Apple (NASDAQ:AAPL) has a history of rolling out the most successful and innovative products. The company is not only capable of continuous innovation in its hardware, software, and services but also knows how to monetize its portfolio of offerings. The company has fully loaded its product pipeline and is all set to launch a number of products this fall including phablets, wearables, and iServices.
The tech giant in order to stay competitive and maintain its superiority over the rivals has announced some of the most innovative advancement in all of its product types and in this report I will discuss all of them in detail along with their impacts. First let's talk about the enviable portfolio of services, including music, payments, etc., that Apple has built and how this combined with Apple's multi-product compute offering creates a sustainable competitive advantage for the company.
Apple's iServices and iOS platform is an underappreciated growth and margin lever for the company. As the investment firm Goldman Sachs (NYSE:GS) recently stated in its report, The "Next Big Thing" isn't Hardware, that while the upcoming hardware refreshes will act as powerful near-term drivers of earnings momentum and stock performance, but platform enhancements such as mobile payments, connected home solutions, and personal health monitors should be far more important for driving switching costs and installed base expansion over time, and this is what will determine if Apple's cash flow can remain robust and substantially increase from current levels.
Adjusting Sails in the Direction of Winds
Apple's more than 800 million user base in more than 155 countries provides it an unprecedented understanding and access to the digital consumer. The company's huge user base not only allows it to expand its product offerings but also creates significant switching costs in terms of both time and money for users. Apple's iServices portfolio has evolved over the years and now includes a range of services including App store, iCloud, iMessage, and now HomeKit, and HealthKit.
Let's first talk about Apple's position in the music industry. Since the launch of iTunes back in 2003, Apple has been synonymous with music. The company has been named both friend and foe of the music industry. The company provided a legitimate means of music consumption from what otherwise could have been susceptible to online piracy.
Apple introduced iPod in 2001, iTunes in 2003 and iPhone in 2007 and each of these new launches had a catalyzing effect on the digital music consumption. Although all of these launches were of significant importance, with the launch of iTunes stores, in particular, Apple not only revolutionized the music industry but also changed itself. Separately, with the introduction of iPod and iPhone, the company not only changed the music industry by making it more accessible, affordable and consumable as evident from more than 25 billion downloads from the iTunes store, but it also somewhat accelerated the decline of the music industry as music sales declined from $27 billion in 2001 to the current sales of $15 billion.
The music industry has been shrinking since 1998 led by the migration from physical CDs to digital formats. The digital music revenues, which account for 39% of the whole music market, also seem to have peaked as sales declined for the first time last year by 2%. The decline was primarily led by the emergence of the internet radio and music subscription services like Spotify, Deezer, Beats, and Pandora.
- The Rise of Subscription Services
While the digital music revenues have peaked, revenues from the subscription based services are expected to provide boost to the music industry as they are well placed to generate incremental value for the industry. I think the online streaming services will totally transform the growth profile of the music industry by providing the user a continuous access to every kind of music at all the times as compared to the traditional pay-as-you-go model for physical CDs and digital downloads.
There are a number of reasons why I think the subscription service will transform the growth profile of the music industry. First of all these subscription services generate higher per user revenue compared to digital or physical music purchases. Compared to the $50 generated by the average purchase of physical or digital music, a premium subscriber to Spotify, Rdio or Google's streaming service spends $120 per year on music, or enough to buy about 12 digital albums. Secondly, the EBITDA margin (Credit Suisse estimates) for the label on music subscription revenues is approx. 40% compared to 34% in digital and 10% in physical.
Lastly, the music subscription services provide more utility to user because of continuous access and music discovery at zero marginal cost and access to shared playlist functions. I think that the services provided by these online streamers are attractive enough to encourage a significant proportion of consumers in the developed markets who pay nothing for the music right now to start paying.
- Not without its disadvantages
One downside of this change in the global music consumption patterns for Apple is that while the shift would generate incremental revenues for the industry, it will also have a deteriorating effect on Apple's revenues. Apple's iTunes account for a significant 75% of global revenues generated from the digital music downloads and any decline in digital music sales directly affects Apple and can have a disparate effect on the company's current services stream.
Despite the consistent increase in the iTunes software and service revenues in the past few years, the revenue per user is steadily declining. This is because of the company's customer base, which is growing at an even faster rate than the revenues. The declining revenue per user can be attributed to a combination of digital downloads being cannibalized and changing consumer music listening habits, as the iTunes users are abandoning the traditional digital downloads for online streaming services such as Pandora, Spotify and Apple's own recently launched iTunes radio.
