Neil Cybart 9/18/15 Neil Cybart 9/18/15

iPhone Launch Weekends are Getting Silly - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts available to everyone, I send out an exclusive daily email about Apple to members (10-12 stories per week). You can subscribe here. The following story was sent to members on September 15th.

iPhone Launch Weekends are Getting Silly

On Monday morning, Twitter went a bit crazy right around 8:30 a.m. ET as some began wondering if Apple would issue a press release disclosing how many iPhone pre-orders it saw this past weekend. Apple had done exactly that last year, reporting four million iPhone 6 and 6 Plus pre-orders.

We didn't get a press release this year, but instead an Apple statement disseminated through the press. It's rather short, so I've included the entire statement below:

"Customer response to iPhone 6s and iPhone 6s Plus has been extremely positive and pre-orders this weekend were very strong around the world. We are on pace to beat last year's 10 million unit first-weekend record when the new iPhones go on sale September 25. As many customers noticed, the online demand for iPhone 6s Plus has been exceptionally strong and exceeded our own forecasts for the pre-order period. We are working to catch up as quickly as we can, and we will have iPhone 6s Plus as well as iPhone 6s units available at Apple retail stores when they open next Friday."

There was a little bit for everyone in that statement, but the biggest takeaway I got from that is that this entire fascination with opening weekend sales feels old, a relic from a begone era. Essentially, its a leftover from the smartphone wars where opening weekend sales were a sign that your phones were popular.

As expected, Wall Street analysts quickly began trying to read in between the lines, figuring out a way of using Apple's 103-word statement to judge their 2016 iPhone sales estimate. This represents the fundamental problem Wall Street has with Apple. The focus is on the wrong thing. I even saw some analysts comparing this year's Saturday morning iPhone pre-order release to last year's Friday morning release and then making some guesses as to what it all means about year-over-year growth. It's getting silly.

This trend of Apple releasing iPhone opening weekend sales number goes back to the original iPhone and that is one reason why so many observers are so flummoxed with yesterday's statement from Apple. We were accustomed to very detailed iPhone and iPad opening weekend sales announcements and now we are getting less and less in the way of disclosure. In reality, the usefulness of these releases has steadily declined, but most people haven't noticed.

When you consider that we are effectively using 4-5 million iPhone pre-orders to try to discern how Apple will do over the next 12 months selling up to 270 million iPhones, the silliness becomes apparent.

My philosophy on Apple announcing sales numbers has been very straight-forward. If Apple thought it had something to gain from releasing sales numbers, then they should release them.

Early iPod sales numbers? Tell the world that Apple actually has a product people want.
Early iPhone sales numbers? Tell the world that people actually want a smartphone with no physical keyboard.
Early iPad sales numbers? Tell the world that people really do want "just a big iPod touch."

By releasing sales numbers, Apple had something to prove to the world. That motivation is disappearing with iPhone. Opening weekend sales now represents just 4% of annual iPhone sales. Instead, analysts want Apple to release numbers in order to parse out if iPhone sales are growing or not. It's that simple. Of course, Apple ends up releasing iPhone sales numbers in financial filings anyways, but the short-term focus takes precedence.

In reality, Apple's language around opening weekend sales has become more vague over the years, especially last year:

iPhone 1st gen (2007) = 1M in 74 days (U.S. only - AT&T)
3G (2008) = 1M in 3 days (21 countries)
3GS (2009) = Over 1M in 3 days (9 countries)
4 (2010) = 1.7M in 3 days (600,000 pre-orders on first day) (5 countries)
4s (2011) = Over 4M in 3 days (1 million pre-orders on first day) (7 countries)
5 (2012) = Over 5M in 3 days (2 million pre-orders on first day) (9 countries)
5c / 5s (2013) = 9M in 3 days (11 countries including China in launch window for the first time)
6/ 6 Plus (2014) = Over 10M in 3 days (4 million pre-orders on first day) (10 countries not including China)
6s / 6s Plus (2015) = Better sales than last year (12 countries including China)

The reason I say that the language is a bit unclear is that last year's "over 10M in 3 days" could very well have been closer to 11M iPhone units, but instead Apple felt "over 10M" would be good enough when compared to the 9M iPhones reported in 2013. Expectations weren't too high since China wasn't in the original launch country list last year. The market would understand if Apple didn't report too much of a sales increase from 2013. This point only goes to show how irrelevant iPhone opening weekend sales have become.

Over the past few years, iPhone opening weekend sales have been more a sign of how Apple has been able to ramp iPhone supply instead of demand. Without going into too much accounting detail, the only iPhone sales Apple includes in opening weekend numbers are those units that have been shipped to an end user. If you pre-order an iPhone, but need to wait a few weeks to receive it, you are not included in opening weekend sales. The pre-order numbers were therefore a bit clearer picture of demand since a pre-order is not the same thing as a sale. Of course, Apple started releasing pre-order numbers once opening weekend sales numbers started to look less attractive on a year-over-year basis.

I would not be surprised if Apple eventually moves away from announcing opening weekend product sales altogether. Apple has shown no interest in disclosing Apple Watch sales, and Apple stopped releasing opening weekend iPad sales right around when unit sales started to decline (another sign that disclosing opening weekend sales is one big game). Critics will say Apple stopped releasing sales because of weaker sales growth. While iPhone sales growth may very well slow, I rather look at it as Apple is now a much bigger company in a different landscape. The Android/iOS activation wars are over. There are other ways to convince the world that iPhones are popular and worth buying besides releasing opening weekend sales. In addition, opening weekend numbers aren't even a good measure of iPhone growth. If we compare the change in opening weekend sales to the corresponding iPhone growth over the following FY year:

2010: 70% growth in iPhone opening weekend sales (81% iPhone unit growth in following year)
2011: 135% (73%)
2012: 25% (20%)
2013: 80% (13%)
2014: 11% (38%)

I look at that discrepancy as reason for why opening weekend sales is not the most useful parameter to judge iPhone sales.

Over the years there have been ulterior motives to disclose opening weekend sales. Times change. It's making less sense these days to disclose arbitrary sales numbers spanning a few days.

Along with the preceding story, the full list of stories sent to Above Avalon members this week included:

Become a member today to receive these stories (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

Neil Cybart 9/14/15 Neil Cybart 9/14/15

The New Apple Era

We love our smartphones. Not only have they become our most used computer, but more importantly, smartphones provide an unimaginable amount of power at our fingertips. However, the smartphone form factor leaves opportunities for other devices to provide this same kind of incredible power only in even more personal ways. Apple is laying the groundwork for new platforms based on wearables, the connected home, and eventually the car that will combine to form one large encompassing ecosystem that ushers in a new level of personal technology. We are entering a new Apple era.

The Old Era

Apple's product line used to be thought of as a stool with each leg representing a different product. While a few legs were clearly more popular and financially lucrative than others, Apple was a technology company that sold a handful of hardware devices with iTunes (and increasingly iCloud) serving as the glue that held everything together.

Consensus was set on the iPhone, iPad, and Mac forming an ecosystem that will play a crucial role in our lives. In reality, these three product categories are much more similar than people have been thinking. New platforms are needed to help make technology more approachable and personal.

The New Era

The iPhone, iPad, and Mac are converging into one central "brain" while new platforms will be formed focused on key aspects of our lives including transportation, home, and body (wearables). In this new era, the iPhone is positioned as the center point of our digital lives with iCloud and Apple services representing the glue connecting everything together.

Earlier this year at WWDC, Apple unveiled watchOS, its first wearables platform. Last week, Apple added a new platform to the mix with tvOS. The two platforms serve as examples for how Apple will eventually embrace bigger themes like wearables and the connected home (and eventually the car). All the while, iOS is maturing and becoming a platform for a range of mobile devices with various screen sizes.

The Opportunity

iPhone. The iPhone, iPad, and Mac product categories will continue to merge. In the future, the three product lines will run the same operating system with the degree of mobility, as measured by screen size, positioned as the primary differentiator. The iPhone will always have the most power due to its mobility, while the iPad brings multi-touch (and eventually 3D Touch) to a bigger screen. All the while, the Mac includes the best keyboards for those jobs that require a significant amount of typing. The differences between the three product categories will continue to shrink.

Apple's new 3D Touch feature not only brings an additional user interface to iPhone, but should be thought of as the missing piece for allowing iPhone screens to become even larger without increasing the iPhone's form factor. 3D Touch begins to reduce the need for the home button, which has turned into a type of reset button used to switch between apps. By removing the iPhone home button and filling the additional space with screen real estate, the iPhone will only gain more power and capabilities when compared to devices like the iPad mini and Air. Less mobile devices, like the larger screen iPad Pro, will continue to become more like the Mac, with the primary difference between the two product categories continuing to be the keyboard. Bringing 3D Touch to the iPad Pro and supporting a tactile onscreen keyboard may be the next step to further blur the lines between iPad and Mac. At the same time, the Mac continues to move towards the iPad with a new revolutionary design that places mobility as a key value proposition. The end result is a world where iPhone can accomplish most basic computing tasks with iPad/Mac running the same operating system serving the high-end.

Wearables. In just a little over two months, Apple went from selling its first genuine wearable device to unveiling an SDK for native Apple Watch apps. While many have tried to think of Apple Watch as a mini iPhone on the wrist, in reality, the Apple Watch represents a different type of power requiring a complete rethink of what kind of jobs can be done on the wrist. Last week, Apple rolled out a significant update to Apple Watch in the form of a new Hermès collection and new Apple Watch sport bands. This update exemplifies how success in wearables is determined by much more than just the idea of putting technology on a wrist. There are different types of emotions and guiding principles that enter the equation when thinking about devices that are meant to be worn on the body.

Apple's new Hermès partnership is a game changer in that Apple is not just embracing the concept of luxury, but is set on showing the world a completely new type of personal technology. The entire luxury industry needs to take note of what Apple is trying to accomplish as software continues to move quickly into other elements of the luxury wearable market. Apple isn't taking the same page from its iPhone playbook and applying it to wearables. Instead, the strategy is being adapted to fit the environment. It is incredibly intelligent and bodes well for new platforms such as TV (home) and eventually the car. As for wearables, the much bigger concept of body and mind are brought to the forefront as health tracking will likely be positioned as a key value proposition in the wearables category. In addition, identity and geolocation themes will likely become popular. Each case is made possible by the fact that a wearable device does a better job of being carried and representing the user than a smartphone does.

Home. Apple TV is the start of a much broader move by Apple into the connected home category. The primary takeaway from the all-new Apple TV is that Apple is including a new user input in the form of voice. Siri not only took front and center stage when it came to Apple's September keynote invites, but the personal assistant is quickly being able to handle an increasing number of tasks beginning with content curation and discovery, and then eventually handling automation tasks. Apple TV may be focused today on delivering content to a big screen but will likely move to become a device able to turn spacial and facial recognition into a new realm of personal computing. Apple began controlling the living room years ago with the iPhone, but Apple TV will begin to better address the ideas of the connected room in a more direct way than the iPhone will ever be able to. Similar to wearables, Apple is relying on a new class of hardware (and user interfaces) to make technology approachable and personal.

Car. Apple wants to design its own self-driving car. This is a company that has no interest in just creating a platform so that less capable car manufacturers can ruin the user experience. We are quickly moving to a world where technology will take over the transportation industry, and Apple has no choice but be part of the mix. The Apple Car's key value proposition won't revolve around performance, but rather good design and an intuitive user interface (not having to drive at all is an entirely new level of intuitiveness). A self-driving electric vehicle is nothing more than a mobile room on wheels, which only emphasizes the concept of personal technology as we all won't want to ride in the same kind of room. Accordingly, the themes of connected home and self-driving cars become intertwined.

Apps Provide a Personal Touch

Apple wants to position apps as the guiding principle of its strategy to move from a company that sells a collection of computing devices to delivering a complete user experience that spans most tasks that make up our daily lives. The app ecosystem transformed the iPhone into an all-powerful device by allowing each device to become something unique to its user. Apple is looking to do the same with Apple Watch (watchOS) and now Apple TV (tvOS). The hardware remains a critical requirement for ultimate success, but apps complete the picture.

Looking back at Apple's WWDC keynote, the significance of the "The App Effect" video that was shown takes on a whole new meaning after seeing Apple unveil watchOS and tvOS. While the video was focused on iPhone apps, it is reasonable to one day replace "iPhone" with "Apple Watch," "Home," and even "Car." Apple looks at apps as the path to accomplishing its long term goals.

The App Store has grown from 500 apps to well over a million in just 7 years. The software world is now a level playing field for developers and the experiences they are creating have enriched, empowered and truly changed all of our lives.

Apple's new platforms will be embraced by app developers because the categories that Apple is playing in are simply too large and lucrative to ignore. App developer characteristics may change as larger developers begin to control more of the app environment, likely continuing to push down the price of paid downloads with business models based instead on subscriptions and services. At the same time, Apple is in a prime position to embrace and help push its own suite of apps. The IBM partnership may be positioned today for iPad in the workplace, but such a partnership could one day embrace a range of new apps across product categories. Along similar lines, the Cisco partnership is already expected to begin embracing new product categories other than iPhone, iPad, and Mac.

The Long-Term Plan

The iPhone was launched in 2007 and in just eight years has gone on to not just change the world, but provide a framework as to how apps and software can begin to take over other key aspects of our lives. As we look much further into the future, it is likely incorrect to assume that an iPhone will always be required in order to get the most out of the connected world.

In the future, the iPhone may melt away, and a range of devices will be able to provide an unimaginable level of personal technology. Apple Watch will likely be able to stand on its own in due time. As the definition of work changes, more and more will be designated for the wrist, further strengthening the appeal of wearables. Transportation and the connected home will be looked at as providing the same kind of personal experience.

Targeting our Time

Apple's long-term goal is to bring personal technology into new parts of our lives. Looking ahead, the iPhone will not be able to bring this kind of technology to every part of our lives. Instead, Apple will rely on new platforms and devices suited to address our particular needs. The best way to predict where Apple is looking to expand is to look at the time. The aspects of our life that take up most of our time are the most likely opportunities as to where Apple will see if it has something to contribute.

Making technology personal entails moving beyond just simply combining hardware and software. Instead, the way the hardware (and software) looks, feels, and moves will become crucial factors, all of which are things Apple has been perfecting for years. The groundwork is being laid for an era in which the iPhone is just one piece of the personal technology puzzle.

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Above Avalon members have access to my full notes and observations from Apple's September keynote.

Neil Cybart 9/4/15 Neil Cybart 9/4/15

Bill Graham Civic Auditorium Intrigue & Above Avalon Premium Weekly Recap

Along with periodic Above Avalon posts, I send out an exclusive daily email about Apple to members (10-12 stories per week). You can subscribe here. The following story was sent to members on August 31st.

Bill Graham Civic Auditorium Intrigue

Apple keynotes are products in themselves. While it is easy to spot the immense level of training and practice that goes into delivering the keynote, the entire event plays a role in how Apple wants to explain itself to the world.

In today's media landscape, an Apple keynote has taken on a different role, maturing from the single most important way to drum up interest in a product, to one step in a series of events, interviews, and presentations aimed to keep Apple at the top of the ever-changing news cycle. Along those lines, an Apple keynote, all the way down to the venue choice, can be an incredibly useful and valuable piece for figuring out Apple marketing and strategy.

Over the past four years, Apple has relied on three primary locations for its keynotes: Town Hall at Apple HQ, Yerba Buena Center for the Arts in San Francisco, and of course Moscone West for WWDC. The one exception was last year's iPhone 6/6 Plus and Apple Watch event held at the Flint Center. That particular venue was noteworthy not just for its larger auditorium seating capacity, but also for the clear excitement and anticipation surrounding the event as Apple entered its first new product category since the iPad in 2010.

Past Apple keynotes:

2012 - February 22 - Yerba Buena Center for the Arts
2012 - WWDC - Moscone West
2012- September 12 - Yerba Buena Center for the Arts
2013 - WWDC - Moscone West
2013 - September 10 - Town Hall at Apple HQ
2013 - October 22 - Yerba Buena Center for the Arts
2014 - WWDC - Moscone West
2014 - September 9 - Flint Center for the Performing Arts at De Anza College
2014 - October 16 - Town Hall at Apple HQ
2015 - March 9 - Yerba Buena Center for the Arts
2015 - WWDC - Moscone West

Seating capacities for these locations ranged from the smaller Town Hall (301) and Yerba Buena Center (757) to Flint Center (2,405). WWDC has 5,000 total attendees although not everyone is able to have a seat in the main Moscone West keynote room.

Speculation over Apple's upcoming event started to take off last week when Hoodline, a San Francisco neighborhood news site, published a story about there being quite a bit of activity taking place at the Bill Graham Civic Auditorium despite nothing being publicly planned for the venue until mid-September.

Regulars began to notice security guards and police officers stationed around the building. In addition, there had been quite a bit of construction activity, including the installation of large power generators and AC units outside blocking a few lanes of traffic. One Hoodline reader commented that he saw forklifts bringing in what appeared to be temporary flooring. Apparently, whatever was being done inside had been going on for weeks.

Last Wednesday, Hoodline ran a story that said Apple was indeed the company up to something at the Bill Graham Civic Auditorium and that there were a number of street closures around the building planned for the week of September 8th to 10th. As a fun fact, the Apple II was introduced at the same location in 1977 at the West Coast Computer Faire. Back then it was called the San Francisco Civc Auditorium. My interest was piqued by the Bill Graham Civic Auditorium being the choice for Apple's next keynote.

