds the potential of becoming the primary input for mobile computing, serving as the assistant that people thought Siri on iPhone was going to become. Meanwhile, the iPhone's relevancy doesn't necessary decline in an Apple Watch-focused world. Instead, the iPhone continues to gain power and capabilities from both the iPad and Mac. The Apple Watch has the potential to overpower iPad in terms of popularity and usage. The device's upgradability is the primary unknown as to whether unit sales will indeed surpass the iPad. However, odds look to be in the watch's favor.
Apple's main selling strategy is to get consumers into an Apple retail store and in front of a watch. It is somewhat similar to the way the iPad took off once people played with one. The obvious difference is that it is much harder to "play" with an Apple Watch in an Apple retail store, and it will likely require an appointment.
Apple is coming up with various devices that each serve a different function, letting the user interact with technology in a few unique ways. Going forward, I suspect the iPhone and Apple Watch will garner the most attention while the Mac is positioned as a product for higher power computing needs. By entering into wearables, Apple is getting its first taste of personalized technology built around accessories (bands) and luxury. The key question going forward is what will Apple learn from this process (both in terms of manufacturing and sales) that can be applied to future Apple Watch editions as well as other wearables? For Apple, the Watch is one way to play a much more significant role in an iPhone user's life.
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Apple Won't Look the Same after Monday's Apple Watch Keynote
The Apple Watch represents the biggest product bet Apple has placed since the iPhone in 2007. Apple will never be the same kind of company once Apple Watch pricing is revealed on Monday. Management's primary focus during Monday's "Spring forward" Apple Watch event will be showing how a premium mass-market technology brand can embrace luxury without alienating a portion of its customer base. On one hand, Apple Watch is a device that seemingly no one asked for, but on the other hand, it is a device that holds enough potential to reshape the mobile landscape by altering the way consumers use iPhones.
Goals for Monday's Keynote
Reposition Apple as a premium mass-market luxury brand. Apple is currently a premium mass-market brand, selling gadgets to addressable markets that number in the hundreds of millions. With Apple Watch, Apple is entering new territory, embracing luxury and the required scarcity of supply that comes with a luxury label. Such scarcity at the high-end is obtained by controlling the demand side of the equation through high prices. Apple Watch Edition collection prices will likely shock those observers who aren't aware of Apple's motivation to become more like a luxury brand. At the same time, Apple is holding on to its premium mass-market heritage by selling Apple Watch Sport at a $349 starting price.
As confirmed in The New Yorker Jony Ive profile, Apple's decision to embrace luxury is deliberate and likely taken in recognition that to be successful in the wearable space, a new strategy would be required. Consumers need to feel connected to a wearable accessory as the device becomes an extension of their personality. Apple's new premium mass-market luxury brand will also help drive subsequent demand for new product categories that position fashion and emotion as key buying determinants, with materials utilized as differentiation between luxury items and premium mass-market goods.
Apple will need to frame this branding message a bit before revealing Apple Watch pricing in order to clearly demonstrate that Apple Watch is targeting everyone from high school students to senior executives with three distinct watch collections, and not just luxury items with low-end counterparts.
Explain Apple Watch. Apple will likely demonstrate through app demos and talking points why the Apple Watch exists: to shift some utility from the iPhone to the wrist. Management can also discuss stand-alone features such as health tracking. There is some risk involved here. Talk up the device functionally too much, and the iPhone upgrade cycle may be put at risk as consumers hold on to iPhones for longer and instead buy new Apple Watches. Talk down the device, and consumers will choose to bypass it altogether. The ability to market Apple Watch in context of the entire Apple ecosystem is a powerful variable that literally no other company can copy, and I would expect Apple to reiterate that. In many ways, some of Apple Watch's features may need to be demonstrated not so much to sell Apple Watch, but to sell the Apple Watch plus iPhone combination.
Soft sell the Apple Watch. Apple has consistently used timekeeping, communication, and health & fitness as Apple Watch marketing tent-poles. If one is expecting Apple to drastically change from this strategy when it positions Apple Watch to the public on Monday, there may be some disappointment. Apple spent only 12 minutes demoing Apple Watch last September. On Monday, there will undoubtedly be much more time to demo various apps, including possible in-house apps or features that Apple kept under wraps.
Contrary to consensus opinion, Apple will rely on soft sell messaging where the overall message is that Apple Watch is a personalized device capable of doing various tasks. Relying on a strategy similar to the way iPhone and iPad were sold may fall flat for a luxury item. Instead, Apple needs to rely on the device itself, including its look and design, to spark interest. The hardest part will be getting consumers interested in the device. Once that relationship is established, Apple can rely on its retail infrastructure to turn interest into a sale, and then that's where Apple's marketing message comes into play.
