Daily Email from January 31st, 2017

The following email was sent to Above Avalon members on January 31st, 2017. 

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

January 31, 2017

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.  

Today's stories: Fitbit Is in Trouble, Apple Watch Momentum Is Building, Deep Dive into Microsoft Surface Sales

Hello everyone,

Today is Apple earnings day. The company will release results at 4:30 pm ET. We will go over the results on Wednesday and Thursday.

Fitbit Is in Trouble

There has always been a feeling in the air surrounding Fitbit that the company was facing long odds. Not only did the company need to continue selling tens of millions of wearables devices per year (not an easy thing to do), but management would need to also figure out what to do about Apple entering its turf.

For a few quarters following the Apple Watch launch, Fitbit seemed to be actually doing OK. Management was seeing success when it came to marketing and branding. Fitbit was even growing its unit sales lead over the first generation Apple Watch. While there were some concerns brewing under the surface, such as worrying user engagement trends, Fitbit seemed to be making a name for itself in the health & fitness wearables market.

The situation changed dramatically with Fitbit's 3Q16 results this past October. (Fitbit's 3Q includes July to September.)

Here's the beginning of the Above Avalon daily update from November 3rd, 2016:

"The largest wearables company in the world has officially hit a brick wall. Fitbit reported very weak 3Q16 earnings yesterday. Management's conference call was one of the worst I have listened to this year. You knew it was going to be bad when CEO James Park kicked off his comments with: we are starting to see some headwinds in the business, including softening in demand.

At the heart of the issue is a company that just doesn't know what is going on in the wearables market."

The holiday quarter was supposed to include the best five week stretch of the year for Fitbit. The company would typically register as much as 40 percent of its annual sales from October to December. However, troubling signs began to appear as early as August and September. Demand for Fitbit products just wasn't materializing as management expected. Fitbit's awful sales guidance for the holiday quarter implied that the company was about to hit a brick wall in terms of growth.

Fitbit pre-announced those bad holiday results yesterday. The initial guidance range, released in October, called for $725M to $750M of revenue. Fitbit now expects to report revenue in the range of $572M to $580M range.

That is what you call a company in free fall. There just isn't any other way to describe it. Fitbit sold just 6.5M devices in 4Q16. To put that number in context:

Fitbit - Unit Sales

  • 3Q15: 4.8M
  • 4Q15: 8.2M
  • 1Q16: 4.8M
  • 2Q16: 5.7M
  • 3Q16: 5.3M
  • 4Q16: 6.5M new data point

Fitbit sold 21% fewer devices in 4Q16 than in 4Q15. More alarming, whereas the 2015 holiday quarter saw a 71% increase in unit sales quarter-over-quarter (i.e. from 3Q15 to 4Q15), Fitbit saw just a 23% increase quarter-over-quarter for the 2016 holiday season. To put these sales numbers more bluntly, consumers turned away from Fitbit in droves. As we will see, there is evidence that even this 6.5M unit sales number is artificially high.

Management's explanation as to what is unfolding is not reassuring. Here's Fitbit CEO James Park:

"Fourth quarter results are expected to be below our prior guidance range; however, we are confident this performance is not reflective of our brand, market-leading platform, and company's long-term potential. While we have experience softer-than-expected holiday demand for trackers in our most mature markets, especially during Black Friday, we have continued to grow rapidly in select markets like EMEA, where we grew 58% during the fourth quarter."

Just a few months ago, management was talking up the incredible opportunity remaining in the U.S. given Fitbit's penetration rate (~40M Fitbit devices vs. 230M smartphone owners). Historically, the U.S. comprised the vast majority of Fitbit sales. The company recently said Asia was becoming a headache. This leaves Europe as Fitbit's last remaining source of growth.

Fitbit decided to take a number of financial steps to shore up its business:

  1. Write down tooling equipment and component inventory by $68M. Code: Weak customer demand caught Fitbit off guard. The environment has deteriorated to such a degree that Fitbit needed to reassess some of its asset values.
  2. Increase rebates and channel pricing promotions by $37M. Code: Fitbit had to slash pricing in order to move product that wasn't selling. It looks like Fitbit's 6.5M unit sales for the holiday quarter was artificially high due to channel stuffing. Sell-through demand for Fitbit products was probably less than 6M devices. That's a nearly 30% decline in demand year-over-year.
  3. Increase return reserves by $41M due to greater channel inventory. Code: The product that Fitbit was able to sell with discounts and promotions will likely face elevated returns.
  4. Increase warranty reserves for legacy products by $17M. Code: People are having quality issues with older Fitbit devices.