After Apple sent out event invites this past Thursday, I took a closer look at the venue choice since it still stood out to me. The first thing that caught my attention was that the building is quite large with a 7,000-person capacity, which is nearly 10x larger than the Yerba Buena Center. The other aspect of the location that seemed a bit strange is its layout and floor plan. It is actually an arena with a high ceiling. Along with music concerts, the venue is used for trade shows and sporting events. There is a large flat seating area (similar to Moscone) surrounded by a significant amount of balcony seating in a U-shape. It is quite different from prior Apple keynote venues.

Using such a large venue for an Apple product unveiling obviously brings up the question if Apple is planning on having a large guest list including press and guests from a wide range of industries. Last year, Apple invited quite a few additional people to the Apple Watch unveiling at the Flint Center. Not only were there people from the fashion and fitness industries on hand, including more celebrities than normal, but there were also a significant number of Apple employees in attendance. Most of the Flint Center's 2,500 seats were filled. What could Apple possibly do with an area with nearly 4,500 additional seats?

After posting that question on Twitter, I didn't find much evidence to suggest that Apple had invited that many more people than was the case with previous events. However, I did start to get a few clues as to what Apple may have had in mind by choosing the Bill Graham Civic Auditorium. One Above Avalon member pointed me to a tweet musing that Apple may look to transform the inside of the building into a space that would be completely unrecognizable. Last year, Dot Party, an event series created by Markus Persson, creator of Minecraft, held a concert at the Bill Graham Civic Auditorium. After quite a bit of construction, the space was turned into a pretty interesting concert/music hall.

A few people have speculated Apple may in fact be building an entire structure within the arena (which explains all of the extra air cooling machinery). Think of something like an enclosed stage/audience seating area positioned next to another completely enclosed room housing the demo area. One large open space would be turned into a series of still-large rooms.

Putting all of the pieces together, it is likely that Apple chose the Bill Graham Civic Auditorium due to the ability to customize the space much more than what would be possible at locations like the Yerba Buena Center. In addition, the space is able to handle a more decent-sized crowd than Town Hall at Apple HQ. However, it does not seem likely that Apple is planning on having a record guest list numbering close to 7,000 people.

Judging by the Apple event invitation byline of "Hey Siri, give us a hint." one can deduce that Siri will play a pivotal role in the event. In addition, with rumors that Apple will unveil a new Apple TV, the prospects of a Siri-controlled Apple TV may require unique stage and demo areas. Don't forget how Apple constructed an entire temporary structure next to the Flint Center last year just to house a special demo area. The same level of construction seems to be occurring at the Bill Graham Civic Auditorium, only inside.

Eventually, Apple will host many of its product events at the 1000-seat underground auditorium being built at Apple Campus 2. However, I would not be shocked if Apple still goes elsewhere for a keynote from time to time (like WWDC and other locations). The ability to suit a particular site for a specific product can be incredibly rewarding.

A few weeks worth of construction at a new venue means that the location for this upcoming Apple keynote will add to the mystery and intrigue leading up to September 9th.

Along with the preceding story, the full list of stories sent to Above Avalon members this week included:

Apple Watch's Biggest Competitor

The Android Smartwatch Army

Apple's Original Programming Temptation

Apple Event "Leaks"

Global Smartphone Trends for July

The Apple/Cisco Partnership

Apple Takes Washington

Thursday Q&A: How is the premium email going? Spoiler: It's going great.

Neil Cybart 9/3/15 Neil Cybart 9/3/15

Apple's Cheaper Stock Buyback

It is becoming cheaper for Apple to buy back its shares. Since Apple reported 3Q15 earnings, AAPL shares have been down by as much as 30%. Looking ahead, AAPL volatility will continue as the market continues to worry about slowing revenue growth in China. With $50 billion of share repurchase authorization remaining, Apple is in prime position to take advantage of stock market volatility and buy back its stock at a 15% discount to all-time highs resulting in up to $4 billion of "savings" over the next six months.

Apple Valuation

Stock valuation is a complicated subject. While finance textbooks explain how to take a series of numbers and assumptions and arrive at a stock's intrinsic value, the truth is market participants determine a stock's true worth. A stock price is merely the point at which a buyer and seller agree to exchange shares. Emotion and psychology play just as important of a role in determining a stock price as sales, earnings, and growth potential.

Apple is currently trading at a 11x forward earnings multiple (20% EPS growth), a 40% discount to the overall market's 18x forward earnings multiple. If excluding $35 of cash per share, Apple is trading at a 7x forward earnings multiple, a 60% discount to the overall market. If Apple traded with a 18x forward earnings multiple ex-cash, shares would trade at $225, a 100% premium to the current market price.

Growth Concerns

Many look at the valuation discrepancy as evidence that Apple is being penalized by Wall Street due to the lack of confidence in its ability to grow. However, nearly every sell-side Apple analyst is relying on higher earnings multiples, despite slowing operating income growth, to arrive at target prices that are well above the current market price. This doesn't strike me as overly pessimistic.

Instead, Apple continues to suffer from a lack of confidence and conviction on the part of current and prospective shareholders. Since growth concerns are a bit generic, more specific issues plaguing Apple continue to include doubt that strong Apple customer loyalty will continue and a business model that makes it difficult to forecast earnings.

Apple Customer Loyalty Doubt. It is no secret that Apple is the iPhone company. With the product representing 60% of revenue and 80% of operating income, the iPhone deserves the attention it is receiving on Wall Street. However, there continues to be a general lack of understanding over the dynamics underlying iPhones sales, including the impact that Apple customer loyalty has on sales.

Approximately 75%-80% of iPhones sold each year are to previous iPhone owners. Many on Wall Street look at the fact that Apple is relying on its existing user base to drive sales as a negative. Not only do repeat customers make up a significant amount of iPhone sales, but this actually describes Apple's business model. A company that sells not just products, but experiences, relies on repeat customers to offset any negative implications from the decision to not chase market share. This is one reason why Apple management has a tendency to focus on customer satisfaction rates whenever possible. High satisfaction is suspected to eventually turn into loyalty and repeat customers.

When thinking about iPhone sales growth in 2016, having approximately 75-80% of unit sales come from the 525 million iPhone user base is an indication that the Apple machine is functioning properly. The iPhone upgrade cycle is dependent on evolutionary features that do not over serve the customer base but instead entice upgrades. A high percentage of repeat iPhone customers is actually a strength for Apple, not a weakness. Apple would then need to focus on bringing in approximately 40 million new users to the iOS ecosystem annually in order to report ongoing iPhone growth. When considering the large market opportunity in China and ongoing troubles with Samsung, this 40 million new user target is achievable.

One of the concerns Wall Street has with Apple's customer loyalty is questions about how long the trend can continue. The ongoing debate over smartphone "subsidies" going away (they aren't), not to mention cheaper smartphone alternatives from China, are continuously positioned as factors that may cause iPhone owners to look elsewhere for their next smartphone.

A few Apple analysts have attempted to tackle this customer loyalty issue indirectly by coming at it from an ecosystem angle. By attaching a certain amount of revenue (and profit) to each iOS user over time, one can start to look at the iOS user base as a large annuity that will kick off profits each year. While the idea doesn't exactly rely on the most politically-correct analogy, the general idea is a fair one to make. The problem is that it does little to drive increased confidence that Apple's high customer loyalty will continue in the future.

Difficult Business Model to Forecast Trends. Apple has a business model that makes it very difficult to forecast financial trends 3-5 years out. While some of this is born from the company's thoughts on secrecy and surprise, the reasoning actually goes much deeper. Apple's business model is built on the belief that things will not remain steady over the long-run. Management is constantly looking to break itself, only enjoying key sales milestones for a short while before looking to do something else. In recent years that may have meant cannibalizing existing products, while in the future, it may be moving from its comfort zone into new industries. Compare this to something like Google's search business which had never been thought of to be in trouble by many on Wall Street until only recently or Facebook's recent announcement that 1 billion people went to Facebook in a single day. These businesses, while inherently more complex and confusing than Apple, are thought of as more sustainable over the long-run, while Apple's business comes across as more susceptible to market forces.

This lack of business model visibility boils all the way down to granular features found in Apple products. When Apple introduces a new user interface for iPhones next week, it will be difficult for many to envision such a feature becoming a crucial feature across the iPhone line one day, opening the door to significant design changes. Apple is well aware of the 3-5 year plan with features and products, often introducing certain features just to serve as a stepping stone to future revisions. Extend this exercise to nearly every Apple action, and the end result is Wall Street placing heavy reliance on short-term actions with little to no value attached to the long-term. It is tough to value something that will happen in the future when it is not obvious it will occur.

Even though this model of constantly looking to change the equation plays a key role in Apple's goal of remaining relevant over the long-term (what if Apple never moved past the iPod?), from Wall Street's perspective, such never-ending change is difficult to measure and value. Moving from counting iPod profits to iPhone margins, and soon financials behind monthly automobile leases, is not easy and results in low conviction. The end result is lower valuation multiples to compensate for this unknown. I suspect this has been one of the primary reasons over the years for Apple's valuation discount to the market.

Google and Amazon continue to stand out to investors as both companies share some similarities with Apple in terms of unknown futures. The difference is that while Apple is reporting strong profits on very disciplined expense management, Google and Amazon are considered founder-led companies that keep profits artificially low due to excess expenses and investment. As a result, Google and Amazon are rewarded with higher valuation multiples on what appear to be more mediocre profit and growth trends compared to Apple. Some may disagree with this treatment, but the thing to keep in mind is Wall Street will continue to think a certain way until it no longer wants to. It is impossible to predict when that moment will arrive.

Apple's Share Buyback Program

I continue to view Apple buying back its shares as the most appropriate use of excess cash that is not needed for organic growth and M&A.

As of June 27, 2015, Apple had $50 billion of share buyback authorization remaining out of a total of $140 billion of authorization. Theoretically, Apple could repurchase 8% of itself without any additional authorization from the board of directors. However, when looking at cash available for buyback, it becomes clear that Apple is not in a position to buy back that many shares at this time.

Apple is only able to use U.S. cash on hand to repurchase shares and as of June 27, 2015, Apple had $22 billion of domestic cash ($181 billion is held offshore). When forecasting earnings through the second half of CY2015 and taking into consideration debt issuance and U.S. free cash flow generation, Apple will have approximately $50 billion of domestic cash available by year-end. After adjusting for routine cash needs, including cash dividends, as well as the need for a cash buffer, Apple will likely be in a position to spend $20-$25 billion on buyback over the next six months (July to December 2015).

Apple management can make a dollar worth of share buyback go much further when Apple's stock price is depressed. With shares down 15% from all-time highs, Apple could theoretically buy back 15% additional Apple shares with the same amount of cash resulting in a "savings" of close to $4 billion over the next six months.

There are three likely strategies Apple can take in regards to its buyback:

1) Scheduled Share Repurchases. Apple could follow a very strict schedule as to when excess cash is spent on buyback. It would be equivalent to an investor buying an index fund the same day each month to gain market exposure, regardless of whether the market was up or down. As each quarter comes and goes, Apple will spend the same amount on buyback, resulting in additional shares being bought if the share price decreases. There is evidence of Apple following this type of repurchase schedule with $5 billion spend on share buyback in 4Q13, 1Q14, 3Q14, and 1Q15.

2) Opportunistic Share Repurchases. Instead of simply following a schedule, Tim Cook and Luca Maestri could take stock valuation and timing into greater consideration, resulting in an ebb and flow to the pace of buyback. Apple has shown the tendency of being opportunistic, such as in February 2014, when Tim Cook announced Apple had repurchased close $14 billion of shares over the span of two weeks (shares were trading around $70 at the time).

Beginning in 3Q15, Apple initiated a new accelerated share repurchase arrangement (ASR). The mechanics of such a program may at first seem a bit opaque, but they are actually relatively straightforward. The investment bank(s) handling the ASR borrow AAPL shares in order to deliver a large number of shares to Apple up-front. The banks then proceed to buy back shares over the span of weeks and months to cover their borrow. With AAPL shares having been weak since 3Q15 earnings, Apple will actually be able to take full advantage of its lower stock price by receiving cash back from the investment bank(s) in charge of the ASR.

3) Hybrid Strategy. Apple can combine the two strategies, and have both a scheduled buyback plan in place in addition to buying more shares during times of market weakness. Judging from historical trends, Apple management is following this strategy, suggesting there may be increased motivation to increase the pace of buyback during times of market weakness.

In reality, few companies take aggressive, bold moves with buyback programs during periods of market turmoil. Instead, capital management strategies tend to become more conservative as companies prepare for adverse capital market conditions. There had been a noticeable decline in the pace of Apple buyback recently, but it's difficult to know if it was due to a rising stock price, depleted U.S. cash reserves, or a combination of the two factors. Year-to-date, Apple spent $17 billion on buyback, 26% less than the $23 billion spent during the same time period in 2014. It will be important to see if this pace changes in the face of market volatility and lower share prices.

Volatility Will Continue

There is no evidence to suggest that AAPL volatility will decline anytime soon. The market will focus on slowing EPS growth in 2016 while in reality, there will be much deeper issues at play. Customer loyalty and Apple's eventual embrace of new product categories will likely continue to be ignored by Wall Street. One of the primary ways for a $640 billion market cap company to grow in terms of valuation multiples is for current shareholders to become more comfortable owning a greater share of the company. As long as there are still basic misunderstandings about how Apple thinks about the future, valuation multiples will remain range bound, and management will rely on the share buyback program to take advantage of any perceived market dislocation.

Receive my exclusive analysis and perspective about Apple in a daily email containing 2-3 stories (10-12 stories a week). For more information and to sign up, visit the membership page.

Members have access to the Above Avalon stock buyback primer which can be used to become familiar with Apple's share buyback.

Neil Cybart 8/25/15 Neil Cybart 8/25/15

Apple's Plan to Destroy the Large Cable Bundle

The cable bundle is misunderstood. While analysts and pundits focus on when the cable bundle will finally succumb to Netflix, HBO, and Hulu, the reality is the future of television will be built on the video bundle's back. Due to attractive economics, video bundles are one of the best values in the media space and will remain the dominant way we receive premium video content. We are quickly approaching the point where Apple can capitalize on market dislocation to destroy the modern-day big cable bundle with a leaner bundle that is built to thrive in a mobile world.

Video Bundle Economics

The cable bundle has been one of the best consumer deals in the modern era. By subsidizing content's true cost, the bundle makes it possible for consumers to receive a vast amount of video content for an artificially low monthly price. The bundle works marvelously well as long as everyone pays into the system, and this has been the case for the last 20 years. Nielsen estimated there were 116 million homes with televisions in the U.S., of which approximately 100 million had some form of pay TV for the 2014-2015 TV season. ESPN is one of the most widely distributed cable networks, reaching 95 million homes. ESPN has a farther reach than Facebook, a testament to how much power the cable bundle holds.

While the video bundle will remain relevant for many years, the content associated with the bundle will change. New companies have relied on the old bundle parameter, namely, selling a wide range of content to as many people as possible to carve out a piece of the subscription video streaming market. Companies like Netflix, HBO, and Hulu sell video bundles. Instead of charging viewers by individual shows and series, these companies charge for access to a wide selection of content appealing to a range of consumers.

Most cable networks are in existence today because of the large cable bundle. Without the bundle, these networks would not be able to fund their current slate of programming. The mistake many people make when analyzing the bundle is to ignore the value of access. Having a window to nearly 100 million households is in many ways more lucrative than the pennies or nickels that the average channel receives from each household each month. This is a cable distributor's key selling point, and we often see fighting between content owners and distributors over access.

The Trickiness in Going Direct to Consumer

When contemplating the future of television, many have thought the strongest cable networks can one day bypass the large cable bundle and sell their programming direct to consumer. For simplicity's sake, I position ESPN and AMC as the poster children of this theory. In the current system, ESPN receives approximately $6 per month from every household subscribing to cable. AMC receives quite a bit less, approximately $0.50, although it is still well above the average $0.15 received. If ESPN and AMC were to leave the bundle and embrace the direct to consumer model, they would need not only to make up lost subscriber fee revenue, but also contemplate losing access to 100 million households. AMC relies on that access to sell new series, like "Fear the Walking Dead," to viewers. "Fear the Walking Dead" just became the highest-rated series premiere in cable TV history thanks to AMC's reach. ESPN also benefits from grouping sports programming into one channel, appealing to a much wider fan base, including those who may only watch a game or two each month.

There is no question that the best networks will have loyal fans ready to pay top dollar for a direct to consumer option. However, that won't be enough since these networks are simply not built to support such a model. It will be very difficult for ESPN and AMC to stop subscribers from signing up for their content only to watch their favorite series or sports season and then cancel their membership afterwards. With the cable bundle, such month-to-month volatility does not exist.

I am very skeptical that a cable network will be able to go 100 percent direct to consumer. The economics are just not in their favor. Instead, a hybrid approach may work although in many instances, the best case scenario would be to just get to a point that matches the current large cable bundle. There is much incentive on the part of cable networks to make the bundle work.