Questions
What will be the price range for the Watch collection? Edition collection pricing will be established with scarcity in mind. Watch collection pricing will determine how big of a seller the mid-tier option will be when compared to the Sport collection. If Watch collection is priced near $500, it may be tough to forecast which will sell more: Watch or Sport. However, if Watch collection is priced above $1000, the Sport collection will be the primary beneficiary from a unit sales perspective.
Will there be new watch bands? While most of the attention has been given to the various watch faces, the bands may be the bigger story of the day. Details ranging from price to availability will help determine how versatile Apple Watch can be and how much fashion enters the buying decision. Is there a possibility Apple will unveil new ultra-luxury bands priced well over $10,000?
What will the Apple Watch rollout look like? Reading in between the lines, it would seem that the Apple Watch rollout will be more measured than previous product launches that we are used to. The going assumption will be that the U.S. will get the device at launch. Tim Cook mentioned Germany will see the device in April, which implies that there will at least be a handful of countries receiving the device within the launch month.
The Apple Watch is a big deal for Apple. Not only does the device represent a new product category, but success will be dependent on behavioral change related to iPhone usage. Wrist real estate is in precious demand, and I continue to see an upcoming battle for ultimate wrist supremacy. Apple's strategy will be to mask additional utility with fashion and design. Luxury presents a number of opportunities, and challenges, for Apple. As recent executive hires have shown, Apple is ready for the challenge. Apple will never look the same after Monday.
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Tackling AAPL's $1 Trillion Question
Apple currently has a $750 billion market capitalization ($612 billion enterprise value). There are two factors that will determine whether Apple will reach a $1 trillion market cap: future financial performance and investor's willingness to pay for that performance.
Future Financial Performance
Apple's cash flow and earnings provide the best view on Apple's ability to sell products. Fortunately for investors, both data points are relatively straightforward with little in the way of required adjustments. Apple has $12 billion of deferred revenue on its balance sheet related to the way software is accounted for, but the overall impact to the bottom line won't change any conclusions found in this post. Carl Icahn raised issues concerning non-cash tax accruals, which have roughly a 10% impact on Apple EPS, but it remains to be seen if such an adjustment is completely warranted. Similar to the deferred revenue, I don't see the adjustment being a factor in the $1 trillion debate.
Apple reported $44.5 billion of net income ($7.42 EPS ) in CY2014. The degree to which Wall Street forecasts future earnings depends on the industry being analyzed. For financial companies, certain financial metrics are typically forecasted three to four years out, while for a company like Apple, estimating beyond two years is a stretch. Investors understand the volatility inherent in consumer technology companies and estimates, especially looking out beyond two years. For CY2015, I am expecting Apple to report $55.8 billion of net income ($9.95 EPS), implying 25% net income growth and 34% EPS growth due to the impact from share buyback. Potential earnings from unannounced Apple products are typically not included in forward estimates. Even though Apple will ship new product categories in the future, most investors are not willing to give credit for that potential EPS boost until more specific information is known.
Investor's Willingness to Pay For Performance
The much harder part in forecasting Apple's future value is related to gauging investor sentiment about Apple's future. Apple's price-to-earnings (P/E) ratio is the primary metric used to value Apple, with price-to-cash flow (P/CF) ratio serving as a secondary measure. Both ratios serve as a representation of how much an investor is willing to pay for a dollar of earnings. As an example, a P/E of 10x would indicate that investors are willing to pay ten times the amount of earnings in order to own a piece of the company and that future earnings stream. The P/E multiple mostly reflects growth expectations. If a company is expected to report strong earnings growth, a higher P/E multiple may be warranted. A P/E of 75x would indicate investors are willing to pay much more for a dollar of earnings because those earnings are expected to experience above average growth. Accordingly, companies with more mature growth have historically had difficulty achieving a P/E above the market average of around 20x.
With AAPL trading around $130/share, Apple has a 17.5x trailing twelve month P/E ratio, which is a bit lower than the overall market. I'm not a fan of trailing P/E ratios because the future is more important than the past. In addition, the current stock price already reflects future growth, so trailing P/E ratios are a lagging indicator (i.e. they don't provide much value). With the stock trading at $130/share, Apple has a 13.1x forward P/E ratio, which is a discount to the average 16x P/E for large cap tech stocks.
Requirements for $1 Trillion
Apple could reach $1 trillion ($171.50/share given current shares outstanding) in two ways:
A) Higher P/E multiple. Apple shares would increase in price if investors are willing to value the company using a higher P/E multiple. Currently Apple has a 12.9x forward multiple. How much higher would the multiple need to increase for Apple to be valued at $1 trillion assuming earnings remain unchanged? Investors would need to pay a 17.2x forward P/E multiple, which is 33% higher than the current 12.9x multiple. Why would an investor be willing to use a 33% higher P/E multiple to value Apple's expected future earnings stream? Two of the more likely reasons include an overall stronger equity market where the overall tide rises as investors rush into equities, and increased confidence in Apple's products and outlook.