As for 2017 guidance, management is looking for $1.5B to $1.7B of revenue. A few things jump out at me. Fitbit management has zero credibility on Wall Street. It's surprising that Fitbit is even bothering with guidance. The company misread near-term demand for its products by nearly 25 percent. How can Fitbit be in a position to estimate demand 12 months out? The second takeaway is that the guidance Fitbit did provide is downright awful. Fitbit reported $2.2 billion of revenue in 2016. Management is forecasting its business to decline 30 percent in 2017.

Three months ago, Fitbit said it expected to have $900M to $950M of cash right about now. A few Above Avalon members were quick to throw skepticism at such a claim. That skepticism proved correct. Fitbit actually had $700M of cash at the end of December.

In order to shore up its liquidity, Fitbit is looking to cut its annual operating expenses by 20% to $850M. Since sales & marketing and R&D make up the vast majority of Fitbit's operating expenses, those budgets are likely going to get slashed. Fitbit is also letting go of 110 employees (6% of its workforce). Unfortunately, history has shown that management teams in Fitbit's position often underestimate the degree of required downsizing.

Fitbit needs to downsize in response to declining sales. If we assume management was initially expecting sales growth in 2017, the company's new guidance implies that the company will likely have $400M less in gross profit to work with. (This is my estimate obtained by taking management's new 2017 revenue guidance, subtracting it from a hypothetical situation where Fitbit was able to grow revenue in 2017, and then applying a 50% margin to the difference.) This is money that would have funded marketing, R&D, and M&A (a form of employee acquisition).

The company appears to be afraid of a widespread brain drain as it wants shareholders to approve "a program under which certain employees may relinquish out-of-the-money options at the time of the exchange in return for a fewer number of restricted stock units."

Fitbit shares traded down 16% yesterday to $6. The company is now valued at $1.3B or 1.9x cash. The company's cash total is going to be a moving target going forward. For context, Apple is trading at 5.4x net cash. It seems like Fitbit is trading with some M&A premium. However, it's not clear who will want to step in as an acquirer at this point.

The most worrying thing for Fitbit is that its largest risks are beginning to materialize. Fitbit has some top engineering talent when it comes to wrist wearables. It is going to become that much harder for Fitbit to retain this talent. In addition, Fitbit's future was built on the premise that it would be able to release new products that customers wanted. If the company is forced to slash its R&D budget due to declining sales, how will the company compete with Apple? I'm not sure there is a genuine answer.

Apple Watch Momentum Is Building

It is impossible to talk about Fitbit without focusing on Apple Watch. Judging by public statements, Fitbit management is still in complete denial when it comes to the impact Apple Watch is having on its business.

Here's Park in Fitbit's press release from yesterday:

"As the overall wearable category leader, we exited the year with an engaged community of over 23.2 million active users, making us uniquely positioned to be the partner of choice for the healthcare ecosystem, which is a key component of our long-term strategy."

The problem for Park is that the Apple Watch ecosystem will likely surpass 23M active users in a few months. It is also becoming likely that Apple will soon earn the "overall wearable category leader" title from Fitbit as well.

However, if judging by actions, Fitbit management is very aware of the threat Apple Watch poses to Fitbit's long-term viability. Fitbit is running as fast as it can into the smartwatch market.

Here's more from Park:

"We believe we are uniquely positioned to succeed in delivering what consumers are looking for in a smartwatch: stylish, well-designed devices that combine the right general purpose functionality with a focus on health and fitness."

Park is describing Apple Watch.

In less than 12 hours, we will get some data as to how Apple Watch performed over the holidays. My estimate is that Apple sold 5.4M Apple Watches during the holiday period. This would be a very strong number for Apple. However, simply comparing Apple Watch to Fitbit sales may hide one of the more important developments in the wrist wearables space.