Time for Action

The mobile revolution has weakened the large cable bundle's fundamental underpinning. Mobile hasn't changed just the way we communicate, but also the way we create and consume content. Having new types of video content in our pocket has led us to no longer sit in a particular room at a particular time to watch a particular show. As smartphones continue to grow in screen size, all other pieces of smart glass in our lives, including our television sets, will lose value and importance.

The old definition of TV doesn't do justice to the much wider array of available content that we now have at our fingertips. As smartphone adoption grew, the idea that anyone could be a content creator became reality. While YouTube may still lead in terms of mindshare when thinking of user-generated content, we also have plenty of interesting content found on video-sharing networks like Vine, Snapchat, and Periscope, not to mention premium content from the likes of Netflix, HBO Now, Hulu, and Amazon.

One example of an entirely new form of content that people are increasingly turning to is vlogs, which is short for video blogs. The following Google Trends chart highlights vlogging's expanding popularity. The vlogging industry, notorious with young people chronicling their daily activities, is still in its infancy. Vlogging combines elements of reality TV with scripted television as many vloggers record real-life situations although the heavy use of editing and some pre-planning suggest there are also elements of a regular sitcom.

Exhibit 1: Google Trends for Vlogging

All of this new and entertaining content made available due to mobile and new video bundles suggest that the large cable bundle is a house of cards held together by cable distributors. We have evidence that the large cable bundle is fraying a bit at the edges although collapse is not imminent. Disney CEO Bob Iger started a panic on Wall Street a few weeks ago when he disclosed on Disney's earnings conference call that ESPN had continued to see modest subscriber losses. Anyone following ESPN's recent cost cutting initiatives, including a move away from expensive on-air talent, would have seen this news coming. Assuming Iger's comments about ESPN subscriber loss trends remain unchanged for the rest of the year, ESPN will likely report a 2-3 million decline in subscribers in 2015, which may actually represent a slight improvement in the rate of decline compared to last year.

Exhibit 2: Change in ESPN Subscribers

Although ESPN is experiencing recent weakness, there is no evidence to suggest an exodus from the bundle is taking place.

I suspect cable subscriber trends are being impacted by cable distributors. As anyone trying to cancel his or her cable can attest to, it is not the easiest process, and very often consumers receive discounts or other promotions from their cable company to keep the bundle instead of completely canceling cable. The problem for many cable content owners is that if things remain status quo, we will enter a vicious cycle where weaker cable viewer ratings will result in less ad revenue, leading to inferior programming, which will only drive weaker ratings over time. Instead of there being a quick implosion, the cable bundle would deteriorate over time. The cable industry needs that one factor that will not only cause the house of cards to fall, but also address fundamental issues plaguing the large cable bundle.

Apple's Plan

The modern-day cable bundle is now vulnerable. Apple's strategy to destroy the large cable bundle would entail taking the best parts of the current bundle and creating an improved bundle. Essentially, Apple would be using a slimmer cable bundle to kill the large cable bundle. This may not seem too innovative. However, it is one way of addressing the biggest issue people have with their large cable bundle: finding and watching content at a time of their choosing.

As has been previously reported by the WSJ and Re/code, Apple's slimmed down cable bundle would include 20-30 channels and be delivered over the internet to iOS devices. These channels could be considered as home to the best content found within the current large cable bundle. Similar to the modern cable paradigm, the combination of monthly subscriber fees and advertising revenue would represent the primary funding sources for networks included in the bundle. Add in live programming like sports, which come with a hefty price tag, and local news, which depend heavily on advertising revenue, and a new kind of bundle begins to take shape.

Why would networks work with Apple? Having a customer base of nearly 90 million iPhone users and rising in the U.S. is very appealing to content owners. In an era where content bundles obtain their economics by having the widest access, 90 million users represent great opportunity. Similar to how Apple Music will be available on Android, it would be in Apple's best interest to make this new video streaming bundle available to Android as well.

With a rethought cable bundle, Apple would be appealing to the 95 million households that still subscribe to cable, not those who stopped paying for cable. To destroy the large cable bundle, Apple will need to have current cable subscribers be willing to go through the hoops of canceling their current cable with their distributor. The house of cards would then collapse.

Sling TV

On paper, Sling TV, an over-the-top video service owned by Dish Network, sounds similar to the bundle Apple would be looking to put together: a collection of 22 channels, including ESPN, for $20 per month. The problem is Sling TV is designed for those who aren't subscribed to cable, the exact opposite target market for an Apple streaming video service. Sling TV has limitations that cable payers would simply not be able to put up with such as only being accessible on a single device at a time and not including broadcast networks or stations. There are also valid questions over the quality of Sling TV's streaming with many reports of inferior viewing experience during popular shows.

Video Bundles on a Smartphone are the New TV

Mobile will determine not just television's future, but also video's future. Any company or producer that thinks otherwise will likely be left behind to fight over legacy remnants of a bygone era. Instead of some truly revolutionary video streaming service that leaves all prior ideas about cable and TV in the dust, we are headed towards a future that has distinct similarities to the past, namely a handful of companies subsidizing a vast amount of content by offering video bundles to tens of millions of people. The large cable bundle's demise will occur when the 95 million U.S. households that still pay for cable each month are presented with an attractive alternative that takes the best parts of the bundle, adds better discovery and curation, and finally embraces mobile.

Receive my exclusive analysis and perspective about Apple in a daily email containing 2-3 stories (10-12 stories a week). For more information and to sign up, visit the membership page.

Neil Cybart 8/24/15 Neil Cybart 8/24/15

Apple Scouting a Self-Driving Car Testing Area - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on August 17th.

Apple Scouting a Self-Driving Car Testing Area

In an article with quite the intriguing title of "Documents confirm Apple is building self-driving car," the Guardian became the latest publication to add their take to the ever-growing Apple Car debate.

Here's the Guardian:

"Apple is building a self-driving car in Silicon Valley, and is scouting for secure locations in the San Francisco Bay area to test it, the Guardian has learned. Documents show the oft-rumored Apple car project appears to be further along than many suspected.

In May, engineers from Apple's secretive Special Project group met with officials from GoMentum Station, a 2,100-acre former naval base near San Francisco that is being turned into a high-security testing ground for autonomous vehicles."

The Guardian published certain parts of correspondence between Apple and GoMentum Station, obtained under a public records act request. The language would seem to show that Apple was interested in doing something at the testing location.

Frank Fearon, an Apple engineer wrote: "We are hoping to see a presentation on the...testing grounds with a layout, photos, and description of how the various areas of the grounds could be used." Additional correspondence from Apple included: "We would...like to get an understanding of timing and availability for the space, and how we would need to coordinate around other parties who would be using [it]." Meanwhile, Jack Hall, a program manager at GoMentum Station responded saying a tour of the facility needed to be postponed along with saying: "We would still like to meet in order to keep everything moving and to meet your testing schedule." In reference to Apple showing interest in the site, Hall told the AP, "We don't know. [Apple hasn't] said what they want to test. It could be an iPhone."

In a rather comical confirmation that Apple did in fact reach out to GoMentum, an executive director at the Contra Costa Transportation Authority, owner of GoMentum Station, told the Guardian: "we had to sign a non-disclosure agreement with Apple...We can't tell you anything other than they've come in and they're interested." So much for that non-disclosure agreement.

The first thing that stood out to me about this report is that it was indeed a great find by the Guardian. It would seem that the GoMentum Station project was thrown back in the public spotlight a few weeks ago when the town of Concord and the Contra Costa Transportation Authority reached an agreement for how the space will be governed. GoMentum Station won't just be a testing site for self-driving cars, but also vehicles with self-driving technology and "smart" traffic signals and other technologies. Up to five automakers and 15 other companies may use the base with Honda and Mercedes-Benz having already agreed to test autonomous vehicles there.

Before then, the only confirmation that this site was going to be used to test self-driving cars seemed to come from a press release from this past October saying Mercedes signed up as a test partner. Considering that Apple communicated with GoMentum Station officials from this location only a few months ago, it's likely that the Guardian may have been the first outlet to find this scoop, or certainly unveil the details of correspondence between Apple and GoMentum.

The other aspect of the article relates to the seemingly definite title and byline in which the Guardian said: "Correspondence obtained by the Guardian shows Project Titan is further along than many suspected and company is scouting for test locations." There was nothing found in the correspondence published in the article that showed Apple was looking to test an actual Apple-branded self-driving car. Instead, we have information indicating Apple showed interest in using the testing area.

Instead of Apple looking to test a complete self-driving car in the near-term, it is much more likely that Apple is interested in using GoMentum Station to further advance its self-driving technologies. Think more along the lines of the cameras, sensors, and software that would make up the navigational brain of the car rather than a full car with carbon fiber and battery. Being able to test a self-driving rig in a real-world scenario with weathered roads, railroad track crossings, and tunnels would be an essential stage for Apple to take before getting to the point of testing the "Apple Car."

With nearly all evidence pointing to Apple giving the Apple Car project the green light approximately a year ago, I'm skeptical that Apple has a fully functional prototype ready to hit the road. The timing for something like that so soon after a team had been assembled (and is still being put together judging by recent hires) just doesn't sound right.

Apple is unable to test its self-driving technology on public roads in California without going through the permitting process which would serve as confirmation that Apple was indeed testing self-driving car technology. While Apple wouldn't need to disclose much information as part of the permitting process in California, aside from any information related to accidents, the mere confirmation that the company was looking to test self-driving car technology wouldn't exactly fit with Apple's model of placing an incredible amount of value in secrecy and surprise. If public roads are out of the question, that would mean that the only other option is GoMentum Station, another privately owned plot of land, or an Apple-owned location. There are plans to have other fake towns built around the U.S. to test self-driving cars, like Mcity, which is a 32-acre fake town in Michigan that opened last month. Ford, GM, Delphi and Toyota have all shown interest in using Mcity for testing. Considering GoMentum Station's proximity to Apple's resources and staff, this particular location in Concord would seem to be too good to be true.

Recall the WSJ article from this past February which explicitly made the claim that Apple's Titan project did not include a self-driving car. I think that was a head-fake, purposely passed down the grapevine to throw off competitors. There is increasing evidence that self-driving capabilities may in fact be positioned as an eventual selling point for an Apple-branded car. Self-driving technology, or even just the beginning stages of it, would go a long way in positioning such things as safety and convenience as attractive value propositions to consumers.

If you're Apple, a 2,100-acre former naval base lined with barbed wire would certainly seem to be a testing site worth checking out.

Along with the preceding story, the full list of stories sent to Above Avalon members last week included:

The iPhone's Future (six sections - Too Much Focus on the Near-Term, the iPhone's Changing Role in Our Lives, Form Factor Optimization, Addressing Price Layers, Changing Resource Allocation, About that Watch...)
Samsung's Unpacked Event
Comcast's Latest Investment in BuzzFeed and Vox is Significant
Abysmal Cable Network Viewership Trends
More Evidence Apple Music is Doing Just OK
Sprint is Betting the Company on iPhone
Free Cash Flow 101 (a key AAPL valuation metric)
A Closer Look at iPad Financials
A Closer Look at Mac Financials
Thursday Q&A (Why U.S. mobile carriers seem to love the iPhone all of a sudden?)

Become a member to receive these stories (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

Neil Cybart 8/14/15 Neil Cybart 8/14/15

U.S. Watch Sales Collapsed in June - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on August 11th.

This story flew under the radar late last week. Watch sales in the U.S. seem to be collapsing. Here's Bloomberg:

"U.S. watch sales fell the most in seven years in June, one of the first signs Apple Inc.'s watch is eroding demand for traditional timepieces. Retailers sold $375 million of watches during the month, 11 percent less than in June 2014, according to data from NPD Group. The 14 percent decline in unit sales was the largest since 2008, according to Fred Levin, head of the market researcher's luxury division."

A 14% year-over-year drop in unit sales is a pretty significant drop. According to NPD, timepieces priced from $50 to $999 saw declines in June, with the $100 to $149.99 range seeing the biggest drop, registering a 24% decline in unit sales. Just a few notes about NPD's data: they rely on consumer surveys along with point-of-sale data collected at individual retailers. NPD doesn't include sales from boutiques owned by watch brands, supermarket chains like Walmart, and online retailers. Think of it as if you are willing to share your sales data with NPD, you will then get much more comprehensive data from NPD in return.

Let's get the obvious out of the way first: we don't know if the Apple Watch is the reason for this watch implosion. Consider that Fitbit's earnings implied that the company sold at least 1 to 2 million devices in June, most of which were in the U.S. I think it is much safer to say that something is going on in the "wrist wearable" market because this watch sales decline is just too significant.

Apple could very well have been the top watch manufacturer in the U.S. during the month of June when looking at revenue. While NPD pegged U.S. watch revenue in June at $375 million, it is likely Apple sold around 1.5M Apple Watches in the U.S. during the same period bringing in somewhere around $700 million of Watch revenue. This estimate comes from the fact that Apple sold between 2 and 3 million Watches last quarter at an average selling price (ASP) of around $475. My theory is that the U.S. represented an outsized portion of Watch sales because of the number of U.S. Apple retail stores, which were important locations for showcasing the Watch to consumers. In addition, Watch sales were backloaded in June due to supply/demand imbalance.

There is evidence to suggest that much of the collapse in U.S. Watch sales was segmented to the low-end of the market. Swiss watch export trends did not show a similar level of collapse in June with U.S watch revenue actually up 5% in June.

When you add Apple Watch U.S. sales to those of other wearables like Fitbit, you likely had 2-3 million "smart wrist devices" being sold in June, which would come very close to outpacing the number of watches sold in the U.S.

It is an understatement to say we are still the early days of wearables (I have only seen one Apple Watch in the wild, although I am seeing more Fitbits these days), but I would look at NPD's watch sales data as one of very first pieces of evidence that there could indeed be deterioration in the traditional watch market caused by smart devices in the form of watches and fitness trackers with Apple and Fitbit being the market leaders.

Since owning Apple Watch, I'm more confident in saying the device may be a bit much to get used to at first if you are a luxury watch owner. It's not due to any particular inferior aspect of Apple Watch, but instead just the fundamental difference between wearing a computer on your wrist that tells time and so much more and a luxury watch that is worn for other reasons besides just giving you the time.

I do think it is more likely that Apple Watch will initially impact the low-end watch industry, which I will call "casual watch owners," those who may buy a $99-$299 watch just to have something on the wrist. This may explain why, according to NPD, the $100 to $150 space saw the biggest drop even though the Apple Watch retails for a good 3-4x the cost. In addition, watch loyalty at the low end is likely to be weak, and these consumers would be continuously on the lookout for new things to wear. Said another way, buyers in the $100 to $150 Watch range are more likely to experiment.

Given June's awful U.S. watch sales data, it is important to monitor if this is the start of a trend throughout the summer. If there are continued sales declines, then we are in a much stronger position to make more solid declarations about smart wrist wearables.

Along with the preceding story, the full list of stories sent to Above Avalon members this week included:

China's Yuan Devaluation and Apple (2,500-word story broken into various subtopics: What Happened?, Brief Background, Apple's China Growth Story is Cracking, Continued Yuan Devaluation Headwinds, Where Does This Leave Apple?, Final Takeaways)
The Smartphone Subsidy Myth
Thoughts on Alphabet
Finding iPad's Future
Apple Music Family Membership Strength
Jimmy Iovine on Curation
Cable's Problem
Fossil is Seeing Issues in the Watch Market
Thursday Q&A (AAPL valuation metrics)

Neil Cybart 8/10/15 Neil Cybart 8/10/15

Finding iPad's Future

The iPad raises interesting questions in terms of Apple strategy. A product that carries so much brand relevancy that it still represents the entire tablet market now finds itself the leader of a category that has lost all momentum as other product categories marginalize the tablet form factor. Although Apple is still selling more than 10 million iPads per quarter, there is something about the iPad that just doesn't sit right with me. We have gotten to the point that the status quo will likely lead to the iPad and the modern-day tablet becoming irrelevant over time. A new direction for iPad is needed based on a fundamental rethink of tablet computing.

The Current Tablet Market

The tablet market is in complete disarray. Only five short years ago, the iPad helped jumpstart the category, ushering in multi-touch computing and the modern-day app revolution to large-screen devices. Today, there has never been a time when the tablet market faces so much unknown.

A quick look at iPad and tablet shipment data would show that things have gotten bad in recent quarters. However, in reality, things are much worse than quarterly shipment data would suggest. The seasonality found in the tablet segment makes it difficult to see these long-term problems. A much better way at understanding what has been taking place is to look at the year-over-year change in shipments on a trailing 12-month (TTM) basis, highlighted in Exhibit 1. This smoothing effect highlights that the iPad and tablet have been on the decline for years and things continue to worsen with the overall tablet market hitting negative territory for the first time. All momentum has been lost.

Exhibit 1: Change in Trailing 12-Month (TTM) Tablet Market and iPad Shipments

After kicking off the tablet market in 2010, Apple went on to sell a cumulative 84 million iPads in just two years. The iPad's initial success was simply unprecedented, with unit sales outpacing the iPhone's relatively "slow" start by 2.5x. I suspect Apple wasn't just caught off guard by the iPad's success, but was led to believe that the iPad represented the future of computing. Many thought the iPad would outshine the iPhone.