B) Stronger earnings growth. If we assume the forward P/E multiple remains unchanged at 12.9x, then Apple would need to grow earnings by another 32% to reach $1 trillion. Assuming Apple grows earnings by approximately 15% annually over the next 2-3 years, Apple would be valued at $1 trillion sometime in 2017. I have doubts it will ultimately play out this way though as I have difficulty seeing the P/E multiple remaining unchanged for the next three years. Investors will likely change their opinion on Apple at some point over the next three years, either becoming more positive or negative.
Easiest Path to $1 Trillion
Apple can reach $1 trillion if investors become 33% more optimistic (using P/E multiple as a proxy) about Apple's future or if Apple is able to grow earnings by 32%. I think Apple's best chance of reaching $1 trillion will be a mixture of the two: higher-than-expected earnings growth and a higher P/E multiple as investors show renewed confidence in Apple as an ecosystem with annuity-like features (a stream of device and services revenue).
With shares trading at $128, investors are relying on certain expectations for Apple, including iPhone and Apple Watch sales, to value the company. Since the iPhone accounts for over 70% of Apple's operating income, any significant change in sales expectations going forward will play a large role in the way investors value Apple. Last week, I detailed an achievable strategy for Apple to grow annual iPhone unit sales by 50% within three years. Is this type of growth reflected in the stock price at current valuations? The question will depend on how many investors believe the strategy is achievable. I suspect there is a bit of skepticism surrounding the thesis.
As for Apple Watch, I published Apple Watch sales estimates of 20-30 million units for the first 12 months on the market, rising to 40-60 million units in the second year on the market. Consensus currently stands around those numbers, with 15-20 million Apple Watch units expected to sell from April to December. In theory, Apple's current $128/share price and analyst estimates already reflect these Apple Watch projections. Therefore, actual watch sales would need to come in stronger than these estimates for positive EPS revisions. In a scenario where EPS estimates are rising due to stronger iPhone or Apple Watch sales, investors may also be willing to pay more for those higher earnings, resulting in a rising P/E multiple.
Given the current share price, Apple is 33% away from a $1 trillion market cap. While that may seem close, it represents nearly $250 billion of additional market capitalization, hardly an easy feat. Apple's best shot of reaching the arbitrary value milestone is reporting stronger than expected iPhone sales over the next 2-3 years and having a successful Apple Watch launch. Since it is impossible to know why every investor buys or sells AAPL shares, no one knows if Apple will reach a $1 trillion market cap. As long as the economy and equity market don't experience any huge shocks or surprises, Apple's existing product categories have enough potential to propel the stock to $1 trillion train.
How about $2 trillion? That is a much more complicated story that deserves its own post.
Wildcard: Apple's stock buyback program represents a very significant unknown in this discussion. Apple has the potential of buying back close to 20% of itself within three years. How will that impact the odds of AAPL reaching $1 trillion? In order to gain a bit of perspective in terms of size, Apple's buyback over the next two years has the potential of boosting EPS by 10-15%. Most analysts should have this type of buyback already included in their estimates and therefore already priced in the stock. The impact that the actual act of buying back shares has on AAPL is another story. There could be a beneficial impact on AAPL shares if management decided to accelerate share buyback and current shareholders show little motive to sell shares. In such a scenario, there would be upside pressure on the stock as the market price rises to find the point where supply and demand is in equilibrium. Conversely, if management slows buyback, any support that resulted from Apple being an active buyer in the market has been removed which may result in stock price weakness. I suspect the stock buyback and Apple's $178 billion of cash are something to keep a very close eye on going forward.
This report was produced by Neil Cybart on March 3, 2015 and is not meant to be used as investment advice.
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Samsung's Smartphone Dilemma
Samsung unveiled the Galaxy S6 and S6 Edge yesterday at Mobile World Congress. Following a 45-minute keynote that lacked much purpose besides highlighting how mistakes made with the Galaxy S5 have now been corrected, I'm left wondering who is Samsung's primary customer: mobile carriers or phone manufacturers? Is Samsung losing all sense of reality by ignoring consumers and instead shipping smartphones in order to drum up marketing for its stronger smartphone components business? I'm no longer confident I know why Samsung is selling smartphones.