Apple Watch may be seeing success in pushing the wearables market in a new direction. Instead of splinting into dedicated health & fitness trackers and smartwatches, the entire market appears to be moving towards smartwatches. This is why it is so strange that Park is quick to say that Fitbit is running towards smartwatches but has never commented that Apple Watch is impacting Fitbit. The simple fact that Fitbit is being forced into smartwatches tells us that Fitbit is merely leading Apple Watch, and that is not a position you want to be in.

Deep Dive into Microsoft Surface Sales

One of the more interesting questions facing Apple's Mac business has been whether a portion of the Mac user base would flee to an alternative platform. This transition could be linked to a few reasons, including frustration with Apple's update schedule for the Mac and/or excitement surrounding new hardware from competitors.

Recall Microsoft's recent claim of seeing a record number of people switching from Mac to Surface. The company provides up to $650 off Surface Book or Surface Pro to users who trade in a MacBook Pro or MacBook Air.

Late last week, we received the latest sales data for Microsoft's Surface products as part of Microsoft's earnings release.

Microsoft Surface Revenue

  • 2Q15: $1,077M
  • 3Q15: $715M
  • 4Q15: $888M
  • 1Q16: $672M
  • 2Q16: $1,350M
  • 3Q16: $1,110M
  • 4Q16: $965M
  • 1Q17: $926M
  • 2Q17: $1,320M new data point
  • Sum: $11.711B

Microsoft reported $1.32B of Surface revenue over the holiday quarter. While unit sales are not disclosed, we can back into an estimate of around 1M to 1.2M devices sold based on average selling price.

Nearly every report focused on Microsoft's earnings positioned $1.3B of Surface revenue as a resounding success, especially since results didn't include much from new product categories.

My stance on Microsoft Surface has been consistent. While it may very well be serving its purpose as a way to motivate Windows OEMs, Surface sales do not match the narrative found in the tech press. Consumers are not embracing Microsoft Surface in droves. According to Microsoft, commercial demand for Surface was up 25%. Since overall Surface revenue was down year-over-year, this would seem to imply that consumer demand was also down year-over-year. This is odd since Microsoft had said that November was the best month yet for consumer Surface sales.

We have niche hardware that is seeing some adoption success in enterprise. Will wider availability of the $2,999 Microsoft Surface Studio change this narrative in 2017? It's doubtful.

This isn't to suggest that Apple should ignore Surface. There are some who think Surface is a slow, gradual movement that will take years to eventually reach a $10B revenue per year run rate. There may be a case to make for such a development. However, this is not what is being pushed in the press. Instead, it's labeled as a genuine Surface vs. Mac battle among consumers. Microsoft has been happy to build up that battle in recent months. However, sales numbers don't lie. If it's a Surface vs. Mac battle among consumers, the Mac is doing fine.

Each daily email is approximately 2,000 words and contains 2-3 stories (10-12 stories/week). 

Story topics include:

  • Strategy and business analysis
  • Financial modeling and estimates
  • Perspective and observations on current news events, competitors, earnings, and keynotes

To become an Above Avalon member, visit the membership page.

Daily Email from November 16th, 2016

The following email was sent to Above Avalon members on November 16th, 2016. 

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

November 16th, 2016

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.  

Today's stories: Apple Releases New Design BookNostalgia vs. Inspiration, This Is Jony's Apple

Happy Wednesday. Today's update is going to be dedicated to Apple's new design book. There are a lot of layers to this product.

Let's jump right in...

Apple Releases New Design Book

Apple wasn't completely done with this year's product unveilings. Yesterday, the company unveiled a new design book that tells the story of design at Apple. Here's Apple in a press release:

"Apple today announced the release of a new hardbound book chronicling 20 years of Apple's design, expressed through 450 photographs of past and current Apple products. 'Designed by Apple in California,' which covers products from 1998's iMac to 2015's Apple Pencil, also documents the materials and techniques used by Apple's design team over two decades of innovation.

The book is dedicated to the memory of Steve Jobs."

The book comes in two sizes: small ($199) and large ($299), and is currently available through Apple's online store in nine countries, in addition to 13 Apple Retail stores in the U.S.