Moreover, the new users are setting up accounts primarily for downloading games and other free apps rather than buying music for their tablets and smartphones. This is negatively impacting iTunes revenue per user as effectively no revenue is being generated by these new users. Despite these changing consumption patterns, I believe that the revenues generated from the online services would largely offset any loss the company might face going forward. The company realizing the huge opportunity in online streaming has acquired Beats Electronics along with its online streaming music app, Beats.
- And Then Came The Beats Acquisition
Apple with its acquisition of Beats Music for $3 billion is going to further accelerate the development of rapidly growing music subscription market. The acquisition is not only one of the biggest but also unique in the sense that the company for the first time acquired an alternative brand. Apple's installed base of 800 million users on its iTunes platform would provide Beats with a global distribution platform through a virtually frictionless payment system. Although the company could have developed its own service, the acquisition provided it with a readymade streaming service that it can scale with its own large set of skills and resources and at the same time focus on its core and shortly due hardware launches.
Integrating Beats Music into Apple's iTunes and App stores could raise its profile, giving it more subscribers, accelerating the rollout, thereby impacting the entire market by rapidly offsetting the decline being driven by alternative platforms. Apple's huge user base and vast operations provide Beats with a very high level of scalability. Dr. Dre and Jimmy Lovine joining Apple would also be a significant value addition to Apple's human resource. In an interview, Tim Cook talking about the two personalities said that they are "really unique" and that "it's like finding the precise grain of sand on the beach. They're rare and very hard to find." The company sees both these talent acquisitions as providing major contributions to the company going forward.
In addition to the acquisition of Beats music streaming service, the company also acquired Beats Electronics which produces the accessories that have become ubiquitous in the high-end audio market. Beats is the market leader in the $100 plus U.S. headphone industry and has more than 60% market share. Beats has shown a strong and sustained growth over the years. The company generated nearly $1.5 billion in revenues in 2013, more than quadruple its revenue earned in 2011 ($350 million).
Apple's Foray into the Multi-Billion Dollar Mobile Payments Industry
The way we pay for our goods and services is changing, as the world migrates from cash and plastic money to apps on smartphones. While financial institutions, retailers, wireless, traditional mobile payment services, and device makers are all trying to take the controlling interest in this multi-billion dollar industry, mobile payments have yet to take off with the consumers. According to a Forbes report, humans made $15 trillion worth of retail transactions in 2013. So it's not a surprise that players in different industries are trying to take a controlling interest in this new digital ecosystem, which will mean billions in transaction fees, huge amount of consumer data, and targeted advertising. Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), MasterCard (NYSE:MA), and Visa (NYSE:V) are all in this race.
Tim Cook while discussing potential future plans hinted that Apple might also join the race in the near future and enter into the mobile payment space by leveraging the secure Touch ID fingerprint scanner on iPhone 5s to authenticate transactions. However, unlike the competitors, Apple's iPhone 5s doesn't have the NFC chip, which according to rumors Apple is expected to incorporate in iPhone 6. Apple's foray into mobile payments is not only to stay ahead of the competitors in innovation and to increase customer loyalty, which in turn would drive sales, but also to monetize the service by generating revenues through advertisements, subscription fees, and transaction fees.
- Monetizing User Purchasing Data
Apple in addition to generating revenues from iTunes and Apps store can generate an additional revenue stream from third parties by collecting and processing users' purchase data and provide it to advertisers. Companies such as Facebook (NASDAQ:FB) and Google are already doing this and the users are willing to give private data in exchange for improved and free services. While admittedly Apple needs to be careful with its use of data to avoid user backlash, the company with its acquisition of Quattro in 2010, has gained some expertise in iAds.
According to eMarketer, Apple generated $260 million of advertising revenues in 2013 and in 2014 these revenues are expected to grow by 87% to $487 million. I believe that growth in the revenues from advertisements based on user purchasing trends can significantly increase the iAd's growth. Amazon serves as an example; the company generated $835 million of advertising revenue with 200 million accounts in 2013. According to Morgan Stanley estimates, every $100 million of iAd revenue equates to 5 bps of total company revenue growth and $0.03 of EPS, based on the margin of internet advertising companies. A similar advertising revenue per user as Amazon would likely translate to over $3 billion iAd revenue and $0.91 incremental EPS for Apple. Now this is huge.