Following last year's Mobile World Congress, it was obvious that Samsung was undergoing its second Crisis of Design. As expected, the Galaxy S5's reliance on plastic and gimmicky software contributed to Samsung losing all momentum as a smartphone manufacturer. Increased competition from both the high-end and low-end caught Samsung sleeping. Yesterday, Samsung pressed the reset button on its smartphone strategy as its latest flagship phone was positioned as a fix to last year's mistakes. Whatever option Samsung went with last year, the opposite choice was taken this year. Citing "design of the future," Samsung dropped all of the plastic, opting for metal and glass. Meanwhile, 40% of the phone's features were cut as Samsung used shaky marketing spin to position the reduction as evidence of a new strategy focused on "design with a purpose." Samsung took a few pages from the Apple playbook and removed features such as a removable battery, expansion memory, and water proofing, all of which were reasons that hardcore Samsung fans had stuck with the brand in recent years.
The problem facing Samsung is that nearly every one of the changes made with this current crop of phones was the right move. Better hardware and fewer features have been the trend in the premium phone segment for years and the current winners have been busy building their platforms on the trust such a strategy has formed with consumers. However, Samsung's loyal customer base had remained engaged because Samsung was trying to be different, offering consumers choice and options, while design was considered an after-thought. These consumers place more value in removable batteries and the ability to swap out memory, not the look of the device. By trying to be like another premium smartphone manufacturer, Samsung may have shot itself in the other foot.
Samsung didn't change its entire smartphone strategy. The company reiterated their goal of doing things first so that others will follow, which supposedly leads to more innovation. However, a few minutes later, Samsung announced a mobile payments platform called Samsung Pay using nearly the same presentation and talking points that Apple used five months ago when announcing Apple Pay. Interestingly, the presenter skimmed through this part of the presentation, with very few details as to Samsung Pay's implementation and the fine print. Samsung is apparently licensing the fingerprint reader technology from a third-party, which raises some questions as to the background and long-term sustainability of the feature. I thought this Samsung Pay example summed up the conflict found throughout Samsung's entire presentation.
Samsung was more focused on mentioning key words such as design, hardware, camera, and mobile payments, instead of discussing why certain things were being done or removed from the phone. This lack of clarity has been Samsung's problem for years as the company has mostly relied on offering consumers choices that other smartphone makers decided not to pursue. The problem is Apple is now selling larger screen iPhones, and Xiaomi and other local Chinese smartphone vendors are selling decent hardware at lower prices. Samsung's differentiation has disappeared. Samsung may not be at the point of utter desperation, but they certainly came off as remaining quite nervous. Samsung says they want to be first in mobile, but they show great discomfort in leading.
If Samsung is relying on its premium smartphones to market screens, processors, and other components to other smartphone vendors, instead of giving the consumer a good experience, I highly doubt the company will be able to regain the Galaxy sales momentum lost in 2014. Smartphone competition continues to intensify and companies without a mission statement built around the consumer will find dimming prospects. Samsung's refocused attention on its smartphone components business is becoming a major liability and dilemma for the company's ambitions as a smartphone manufacturer.
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Apple's Initial Watch Ad in Vogue is Nearly Perfect
With Apple Watch Keynote 2.0 scheduled for March 9th, the Apple Watch will once again become the talk of the town in tech, fashion, and design circles. In anticipation of an April launch, Apple officially kicked off its Apple Watch marketing campaign with a 12-page spread in the important March issue of Vogue, valued at $2.2 million. I thought the ad was effective in highlighting the Apple Watch as a fashion piece that values design and luxury.
There are only so many brands that can get away with just simply having Watch on a blank page. That one page is estimated to have cost Apple close to $200,000.
Watch Sport
Interestingly, the green fluoroelastomer band made the cut. Apple included a screenshot of the Activity app.
Watch
The milanese loop provides great imagery (this same shot is on Apple's website), while the profile shot is able to show the band's clean and minimal nature. Notice the lack of technology in these shots.
Watch Edition
The rose gray modern buckle could be mistaken as a band from any luxury watch. Meanwhile, a sophisticated and sleek black watch face is used to highlight the Edition collection.
I think this ad is nearly perfect because it effectively gets the message across that this luxury item is much more than just any old watch without actually showing much, if any, of the technology that makes Apple Watch revolutionary. Apple is delicately positioning design and fashion ahead of the device's primary selling point: bringing utility back to the wrist.
Apple is walking a thin line when marketing Apple Watch as the device has to be positioned for everyone, from students to fashion-minded executives. The ad takes many cues from other fashion-oriented ads with minimal text and no prices as the brand is the primary product being sold. I would be very surprised if Jony Ive did not play a major role in creating every page of this ad.
This Apple Watch print ad reminded me of iMac ads from the early 2000s, in which the product also did the talking. In what may be a sign of Apple's increased brand power, and also the difference in target markets (Vogue versus tech publications), notice how much text is included in these iMac ads.