While the book is focused on Apple design, it is actually a reflection of the culture put in place by Jony Ive, Apple's Chief Design Officer. Here's Jony explaining why such a book exists:

"This archive is intended to be a gentle gathering of many of the products the team has designed over the years. We hope it brings some understanding to how and why they exist, while serving as a resource for students of all design disciplines."

This book set off a firestorm yesterday from all corners of the Apple punditry/analyst community. Some think it is a sign of major trouble at Apple. Others think it is an interesting idea that should have been done by a third-party. And you have a small group that sees this as yet another sign of Apple Industrial Design's (Apple ID) growing power and influence within Apple (more on this shortly).

Jony ended up doing more press for this design book than he did for the iPhone 7 and new Apple Watch back in September. I counted two interviews (one was with Wallpaper and the other was with a Japanese design blog called Casa BRUTUS).

If there was still a question as to how important this design book is to Jony, he also narrated a two-minute video containing behind-the-scenes footage of the Apple ID group (and there looked to be quite a few product designers as well) working in the designs labs. It was pretty remarkable. (The video is available via YouTube here.) The only other time we had gotten such an inside look at the design labs was during the Charlie Rose interview last year.

Historically, Jony has played a major role in producing product videos in which he narrates. It is likely he played a major role in putting together this latest video as well.

Apple spent eight years working on this design book. Many of the Apple products featured in the book actually had to be purchased. The design team treated the book just like any other Apple product. Apple developed custom forms of paper and custom inks in order to "accurately and objectively" portray the products. All of the photographs were taken by Andrew Zuckerman, specifically for the book. Some shots involved Apple using the same composition as product launch photos, such as recreating the scene of five colorful iMacs. Since Apple spent years on this project, some of the earlier photographs had to be retaken because photographic technology had improved over the years. The team even came up with special packaging to make the unwrapping "enjoyable."

Nostalgia vs. Inspiration

Soon after Apple published the press release announcing the design book, I saw more than a few people quickly look at this product as a sign of Apple going down memory lane, chasing nostalgia. I disagree.

As defined by Merriam-Webster: Nostalgia: pleasure and sadness that is caused by remembering something from the past and wishing that you could experience it again.

The book is not about Apple being nostalgic, taking time away from the future in order to soak up glory from the past. Instead, the book is designed to peel a few layers behind the mystery known as Apple design.

Notice how the book is both for the Apple ID group (a tool for inspiration) and the public (a way to better understand what drives Apple). The educational component explains why Apple is actually selling the book instead of just creating the book for Apple employees. Apple plans on giving the book to all of the major design schools around the world.

Jony listed a number of reasons for why this design book exists:

  1. To see the objects out of their functional context.
  2. To see the objects in a context of the subsequent products.
  3. To educate people on how their manufactured environment came to be.

There is significance found with the timeline of products that are featured. Instead of chronicling Jony's time at Apple (he began in 1992), the book begins with the 1998 iMac. This is a very subtle, but important clue as to why this design book exists.

The iMac was the first product to benefit from Apple's design-led culture. Here's a brief backstory to the iMac from my piece "Jony Ive Is Making People Uneasy."

"Jony holds an incredible amount of power because Apple is a design-led company. Apple's functional organizational structure and culture are set up in order to give the Industrial Design (ID) group absolute power. ID holds more power at Apple than any other group.

This structure was put in place more than 15 years ago with the iMac being the first product to take advantage of this new culture. Up to the late 1990s, engineers held the most power at Apple. Designers were merely tasked with skinning Apple products created by engineers. With the iMac, ID was afforded the freedom to move ideas from conception to reality without compromise. While Steve Jobs was the primary architect of this new power structure, the relationship he had with Jony undoubtedly played a role."

Accordingly, this design book isn't about Jony Ive. It's not some type of "Jony's Greatest Hits" collection. Jony isn't trying to soak himself in nostalgia of better times (which doesn't even make sense since today's products are arguably the best designed products Apple has ever released).

Instead, this design book is about the philosophy and processes that have guided Apple ID for the past 18 years. There are actually Apple products that are not included in the design book, which sets this book apart from similar books from third-parties over the years.