In relatively short order after launching the category, Apple uncharacteristically expanded the iPad line to include a completely different form factor known as the iPad mini. The motive was primarily based on price, making sure there wasn't a repeat of the Windows vs. Mac battle from the 1990s in the tablet market due to Apple letting competitors underprice iPad. The iPad mini was soon called the best tablet ever, evidence that the larger form factor was losing a bit of its luster in just two years. Many didn't see it, but tablets were quickly turning into content consumption devices where price was a leading purchase decision.

We now find ourselves with a tablet market where Apple and Samsung are losing share to "Others," which is represented by dozens of firms selling mostly generic tablets used to consume media, depicted in Exhibit 2.

Exhibit 2: Global Tablet Market Sales Share

On a profit and mindshare perspective, Apple continues to lead the way. Instead of wishing for smart television sets, the future of TV watching is taking place with $99 tablets.

When looking at iPad's declining ASP trends, consumers continue to choose older, less costly iPads, another indicator that tablet computing is shaping up to be something different than we have been led to believe. A product category with a use case summed up by Netflix watching is quite problematic since it is that much harder to sell a differentiated product, leading to a rush to the bottom in terms of pricing, quality, and features.

Momentum is not on the side of iPad. Larger screen iPhones have been in the market for only 10 months. The latest Macbook, which effectively gave us a look at where the MacBook is headed, has been out for only a few months. These two products are game changers not just in their categories, but for tablet computing. It is becoming that much easier to recommend an iPhone or Macbook over an iPad.

Tablets Are Being Used for Consumption

When the iPad first started to show signs of trouble, many market observers were shocked, thinking Apple must be losing to low end Android tablets. In reality, one reason sales momentum was slowing was iPad owners weren't upgrading their device. Using Fiksu data and my own estimates, consumers have held onto their iPad, on average, for three years, which is longer than the iPhone's 2.6-year upgrade cycle. Since the tablet category is still young, the iPad's three year upgrade cycle is still extending and will likely go out as far as 5-6 years. The theory that a longer upgrade cycle was impacting iPad sales began to be used in the press and conference calls.

Exhibit 3: Current iPad Mix (model and model year)

While there is nothing inherently wrong with a long upgrade cycle, as seen with the Mac, which continues to report solid sales momentum, the reasoning behind holding on to tablets for years is much more troubling. There are currently approximately 3 million units of the original iPad still in use, or 20% of the devices Apple sold. For the iPad 2, it is possible that close to 60% of the units Apple sold are still being used. These two devices are not superior tablets. The initial iPad lacks a camera, while the iPad 2 has a mediocre camera. When compared to the latest iPads, these first two iPads are simply inferior tablets with slow processors, heavy form factors, and inferior screens. But none of that matters with owners. This is problematic and quite concerning, suggesting that many of these tablets are just being used for basic consumption tasks like video and web surfing and not for the productivity and content creation tools that Apple has been marketing.

There are signs that Apple believes there may be some kind of iPad revival around the corner. Since the average iPad upgrade cycle is three years and counting, does this mean that Apple may benefit from some sort of upgrade cycle? I'm skeptical. Why would someone upgrade an iPad that is just being used to watch video?

Potential Isn't Reality

On the surface, the iPad's declining sales momentum is difficult to comprehend. There seem to be so many use cases for larger-screen multi-touch computing devices across a number of industries. We hear about "iPads in the classroom," new and interesting enterprise apps resulting from the Apple/IBM partnership, plenty of anecdotal evidence of children loving to play games on iPad, and of course, iPads replacing desktops, laptops, and televisions. Apple has consistently referred to superior iPad satisfaction rates on earnings calls which support the idea that people love their iPads. Yet in the face of all this potential, we are just using iPads for Netflix and YouTube.

On closer examination, there are cracks in the iPad story. School districts have seen mixed results with iPad adoption programs. We have seen a few high-profile disasters where the combination of a lack of curriculum built for the iPad, along with high costs, made the iPad not the magical device in the classroom once thought. The idea of replacing student books with iPads never materialized due to poor incentives in the textbook industry, not to mention technological limitations found with the device.

The scope of iPad in enterprise still remains mostly a dream. We are seeing more stories about enterprise embracing Macs, not iPads. Meanwhile, consumer usage on iPad has moved away from content creation apps. Take a look at the iPad App Store to see the lack of compelling apps for larger screens for additional evidence of iPads being used much more for basic content consumption.

Things are Getting Worse, not Better

Back in October 2014, I wrote a post titled "Thoughts on iPad," in which I explained the iPad's ultimate sales trajectory would be much more modest as Apple was selling large-screen iPhones and thinner Macs. While I received an incredible amount of pushback at the time, trends have largely materialized as I expected. The continued migration of smartphone manufacturers to 5+ inch screens was not just a game changer for the smartphone market, but will come to represent a watershed moment for the tablet market. Many of the use cases once destined for the iPad are permanently gone, now taken up by the iPhone and MacBook.

Another consequence of growing large-screen smartphone popularity is that it is becoming increasingly difficult for Apple to market the iPad Air and iPad mini. Features such as cameras and even Touch ID simply don't make as much sense on a device that can't be comfortably held in one hand or carried in a pocket. Apple has tried to position the iPad as a mobile device, emphasizing its ability to take photos and video on the go, but it's not realistic to assume people will prefer an iPad to an iPhone in such settings.

Not only are tablets being used for more rudimentary purposes, but smartphones and laptops are crippling the odds of tablets being used for much more. The iPad market is in trouble and if there are no changes made to the lineup, Peak iPad is on the table. Peak iPad is a simple concept driven by the belief that underlining structural changes to the tablet market would result in the iPad losing most of its value propositions, leading to a permeant decline in sales. For example, Peak iPod is alive and well as even though Apple is still selling iPods, the product category will never reach record quarterly sales. Meanwhile, while some argued that we had seen Peak Mac, we instead were just in a sales slump that quickly reversed itself with a revamped product line. The Mac's value propositions were still alive and well. In a world where smartphones are getting larger and laptops are getting smaller, the Peak iPad theory is starting to look more likely as time goes on. Something needs to be done to create new tablet value propositions, redefining its role in the mobile revolution.

Apple's Plan for iPad

It is time to fundamentally address the problems with multi-tech tablet computing. The answer is to introduce a new product subcategory at the high-end of the tablet market. With video consumption taking over at the low-end, it becomes that much harder to sell a differentiated product at a low price. Apple has better chances of pushing the tablet market forward by looking at the high-end of the market where a superior experience is able to be sold at a premium price.

By selling a device that is truly designed from the ground-up with content creation in mind, the iPad line can regain a level of relevancy that it has lost over the past few years. In every instance where the iPad is languishing in education and enterprise, a larger iPad with a 12.9-inch, Force Touch-enabled screen would carry more potential. Simply put, the iPad needs to stand out from the iPhone and Macbook. The iPad Air and iPad mini aren't doing it.

Education. Instead of pushing the idea of every student having an iPad, which is difficult when considering costs and the fact that most students already have a smartphone and laptop at home, school districts could set up "iPad Plus" rooms with 20-30 of the larger iPads reused throughout the day by various classes. A new larger iPad with nearly 80% more screen real estate than the iPad Air, dedicated accessories like a smart pen, and better covers and stands can go a long way. It can become part of art and design classes, not to mention a number of different disciplines, including those where writing is involved. Writing a term paper on an iPad mini or even iPad Air is not fun. A larger tablet with full-size on-screen keyboard using Force Touch to resemble the haptic feedback of a real keyboard may be a game changer.

Enterprise. A larger iPad could be positioned as a laptop replacement whereas today's iPads are stuck in a weird place as a secondary computer. Any design-oriented field would instantly see value in using these larger iPads while traditional industries such as finance and banking would see a much easier adoption rate if legacy products like Excel are made that much more easier to use.

Consumer. A large iPad could continue down the path of replacing old laptops and desktops, becoming a user's primary computing device. The much easier ability to type means that nearly every possible computing use case would be covered. This 12.9-inch iPad Plus will begin to look much like the Mac in terms of sales with a slow and steady sales uptick, followed by an orderly upgrade cycle. The key for such a device will be once again redefining where a tablet should sit in someone's product portfolio. We know everyone will have a smartphone. The question would be if a new type of device can exist between an iPad Air and MacBook.

Over the years, we have come up with differing degrees of the "perfect combo" for computing. It used to be an iPhone and iPad. Then it became an iPhone and iPad mini. Now many say iPhone and MacBook. The question will be whether or not a product can be created that will serve as a high-end creation device that compliments an iPhone.

What Does Success Look Like with a New iPad?

An iPad Plus does not need to sell like an iPhone or even like an early edition iPad to succeed. As long as the product has use cases that are sheltered from other products, Apple would be able to reposition the iPad line for a more sustainable path not just for growth, but ultimately for outright survival. If the end goal is to ship devices that help solve users' problems, Apple will have a winner on its hands. A more capable iPad Plus has a much better chance of becoming relevant in a world where the iPhone is already the all-powerful device everyone owns. The early days of the iPad era provided many opportunities to see how the definition of work is changing. A new tablet subcategory that does a better job of pushing the definition of work forward is needed. Tablet computing has a much brighter future than just being used to watch Netflix and YouTube.

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Neil Cybart 8/3/15 Neil Cybart 8/3/15

Apple Watch is Coming to Best Buy - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on July 28th.

Apple Watch is Coming to Best Buy

The Apple Watch continues to throw us curve balls. The latest is courtesy of a Best Buy press release:

"The Apple Watch, one of the year's most talked about and innovative products, is coming to Best Buy.

Starting Aug. 7, Best Buy will be the first national retailer, other than Apple Stores, where customers can buy the Apple Watch. It will begin to arrive in more than 100 Best Buy stores and will also be available on BestBuy.com. Another 200 of our stores will have the Apple Watch in time for holiday shopping."

The first thing to note is the relatively slow roll-out. Even though August 7th is next week, it sounds like it will take some time for Apple Watch to be in the first 100 stores. The U.S. holiday shopping season is still four months away, and there are 1,050 Best Buy stores in the U.S. For there to be only 300 stores to have the Watch by November suggests that there will likely be special Watch display areas set up in the Apple areas within Best Buy stores. Will Apple utilize Watch display tables similar to the ones in Apple retail stores or will Apple build special (smaller) tables just for Best Buy?

It's clear we should expect the Watch to be sold in a refined way, even at Best Buy. That is one reason why the Apple Watch display tables are so great, representing a new take on how luxury watches are displayed to the public. Traditionally, you think of a watch display case in a Bloomingdale's where dozens of watches are packed together in glass cases. In terms of other smartwatches, the display method is nothing short of a mess with some Android Wear devices attached to tables like a pen chained to the table at a bank.

Best Buy detailed the Watch models that will be available in its stores: "[C]ustomers will be able to see, try and buy 16 Apple Watch models - including Sport and Watch models in both 38mm and 42mm sizes - and nearly 50 accessories, including watch bands, screen shields, stands, chargers and more."

Does "try on" mean I would be able to wear the Watch or simply play with the device while it is stationed to the table? There are still questions left unanswered.

The much bigger stories here are the expanding Watch retail distribution and the delicate balance Apple has to manage between selling luxury and premium mass-market items.

Apple Watch is currently sold in 266 Apple retail stores in the U.S., so this Best Buy deal effectively doubles the retail presence in the U.S., which should not be underestimated. It's important to remember that there are millions of people that don't live near an Apple store and have not had the opportunity to see or play with Apple Watch. I would expect other retailers to sell Apple Watch in time for the holidays as Apple management stressed that key shopping time frame on last week's earnings call.

Over the past few weeks, because there has been so much attention given to whether the Apple Watch has been a flop or not, many have forgotten that Apple is now a premium mass-market luxury brand. By selling Watch models ranging from $349 to $17,000, Apple needs to rely on a particular kind of retail strategy in order to not alienate certain customers.

As I wrote a few months ago, the answer seems to be segmenting the Sport and Watch models from the Edition. Such segmentation makes it possible to sell the Sport and Watch in more mainstream retailers while not hurting the appeal of the Edition, or at least that would be the theory.

Here's a snippet from a post I wrote back in March titled, "The New Apple: Embracing Personalized Technology with a Luxury Twist":

"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'...There will likely be very few instances of $349 Apple Watch Sports being sold next to $17,000 Apple Watch Editions."

We are in unchartered territory, not just because we are talking about a personal luxury tech gadget, but because Apple is actually pushing a different kind of luxury with all of the watch models having the same fundamental functionality, the only difference being aluminum, stainless steel, and gold watch cases.

While some may poke fun at Apple Watch being sold at Best Buy, in reality the decision makes perfect sense and will not hurt the luxury image that Apple is going after because of the Watch collection segmentation that is present.

Along with the preceding story, the full list of stories sent to Above Avalon members last week included:

Apple Talked with BMW About Electric Cars
The Unknown Tablet Market
Elon Musk is Experimenting (with electric car retail)
I Saw My First Apple Watch in the Wild
New Apple Watch Ads
Apple Music Subscriber Numbers
Apple Music's Problem
Motorola's New Phones
Why There's Nothing Quite Like iPhone
Thursday Q&A - Media Edition (Disney, Snapchat, and Vine)

Become a member to receive these stories and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

Neil Cybart 7/27/15 Neil Cybart 7/27/15

Apple Car Development is Advancing - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily email about Apple to members (10-12 stories per week). The following story was sent to members on July 21st.

Apple Car Development is Advancing

The Apple Car development project appears to be on track. The WSJ is out with a new report indicating Apple continues to hire auto-related executives and researchers. The latest are Doug Betts, one of the highest auto executives confirmed to now work at Apple, and Paul Furgale, a researcher involved in autonomous vehicles, mapping, and robotics.

Since the Apple Car project remains unconfirmed, the primary evidence we have to judge the project's progression (or lack thereof) is hires and fires that are likely related to Apple's efforts with automobiles.

Here is the WSJ:

"Mr. Betts could be the first major automotive executive to join Apple with experience leveled more at the manufacturing side of the business.

For nearly two decades, he has worked in product quality and manufacturing at an auto company, first as a general manager at Toyota Motor Corp. and later as a vice president at Nissan Motor Co. and Chrysler Group LLC, now FCA US LLC.

In 2009, when Fiat SpA took over Chrysler, CEO Sergio Marchionne tapped Mr. Betts to lead the company's quality turnaround, giving him far-reaching authority over the company's brands and even the final say on key production launches.

Mr. Betts abruptly left Fiat Chrysler last year to pursue other interests. The move came less than a day after the car marker's brands ranked poorly in an influential reliability study."

The WSJ is being pretty kind here in describing Betts' departure. Most industry watchers think Betts was fired this past November due to Fiat, Jeep, Ram, and Dodge taking the bottom four slots on the influential Consumer Reports reliability survey, with the Chrysler brand not far behind.

Obviously, news of Betts being fired due to poor quality performance wouldn't seem to sit right with this latest news from the WSJ that Apple hired him. What is going on?

Industry watchers say Betts was likely used as a scapegoat as the quality problems facing Fiat due to acquiring Chrysler were simply insurmountable and indicative of much bigger company and culture issues, things that one person would not be able to solve on their own. The Daily Kanban, a site dedicated to covering news and analysis from the auto industry, with a focus on Toyota, summed up Chrysler's problems well:

"Chrysler's quality problems seem to be coming from nearly every possible corner. In just a few of the most recent issues to hit the media, FCA [Fiat Chrysler Automobiles] has shown it has problems with everything from a lack of development testing (vibration leading to cracks in Ram Ecodiesel exhaust coupling), to assembly problems (Hellcat fuel leaks). Supplier problems have also featured heavily in FCA's quality snafus, most recently in a recall of Chrysler 200 transmissions due to 'inconsistent assembly procedures at a supplier's plant,' even as [FCA CEO] Marchionne has targeted supplier profits. But perhaps most troubling is the evidence that FCA simply isn't able to catch quality problems before cars go out to customers...

[A] fired executive scapegoat and a snarky [YouTube] ad were deemed a solution to a long-term quality problem. Little wonder Chrysler still finds itself at the bottom of Consumer Reports recommendations."

When you take a step back, Betts' hire at Apple makes much more sense. Betts is a senior level auto executive with stints across a number of companies, including time as head of product quality and supply chain for the Tundra, Sequoia, and Sienna at Toyota in Indiana, where manufacturing techniques are still the envy of the auto industry. This may just be coincidence, but all three of those Toyota vehicles are either SUVs or trucks, and Apple's car project was rumored to include a larger, minivan-type vehicle. Even though he was not able to turn around FCA's fortunes, it is very well possible that Apple sees value in applying his skills and experience to their current project.

One other aspect of Betts that many may not catch is that he has previous experience as Head of Total Customer Satisfaction for Americas at Nissan, which in car lingo means controlling the experience a customer has with a car brand, including everything from how a car is built, to it being bought at a dealer. Betts was overlooking the Nissan experience. Now recall how Apple is all about selling experiences. It sure does seem to fit in my mind.

On his LinkedIn [update: his profile has been deleted], Betts is likely using misdirection, simply saying he is working in Operations at Apple, similar to how former Mercedes R&D head, Johann Jungwirth, lists his job duty at Apple as Director of Mac Systems Engineering.

Betts would seem to be a senior-level hire for the Apple Car group, overseeing an entire team or division within the larger initiative led by Steve Zadesky. It is this type of structure that makes me much more bullish of a full-fledged product under development.