While having a large ad within Vogue is important, in theory anyone with money (and a good ad agency) can get a 12-page spread. The goal is to be on the front cover, which can't be bought in reputable magazines. In one chapter of Adam Lashinsky's "Inside Apple", the story of Steve Jobs lecturing an ad buyer included Steve's often-repeated response: "You worry about the back covers. I'll take care of the front covers." The key test will be if Vogue puts Apple Watch on the front cover. Google Glass got a 12-page editorial spread in 2013 and Apple Watch was featured on the cover of Vogue China, so maybe there is a chance we see Apple Watch on the coveted September issue of Vogue. Regardless, Apple is off to a good start with its Apple Watch marketing campaign.
Apple's Strategy for Growing iPhone Sales by 50% in Three Years
The iPhone is a juggernaut with unit sales up 25% in 2014, representing close to 70% of Apple's operating income. Many market observers are wondering if Apple is approaching a limit to iPhone sales growth. With the iPhone 6 and 6 Plus representing possible inflection points in the phone market, the ingredients are in place for Apple to sell 300 million iPhone units annually within three years, which would represent 50% growth from the 193 million iPhones sold in 2014. By executing on a number of achievable tasks, including taking advantage of weaker smartphone competition, building a wider sales distribution network, broadening the iPhone lineup, and increasing the iPhone's value proposition, Apple would be in a position to increase its phone market share by more than 400 basis points from 11% to 15% within three years.
The iPhone Growth Strategy
I continue to view doubling down on iPhone is in management's best interest as the iPhone 6 and 6 Plus serve as possible inflection points, reinvigorating the iPhone line. Apple can market the larger-screen iPhones to the hundreds of millions of smartphone users who did not buy an iPhone as their first smartphone over the past few years.
There are a number of pieces that need to come together for Apple to sell more than 300 million iPhones annually within three years.
Maintaining the iPhone Upgrade Cycle. With approximately 80-85% of iPhone unit sales coming from previous iPhone owners, it is crucial that Apple maintains a healthy iPhone upgrade cycle. Assuming a 2-3 year life cycle and relying on a few data points from Apple's recent earnings call, I estimate that approximately 185 million iPhone users are likely to buy a new iPhone in 2015, up from 165 million users in 2014 and 130 million users in 2013. Exhibit 1 highlights how crucial iPhone upgrades are to total iPhone sales.
Exhibit 1: iPhone Unit Sales Breakdown (iPhone Upgrade vs. New to iPhone)
The significant increase in iPhone upgrading in 2014 was driven by the iPhone 6 and 6 Plus and that trend will continue in 2015. As the iPhone user base expands, it is not hard to fathom that close to 250 million iPhone users will be upgrading their iPhones on any given year by 2017. Apple would likely position the screen, battery, and camera as some of the more marketable upgrades each year, as well as upgraded components including the fingerprint sensor, speakers, headphone jack (or lack thereof). In addition, Apple will continue to update the iPhone's form factor, including cosmetic chances, as well as altering width and weight.
Appealing to Android Users. Android represented approximately 80% of global smartphone sales in 2014, depicted in Exhibit 2. In order for Apple to achieve 50% iPhone unit sales growth within three years, Apple needs approximately 40-45 million iPhone unit sales annually to come from new users who currently don't own an iPhone. Android would be positioned as the most likely target for these platform switchers given Windows' low market share and Blackberry's lack of sales.
Exhibit 2: Smartphone Shipments and Market Share
Tim Cook mentioned on Apple's most recent earnings call that iPhone 6 and 6 Plus saw a higher Android switcher rate than the previous three iPhone launches. Exhibit 3 highlights this increasing trend of non-iPhone users making up a larger share of total iPhone sales. Given market dynamics, it will be difficult to have non-iPhone users make up more than 20-25% of iPhone sales, unless the iPhone upgrade cycle slows or Apple is more successful in getting new users to the platform.
Exhibit 3: Percent of iPhone Sales to Non-iPhone Users
Considering that Apple sold 20-30 million iPhones to new users annually since 2012, it is achievable to grow this to 40-45 million new users a year (the range required to grow iPhone shipments 50% by 2017). China Mobile alone may represent 15-20 million new iPhone users a year.