Here's Jony in his own words going into detail as to why he felt it was important that such a book existed:

"The biggest challenge for us was the fact that our focus and preoccupation is always on the future. So that tends to exclude much time to look back at the work we have previously done. Sometimes if we are struggling with a particular issue then that gives us reason to go back and look at the way we have solved problems in the past. But because we've been so consumed by our current and future work we came to realise we didn't have a catalogue of the physical products. So about eight years ago we felt an obligation to address this and build an objective archive."

One word: inspiration.

Here's more from Jony:

"We were intrigued how we could objectively describe, define and catalogue the objects and try to give people a sense of how they are made. Not how they were designed, but how they came to be. How they were manufactured and how you can transform these often-anonymous materials into something that is valuable and useful."

You can sense a theme here. The book is not about individual Apple designers or even the Apple ID group, but about the culture and environment that guides the Apple ID group. The key difference between those two entities is that by focusing on the product, the book actually ends up being about the design process. This turns the design book from containing page after page of nostalgia into something different.

However, one question that remains is "Why now?"

Jony even discussed how the design team had to purchase some of the older Apple products in a nod to the lack of nostalgia that exists within the design labs. We know the motivation behind the book, but why publish it in November 2016? Apple even says the book chronicles 20 years of Apple design, even though only 17 years of products are covered (1998 to 2015).

While watching the video for the design book, some of Jony's comments jumped out at me:

"This book captures a point in time of incredible transitions and quite shocking change. You understand the nature of an object so much more when you understand how it came to be. The book tells dozens and dozens of stories. You see momentum. You see learning. Of course, as designers you live in the future. It's not that we're not interested in the work we have done before, it's just that we are so consumed by what we haven't done yet."

Reading between the lines, this Apple design book is meant to serve as inspiration for an Apple ID group that is embarking on a new journey involving new materials, processes, and products. In a way, Apple is closing one chapter in order to open a new one. Apple's design language has not remained static (just look at the Mac over the years for evidence). It feels like given Apple's product direction, a new design language is being created.

This Is Jony's Apple

It is crucial for us not to miss one obvious point with this design book. Jony wanted this book to exist.

We are seeing Jony's Apple in full force.

That statement isn't meant to downplay Tim Cook's contributions or to imply that Jony has in some way taken Apple hostage. Instead, we are seeing an Apple that is comfortable placing complete control of the user experience in the hands of the Apple ID group. This design-led culture was installed in the late 1990s and all indications point to Tim Cook doubling down on the idea.

This design book probably would not have existed 10 years ago. Of course, we will never be able to know for sure. While some look at that as a source of concern for Apple, I look at it as merely a sign of change.

One example of this change is that Apple is much more willing to explain its story using the people developing Apple products. Circling back to the Charlie Rose interview from last year, Tim Cook had a short, but interesting comment about the motivation for providing Rose such a revealing look inside Apple:

"With a consumer company, people want to see the team behind it."

There is no question that Apple has embarked on a multi-year campaign to make the public become more familiar with the people and processes behind Apple products. We went from the era where Steve Jobs controlled nearly all public outreach to pretty much every senior Apple executive now taking part in various forms of PR.

Just take a look at last month's Mac event - Phil Schiller did a number of interviews, Federighi did a few video interviews, Jony even sat down for an interview. All of that was done for just one product. We then have PR opportunities given to additional Apple employees, including team managers. This is part of a well-thought out strategy meant to explain Apple's mission.

There is a very legitimate counter argument to this new philosophy within Apple. One can say that the product should speak for itself. Consumers should buy Apple products because the product will improve their lives, not because of being familiar with the design story or people behind the product.

However, I would push back against that narrative.

By sitting down with Charlie Rose in the design lab, or selling a design book, Apple is weaving a narrative that transcends any one product.

Saying "This is Jony's Apple" doesn't mean that Jony is single-handedly guiding Apple forward. In reality, after his promotion to Chief Design Officer, Jony has actually moved away from day-to-day managerial activities at Apple. Instead, we are seeing an Apple that is placing a bet that design will be the variable that leads the company forward.

There will be plenty of challenges and detours along the way. This design book is meant to help Apple find the path when those challenges arise. The book will help Apple move forward.

Each daily email is approximately 2,000 words and contains 2-3 stories (10-12 stories/week). 

