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Predicting The Second Quarter

The last quarter of 2016 was Apple’s biggest ever. $78.4 billion in revenues. 78.3 million iPhones. Both records. Earnings of $3.36[1] and cash reached new highs. The growth was modest but Services is now not just the second largest revenue but also the fastest growing, on track to doubling in four years.

The reason for this is the vastness of Apple’s user base coupled with the loyalty the brand engenders. The company reached one billion active devices more than a year ago and is quite likely to have nearly a billion users. Not just any billion either–the best billion most probably.

The realization that Apple benefits from extreme quantity and quality of customers has led some observers to defer the imminence of Apple’s demise. Share prices have risen lately to new highs and the ratios between these prices and earnings have started to come closer to the average of other large companies.

But enough with the reductio ad absurdum. Let’s look at the next quarter. The company has been very precise with its own offered predictions (guidance) so it’s a simple task to make an accurate forecast. The history of guidance vs. outcomes for revenues is shown below:

Placing the pipper on the upper edge of the guidance range was a safe targeting method for 11 of the last 17 quarters. We have never seen a drop below the bottom of the range but had a few overshoots, some huge. Doing this for the latest quarter and working backwards to the individual product contributions to revenue and using historical margin and cost patterns we can get the following core financial performance metrics:

Fiscal Q2 2017:
Rev ($B) 53.4
EPS ($/share) 1.96
iPhone (thousand units) 53100
iPad (thousand units) 9900
Mac (thousand units) 4100
Watch (thousand units) 2300
Services ($ million) 7129
Other products ($ million) 2300
Gross margin (%) 37.8

I sent these estimates to Philip-Elmer DeWitt and I recommend looking at his survey of the other analyst estimates on his excellent Apple 3.0 blog.

Overall, the quarter is shaping up to offer slight growth y/y and indicating a plateau formed after the surge from the iPhone 6 surge in ’15. All eyes are on the “super cycle” for the next iPhone.

The reason it’s “super” is that the iPhone has a 2+ year cadence for form factor changes and the user base updates on a similar cycle. The demand is vast due to the user base and accumulated age of devices in use. Expectations are that supply will be offered to meet this demand.

If history is a guide then the next iPhone will be the best iPhone ever.

 

Notes:
  1. On shares priced at the time around $105 or 3.2% yield quarterly earnings []

The First Trillion Dollars is Always the Hardest

In its first 10 years, the iPhone will have sold at least 1.2 billion units,[1] making it the most successful product of all time. The iPhone also enabled the iOS empire which includes the iPod touch, the iPad, the Apple Watch and Apple TV whose combined total unit sales will reach 1.75 billion units over 10 years. This total is likely to top 2 billion units by the end of 2018.

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The revenues from iOS product sales will reach $980 billion by middle of this year. In addition to hardware Apple also books iOS services revenues (including content) which have totaled more than $100 billion to date.

This means that iOS will have generated over $1 trillion in revenues for Apple sometime this year.

In addition, developers building apps for iOS have been paid $60 billion. The rate of payments has now reached $20 billion/yr.

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Not included in this payment total are “mobile-first” or “mobile mainly” businesses such as FaceBook, Twitter, Linkedin, Tencent, YouTube, Yahoo, NetEase, Pandora Radio, Google Search, Baidu, Google Maps, Gmail, Instagram, Amazon, eBay, JD.com, Alibaba, Priceline, Expedia, Salesforce and Other Enterprise Software, Ride Sharing Apps, AirBnB and many other services which monetize independently of the App Store.

I estimate that the cumulative revenues enabled by iOS across these businesses have exceeded $500 billion, with a rate of revenue soon to reach $300 billion/yr.

The revenue numbers can only hint at the change in behavior among users. An iPhone is unlocked 80 times a day. Assuming 600 million devices in use there are 48 billion sessions on iPhones every day. 17.5 trillion sessions every year. It is these instances of interaction and engagement which are desired by all businesses built on top of the ecosystem.

These instances of engagement must be multiplied by the quality of the customers which Apple captures. iOS users spend more and are more loyal than those on alternative platform thus qualifying the platform as “premium” and thus adding to its value in the eyes of developers, content producers and service providers.

As the install base of iOS increases and as users hire the devices to do more and spend more time with them the virtuous cycle of value creation will continue and accelerate.

There is a temptation to think that such a business is fragile and will be disrupted. Challengers appear daily and the number of iPhone “killers” is not measurable. One can cite the billion users of Nokia phones which defected. One can cite the loyalty of BlackBerry users that evaporated. One can even cite the juggernaut of Windows and how it became impotent. One can cite the vast number of Android devices offered at low prices.

But there are reasons to believe that the iOS empire is far stronger and resilient.

Unlike Nokia’s phones, Apple’s product is an ecosystem with network effects and dependencies on software and services. It’s also a monolithic product with a singular interface and form factor.

Unlike BlackBerry, the iPhone does many jobs–too many to count. Indeed the iPhone evolves and changes its core value over time.