With a target of acquiring 40-45 million new iPhone users each year, Apple would be aiming for the top 4% of the Android base, which is a plausible goal. In terms of the most appropriate Android competition, 40-45 million represents less than 15% of Samsung's annual smartphone shipments. The high-end Android phone environment is quite different in 2015 as Samsung has lost momentum and Apple has a more competitive phone in terms of screen size. Samsung still has 20-30% share of the smartphone market in many developed countries, and those users will eventually be ready to upgrade their phone. Samsung has loyalty rates close to 60% in its strongest market (U.S.). Apple has a 90% loyalty rate. While 60% loyalty may seem high, the other way to look at it is 40% of Samsung's base will likely look at what else is in the market when it is time to upgrade phones. This trend may represent Apple's best opportunity to convert Android users to iPhone in developed markets. For the first time, premium Android users will walk into a mobile carrier store and compare similar-sized iPhones and Samsung Galaxy phones.
Appealing to Feature Phone Users. If Apple picked off 40-45 million premium Android users each year, within three to four years, much of the high-end Android market would have switched to iPhone, which may not be the most realistic assumption. In that case, Apple will also likely need to rely on feature phone users looking to buy their first smartphone. With smartphone penetration around 75% in the U.S., according to comScore, and lower penetration rates else where in the world, there is still opportunity for Apple to appeal to customers looking to buy their first smartphone. Gartner estimated there were around 900 million feature phones sold in 2013. While some may think late adopters in developed markets will gravitate towards low-end smartphones, I actually think the opposite may occur as late adopters (especially the top 5-10%) may look at a smartphone as a laptop/desktop replacement and be willing to spend more money on an smartphone.
Exhibit 4 displays overall phone shipments, including the roughly 600-700 million feature phones likely shipped in 2014. Samsung's market share decline (22% from 25%) was likely a result of Apple's stronger iPhone lineup and more competitive offerings from Chinese smartphone vendors.
Exhibit 4: Overall Phone Shipments and Market Share
In China, 20% of iPhone sales last quarter were to first-time smartphone users. Add these first-time smartphone buyers to premium Android switchers, and the goal of getting 40-45 million unit sales annually from the 1.7 billion of non-iPhone phone shipments seems a bit more attainable.
Expand Distribution. Apple now has 72% of the world's mobile phone subscriber base covered with 375 carriers supporting iPhone. In recent years, Apple has benefited greatly by adding carrier distribution partners, such as NTT DOCOMO and China Mobile. Apple is still seeing a positive impact from China Mobile despite it being a full year after launch as Apple continues to work on expanding distribution points in China, both in terms of brick-and-mortar retail as well as online. The easy growth phase may be over in terms of carrier expansion, which is why appealing to Android and feature phone users may represent most of the iPhone's near-term growth potential. Nevertheless, countries such as India and Brazil represent untapped sales potential. While such markets are not as established compared to China, there is room to expand iPhone's reach.
Expand iPhone Product Line and Price Points. While a "cheap" iPhone may not fit in Apple's strategy, I would expect management to continue debating the merits of releasing a new 4-inch screen iPhone that is sold at a slightly lower price than the iPhone 6. A smaller iPhone wouldn't be a top seller when compared to the bigger screens counterparts, but I don't think management will consider that as a factor for whether or not to release a smaller iPhone. The fundamental question comes down to whether the experience produced by using a 4-inch iPhone can be better for some users than using a larger iPhone.
In regards to overall iPhone pricing, I would expect Apple to continue bringing down the entry-level price of older iPhone models. I previously laid out how Apple is able to successfully maintain user experiences by selling older models at a lower price. Such a pricing strategy will help maintain iPhone momentum as Apple focuses on grabbing as much profit share as possible at each price level before moving further down market.
Increase iPhone's Value Proposition. Apple is positioning iPhone into critical aspects of our lives (home, health, car, finance) using HomeKit, HealthKit, CarPlay, and Apple Pay. Such efforts are not only to prevent Android from establishing insurmountable positions in key parts of our daily lives, but also to increase the iPhone's value proposition. The Apple Watch may also come into play as an ancillary device meant to break complex tasks into simpler, more manageable ones, may prove to increase iPhone loyalty and serve as a catalyst for driving news users to iOS.
Financial Impact
Selling approximately 300 million iPhones annually (up from 193 million units sold in 2014) would boost Apple's annual revenue by $60 billion. Assuming Apple is able to maintain iPhone margins, boosting iPhone's share of the phone market from 11% to 15% would equate to an additional $25 billion of operating income, or close to $20 billion on an after-tax basis (roughly $4.00/share). Considering that Apple reported $7.42/share EPS in CY2014, it becomes clear that the iPhone is one of the more important drivers for Apple EPS going forward in the near-term, especially with the Apple Watch accounting for a relatively small share of the revenue pie in the first 1-2 years on the market. Exhibit 5 includes Above Avalon's iPhone units sales and growth estimates.