The WSJ has more on Apple apparently hiring Paul Furgale:

"Earlier this year, Apple hired Paul Furgale a well-regarded autonomous vehicle researcher in Switzerland, and has begun recruiting other robotics and machine vision experts to work on a confidential project."

Just to give you a few examples of the type of research Furgale was previously involved in as late as last year, here is a sampling of the publications listing Furgale as a co-author:

Keyframe-based Visual-Inertial Odometry Using Nonlinear Optimization
Lighting-Invariant Adaptive Route Following Using Iterative Closest Point Matching
Infrastructure-Based Calibration of a Multi-Camera Rig
Self-supervised Calibration for Robotic Systems

Here's more from the WSJ:

"Mr. Furgale had been deputy director of the Autonomous Systems Lab at the Swiss Federal Institute of Technology, or ETH. Mr. Furgale previously had led a European Commission project called V-Charge that sought to develop self-parking vehicle technology...

Mr. Furgale has begun recruiting students and researchers to work with him. Apple has hired a graduate student studying at the University of Michigan and has quietly recruited others."

Two points that I get from this news: 1) Compare Betts to Furgale. While one is a senior-level auto manager, the other is knee-deep in technology and research. Apple is hiring a mix of talent from both the legacy auto industry, as well as academia. 2) I look at the earlier reports back in February saying that Apple wasn't researching autonomous vehicles as a head fake, or misdirection. Evidence suggests they are. Of course, we need to take a few steps to get from Point A to Point B, including semi-autonomous features like better parking and highway travel, but like with any product, I suspect Apple is looking farther in the future, at a world where autonomous vehicles are much more likely to control the road.

Betts and Furgale are both interesting auto-related hires that further strengthen the theory that Apple's ambitions in the automobile industry have no bounds.

Along with the preceding story, the full list of stories sent to Above Avalon members last week included:

Apple Earnings Summary - Big Picture, Stock Price Reaction, iPhone: Relatively Quiet (Which is Good), Apple Watch: It's Very Early and Things Look Okay, iPad Sales Growth: Fact vs. Theory, Share Buyback: It's Slowing, Additional Earnings Call Notes
The Day After Apple Earnings on Wall Street
The Wild Ride on Wall Street
Judging Apple Watch Success/Failure
Beme and the iPhone Ecosystem
Apple Music - A Few Thoughts Three Weeks In
Washington Looking at Foreign Cash Tax Reform
Thursday Q&A

Become a member to receive these stories, including my full AAPL 3Q15 earnings recap (will be sent to you via email), and future stories in a daily email containing 2-3 stories (10-12 stories/week). For more information and to sign-up, you can visit the membership page. A weekly option is also available if you prefer to receive one email instead of four each week.

Neil Cybart 7/20/15 Neil Cybart 7/20/15

Flops, Winners, and Outliers

When is a product a flop? What does a winner look like in consumer technology? How can outliers complicate our thought process? The Apple Watch is getting us to ask all of these questions while failing to provide the instantaneous answers that we crave. Not only has Apple's recent success led market observers to put value in short-term thinking and cynicism, but we have lost all context for how to properly measure product success and failure. It is clear that instead of thinking of flops, winners, and outliers as meaning the same thing across products and companies, context and discernment are needed to properly assess reality.

Flops

Apple has single-handedly morphed the definition of a flop. What once referred to products that were never able to make a lasting impression in consumers' minds (e.g. HP TouchPad, Blackberry Playbook) has now expanded to include product sales that are less than the best selling Apple products of all-time. Some of this aggressiveness to slap the flop label on new products so quickly comes from the proliferation of products not ready for prime time. It remains a mystery why the Amazon Fire Phone ever saw the light of day. Similarly, tech companies positioning their R&D efforts into the public sphere with products like Google Glass have gotten us trained to look for and expect instant flops: products that are never able to find a niche due to a plethora of reasons. Flops aren't just kept for hardware products as a number of Facebook apps, such as Poke and Camera, never were able to find an audience before being thrown aside.

Set in this somewhat confusing environment is Apple, a company that has relied on a strategy of placing very few hardware bets in order to focus attention and resources on a handful of products. In some ways, this rare and unique strategy, which other companies look down upon as being too risky for their own taste, would seem to necessitate a different kind of analysis when it comes to flops. Consensus opinion has landed on the stance that if Apple gave the green light to a new product, that must mean Apple expects it sell in numbers like an iPhone and iPad; anything short of this threshold should earn the flop label.

The primary problem with that thinking, and flops in general, are that they require context, both in terms of setting and timing. There is simply too much diversion in company resources and strategy to use the same flop brush across products, not to mention companies. Even though Apple releases very few products, not everything that comes out Apple HQ is positioned to reach tens of millions of users. Going further, certain models or SKUs may be geared toward a very specific niche that doesn't add up to more than 100,000 customers (think: Mac Pro). This introduces confusion and complexity into what is a flop.

Winners

There is still much disagreement over how to quantify winners in consumer technology. Is market share leader the title one should strive for? In the phone industry, the feature phone master, Symbian, was cast aside in a few short years. Blackberry's early smartphone power was decimated within roughly the same time span. While some may point to profit market share as the more suitable choice for determining success, Apple's monopoly on profits in markets that it plays in doesn't sit well with some people. How about year-over-year growth being used as a litmus test for success? There was a time when Microsoft being able to grow its smartphone market share from one to two percent was classified as a resounding success.

Similar to how flops require context for proper judgement, a product's success is also relative. For a smaller company like GoPro or Fitbit, if the latest camera or fitness wearable registered one million unit sales in a quarter, Wall Street may reward the company with accolades and rating upgrades. For Apple, the same sales rate for a more mature product would be a disappointment, and surely earn a flop badge. There is nothing inherently wrong with this differing rating system and one could argue that is exactly how it should work. The problem with that line of thinking is that success for a company like Apple begins to take on mythical proportions. Everything to come out of the design labs would inevitably be compared to iPhone, a product that Apple is on track to sell 250 million units per year.

How should a winner be defined? Ultimately, the easiest and most universal definition may involve measuring a product's trajectory and looking for signs of momentum.

Outliers

If it wasn't already difficult to figure out how to define a flop or winner, outliers may lead us to continue to struggle trying to find answers to these questions. The iPad is a great example of an outlier, a product that had impeccable market timing and an environment ripe for early sales success. The end result is 280 million units being sold in five years. Today, the product is facing questions as to its long-term trajectories with much of its functionality now being met with other products. When the iPad was launched, the running joke was that it was just a big iPod touch. In retrospect, it was that label that likely indicated why it sold so well, so quickly. It was a product that shared most of the allure of iPhone, only with no contract and a much larger and attractive screen. Once the iPhone screen got larger (and the Mac got thinner and lighter), the iPad was squeezed. The much longer life cycle for the product hasn't helped sales either as consumers hold on to their iPads for much longer than their iPhones.

In our attempt to quantify Apple Watch success, comparisons to the iPad may lead to faulty conclusions, both from a positive and negative angle. It may be too optimistic to assume that a new Apple product can see the same adoption rate as iPad. Just as the iPad is now facing a sales plateau, such a barrier may represent an incorrect conclusion as to how well a new product could do over time.

Another outlier question that undoubtedly needs to be asked involves the iPhone. Is Apple's juggernaut truly a one-of-a-kind product? With such a short upgrade cycle, aided by Apple's relationship with mobile carriers across the world, will it be extremely difficult for another product to meet similar annual sales rates?

What to do?

Taking into account the complications and difficulty in defining flops and winners, set within a sea that contains a few outliers, how should one go about measuring a product's performance?

1) Establish Context. What kind of product is being measured? A $99 fitness wearable that requires no other device to do its job or a $3,500 Mac Pro designed for movie makers? Does the product require a monthly contract or other recurring cost? Will a decaying battery over time require the product to be replaced in a few years, or is the product designed to last many years?

2) Establish Parameters. How should success be defined? Obviously there are major differences when discussing hardware and software initiatives. On one hand, quarterly unit sales may suffice while on the other hand, reaching scale in the form hundreds of millions of users may be the only way to reach success. Even within the same product category, different parameters may exist. For a phone, should we measure success in terms of sales share, profit share, or mind share?

3) Look for Momentum. Rather that merely thinking about a product's long-term potential, it is important to find momentum or signs of life. App developer involvement, early success within a specific demographic, or increased word of mouth may all signal that a product has life and potential to grow over time.

4) Measure Results. It is important to find ways of quantifying parameters and momentum. It is not a coincidence that many technology companies have adopted policies that revolve around providing little to no product sales disclosure. While some of this could be related to competitive reasons, the much more likely reason is to hinder Step #3 from above, making it difficult to know if a product is failing in the marketplace. While Amazon is known for its lack of disclosure, the company has not been shy when disclosing the number of Prime memberships. Along similar lines, Samsung was quick to reveal smartphone sales as the company was consolidating power within the Android OEM space, but when facing struggles at both the low-end and high-end of the smartphone market, the company has now adopted a policy of not disclosing smartphone sales. Even Apple is known to partake in the "tell the world good numbers" party while keeping mediocre results private.

These four steps indicate that measuring flops, winners, and outliers is not easy and likely involves much effort and time: attributes that are seemingly in decreasing supply. The iPhone and iPad may have spoiled us when it comes to thinking about what failure and success mean in consumer technology. In order to get a better grasp of what is happening close to the ground, more effort will be required to bypass the rhetoric and rely on logic and processes to guide the thought process. It won't be easy, but we need to start somewhere.

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

Neil Cybart 7/16/15 Neil Cybart 7/16/15

AAPL 3Q15 Earnings Preview

Apple is positioned to report another quarterly earnings beat when reporting 3Q results on July 21st. Apple continues to benefit from attractive year-over-year sales comparisons in China. Overall revenue growth is tracking close to 35 percent, with earnings growth exceeding 50 percent. With the iPhone now representing close to 70 percent of Apple's operating income, the product category has become the single-most important factor driving earnings, and that trend will continue in the near-term. With lingering Apple Watch demand questions, many will use earnings as the first opportunity to back into Watch unit sales. Apple guidance should be informative, reflecting not only a new iPhone launch, but also an early read on July sales and any impact from ongoing economic turmoil in China.

Earnings Preview Reading

Over the past three months, the major stories impacting Apple financials have centered around three topics: the iPhone's growing power, Apple's cash, and China Mobile. The following stories serve as good background reading in the lead-up to Apple earnings.

The iPhone is Taking Over Apple - Apple will be the iPhone company for the foreseeable future. The iPhone's gravitational pull is simply too strong for any new product or service to reach escape velocity and become the next big thing for Apple in the near-term.
Apple's Cash Dilemma - Apple is unable to keep the pace of share buybacks and dividends in line with its foreign cash generation.
China Mobile is a Game Changer for Apple - China Mobile has become Apple's most important business partner.

iPhone: No Change in Momentum

Strong iPhone sales trends in China, Europe, and emerging markets will continue to offset lackluster smartphone growth in the U.S. Last quarter, I estimated China Mobile accounted for nearly 40% of Apple's year-over-year iPhone growth, which was certainly boosted by the Chinese New Year in February. China Mobile's importance cannot be stressed enough as the largest mobile carrier in the world will soon account for 20% of all iPhone shipments. Given lower smartphone adoption rate in China compared to U.S. and Europe, I would expect China to continue representing a majority of iPhone growth for the next few quarters.

Exhibit 1: iPhone Unit Sales Expectation Meter (3Q15)

Mac and iPad: No Longer Earnings Factors, but Still Interesting

Due to the iPhone's elevated share of earnings, the Mac and iPad are no longer relevant from an earnings day perspective. There are still interesting trends at play within each category. The Mac is continuing to take share in a category that is pretty much being decimated with overall PC shipments forecasted to be down 5-10% year-over-year this past quarter. The iPad continues to struggle as the product finds a normalized run rate where the combination of first-time buyers and upgraders results in roughly flat growth. We are not there yet.

Exhibit 2: iPad and Mac Unit Sales Expectation Meters (3Q15)

Apple Watch

Even though Apple is not expected to disclose Apple Watch sales, keen observers with an Apple earnings model will be able to back into a relatively good approximation of Apple Watch sales. I am expecting Apple to have sold 4.25 million Apple Watches from April to June. While there has been much debate as to how the Apple Watch has been selling, more time will be needed to gauge normalized demand; there was evidence of pent-up demand at launch as would be the case with any new Apple product category.

Guidance

Management's guidance will be useful for a few reasons. Since we are quickly approaching the new iPhone launch, guidance will help determine what Apple has seen so far in the month of July in terms of iPhone demand. While there shouldn't be much spillover just yet from the volatile Chinese stock market, any caution built into China sales due to economic concerns may become apparent in guidance. In addition, next quarter will present a more informative view on Apple Watch sales as we move away from launch.

Exhibit 3: Revenue and Margin Guidance Expectation Meters (for 4Q15)

Screen Shot 2015-07-16 at 9.09.39 AM.png

Wall Street Concerns

The biggest headwind facing Apple continues to be fears of slowing iPhone growth in 2016. As has been the case for the past few conference calls, analysts will look for any new commentary on Android switcher rates and iPhone penetration in China and other developing markets. If 2015 was the year of China Mobile and large screen iPhones, company observers are becoming skeptical that the new iPhones will be able to sustain the same type of growth rates next year.

For additional commentary and perspective on Apple's upcoming earnings, become a member to receive my premium emails from this week (Tuesday, Wednesday and Thursday). To receive these emails and future daily emails containing Apple analysis (10-12 stories per week), sign-up here.

Neil Cybart 7/9/15 Neil Cybart 7/9/15

The iPhone is Taking Over Apple

One theme has become clear in 2015: the iPhone's gravitational pull is simply too strong for any new Apple product or service to reach escape velocity and become the next big thing for Apple in the near-term. From a financial and business perspective, the iPhone is the only product that matters. The iPhone is amassing so much power at Apple, it is difficult to imagine any product being able to dramatically surpass the iPhone in terms of importance over the next five years. Apple will be the iPhone company for the foreseeable future, and that classification introduces opportunities and risks that Apple will need to navigate over the coming years.

Perspective

This past month, the iPhone celebrated its 8th anniversary. It is easy to forget how significant of a factor the iPhone has been to Apple's business since launching in 2007. Taking a look at cumulative data over that time span helps to put the iPhone's one-of-a-kind product status into perspective.

726 million iPhones sold
$443 billion of revenue (50% of total)
$200 billion of gross profit (60% of total)
$120 billion of net income (60% of total)

As a sign of continued iPhone momentum, Apple is now selling up to 250 million iPhones a year, or close to a third of total iPhones sold to date.

iPhone's Importance to Apple's Financials

Everyone knows the iPhone is a crucial part of Apple's business, but few realize the extent to which the iPhone is literally taking over Apple's financials. In the first half of FY2015, the iPhone accounted for 69% of Apple's total revenue, up from 57% of revenue during the same time period last year. In terms of gross profit, the trend is even more pronounced, with iPhone accounting for 81% of Apple's gross profit over the past two quarters, up from 68%. Much of this change is related to strong iPhone sales in China following the iPhone 6 and 6 Plus launch in addition to China Mobile beginning to sell the iPhone last year. It has gotten to the point that Apple's quarterly earnings reports should be renamed "iPhone sales updates" because no other part of Apple's business is able to impact the financial statements quite like iPhone.

Exhibits 1 and 2 highlight the iPhone's overall contribution to Apple's revenue and gross profit.

Exhibit 1: iPhone Revenue as Percent of Total Apple Revenue (Fiscal Year)

Exhibit 2: iPhone Gross Profit as Percent of Total Apple Gross Profit (Fiscal Year)

The iPhone's strong margins and short upgrade cycle contribute to the device's significant share of Apple's revenue and earnings as iPhone users are likely to upgrade their high-margin phones every two or three years.

One example of how important the iPhone is to Apple's earnings is a hypothetical scenario in which Apple missed iPhone unit sales quarterly expectations by 10%. Such a scenario wouldn't necessarily be too much of a stretch considering Samsung misjudged demand for the Samsung Galaxy S5 by 40% last year. If Apple missed iPhone sales expectations by 10%, or five million units, EPS would have fallen by 10%. If we then assumed iPad or Mac sales missed expectations by 10%, the resulting EPS impact would be a rounding error.

It is getting to the point that the iPad or Mac are nothing more than asterisks on Apple's quarterly earnings reports which is saying a lot given their influence and sales numbers. Even the pace of Apple's capital return program is starting to be controlled by the iPhone given the product's significant contribution to U.S. cash flow and consequentially available funds to spend on buyback and dividends. Over the course of eight years, the iPhone has earned more than $100 billion of cash for Apple, which has gone a long way in buying back shares and paying dividends.

iPhone's Importance to Apple's Business

From management's point of view, the iPhone's significant power presents both business opportunities and risks. The iPhone's success has given Apple a formidable presence in mobile in terms of market power and positioning. Across the world, the iPhone 6 and 6 Plus have helped Apple grow market share, with a total iPhone user base close to 500 million. This environment remains quite appealing to developers and third-party companies willing to invest in the iOS ecosystem.

Besides funding the capital return program, the cash flow produced from iPhone sales has also been used to help develop new products and initiatives. While iPod sales helped fund iPhone development, iPhone sales will help fund Apple Car development.