Although different in many ways from Windows there are strong similarities in terms of loyalty and persistence of users. iOS even developed a dominant position in enterprises. Microsoft’s attempt to become a hardware company is a testament to the confluence of the two business models.

And whereas Android was originally seen as the “good enough” iPhone, potentially disrupting it, it turns out to be the ersatz iPhone. Chances are higher that users will switch from Android to iPhone and not the other way. Again, the reasons have more to do with the ecosystem and quality of users (which are hard to measure) than with the hardware (which is easy to measure.)

As we look toward the second decade of the iPhone, the expectation isn’t one of another “big bang” but a process of continuous improvement. The market is nearing saturation so the goals must be to capture more switchers from Android. Apple has achieved this with the Mac: survival, persistence and eventual redemption.

More exciting is the apparent expansion of a network of ancillary “smart” accessories. The Apple Watch, the AirPods, Pencil and possible new wearables point toward a future where the iPhone is a hub to a mesh of personal devices. The seamless integration of such devices is what has always set Apple apart.

 

Notes:
  1. Includes forecast for first six months of 2017 []

Post-keynote Apple event San Francisco – September 8

 

I will be presenting my latest analysis of Apple at the Sustain event in San Francisco on Thursday Sept 8th, the day after Apple’s keynote, along with Ben Bajarin, Carolina Milanesi who will alsob equipped with their latest market insights.

sustain-title-white

There is a time to disrupt and there is a time to sustain.

Sustain event is about understanding Apple’s levers of control to sustain the iPhone as it moves into direct competition with Android. We will also examine positions of top five technology brands: Apple, Amazon, Facebook, Google, and Microsoft.

Learn more about the event at Airshow.io. Given he short notice, we are keeping this event on the small side so reserve your seat soon.

Dialogue with Sviatoslav Rosov for CFA Institute Magazine

 

Why is an expert on disruptive technology “worried” about financial innovation?

 

Excerpt from “Chaos Is Hard to Predict”

Does technical innovation always end in displacement/ replacement?
The professions being challenged include physicians, lawyers, consultants, and analysts. Algorithms and sensors could conceivably displace some subset. However, it’s not a certainty. One way to fend off automation displacement is to redefine and change the scope of the profession.

The classic example is from the birth of the Industrial Revolution. As machines replaced certain tasks, new jobs were created which required higher skills and hence edu- cation, leading to universal matriculation and eventually the popularity of higher education. Professionals need to “invent” new jobs for themselves as a means to keep disruption at bay.

Read more: CFA Institute Magazine.

 

Apple Assurance

Apple is categorized as a vendor of consumer electronics. More specifically, a member of the “Electronic Equipment” industry in the “Consumer Goods” sector. If indeed this is what it’s thought to be selling, there is a problem because it isn’t  what its customers are buying.

Apple’s customers buy a mix of hardware, software and services under a brand that assures a certain quality of experience. This bundling and integration of otherwise disparate things is why the brand is such a success.

This anomaly between what Apple is thought to sell and what buyers actually buy can leave the casual observer confused. As a result the company’s categorization as vendor of hardware deeply discounts its shares. It is, in other words a less valuable business. This is because a seller of consumer electronics does not benefit from “system valuation” since there is minimal loyalty to the product after the sale.

The consumer electronics vendor has no network to leverage, no ecosystem adding value after the sale, no platform and works through multiple levels of distribution to reach the customer. In contrast, a system vendor can expect benefits from network effects, ecosystems, and a coveted relationship with the end user.

The result is that the valuation of a consumer electronics vendor is based on the momentum of individual products. Apple has always been valued this way. Each hit product is considered to be a stroke of luck/genius and the chances of recurring are discounted to about zero. Regardless of the fact that it has a track record of “home runs”, Apple’s hit rate is not considered sustainable.[1]. Certainly Apple is not valued as being able to generate reliably recurring revenues.

But what if we were to value Apple on the basis of what people are buying rather than what it’s thought to be selling?

The model is simple enough: determine the number of users, estimate the lifespan of the products, and figure out the services attached to the products; then, given the price, obtain a price per product per day. You then can get a recurring revenue figure.

I did just that and the results are in the following table:

Screen Shot 2015-09-15 at 5.13.27 AM

Notes:
  1. The P/E ratio is the primary indicator in this analysis []

Breaking the Law

For the first time in many years I feel that there is some potential uncertainty in the results Apple will announce. After a period of excellent accuracy (shown in graph below), the company’s guidance has begun to diverge dramatically from reality and the trend might continue this quarter. The cause might be unanticipated demand for the iPhone 6/6 Plus. The growth rate for the product was 46% in Q4 and 40% in Q1. This is unanticipated because growth rates have been below 20% for five quarters and below 50% for eight.

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This slowing of growth was explainable given the rate of diffusion of smartphones in the global population. Within the US and some other early adopting economies the market is reaching late stages where most people have switched to smartphones. Globally we are at a more modest 30% or so but in many of the late adopting economies Apple does not have wide distribution.