Exhibit 5: Above Avalon's iPhone Unit Sales and Growth Estimates (Calendar Year)
The Big Picture
In 2014, the iPhone represented approximately 11% of phone market sales. While some question if there is much growth left in iPhone, I think there is an attainable strategy that can lead Apple to grow annual iPhone sales by 50% from 193 million units in 2014 to approximately 300 million units in 2017. In such a scenario, the iPhone would represent 15% of the phone market. For some perspective, even after growing iPhone sales by 50%, five out of six people buying a phone in 2017 would still be choose something other than an iPhone.
Obviously, execution remains key, and I continue to think maintaining the iPhone upgrade cycle is Apple's most difficult task. If users stop seeing the need to upgrade their iPhones every 2-3 years, it will be difficult for Apple to achieve 300 million unit sales within three years as there won't be enough new users coming from Android and feature phones to offset the decline. In terms of appealing to Android and feature phone users, the current iPhone lineup has never been stronger. For the first time, Apple will have iPhone models that display very well next to big Android phones in mobile carrier stores. Many consumers go to carrier stores not knowing which phone they will end up purchasing, so having a competitive product with a large screen may be a big factor in explaining how Apple can grow market share. In emerging markets, Apple continues to improve iPhone's distribution infrastructure in order to sell less expensive, older models at additional points of sale. It is in Apple's best interest to double down on the iPhone given current market dynamics and the 2-5 year outlook.
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Apple Is on Track to Buy Back 20% of Itself by 2017 (Video)
An update on Apple's share buyback program. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017.
Don't Focus on Apple Watch Edition Pricing
The ongoing debate over Apple Watch pricing is causing many to miss the big picture: Apple wants the Apple Watch to be for everyone. By selling a device for the wrist, Apple is trying to appeal to a wide range of consumers, from high school students to senior executives. In such a scenario, price is only one piece of the puzzle as Apple positions Apple Watch as both a mass-market good and luxury item.
Tim Cook and Jony Ive have been quite clear from the start: Apple Watch is the most personalized device Apple has ever made. Apple's goal to make wearable products required taking a different page from the old product playbook. Personalization was crucial as different options based on color, material, and style were required. Apple priced the entry-level Apple Watch Sport collection to be a mass-market good, attainable for mostly anyone willing to spend money on an iPhone accessory for the wrist. Prices will likely rise to thousands of dollars for the Edition collection to appeal to the consumer who wants a well-crafted device serving as a luxury status symbol. It really doesn't matter what price the high-end models cost as Apple's strategy will be the same: segmenting the market between mass-market and luxury.
Luxury denotes supply scarcity at higher prices, while mass-market denotes abundant supply at low prices. In an attempt to chase profits and market share, some companies with a traditional luxurious brand are trying to appeal to the mass-market. Such "mass-market luxury" brands can be seen in the automobile industry as Mercedes-Benz, BMW, and Audi continue to move down-market with entry-level vehicle options priced around the ultra-competitive $35,000-$40,000 range. After closer examination, one would see that these prices are artificially low as additional upgrades and options are required to truly get the "experience" of owning one of those high-end brands. By moving down-market, these brands are losing their luxury status and diluting their brands by removing features. Just as mass-market luxury is an oxymoron, many of these brands may be harming their long-term reputations.
Instead of following the automobile playbook when it comes to appealing to both mass market and luxury, Apple is taking a different strategy with Apple Watch. Rather than selling a cheaper Apple Watch model with fewer features, Apple is relying on different materials to establish distinct watch collections. The Apple Watch experience isn't dependent on price. Apple Watch Sport provides the same technological capabilities as Apple Watch Edition; both show notifications, monitor daily activity, and accept incoming tap messages. Instead, the three Apple Watch collections contain different materials, which help give the Edition a more luxurious status with precious metals and greater craftsmanship, compared to the Sport's anodized aluminum and Ion-X glass watch face. By focusing on materials variance instead of feature variance, Apple is hoping to be able to sell a product that appeals to the mass-market and luxury circles at the same time. To complete the sale, Apple will likely need to rethink its retail distribution as well.
There may be Apple retail stores that go days or weeks without selling the most expensive Apple Watch Edition watch face and band combination if it's priced at $20,000. Meanwhile, a customer going into an ultra-luxury jeweler would likely be insulted seeing a $349 Apple Watch Sport being sold next to some of the world's most expensive watches. If Apple is interested in having such a wide variation in price for Apple Watch, a new retail distribution model would likely be utilized. Apple can rely on segmentation for setting up kiosks or a store-within-a-store in high-end shops that sell only Apple Watch Edition or Watch collections. There are reports of Apple building a store-within-a-store in a high-end Paris department store (probably not that high-end as to exclude Sport collection though), but that general idea can be expanded into even more high-end retail locations. Meanwhile, there may not be much reason to stock Apple Watch Edition collection options at big-box retailers like Walmart and Best Buy. By using a more segmented retail distribution, Apple may avoid some of the backlash from appealing to wealthy and less wealthy customers at the same time, which apparently worried executives as reported in The New Yorker profile of Jony Ive.