Nevertheless, very strong iPhone growth trends do present some risks. From Apple's point of view, it is in their best interest to keep the iPhone user base vibrant and engaged. Such efforts go a long way in preventing fragmentation or stagnation. Accordingly, a situation may arise in which Apple finds itself with such a large iPhone user base that a growing number of users do not upgrade to the latest OS version, weakening the iPhone ecosystem.

In iOS 9, Apple included a series of features to address and turn around slowing iOS adoption rates likely due to users not having enough iPhone storage. As one example, users will receive a pop-up when trying to install iOS 9 on a device with insufficient space and offer to temporarily delete apps in order to make room for the update. The deleted apps would be reinstalled once iOS 9 has been installed. In addition, app thinning, app slicing, on-demand resources, and bitcode are all designed to maintain the vibrant nature of the iPhone user base, especially those who may be using older models.

Another risk created with strong iPhone sales is the difficult part of needing to push the iPhone forward in terms of hardware or software design while facing a growing amount of pushback from users opposed to change. The theory here is that the larger the user base, the more heterogeneous the composition including variation in taste and desires. The end result may be that changes alienate a group of iPhone users. One example of this is Apple changing the iPhone dock connector. A software example is how iOS 7 brought a new look to everyone's iPhone. The fear of embracing change due to potential user pushback or revolt has led to disaster at other technology companies since the lack of change gave competitors room to offer a better product. Evidence would suggest Apple has no intention of following a similar path. Take a look at the newest Macbook for evidence of Apple not being afraid to push design forward even if it meant alienating some users.

One of the biggest risks that Apple faces from a strong iPhone is that the product's importance leads management to ignore other opportunities that may seem too small to matter and are unlikely to reach the iPhone's stature in terms of revenue and profit. In reality, it is those kinds of risks that need to be taken in order to be in a position to eventually ship a product that will one day surpass the iPhone in terms of importance. Once again, Apple seems to be aware of this risk as the Apple Watch certainly contains attributes that may one day lead to people being able to accomplish a good portion of their computing needs with just a device worn on their wrist.

Strengthening iPhone's Value Proposition

The next five years for Apple will likely focus on new products and services positioned to increase the iPhone's value proposition instead of become the next big thing that will eventually surpass the iPhone. On some level, that may sound like Apple is operating in a lower gear than it did in the 2005-2010 period, and in some ways that is true for the simple fact that it is incredibly difficult to ship a product that is more important than the iPhone within a few years of its birth. This dynamic raises some interesting questions including whether this is one reason for Jony Ive's promotion to Chief Design Officer, which frees him from day-to-day managerial duties and instead allows him to look at more strategic tasks in terms of Apple design. These tasks include adapting the company's retail infrastructure to embrace luxury wearables.

It is impossible to say Apple will never ship a product as important and profitable as the iPhone because "never" is quite a long time. Most consumers spend $600-$700 on an iPhone every two or three years which means there is plenty of opportunity to have people spend more money on new Apple products and services. However, over the next five years, the iPhone will remain the most important product that Apple sells, and it would seem that Apple wouldn't have it any other way.

One of Steve Jobs' quotes that has been displayed at Apple HQ sums up Apple's long-term plan with the iPhone really well: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next."

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Neil Cybart 7/3/15 Neil Cybart 7/3/15

Trent Reznor Talks Apple Music & Above Avalon Premium Week in Review

Along with periodic Above Avalon posts, I send out a daily update containing stories (10-12 per week) to Above Avalon members via email. The following is a sample story sent to members on July 2nd.

Trent Reznor Talks Apple Music

We are getting a much clearer picture of how Apple Music was created through the creative direction of Trent Reznor.

As a very brief background on Reznor, he, along with Ian Rogers, joined Beats to help launch a music subscription service. The end result was very similar to what we see today with Apple Music.

Reznor has been quite vocal in the past about the music industry and the volatile relationship between artists and music labels when it comes to money. He experienced the music industry from both the perspective of an independent artist and the view of an artist receiving support by a major label, which serves as good background for working on a music subscription service.

Apple has made Reznor available for the Apple Music PR tour and Pitchfork published an interview with him yesterday. I enjoyed the interview for all of the imagery and candor found in his answers.

Here's Reznor on the problem found with most music streaming services:

"I feel like I'm walking into a big box store where all the merchandise is in a cardboard box. I mean, it's there, you can eat all you want. But it's searching for a box in a card catalog versus a place where you walk in and leave kind of blown away by the stuff you didn't realize you wanted when you went in there."

You can start to see that Reznor thinks of music streaming differently than most people. Keep in mind that the product he is describing was what Beats was originally selling. The service never saw widespread adoption before getting bought by Apple. It's easy to see that the message Reznor is describing about how most music streaming sites are awful must have resonated with Apple. Could Apple have built its own music subscription service? Sure, but Beats' music streaming was built on ideals that matched Apple's philosophy. According to Reznor,

"What we tried to do with Apple Music is make the experience around the catalog feel like people that love music have touched it in the various ways it gets presented to you: playlists that noticeably feel better, radio stations that were programmed by people, recommendations that feel less like a computer and more like someone made you a mixtape and you like their taste."

Jimmy Iovine and Eddy Cue described Apple Music as a service a few weeks ago, which now seems much more business-like in retrospect. Meanwhile, I thought Reznor's Apple Music description was the most genuine I have seen published.

You start to understand why Apple is even bothering with music. It's all about selling an experience, something Apple excels at with its current products. That is what Apple means when they say music is in their DNA. There is more here then just Apple thinking they need to do music because they came out with iTunes and the iPod.

Here is Reznor describing what I would say is one of the more controversial parts of Apple Music, Connect:

"[W]e just wanted to make a place where if you're an artist and you want to share something that's more promotional - you're not necessarily looking to get paid on it but you want people to hear it and have as wide a reach as possible - put it up here and it's not locked into anything. You can embed it wherever. It's not meant to just be over here behind this paywall...We wanted to create a place where the people making the art could feel like they could have a center, and ultimately, monetization, and the ability to be provided with some tools that didn't exist as elegantly as they do anywhere else."

I think this is where Reznor's argument, while certainly still making a lot of sense, is being stretched just a bit. The Connect that is being described may be attractive to some artists, but with others there may not be much interest at all. I know in my situation, the 40 artists I am following haven't exactly been active on Connect, but others have said they are seeing plenty of activity. Will we see a split develop among the music community? Will we need to wait until there is a massive audience before we see artists begin to engage more on Connect? Time will tell.

Reznor closes the interview with an interesting take on Apple and risk:

"I'm surrounded by enthusiasm and support and a company that's ready to take risks and allow, what I think, is risky good taste to be a fundamental part of what they're trying to do. It's pretty cool that the biggest company in the world feels that way. It feels good to me right now."

The closer you look at Apple Music, the more you realize Apple is taking a big risk here. While it is a music streaming service just like any other streaming service out there, it is based on ideals that are quite different from others. I think that is why it is so interesting of a product.

Above Avalon members also received the following stories this past week:

Android Switcher Rates Bode Well for iPhone Sales

Q&A Thursday (collection of submitted questions by members)

Apple is Growing Faster than Xiaomi

Apple Music Observations

Apple Music's Problem

Reflections on iPhone's 8th Anniversary

Greece's Impact on Apple

Attaching a Price to Apple's Free Music Trial

The Big Bet Behind Beats 1

New iPhones Entering Production

To receive this past week's stories (will be sent to you via email) and receive future updates containing Apple analysis, use the sign up forms below to subscribe. A weekly option is also available containing all of the week's articles in one email delivered at the end of the week. For more information, visit the membership page.

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Neil Cybart 7/2/15 Neil Cybart 7/2/15

Beats 1 is the New iPod and Apple's Latest Bet

The iPod was hip and cool. A device that was introduced to the world as being able to hold one thousand songs in your pocket went on to be Apple's trojan horse and take over not only the music industry, but also the entire music culture. The iPod won because it was different and cool, working seamlessly with iTunes in bringing emotion and passion back to music. Fourteen years later, Apple finds itself in a new music predicament. Holding on to the paid music download model a few years too long, Apple is once again trying to recapture music mindshare with Apple Music. Instead of competing on technological terms, Apple is positioning Beats 1 as the new iPod, a tool meant to add emotion and coolness to a sea of commodity music streaming services.

The iPod Was Cool

On October 23, 2001, Apple unveiled a device that went on to position the Mac as the temporary hub of our digital lives and ultimately play a role in shaping modern culture. Wearing a pair of white headphones didn't just mean that you had an iPod in your pocket, but also meant that you were a rebel, someone who thought differently.

Something interesting happened with the iPod. It went from a sign of being different to an outright symbol of being cool. During a time when Macs were destined for art classrooms, and mobile phones left much to be desired in terms of design and functionality, iPods were taking over college campuses and schools like nothing seen before. Music was once again something fun, something that could be listened to mostly anywhere. A fact that now seems like a given was a new experience just 10 years ago.

Beats 1 Is the New iPod

With Apple Music, Apple is once again looking to leave its mark on music culture, which is arguably much more important and valuable than the $15 billion of annual digital and physical music sales. We are no longer in the iTunes era. The iPod we have come to know is now just a footnote in Apple's financial statements. Instead, Beats 1 is being positioned as the new iPod.

Consider how during what was arguably the most important day in Apple's music history, nearly the entire discussion was centered around Beats 1. The 30 million songs now available for streaming are nice, but we are already used to that with other streaming sites. Lots of curated music playlists are helpful, but something seems to be missing. Apple's intention on launch day was clear. The buzz surrounded Beats 1. What was Zane Lowe saying? Who was he playing? What are other people thinking?

At first glance, Beats 1 would seem to be a highly unlikely candidate for being the new iPod. How is a radio station with a preprogrammed schedule pushing content to listeners considered hip and cool in 2015?

However, Beats 1 is trying to do much more than be a radio station. Instead of just pushing songs to our iPhones, Beats 1 aims to make us live and breathe music. The modern era of music streaming with millions of songs at our disposal has led us to think of music simply by genre. How else would one sort through millions of songs? As we rely more on the algorithm to control our music listening experience, we are left with a product that is lacking emotion and passion. We remain tied to what we think we know and enjoy. Music discovery is never allowed to materialize. Beats 1 is trying to get us to appreciate and discover music again.

Trent Reznor, one of the masterminds behind Apple Music, explained Apple's motivation to Pitchfork :

"Personally, one of the things that interests me in this space as a fan is that consumption of music is radically different from when I was a kid. You had to make a choice of what you wanted to invest in. There were some good things about that. I listened to some records that I didn’t necessarily like at first, but I listened to them because it was all I had. It shaped the way I think about things. And now that access is ubiquitous and everybody has access, to me, that puts the burden on the service to make music enticing—different portals and entryways and rabbit holes. And what if that experience could be one that turns more people on to great music? I think that’s exciting."

Zane Lowe

Similar to how Apple relied on celebrities to market the iPod, the company is once again adding a new modern twist to the equation with Beats 1, placing Zane Lowe as the face of Apple Music. While he may not be a household name, his ability to discover talent and appreciate the art of music has not been lost. Apple is investing in other personalities along with Lowe, each with a slightly different take and style. But at the end of the day, Beats 1 is Zane Lowe. Notice during the Apple Music launch how Apple executives, many of whom have been quite active on Twitter recently, were quiet. There was not one tweet or message about Apple Music. Instead, it was all Zane Lowe.

Beats Brand Lives On

Even the name of Beats 1 is quite telling. Apple's $3 billion acquisition of Beats last year included branding and people. The Beats brand carries a young, cool and hip connotation while iTunes brings up thoughts of slowness, bloatware, and oldness. I have a difficult time seeing "iTunes 1" having the same kind of impact as Beats 1.

Beats 1 Gives Apple a Fighting Chance

The iPod was a risk. In reality, nearly everything that has turned out successful for Apple was at one time considered to be a big risk. That is not to suggest that everything Apple touches turns into gold, but rather that risk is needed to really change the status quo. Beats 1 is Apple's latest bet. It may not work. People may be turned off by the variety of music and simply not value Zane Lowe's or the other DJ's personality or musical acumen. Radio was mostly declared dead and reimagined as Pandora. Will the world be willing to think again about what radio can be? Trent Reznor summed it up well:

"I’m surrounded by enthusiasm and support and a company that’s ready to take risks and allow, what I think, is risky good taste to be a fundamental part of what they’re trying to do. It’s pretty cool that the biggest company in the world feels that way."

Apple is not starting Beats 1 to appeal to the masses but rather to add something new to the music discussion. After being on the market for years and experiencing refined product and pricing strategy, the iPod changed the game. Beats 1 represents Apple's most likely path toward taking back the music industry. Using a radio station in 2015 to take back music culture - now that is thinking differently.

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Neil Cybart 6/29/15 Neil Cybart 6/29/15

The Great Apple Music Pivot

Apple Music is the right product at the wrong price. Music subscriptions based on human curation and discovery are the future, but putting more than 30 million songs behind a paywall won't help facilitate widespread adoption. Apple Music's family plan option will give the service life, but more is needed. The free music subscription model will eventually be too difficult for Apple to ignore. By pivoting to include free music, Apple Music will then be in a much better position to put the business of music on a path to sustainability. The music industry needs its "App Store" moment, and the combination of free music, Apple's premium user base, and Apple Music's Connect would be the closest thing yet to that vision becoming a reality.

Apple Music Ambitions

While the press has run with the Apple Music versus Spotify storyline, in reality, Apple's music ambitions are much more grandiose. Apple is once again trying to build music sustainability by selling an all-encompassing music service. There is precedent for such lofty goals as the iTunes ecosystem presented the music industry with a much needed reprieve from the rise of piracy and genuine questions of music's sustainability. Apple relied on a service that capitalized on ease of use to stoke demand for paid music downloads. Ten years later, while things may have not changed much as labels are still making short-term decisions guided by money, and there are renewed questions around music sustainability, we now live in a world where free music subscriptions are gaining momentum and acceptance.

One reason Apple is fully embracing paid music streaming and avoiding a free music steaming tier is to change the perception surrounding music's inherent value. By having consumers look at music as something worth paying for - a good with inherent value - it will be easier to get people to pay for music through other mediums in the future. A culture based on free may not bode too well when trying to sell new music initiatives and services. Take a look at the App Store for evidence of this trend.

As Spotify has shown, when both a free and paid streaming option are available, a vast majority of users stick with free. With Apple Music, by not offering a free music subscription option, Apple is trying to increase the paid tier's value as that would be the only way to enjoy the full service being sold. There is no question that Apple Music will gain users, and I would go so far to say that it would be shocking if Apple is unable to become the largest paid music streaming service. It helps that Apple's user base is comprised of premium smartphone users that have shown the tendency to spend more on apps and other content. However, I doubt it will be enough to move paid music streaming far beyond the segment of the population that has been paying for music all along.

The Record Labels

In today's disjointed environment where digital music industry revenue is still coming from many directions, record labels continue to spend big money on marketing and promoting their portfolio of music artists in an effort to gain mind share and exposure. The IFPI estimates that over the past five years, labels have spent $20 billion on artists and repertoire (A&R) and marketing. In this environment, free music streaming is an attractive proposition for record labels because their portfolio of artists is able to reach a much wider audience. Simply put, record labels have taken free music streaming hostage. This is one reason why the major labels put their music on YouTube, Spotify's free music tier, and even went so far as to agree to Apple's initial "no pay" stance on Apple Music's three-month free trial. Ultimately, it is this desire for exposure on the part of labels that represents Apple Music's biggest headache as charging for music is made that much more difficult when music is free elsewhere.

Free Music Streaming

Over the past few years, free music streaming has received a bad rap. Free music subscriptions have the potential to be attractive for both music artists and fans because artists gain valuable exposure while fans have access to a vast amount of music. However, there continues to be one major problem with free music subscriptions: ad-supported free music streaming simply does not provide enough revenue for musicians. There are very few alternative monetization techniques available for the average musician unable to tour or grab sponsorships. Meanwhile, paid music subscriptions, which Apple is betting on, remains niche with no evidence of mass market appeal given the presence of free music options elsewhere. It would seem that the music industry is in quite a predicament.

In 2014, subscription streams income accounted for 23% of the music industry's $6.85 billion of digital music revenue. However, in an alarming sign of what is to come without significant industry change, ad-supported free music stream income, despite having 2.5x the number of users, accounted for only a third of the revenue from paid music subscriptions. The math just doesn't add up for free music streaming in its current form, despite its growing popularity. That doesn't mean that free music subscriptions should go away, but rather that more needs to be done to build other ways of valuing music.

Meanwhile, YouTube remains the most popular option to access free music, with more than 1 billion users. According to the IFPI, approximately 27% of internet users listen to music on YouTube without watching the video. Despite having upwards of 10x the number of users compared to music subscription services, YouTube and other video platforms accounted for only $650 million of digital music revenue last year, less than half of the revenue attributed to subscription services.

One positive sign is we are still in the very early stages of the music subscription era. The vast majority of people have not used music streaming. According to the IFPI, there were only 141 million active users for music subscription services at the end of 2014, of which 41 million were paying global subscribers. For perspective, there are approximately 475 million iPhone users out in the wild. Recent user surveys from Ipsos placed paid streaming usage at 16% while free streaming stood at 35% across 13 selected markets. This suggests that there is still time to come up with new and exciting ways of building monetization into free music streaming.