Of course this thesis is thinly supported. There are many reasons to think that late adopters would still start with iPhone and that earlier adopters of Android would upgrade to iPhone after a few purchase cycles. Thus, the iPhone could prosper in later-adoption or even in post-saturation states of the market.

Indeed, in the post-saturation PC market, Apple is doing very well with the Mac and in the late to post-saturation MP3 player market the iPod did extremely well. This suggests that when it comes to value capture brand, experience and satisfaction trump function, price and share considerations in almost all consumer markets[1]

With so many assumptions put asunder the iPhone business suddenly looks downright lively. I adjusted my own growth assumptions and the resulting figures are shown below.

Notes:
  1. Enabled by design for jobs to be done. See non-technology markets for abundant evidence of this. []

The Critical Path #140: Apple Earnings Call

In this special “live” version of The Critical Path, Horace gets the numbers just minutes before Apples January 27th, 2015 earnings call and dissects them live. The show picks up just after the call finishes with a quick recap and discussion of yet another record quarter.

via 5by5 | The Critical Path #140: Apple Earnings Call.

The S&P 499

Thomson Reuters reported that excluding Apple, the entire S&P 500 grew profits at a rate of 4.4%. Including Apple the figure is 6.4%.

Using one weird trick[1] I calculated the value of profits generated by the S&P 499 (i.e.the largest public companies excluding Apple) in Q4 2013 and Q4 2014.

Apple therefore accounted for nearly 8% of the S&P 500 in the last quarter. A year earlier Apple was a mere 6%.

Screen Shot 2015-02-08 at 8.43.53 PM

 

It should therefore be obvious why Apple’s P/E ratio is 16.1 while the S&P 499 P/E ratio is 19.8.

Notes:
  1. Algebra []

Apple’s Growth Scorecard

Apple’s Net Sales grew at the rate of 30% in the last quarter. Earnings per share grew at 47%. Both of these figures are the highest since 2012.

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It should be noted that although the rate of growth is extraordinarily high, the company never actually stopped growing in the past three years. As the table above shows, net sales has always had positive growth.

Compared with the fourth calendar quarter of 2011, Apple’s sales are 61% higher and earnings per share are 54% share.[1]

This degree of growth at this stage in the history of the markets it participates in is a revelation.

Consider:

  • The PC market is more than 30 years old. In this mature market the Mac has been outgrowing the Windows platform for 34 out of the last 35 quarters.

Screen Shot 2015-02-08 at 5.35.43 PM

 

  • The iPhone was announced eight years ago and it still managed to grow at the rate of 57%.

Screen Shot 2015-02-08 at 5.47.11 PM

  • The market shares of its Mac, iPhone and iPad products are all remarkable only for their paucity.
  • The pricing of all their products is more than double the median for their categories.
  • Regardless of extreme growth, pricing power, headroom and, most importantly, customer loyalty, the company’s prospects are seen as dismal in contrast to its underperforming peers.[2]
  • Such is the plight of the anomalous.
Notes:
  1. Some of the expansion in earnings per share is due to the willingness of shareholders to sell their shares to Apple. 10% of the shares around in 2011 have thus disappeared. []
  2. As measured by P/E or FCF/EV ratios vs. direct rivals, technology companies or the S&P 500. []

Retail in 2020

This year’s Thanksgiving and Black Friday data from IBM shows a continuing pattern of growth for mobile devices. As the graph below shows, in the five years since 2010 mobile devices grew from 5% of the online shopping traffic to 50%.  Traditional computing (desktop and laptop) made up the difference.

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The graph also shows that sales value via mobile devices crossed over 25% of online spending. The fact that mobile shopping is not equal to mobile spending is due to the convenience factor of mobile. It’s more likely that users will spend idle time scanning for bargains or tracking down ideas from friends but wait until they are at home to make the final purchase decisions in front of a computer.

The transition to spending directly from a device is a slower process, but that process was also one that online had to undertake as buyers became comfortable with online commerce. When it comes to payment, buyers are understandably more cautious.

This does not change the prediction made last year that “the transition to post-PC consumption will also be practically completed by 2020”. That leaves six years for mobile saturation and a total transition time of one decade.

At that point I expect 90% of browsing and perhaps 75% of spending to be happening on devices. Some of this will undoubtedly be enabled by biometric authentication as shown by Apple Pay. Trust and ease of use in this technology will undoubtedly accelerate the transition making mobile payments more comfortable and secure than on the legacy computer.

What is less predictable is how much those devices will also be used to transact payments for the physical retail stores. In some scenarios it’s possible that by 2020 a majority of all shopping will be enabled by devices.[1] That would subjugate the retail segment to the power politics of mobile platforms.

It is interesting therefore to note the mix between the platforms in the graphs above.

Notes:
  1. There is also the matter of in-store discovery and advertising via NFC and bluetooth i.e. iBeacon []