Story topics include:

  • Strategy and business analysis
  • Financial modeling and estimates
  • Perspective and observations on current news events, competitors, earnings, and keynotes

To become an Above Avalon member, visit the membership page.

Daily Email from August 30th, 2016

The following email was sent to Above Avalon members on August 30th, 2016. 

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.

August 30th, 2016

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.  

Today's stories: Calculating the iPhone Installed Base, Segmenting iPhone Users by Upgrade CyclesNew 2016 and 2017 iPhone Sales Estimates

Hello everyone. Today's update will be dedicated to iPhone financials. I built a new iPhone sales financial model, and I want to go over some new numbers and assumptions for the iPhone installed base, upgrade cycles, and unit sales.

Before we get to the update, there are two other topics worth mentioning:

Apple Invites. Apple sent out invites yesterday for its September 7th keynote in San Francisco. I will be attending the event. The invitation (seen here) contains bokeh, which is the rendition of out-of-focus points of light, set within a very dark background. This likely hints at some pretty interesting iPhone camera upgrades. All signs point to a dual-lens camera for the iPhone 7 Plus. The invite also contains the words "See you on the 7th," where the "See you..." is another nod to cameras. The event looks to be centered on new iPhones (cameras and audio being the two big items) and new Apple Watches. We will have a much more in-depth preview of the event next week.

Apple/Ireland Update. The European Commission just ordered Ireland to recover $14.5B, plus interest, from Apple in back taxes. I am surprised. That total would seem to imply the Commission classified most of Apple's Irish tax structure as illegal (doesn't make much sense to me). As we talked about yesterday, late signals were pointing to a much lower amount. Even up to a few hours ago, the Irish Times was hearing the amount will be "billions of euro," so clearly there are some disappointed Irish government officials. Tim Cook is out swinging this morning (he just published a letter regarding the Commission's decision). At this point, it's unclear if Apple will actually ever end up paying the $14.5B. Since this news just broke, we will discuss the topic in greater detail tomorrow.

REMINDER: This email is from August 30th, 2016. The following estimates have since been updated. My current iPhone estimates are available for members here


Calculating the iPhone Installed Base

A few months ago, it became clear to me that I needed a revised financial model for estimating the iPhone installed base. My old methodology involved tracking changes to the iPhone installed base on a quarter to quarter basis.

For the first few years of iPhone sales, this is a pretty manageable task. However, with the iPhone 6 and 6 Plus being released in 2014 and the resulting explosion in sales, the model began to get very complicated. When it was clear that the iPhone upgrade cycle was also extending, trying to track the installed base quarter to quarter just wasn't feasible.

I developed a new financial model for estimating the iPhone installed base that relies on annual iPhone sales. This methodology makes it much easier to track the change in the iPhone installed base since there are fewer variables to estimate. In addition, I suspect this new model contains much more accuracy as I can segment the iPhone installed base according to when a user enters the iOS ecosystem (more on this shortly).

In order to estimate the iPhone installed base, we start off with simple iPhone unit sales by fiscal year.

  • 2007: 1M
  • 2008: 12M
  • 2009: 21M
  • 2010: 40M
  • 2011: 72M
  • 2012: 125M
  • 2013: 150M
  • 2014: 169M
  • 2015: 231M

Next, we divide these annual iPhone sales totals into two segments: sales to new iPhone customers and sales to iPhone upgraders (customers who were already iPhone users).

For the first few years, these calculations are rather simple as there weren't many iPhone owners in a position to upgrade in 2007 or 2008.

Jumping to 2010, things become more interesting. Apple sold 40M iPhones in 2010. In order to find the portion of those sales that went to iPhone upgraders, we look back to see which group of iPhone users were likely in a position to upgrade. It turns out that the 12M users who bought an iPhone 3G in 2008 celebrated their two-year anniversary in 2010. Running with an estimate of a two-year upgrade cycle, this means that a good portion of those iPhone 3G users likely upgraded to a new iPhone in 2010. Accordingly, Apple sold 10M iPhones to existing iPhone users in 2010. This is less than the 12M users who bought an iPhone 3G in 2008 because of churn. I include a 13% churn rate for the first upgrade cycle. We then subtract 10M from 40M to reach 30M as the number of iPhones sold to customers new to iPhone in 2010.