Apple Music Pricing

Apple faces an uphill battle with Apple Music pricing largely as result of the music labels. Initially, it was reported that Apple wanted to price Apple Music at $5 per month to match the amount of money people spent on music in iTunes. The labels said no. Instead, with single memberships at $10 per month, Apple Music is priced in-line with other streaming services, offering full membership for $120 per year.

At first glance, Apple Music would appear to be dead on arrival given that price. However, there are a few other variables at play that will result in Apple Music having some life. While Apple was not able to get labels to agree to lower the price for single memberships, Eddy Cue was able to get the labels to come down in price to $15 per month for the family membership. Given that up to six people can be on the same iCloud account, Apple Music's family pricing will likely be much more popular than single memberships.

In addition, it is important to remember that Spotify has 20 million subscribers paying $10 per month for its music streaming service. Since music streaming is still in the early innings, I suspect Apple will make inroads into this market, and it would be surprising if Apple cannot get more than 20 million people to sign up. The problem is that the upside to this number is limited by not having a free music streaming option.

Apple is aware that entering the music subscription era without a free music tier is like entering a fist fight with both hands tied behind one's back. Accordingly, Apple has made certain aspects of Apple Music accessible to everyone. In terms of marketing, Apple's messaging continues to shift the focus away from music streaming (which is mostly a commodity these days) and instead towards playing up the idea of Apple Music as one service containing various ways of listening to music, curation and discovery led by music tastemakers, and interaction with your favorite artists. Said another way, Apple is trying to build music culture instead of being just a paid music steaming service.

Apple's Long-Term Music Plan

Apple will pivot Apple Music to embrace free music streaming. However, any early success seen with family plans will not be lost. Evidence of a vibrant ecosystem and user base would be very appealing to music labels, which would agree to have their artists and catalogues included in a free music streaming tier on Apple Music.

Music Culture/Discovery. Apple is investing heavily in human discovery and curation by allowing tastemakers like Zane Lowe to represent the face of Apple Music. Beats 1 is positioned as a 24/7 radio station guided by one mission: play great music. The point of such a product is to build excitement, push music discovery, and introduce passion back into music. Having a host of DJs ranging from Drake to Elton John is meant to add personality to what has increasingly been algorithm-driven playlists and radio stations. There are many questions as to how one channel broadcasted across the world is going to work, especially considering all of the different tastes represented by the guest DJs. Nevertheless, much of this focus on music culture will remain a central theme of Apple Music regardless of price and whether Apple has a free music streaming tier.

Connect. In what may the most interesting and intriguing aspect of Apple Music, Connect has the potential to be the very early stage of a fundamentally new kind of service that the music industry has never seen. Connect is a way for artists to connect with fans by sharing content such as pictures, short clips, and exclusive material. While the service has very subtle similarities to Apple's ill-fated Ping product, management has learned its lesson that the world doesn't need another social network.

Connect may be so significant, it can represent the music industry's "App Store" moment. Connect can become the primary medium through which artists can monetize their art beyond music. Typically, the argument has been that artists can monetize free music through merchandising and touring. While for some that may work, the much more sustainable method would simply be to create a medium by which fans can support artists directly through either subscriptions or different access tiers. In the process, the definition of a musician changes. We soon can all become musicians with a route to monetization, even if we aren't professionals. Music is the art of expressing our emotion and views on the world. To think that the only people capable of making money from music are those that go on tour and sell t-shirts is missing the much bigger point.

In a world where all music is free, Connect can be the way that artists sell subscriptions for complete access to the process behind their art. Videos, blogs, and other exclusive content can arguably be much more valuable than the actual music itself. In such a world, discoverability and the ability to reach hundreds of millions of users is critical because to find sustainability, an artist would only need to reach a very small group of loyal fans. Instead of 20% of the population paying $120/year for all the music they want, which primarily would go to the big labels and megastars, in this new world, 100% of the population can listen to all the music they want while supporting artists that they feel a connection to.

The theme behind all of this is decentralizing power from a few labels to everyone:

Music will be free. As a result, music artists can reach hundreds of millions, if not billions of users.
Artists have access to information on their fans, making it easy to set up monetization efforts.
Artists can rely on software to monetize their brand (image and personality) primarily through subscriptions and advertisements, but also through merchandising and sponsorships.
New talent can transition from discovery to monetization quickly without many barriers.
The definition of “music artist” becomes boarder to emphasize a wider range of content creators.

The problem with the current music industry structure is that it is difficult, if not impossible, to accomplish many of the preceding bullet points, especially without the support of a label. However, change is in the air. A music artist no longer needs to be sponsored by a Fortune 500 company, sell out the local sports arena, or have 10 million followers on social media to find sustainability. Instead, finding one's true fans and focusing attention on those individuals can lead to sustainability. In such an environment, the most difficult bullet point remains discoverability, which is conveniently one of the underlining themes found within Apple Music.

Measuring Success

Success with Apple Music will change over time. At first, success will be judged by share of the paid music streaming market. The discussion will focus on Apple owning the "premium" music market, or those who are in a position to pay for music. Next, the discussion will focus on ecosystem strength, where the total number of users is paraded around, including those that just listen to Beats 1 and other radio channels. This is where the prospect of free music will be too hard to ignore. Meanwhile, Apple will work on expanding Apple Music's reach into other forms of music content, not to mention mind share. Apple would then introduce a new version of Connect where fans have the opportunity to buy the full experience from individual artists. All the while, the record labels will fight and drag their feet against these changes because they essentially are anti-label, giving most of the power to artists and fans. As Apple begins its new music journey, Apple Music has a future, but a few changes are needed to give the service widespread appeal and the ability to truly add sustainability back to the business of music.

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Neil Cybart 6/26/15 Neil Cybart 6/26/15

Taylor Swift is Backing Herself Into a Corner - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts accessible to everyone, I write 10-12 stories a week about Apple sent exclusively to Above Avalon members via a daily email. The following story was sent to members on June 22nd. For more information and to sign-up, visit the membership page.

Taylor Swift is Backing Herself Into a Corner

Taylor Swift was able to capture much of the Sunday news cycle with a well-circulated Tumblr post with a passive aggressive "To Apple, Love Taylor" title. The seven paragraphs that made up the post can be summed up in three sentences:

"I'm sure you are aware that Apple Music will be offering a free 3 month trial to anyone who signs up for the service. I'm not sure you know that Apple Music will not be paying writers, producers, or artists for those three months. I find it to be shocking, disappointing, and completely unlike this historically progressive and generous company."

Eddy Cue responded within 17 hours saying via Twitter that Apple had changed its mind and will pay artists during the free trial period. Apparently, Apple will pay rights holders on per-stream basis, the details of which were not disclosed [Apple will pay 0.2 cents for each song streamed]. It would seem the rate will be less than the regular rate once the trial period ends. Regardless, the change in Apple's stance occurred very quickly. Does this mean everything is okay? Not quite.

Before I go any further, I think it's important to note that Taylor Swift knows exactly what she is doing. Beginning with her WSJ op-ed last year and her recent spat with Spotify where she removed her entire music catalog from the music streaming service, Swift has fully embraced the message that music needs to be valued appropriately. Not only does such positioning likely hold true to her beliefs, but it serves her well from a business sense.

Taylor Swift is arguably the biggest music act going today. She is one of the few that can sell out venues each night for months across the world. She has spent years developing her fan base and connects with them extremely well. Simply put, she can afford to take these kind of hard stances and use her music as a bargaining chip.

You will quickly discover that you can't go far talking about music without discussing record labels and the complicated structure where everything is done in such a way as to position the dollar as the ultimate goal. In many ways, Taylor Swift transcends all of this talk because of the power she holds. This means that any discussion involving Taylor Swift is often much more ideological than practical as we can ignore the record label.

At the end of the day, this Taylor Swift vs. Apple battle wasn't even about Apple. It's about valuing music. Swift previously battled Spotify. Yesterday, she called out Apple. Tomorrow, she will call out someone else. Apple is simply a symbol of what Swift is fighting for: raising awareness that the music industry is selling an art form that should be valued accordingly.

Swift's primary argument against Apple's 3 month tier was that such a feature does not value music appropriately. If you are a music artist and you release a new album from July to September, you would have received $0 from Apple Music and the 10s of millions of people trying the service out. While simplistic in thought, basically the entire music industry would have received $0 from Apple for those three months. When you say it like that, it is hard not to agree with Swift's argument, and I suspect that is why Apple changed its tune, deciding to pay artists during the trial period. Swift wasn't the only one to raise this issue in recent days, so it is possible that Apple was at least thinking about this topic for a few days and Swift was the final straw.

Even though Swift won this latest battle (Apple probably will face no long-term negative implications from this though), I still think Swift's long-term positioning in terms of valuing music is problematic. Swift is combining short-term goals with long-term ambitions. She is upset with any service or feature that doesn't value music correctly. She raises very valid (and convincing) arguments. However, when looking at the long-term, Swift is likely backing herself into a corner.

One theme that has developed in the music industry over the past decades, especially the last 10-15 years, is that technology is a formidable force. The music industry has not been able to figure out how to find sustainability with music streaming. There is pain in the streets. Taylor Swift, and a handful of other actors, are using what essentially boils down to aggressive negotiation tactics to force change (i.e. getting people to pay for music). In the near-term, Swift's exposure and power will increase. Her fans will like her even more. And she may very well win many battles (as she did vs. Apple).

However, look at what happened with Swift's battle with Spotify. The music streaming service's momentum in terms of user growth (the most important metric for Spotify) has shown no signs of slowing down after Swift pulled her music collection. In fact, one can argue Spotify gained exposure following Swift's very public battle with its free streaming tier. Here is where I think Swift will find some trouble. She will not be able to control technology. Even though she is the most popular music artist in the world today, that is not enough to shift what will be inevitable in terms of music and technology. She is trying to get everyone to play nicely, but no one person holds enough power to keep everyone in line. A stronger Spotify, including a more popular free streaming option, would seem to go against what Swift is advocating.

Look at how Kid Rock turned out in his opposition to paid downloads on iTunes. Technology, and the world, passed him over. The same will happen with Swift if she doesn't change her tune (which I think she will) over time, concerning how music should ultimately be valued.

Swift wants people to value music appropriately. Apple does too. Swift thinks the best way of doing that is to pay for music. I'm not sure Apple feels the same way long-term. Technology likely has other plans in mind (and I suspect Apple does too) in terms of how one can monetize music to ensure sustainability. Free music streaming isn't going away, regardless of how much Taylor Swift hates it.

In addition to the preceding story, Above Avalon members also received the following stories this past week:

Apple Stock Buyback Primer (seven chapters)
Apple's Cash Dilemma (Why Not Just Pay the Tax?)
One Drawback of Holding $194 Billion of Cash
The Symbolism Behind the Gold iPhone
Google's Early Approach to Take On Apple Watch
Calculating Apple Watch Band Profit
Just Doing What's Right (Tim Cook and Eddy Cue edition)
Improving iOS 9 Adoption is High Priority at Apple

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Neil Cybart 6/19/15 Neil Cybart 6/19/15

Wall Street Starting to Doubt Apple Watch - Above Avalon Premium Week in Review

Along with periodic Above Avalon posts accessible to everyone, I write 10-12 articles a week about Apple sent exclusively to Above Avalon members via a daily email. The following article was sent to members on June 17th. Please visit the membership page for more information and to sign-up.

Wall Street Starting to Doubt Apple Watch

One by one, sell-side analysts are starting to turn cold on Apple Watch, a product released seven weeks ago. Yesterday, Pacific Crest analyst Andy Hargreaves published a note saying his confidence in Apple Watch is declining as interest appears to be higher in the iPod than Apple Watch, judging by Google Trends, and something needs to be done or else Apple will struggle meeting Watch expectations. Here's Hargreaves:

"Initial Apple Watch demand has been very strong and our most recent checks suggest Apple remains well positioned to produce enough units to meet or exceed our FQ3 unit estimate of 5.5 million and our F2015 unit estimate of 11 million. However, reviews of the device have been mixed, the fashion angle appears to be leaning a bit too much toward "calculator watch," and general consumer interest as measured by search volume is below the iPod (with an "o")...All of this suggests a dramatic increase in functionality is likely needed to grow unit sales and meet current expectations for F2016 unit volumes. Given Apple's developer community, this is clearly possible. However, our confidence is declining, which suggests risk to our F2016 unit estimate of 24 million is increasing."

I will comment on his Watch sales estimates shortly, but it's important to note what he is arguing: once early adopters buy the Watch, evidence in the form of Google Trends would suggest sales will slow. The focus isn't so much on Apple Watch sales for the current quarter or even next (those will probably be fine), but the follow-through as we move away from launch. Basically, the question being raised is will normal people buy the Watch?

Hargreaves is not the first analyst to raise Watch concerns. On Apple's last earnings quarter, Toni Sacconaghi of Sanford Bernstein took issue with Tim Cook's attitude and tone when discussing Apple Watch. Here's Sacconaghi:

"I just wanted to revisit the watch. Tim, I think you've said, when you were talking about your new products, you said we're 'very happy with the reception' and in response to a previous answer, you said, 'relative to demand, it's hard to gauge with no product in the stores.' I would say relative to other product launches, where your commentary around demand was characterized by superlative after superlative, that assessment feels very modest."

Tim responded, "I'm thrilled with it, Tony, so I don't want you to read anything I'm saying any way other than that. So I'm not sure how to say that any clearer than that." Sacconaghi recently visited with Tim Cook and Luca Maestri and once again he made note of their demeanor, saying their tone was "confident, though not ebullient."

All of this doubt should be expected as Apple chose not to disclose Apple Watch sales. That decision was likely not taken too lightly at Apple HQ. If management announced opening weekend sales, a can of worms would be opened where people would expect such disclosure at every turn and any slight deviation would be marked as a negative. Take a look at iPad to see what being aware that unit sales are declining year-over-year can do to a product's perception.

However, by not releasing sales numbers, doubt and worry are allowed to build as there is no concrete evidence to refute an analyst's analysis. Instead, some are left resorting to analyzing management's tone when talking about the Watch.

I suspect one of the driving reasons that led management to keep Apple Watch sales under wraps is that given the current environment, Apple doesn't need to release Watch sales numbers. With the iPhone selling so well and representing a large portion of operating income, I can see Apple looking at that and saying that there wouldn't be much benefit from releasing Watch sales numbers. When you are selling 50 million iPhones a quarter, announcing four million Apple Watch sales may be lost on many market observers. In addition, the less Watch disclosure, the harder it would be for competitors to respond.

The very little amount of data that we do have on Watch sales (primarily from Slice Intelligence, but also Apple revenue guidance for the current quarter) would suggest that Apple Watch sales look solid (4M so far), although the adoption rate may be a bit weaker than that of the initial iPad in 2010. Said another way, the Watch may indeed take a bit longer to catch on with people compared to how the world seemed to accept the iPad over night. Did Apple expect this and feel it was prudent to not release sales early on? It's possible. In a way, Apple would be somewhat hedging its bet just a bit.

Let's not forget, Apple has been big about disclosing sales numbers if they are strong. That's why I think this decision may be related to iPhone strength. Apple would have decided they weren't going to break out Watch sales numbers months ago. I suspect this is not a decision based on opening weekend sales strength or weakness.

Ultimately, Wall Street is all about expectations. Back in November 2014, my very first Watch sales estimate was for 20-30 million units to be sold in the first 12 months on the market. In March 2015, I fine-tuned my estimate to 28 million units in the first 12 months on the market. These numbers are important because they help frame how I look at the Watch and what would be "disappointing" results or "strong" numbers. Every analyst is different, and that is important to take into account when they issue research notes discussing the Watch. Looking back at Hargreaves' note, his 12-month Watch sales estimate looks to be pretty similar to mine across the board, so he's not overly optimistic or pessimistic.

If analysts' main concern is around Apple Watch sales in 2016, I have a feeling we may need to get used to this Apple Watch doubt. We are in the very early innings of this game, and there is no evidence yet to suggest the Watch has struck out.

In addition to the preceding article, Above Avalon members also received the following articles this past week:

The Genius Move Behind the Phil Schiller Interview
How to Discover Apple Watch Sales
Apple is Playing Offense, not Defense
New Productivity Features Hint at iPad's Future
Fitbit Prices IPO Above Expectations
Cablevision CEO Sees Cable Bundle Dying
Apple's New Search APIs
Apple Retail Store Renovations
Apple Hiring News Editors
Apple Correctly Killed Plans for Beats Wifi Speakers

To read these articles (accessible via email) and receive future articles containing Apple analysis, subscribe at the membership page. A weekly option is also available containing all of the week's articles in one email delivered at the end of the week. Above Avalon is supported 100 percent by its members. Thank for your continued support.

Neil Cybart 6/18/15 Neil Cybart 6/18/15

Apple's Cash Dilemma

With approximately $200 billion of cash on the balance sheet, Apple's financial strength has never been stronger. However, Apple has a growing dilemma on its hands concerning its cash and capital return program. Apple is unable to keep the pace of share buybacks and dividends in-line with its foreign cash generation. As a result, excess cash that is not needed to run Apple's business continues to build on the balance sheet. While labeling a company with $200 billion of cash as having a cash dilemma seems like hyperbole, Apple's valuation metrics will likely be negatively impacted in the coming years if Apple is unable to return this excess cash to shareholders.