Another reason I'm not too focused on Apple Watch Edition pricing is that I suspect the device will display inelastic demand once the price exceeds $5,000-$7,500. Said another way, once Apple sells certain models over a certain price, raising the price may not necessarily correspond to a decline in demand, or at least not in a direct relationship. John Gruber at Daring Fireball thinks Apple Watch Edition may come in options approaching $20,000, while others think $10,000 is a given.
There is a much bigger strategy at play here besides just selling expensive wrist gadgets. There is a battle for the wrist. For Apple Watch to be worn on some wrists, the luxury watch that is currently taking up real estate will need to be put back in its watch case. How will Apple be able to accomplish that difficult task? Selling a luxurious device that contains materials denoting high-end and craftsmanship, like precious metals and special watch bands. It's rather interesting that Apple has been able to go so long without customizing the iPhone. There are cottage industries focused on customizing mass-market consumer gadgets like phones into luxury items. With a wearable, this option had to be offered from the start. I'm not too concerned with where Apple Watch Edition pricing will end up because Apple will be utilizing the same strategy regardless of price: positioning Apple Watch as both a mass-market good and luxury item.
Apple Is on Track to Buy Back 20% of Itself by 2017
Apple is sitting on $178 billion of cash. What does Apple plan to do with its excess cash? It looks increasingly likely that Apple has already given us the answer: repurchase shares. Apple will most likely revise its capital return program in April, raising its share buyback authorization and quarterly cash dividend payout. Assuming Apple relies on U.S. free cash flow and debt issuance to fund share buyback over the next three years, Apple is in a position to spend $150 billion on share buyback, repurchasing another 20% of its outstanding shares by 2017.
Apple raised a small amount of debt last quarter, bringing total long-term debt held on the balance sheet to $32 billion at the end of December. Apple has since raised another $8 billion of debt in 2015, bringing the total amount of debt issued to $40 billion. Net cash (gross cash minus debt) stood at $142 billion ($24/share) at the end of December, depicted in Exhibit 1.
Exhibit 1: Apple's Cash, Cash Equivalents and Marketable Securities
From a foreign cash perspective, Apple now has a $158 billion war chest. Due to strong holiday iPhone sales, Apple's U.S. gross cash (cash and debt) increased last quarter to $20 billion, despite continued share repurchases.
Exhibit 2: Apple Gross Cash - U.S. Versus Foreign
As a reminder, Apple can not use its foreign cash to buy back shares or pay dividends without incurring tax penalties. Instead, Apple must rely on U.S. cash. With only $20 billion of U.S. cash remaining, Apple needs to tap the debt markets and rely on U.S. free cash flow (FCF) generation to fund additional share buyback. In Exhibit 3, I estimate Apple's likely U.S. FCF generation over the next three years and possible debt issuance loads ($25 billion a year as yields remain low).
Exhibit 3: Apple's Capital Sources for Capital Return Program
Apple will kick off approximately $45-$50B a year in U.S. excess capital (including debt) over the next few years which can be used to fund the capital return program. Running with $50B a year in share buyback, shown in Exhibit 4, Apple would be in a position to have bought back 18% of its outstanding shares by 2017.
Exhibit 4: Potential Apple Buyback Scenario
Apple began buying back shares in 2013. If Apple continues the current pace of buyback through 2017, the company would have bought back approximately 30% of the company, meaning roughly one out of three AAPL shares that existed in 2012 would have been bought back by the company. Going forward, management will continue to judge the value of share buybacks by comparing P/E and P/CF metrics versus other uses for cash such as special dividends and organic growth opportunities. As seen in Exhibit 5, assuming Apple maintains the pack of buyback around $50 billion a year, Apple will spend $150 billion in buyback over the next three years, versus $68 billion spent on buyback in 2013 and 2014 combined. Apple will likely be able to raise the quarterly cash dividend each year, but the lower share count will result in only a modest increase to divided expense.
Exhibit 5: Expected Apple Capital Return Program Expenditures
The wild card in this discussion remains AAPL stock price. A higher stock price will make share buyback less attractive, resulting in Apple buying back fewer shares. Conversely, a lower stock price would represent an attractive opportunity for Apple to ramp up its share repurchases. Even after three years of aggressive share repurchase activity and paying quarterly cash dividends through 2017, Apple would have more than $225 billion of gross cash remaining on its balance sheet.
This report was produced by Neil Cybart on February 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.