We repeat this exercise for each year, keeping track of which bucket of iPhone owners was likely in a position to upgrade. For example, iPhone 3GS users were ready for their first upgrade in 2011. In addition, original iPhone owners were ready for their second upgrade in 2011. As the years progress, the calculations become a bit more intense although it still beats the craziness found with quarter-to-quarter gyrations. By time we get to 2016, we have nine different buckets of iPhone owners to keep track of in terms of upgrade cycles.

After running this exercise for each year, we arrive at estimates for the number of iPhones sold to new customers. This data is valuable because we can then add each year together to reach an estimate for the current iPhone installed base.

iPhone Sales (Units) to New Customers

  • 2007: 1M
  • 2008: 12M
  • 2009: 19M
  • 2010: 30M
  • 2011: 54M
  • 2012: 95M
  • 2013: 88M
  • 2014: 82M
  • 2015: 102M
  • 2016: 106M
  • Total: 589M users (this is the iPhone installed base as of year-end FY2016 - the end of September).

One of my previous estimates for iPhone installed base was 554M users as of February 2016. This means my new installed base model is a bit more conservative. Diving into the model in greater detail, I think I am able to capture the full extent of repeat iPhone upgrade behavior much better than before. Since I am including a larger portion of iPhone sales to upgrades, this ends up reducing the number of iPhones sold to new customers.

Do these numbers pass the litmus test? Let's check with Apple's disclosures.

Here's Tim Cook on Apple's 3Q16 earnings conference call:

"[W]e added millions of first-time smartphone buyers in the June quarter, and switchers accounted for the highest percentage of quarterly iPhone sales we've ever measured. In absolute terms, our year-to-date iPhone sales to switchers are the greatest we've seen in any nine-month period, and our active installed base of iPhone is up strong double-digits year over year."

Those comments are extremely helpful. Cook went on to say the majority of iPhone sales in China were to people new to iPhone. My 106M iPhone unit sales estimate to new customers in 2016 represents an all-time high for Apple, which matches Cook's comments. In addition, China Mobile likely led to a boost in iPhone sales to new customers beginning in 2015 with the iPhone 6 and 6 Plus. My estimates reflect a 25% bump in sales to new customers in 2015. My previous model for the iPhone installed base had the number of iPhones sold to new customers falling in 2016.

My estimates also reflect a 22% increase in the installed base year-over-year in 2016, which compares to Cook's "up strong double-digits year over year."

EXTRA: If we bring the topic of the iPhone user base into this discussion ("user base" is different than "installed base" because the iPhone user base includes used iPhones and hand-me-downs), we are probably looking at something around 670M to 690M total iPhones out in the wild as of the end of September 2016. Once again, this is a bit lower than my earlier estimates, but it seems to better match Apple's latest disclosure of more than one billion Apple devices in the wild. The following numbers are my estimates (as of September 2016):

Segmenting iPhone Users by Upgrade Cycles

One issue that many analysts have been having is figuring out what to do with iPhone installed base data. If we assume the installed base is 589M iPhone users, how do we use that data to figure out upgrade cycles? This is important because once we have estimates for the number of iPhones sold to upgraders, we can then combine that data with sales to new customers to arrive at overall iPhone unit sales estimates.

In the past, one very quick method of using installed base figures was to simply multiply the total by a certain ratio depending on iPhone upgrade cycles. For example, if we assume the average iPhone user upgraded their iPhone every 2.5 years, we multiply the overall iPhone installed base by 40% (1/2.5) to reach an estimate that Apple will sell 235M iPhones (40% x 589M) to existing iPhone users each year.

However, there is a big problem with that calculation. It is assuming that all iPhone users are equal in terms of how they view their iPhones and upgrade patterns. In reality, that 589M iPhone installed base includes nearly 200M iPhone users who just bought their first iPhone within the last two years. I suspect these people are less likely to upgrade their iPhones as frequently as someone who bought the original iPhone or iPhone 3G/3GS. (There are much fewer of those early adopters included in the iPhone installed base).