Apple's Total Cash Continues to Increase

Apple currently has $194 billion of cash, cash equivalents, and marketable securities. Not only is this a record in terms of cash held by a single company, but it represents approximately 10% of all cash held on corporate balance sheets. Given Apple's business model, it does not need all of this cash to run its business. With an enterprise value of $583 billion, Apple would theoretically be able to repurchase 30% of itself using the cash on its balance sheet. In reality, things are much more complicated as most of this cash is not able to be used for share buyback because it is held offshore and would be liable for additional tax if returned to the U.S.

Exhibit 1: Apple's Total Cash, Cash Equivalents and Marketable Securities

Most of Apple's Cash is Held Offshore

Apple's foreign cash continues to comprise a growing portion of Apple's overall cash. In the eight years since the iPhone was released, Apple's foreign cash has grown to $171 billion from $7 billion and now accounts for 89% of Apple's total cash, up from 44% in 2007. With approximately 70% of annual revenue coming from outside the U.S., Apple's foreign cash will continue to grow at a much faster pace than its U.S. cash. Apple has been content with keeping foreign cash offshore in order to avoid paying additional tax if it was brought back to the U.S.

Exhibit 2: Apple's Total Cash, Cash Equivalents and Marketable Securities (Foreign vs. U.S.)

Apple has been using some of its foreign cash for organic growth initiatives, including component procurement, international retail and facility expansion, and clean energy initiatives. Even after all of these expenses, cash generation continues to exceed what management needs to run the business.

This past quarter, Apple sold more iPhones in China than in the U.S. for the first time. Rather than this being an isolated event, China will only become a bigger piece of the iPhone sales pie given social-economic trends and an untapped market of more than 600 million phone users. The end result is Apple's foreign cash generation will continue to vastly outpace U.S. cash generation.

Apple's U.S. Cash is Being Depleted

With foreign cash being kept offshore, Apple is forced to use its U.S. cash to fund the capital return program. As a result, Apple has a more "modest" $22 billion of cash available in the U.S., which reflects the impact of more than $40 billion of debt issuance over the past three years. Without issuing debt, Apple would only be able to rely on U.S. free cash flow generation of approximately $20-$25 billion a year to fund buyback and dividends. It is important to remember that Apple needs a certain level of available cash in the U.S. to take care of routine business expenses, not to mention have cash on hand to take advantage of M&A opportunities. It is not prudent to allow this cash total to fall too low, and management has shown the willingness to slow share buybacks instead of depleting U.S. cash reserves.

Exhibit 3: Apple's Cash, Cash Equivalents and Marketable Securities (U.S.)

The Dilemma

Apple's cash dilemma is straight-forward: Apple is generating cash internationally at a much faster rate than it is able to spend on stock repurchases and cash dividends in the U.S. As China continues to make up a larger portion of Apple's product sales, boosting total free cash flow, management is facing some limits as to the amount of available funds used for stock buyback and dividends. The following exhibit shows how the amount of free cash flow (red line) is expected to outpace the amount of cash spent on buyback and dividends (blue line) in the coming years. China is increasingly causing the red line to slope upward as time goes on while the blue line is being pinned as the U.S. is becoming a smaller piece of the overall cash generation pie. In an ideal world, there would no gap between the red and blue lines as most of Apple's free cash flow would be spent on buyback and dividends.

Exhibit 4: Apple's Cash Dilemma

Apple's Options

Management does not have many available options at its disposable for solving its cash dilemma.

Lobby for U.S. Tax Law Changes/Holiday. The preferred option would be returning cash currently held offshore back to the U.S. in an environment with a lower tax rate (15% or less), or during a special tax holiday similar to 2004. Obviously, Apple would want a rate in the single-digits, but Washington politics may make any change to tax policy a long shot. If the tax rate was lowered, Apple would be able to bring back $140-$150 billion of foreign cash and then buy back up to 20% of itself in relative short-order through a public tender offer. At a forward price/earnings ratio of 12x and a free cash flow yield of 6%, Apple management likely views AAPL's current valuation as attractive for such a tender offer.
Continue Issuing Debt to Fund Capital Return. Apple is currently using a combination of debt and U.S. free cash flow to fund share buyback and dividends. As Apple's foreign cash grows, Apple can continue to borrow additional debt. However, Apple's cash dilemma will not be solved as foreign cash generation will still likely outpace the rate of capital return even after considering a realistic amount of debt issuance each year. Eventually, Apple would be holding $400-$500 billion of cash, almost all of it offshore, and $150 billion of debt, all of which would have been spent on the capital return program. Apple would then need to manage its debt obligations, only straining its U.S. cash needs even more. Management may begin to cool to the idea of issuing significant amounts of debt if interest rates rise or if Apple's business slows, further making this option somewhat unsustainable in the long run.
Do Nothing. Management could also slow debt issuance and simply spend less on share buyback. This option would be taken with balance sheet preservation in mind. If Apple slowed all buyback activity, both U.S. and foreign cash would increase and Apple would likely reach $400 billion of total cash in relative short-order. The risk to this option is Wall Street's reaction to Apple sitting on too much excess capital, a scenario that had begun to play out in 2011-2012, and some can argue, is still playing out today.

How is Holding too Much Cash a Dilemma?

Apple's market valuation is obtained in the marketplace at a price where AAPL buyers and sellers are willing to trade shares to each other. If there is greater demand for shares at a certain price, the price will rise until demand and supply are in equilibrium. Investors buying Apple shares are interested in owning a piece of the company's assets used to generate cash in the future. Since a company's value is obtained by discounting future cash flows and excess cash is not involved in future cash generation, the market is forced to include the cash in its Apple valuation. The end result is there is a high likelihood of either Apple's cash being valued incorrectly, or much more likely, Apple's underlying business being valued at a discount. This is the fundamental logic behind those that have been pushing Apple to use its excess cash to buy back more stock.

Unless foreign cash is brought back to the U.S. in order to boost the magnitude of share buyback, Apple's excess cash will continue to grow, and the valuation metric that the market is giving Apple will continue to be suppressed. This is one likely reason why Apple is trading at a 12x forward P/E multiple. Apple CFO Luca Maestri has quite the dilemma on his hands.

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Members have access to the Above Avalon stock buyback primer which can be used to become familiar with Apple's share buyback.

Neil Cybart 6/11/15 Neil Cybart 6/11/15

Apple Is Playing Offense at WWDC

Apple is on the offensive. This is not a company content with standing by and letting Google, Facebook, Spotify and a handful of other third-parties take over critical elements of the user experience of approximately 500 million iPhone users. Instead of just swinging a sword and trying to compete with everyone indiscriminately, Apple is carefully positioning its resources and the overall iOS platform to stress value propositions at which Apple has historically excelled. These include personalization, emotion, and privacy. WWDC highlights how battles are being chosen meticulously as Apple's mission is clear: reducing its dependency on others. With the News app, Apple is trying to change users' habits in terms of how they get content. Apple Music is a test in how successful Apple will be once again in not just getting customers to pay for something that is free elsewhere, but rethinking the music industry. Siri and Spotlight are being positioned as Apple's method for rethinking search. Instead of sitting back and letting third-parties have all the fun, Apple wants more.

The Chess Game Heading into WWDC

Apple had the wind at its back headed into this year's WWDC. The iPhone 6 and 6 Plus have resonated with consumers across the world, especially in China, leading to more than 40% unit growth year-to-date in 2015. One metric that Tim Cook has reiterated on recent earnings conference calls is the Android switcher rate, or the percent of iPhone sales that can be attributed to former Android users. Recent Kantar data and Above Avalon estimates would suggest that approximately 20-25% of iPhone sales in 2015 have come from customers new to iOS, which totals to nearly 25-30 million users entering the iOS ecosystem for the first time.

The iOS platform has hit critical mass; it is large enough to sustain app innovation and developer interest. Nearly every major third-party consumer-facing technology company, including Google, Apple's primary competitor, have all but guaranteed support for the iOS platform, a noteworthy reversal from years of doubt and cynicism from those who warned Apple's smartphone 10% market share may eventually be outmatched by Android's massive reach. The problem with that logic turned out to be that Apple actually has 70%+ market share in the premium smartphone market which includes those who are very likely to use apps and services.

On top of that, Google and Facebook have business models that depend on obtaining data at scale, and Apple's highly engaged users are a prime target. It would be difficult, if not impossible, for Google and Facebook to ignore 500 million iPhone users.

Given the current environment, one would assume Apple is feeling pretty good. Executives could push out an iOS refinement update, watch iPhone sales roll in, and coast along until WWDC 2016. In reality, Apple is more nervous now than ever before.

This nervousness is not born from weakness, but rather strength. Apple is nervous about the unknown, the low probability event, the Black Swan that we can't even imagine. It is with this nervousness that Apple positioned certain new OS X and iOS 9 features as preemptive moves on the hypothetical chess board.

Apple wants to be in a position where it can counter the scenario of Google, Facebook, or another powerful third-party taking over such a large amount of the user experience that Apple's relationship with the user is harmed. People are spending an increasing amount of time on social networks while music streaming is taking over. Even though both of these activities are not directly hurting Apple's financials, it's clear management wants to be better positioned to respond to each trend.

While there are very few, if any, credible competitors that can truly ship software, services, and hardware at scale, it would be theoretically possible for a company to take user engagement on iOS and try to leverage it into a new direction using their own differentiated hardware. If Apple can position itself more strategically as a counter to third-party offerings, reducing its dependency on others, Apple could be in a better position to maintain the user experience and battle third-party apps and services in the future.

Fighting for Your Attention

Although Apple may be seeing success in terms of smartphone sales, a fierce battle has been occurring for our attention once we turn on our gadgets. Press and hold the iPhone home button and the battleground emerges: our home screen. Software and services companies are each angling for our attention. Tech pundits often say Facebook's greatest threat is Google. Instead, Facebook's greatest threat is our short attention span. Services that largely do similar things are increasingly fighting for mind share in the areas of messaging, email, photo storage, and entertainment. When considering that a service can benefit from a network effect, the battle is only intensified as the apps and services with the most users achieve the best quality, thereby making it that much easier to attract new users.

Whereas hardware manufacturers measure success by the 10s of millions of users, for software, success is now measured in 100s of millions. As more people spend more time on smartphones, the battle for our attention is only intensifying. It is for this reason that iOS is such an attractive proposition for companies craving reach and scale amongst premium users.

In the early days of the iPhone, it was common to see a smartphone with lots of apps, each possessing a specific duty or job role. I created separate folders for social apps and news. Today, I still open my social app folder every day, but now my news folder has become irrelevant as I get most of my news from Twitter. This type of fierce competition for my attention is still playing out in area of social platforms and media brands, but it's clear that given the finite amount of attention, there will be winners and losers.

With a suite of over 20 apps, Apple has relied on its vertical integration of shipping hardware, apps and services. In 2012, Apple jumped into maps. In 2014 Apple launched its health, fitness, and payments initiatives. And at this week's WWDC, Apple launched new News and Music apps, with rumors of a video service arriving sometime later this year or 2016. All of these services share one purpose: controlling our time and experience. They are meant to represent tasks or things that we do each day and to which Apple can add differentiation. One should not expect Apple to try to be the answer to everything, such as entering social media or other services that are inherently less fundamental to Apple's product line-up.

News

Apple's News app isn't so much a competitive jab at Facebook, but instead a hook for grabbing people's attention. Apple's description of the new app is quite clear: "News conveniently collects all the stories you want to read, from top news sources, based on topics you're most interested in - so you no longer need to move from app to app to stay informed." With News, Apple is trying to keep our attention just a little bit longer. Take a look at Facebook's Instant Articles and Snapchat's Discover to see what the war over attention is leading to. Technology companies are trying to shift commoditized news into a differentiated service meant to keep you within their properties.

This type of attention-holding strategy isn't new. In brick-and-mortar retail, Walmart includes various stores within its stores, such as vision centers, fast food restaurants, and medical clinics in an effort to get you inside a Walmart. Similarly, Facebook wants people to spend more time within its apps by offering additional services, like news.

I don't view Apple as necessarily trying to rethink news or put other companies out of business. Instead, it is looked at as a tool to enrich the iOS platform while maintaining a closer relationship with the user.

The risk in the strategy is that many users still have to go to Facebook, regardless of reading news. Going back to the Walmart analogy, it would be the equivalent of having to go to Walmart regardless of which medical clinic you visited. Chances are good you will end at the clinic inside Walmart rather than going across town to the stand-alone clinic. At the end of the day, the easiest path usually wins. It is for this reason that I think caution needs to be held before assuming News will be a runaway hit. Instead, I look at it as Apple moving a piece on the chess board, trying to gain a better competitive position in the future.

Apple Music

Apple's ambitions in music are underestimated. As Eddy Cue and Jimmy Iovine have made it very clear, Apple Music is not about music streaming, but rather a new music ecosystem meant to offer listeners across the world (100+ countries at launch) a place to not only access music, but become part of something bigger, interacting with musicians and receiving recommendations. Eddy Cue and Jimmy Iovine don't say it, but Apple Music is inherently built to keep your attention rather than just engage you in the physical act of listening to music. Technically speaking, Apple is now getting into content creation with its 24/7 radio station, Beats 1, as Zane Lowe will have a music show that contains interviews and other content.

Connect, which will serve as a venue for musicians to connect with their fans, while distinct enough from the Ping disaster, contains just enough social media to make people begin wondering if there may be a bit more that meets the eye, where Connect can become a musician's first stop for sharing content. It is important to point out that despite Apple introducing new features that undoubtedly chase people's attention, the company is not being hostile to third-parties. Connect allows sharing through Facebook and Twitter.

Apple Music is competing with the free streaming services of the world, including YouTube. While Apple may have indeed gotten people to pay for music once around (iTunes), it will be challenging for Apple to completely rethink the music industry without a free, ad-supported streaming option. Nevertheless, Apple is going to give it a try, positioning service and a new culture-defining internet radio option, as reasons customers will be willing to give Apple Music their attention and pay for something that can be gotten for free in the next app over.

Siri and Spotlight

We saw hints of Apple's ambitions in search last year, but this year's WWDC all but confirmed that Apple is quickly looking to distance itself from Google search.

Apple's intentions on reducing its dependence on third-parties is not just limited to apps and software. All of Apple's new announcements related to an improved Siri and Spotlight, not to mention a new search API, are meant to have us move past Google dependence. In the process, Apple is able to build on its relationship with the user and not necessarily collect troves of data. Apple feels very confident that it doesn't need all of your data to produce "magic" as Phil Schiller described it. In reality, what Apple is suggesting is that it can produce an enjoyable environment that doesn't let technology overwhelm the user, yet still position the iPhone as a personal assistant. Apple calls it "intelligence," which is appropriately quite different from the connotations surrounding Google's "machine-learning" initiatives.

Pushing Forward with iPad and Apple Watch Software

Apple’s mission hasn’t changed from its founding in the 1970s. As Jony Ive put it at the Condé Nast International Luxury Conference this past April, Apple has always been about making technology more personal. The primary way Apple will be able to continue going down that path is if they control our time and attention by selling gadgets filled with apps and services that we increasingly use to navigate the world.

Nowhere is this strategy more apparent than Apple’s current product line-up, pieces of glass ranging from the Apple Watch to the iMac. At every stage in between, each product possesses a different function or role. This is the primary reason why Tim Cook hasn’t sounded the alarm about the iPad despite the product losing all of its sales momentum. For Apple, the iPad still has a role in the world. It’s just that a greater number of people are able to get their jobs done using iPhones and Macs. At WWDC, Apple all but assured us that a larger 12.9-inch iPad Plus will be released in the future with Split View, Slide Over, and picture-in-picture video. An iPad Plus isn't meant to turn around the iPad line, but instead serve a particular set of needs that can be answered with a multi-touch Force Touch-enabled large display. Some of Apple's products are simply more popular than others, based on screen size and mobility. Success isn't determined by the number of unit sales, but instead how effective a product is in addressing a particular set of problems.

From Apple’s perspective, positioning the iPhone as a computer in our pocket is central to controlling our time because of how we are able to bring the iPhone mostly everywhere we go. Taking things further, in a quest to control even more of our time, what better way than to sell a computer that is literally on us? The Apple Watch is Apple's first personalized piece of technology that can be worn. The outlook for native apps able to tap into much of the advanced components found in the Watch only validates Tim Cook's claim that the wrist is indeed a very interesting place. The day is still early with wearables, but Apple isn't waiting to push the envelope on what can be done on the wrist.

WWDC 2016 and Beyond

When considering Apple’s future, take a look at your daily calendar and at the activities that take up significant portions of your day. Anything from sleeping, watching TV, and commuting to and from work likely represent areas of interest for Apple. Of course, management is quite selective and as Tim Cook mentioned last year, executives actually spend most of their day debating what not to do. Apple is built on a model of placing very few big bets that can change the world, not lots of little bets very likely to fail but not likely to have much long-lasting impact. Apple's offensive strategy was on display at this year's WWDC including additional Siri capability, new and updated apps meant to hold user's attention, and a new Music platform positioned to regain music mindshare. Such tactical maneuvering is indicative that Apple is not pausing despite its improved market positioning when compared to Android. Apple is playing offense.

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