My answer for navigating this trickiness is to segment the iPhone installed base by iPhone upgrade cycle. I run with shorter iPhone upgrade cycle estimates for iPhone early adopters (people who bought their first iPhone in 2007, 2008, 2009, and 2010) while I use longer upgrade cycles for those users who just recently bought their first iPhone. In addition, I included a lengthening process across the board to reflect a maturing iPhone product.

These are the iPhone upgrade cycle estimates that I used when calculating the iPhone installed base, grouped by the year a user purchased their first iPhone: (As an example, if my first iPhone was a 3GS purchased in 2009, I would be part of the 2009 line item.)

  • 2007: 2 years (the average user upgrades their iPhone every two years)
  • 2008: 2.2 years increasing to 2.4 years
  • 2009: 2.2 years increasing to 2.5 years
  • 2010: 2.2 years increasing to 2.5 years
  • 2011: 2.2 years increasing to 2.8 years
  • 2012: 2.5 years increasing to 3.1 years
  • 2013: 2.6 years increasing to 3.1 years
  • 2014: 3.1 years
  • 2015: 3.4 years

Notice how I have users who bought the original iPhone in 2007 as remaining on an average two-year upgrade cycle. However, for recent new iPhone buyers (2015), I assume an average 3.4-year upgrade cycle. Previous calculations that I did for the average iPhone upgrade cycle pointed to an overall average of 33 to 34 months. My current assumptions reflect an overall iPhone upgrade cycle of 36 months.

One caveat: The 106M new customers to iPhone in 2016 end up playing a very crucial role in this subject as they represent 18% of the entire iPhone installed base. If these users upgrade to a new iPhone much sooner than my 3.4-year average, the overall iPhone upgrade cycle will be more like 33 months.

New 2016 and 2017 iPhone Sales Estimates

Four months ago, I published my revised 2016 and 2017 iPhone estimates following Apple's difficult 2Q16 earnings report. My iPhone estimates were:

  • FY2016: 205M (down 11% from FY2015)
  • FY2017: 174M (down 15% from FY2016)

At the time, I stated that these estimates represented what I thought to be sales numbers that Apple had a very good chance of reaching (i.e. they were conservative).

After looking at my revised iPhone sales model, I think my FY2017 sales estimate was too conservative.

My new iPhone unit sale estimates are:

  • FY2016: 211M (down 9% from FY2015)
  • FY2017: 200M (down 5% from FY2016)

For my FY2016 estimate, the iPhone SE is helping to offset very weak iPhone 6s sales. I raised my FY2017 unit sales estimate by 14% due to one reason: I underestimated the number of customers new to iPhone in 2016.

I am now expecting Apple to add 75M new customers to iPhone in 2017. Previously, I was assuming Apple would add 40M new iPhone users in 2017. That 35M user difference was the primary driver for my higher iPhone unit sales estimate in 2017. The underlying reason for this discrepancy is that my revised iPhone installed base model has Apple adding significantly more new users in 2016. If Apple is adding more than 100M new people to the iPhone installed base in 2016, there is no reason to assume there will be an implosion to just 35M new users in 2017. Instead, I am running with a 30% drop to 75M new users. That is still a substantial decline, representing the steepest decline in new iPhone users that Apple would have ever experienced. The reasoning behind that can be found in my article "iPhone Warning Signs."

In terms of iPhone upgraders, back in May 2016, I estimated 135M to 145M iPhone users will upgrade to a new iPhone in FY2017. My revised iPhone model pretty much arrives at the same estimate for iPhone upgrades. This would be an improvement from 2016 when Apple did not do as well with iPhone upgrades (the 6s and 6s Plus just didn't connect with consumers as management expected). The reason I am including an improvement in upgrade patterns in 2017 is due to the strong growth in the iPhone installed base. In 2015 and 2016, I estimate Apple added close to 200M new people to the iPhone installed base (Apple can thank China). While a majority of those users will not upgrade their iPhone in 2017, even a small portion (20-30M people) can move the needle.

Looking out beyond 2017, the overall theme for iPhone will likely be weakening new user growth trends offset by improving iPhone upgrade patterns built on the back of iPhone installed base growth. While slowing new user growth will eventually catch up with upgrade rates, that likely won't happen for a few years. As long as iPhone users continue to upgrade their devices periodically (my current assumption is 36 months, on average), an implosion in iPhone sales over the next few years is off the table.

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