Mobile payments can also be monetized by charging users a subscription fee. Currently Apple doesn't charge anything for the first 5 GB storage on iCloud but charges $25 a year for iTunes Match, which allows users to store all the music they have with the ability to access it anytime on any device. In addition to advertisement, Apple can charge its users a small fee to recommend relevant goods and services, provide targeted discounts, and offer the ease of making mobile payments. Examples of the subscription-based recommendation services include Birchbox, which sends its subscribers a box of carefully selected samples of makeup for a monthly fee of $10. Another example is Amazon Prime, which charges its subscribers $99 a year for free two-day shipping, Prime Instant Video (a media streaming service), and access to Kindle Lending Library.
In addition to generating revenues from mobile through advertisements and charging subscription fees, the company can also lower the transaction fees it pays to the credit card companies by offering better security through finger print sensor, NFC secure element, and tokenization.
iOS 8 - The Next Big Thing?
Apple at its developer conference also introduced a number of updates and few features in its upcoming iOS 8 that will provide upside to its services revenue. The company's upcoming products position Apple to be the central platform in the upcoming Internet of Things computing cycle. The new health app, HomeKit, and the company allowing third parties to use its Touch ID technology lay the ground for Apple to announce its own health-focused products, such as an iWatch, or payment services using finger print authentication in future. These enhancements also indicate that Apple still has the ability to innovate, and they also could drive meaningful platform differentiation when they are released this fall. Let's have a look at some of these products and how they position Apple to be the central platform in the upcoming Internet of Things computing cycle.
"How Are You?" Now Has a Really Accurate Answer
Apple took a huge leap forward by launching its Health App and with it the associated cloud platform, HealthKit. With the increasingly deteriorating condition of the world health and the people becoming increasingly cautious, the company announced its venture into health and wellness sector at the right time. Until now various third-party health related apps have lived on iOS in silos. However, HealthKit aims to break down those barriers by allowing apps to gather information and control devices from a more centralized point. HealthKit would allow third party apps that provide health and fitness services to share their data with the Apple's new Health app and between themselves store all the information regarding the user's health in one centralized and secure location. Moreover, the app would also provide the user with the flexibility to choose which data he/she wants to share with other similar third parties.
The app will collect the user's information on body metrics and will send a notification to the user's doctor if the user health slips from his benchmark. Moreover, the app would also issue an emergency card/ Medical ID on which all the users' information such as medical conditions, medical notes, reactions, allergies and medications would be recorded and it would be accessible even from the locked user screen.
Apple is already in talks with the doctors at Mayo Clinic and other hospitals on how to incorporate health features that are more advantageous as well as on how to incorporate this information into the hospital's information system. Although the initiative is still in its early stages, I think that the App will attract a lot of users as it can record medical information as well as receive practitioner advice. While there are other competitors in the market, neither do they have the scale nor the user base of Apple. Moreover, Apple has aggregated in one place all the functions that others provided in silo. As I mentioned earlier, these initiatives are only in the early stages but Apple appears to be pushing hard to become a de facto platform standard for health, medical and the broader wearables categories over time.
Taking Home Automation to A New Level
In addition to HealthKit, the other major feature announced by the management to be included in the revolutionary iOS 8 is HomeKit. Similar to health, home-related apps on iOS have operated in isolation thus far. HomeKit aims to unify these devices, providing for a common communication protocol. The users would be able to automate their common house tasks such as opening doors, turning on/off light, and adjusting the thermostat by scripting them.
HomeKit is basically an entry into the home automation market by Apple. In order to provide secure pairing and the ability to control devices individually and in groups, Apple has already partnered with leaders in home automation. The company, while developing the product, has also took care of the security risks that the users might face by introducing the feature of common network protocol with secure pairing, which means only the owner's iPhone would be able to perform tasks such as open garage or unlock the doors. The HomeKit and HealthKit platforms are a signal of Apple's desires to extend the reach of its iOS ecosystem and further integrate its functionality into the burgeoning Internet of Things. I believe the company will pursue a payment opportunity as well in the next few quarters. The need for NFC is the only hurdle but it will be solved with iPhone 6 in the fall.
Sharing Is Caring
Apple will now also allow up to six members in a family to share their iTunes accounts and link to a single credit card in order to share their purchased content like apps, books, movies, TV shows and music. Apple's family sharing initiative comes in response to an increasing number of customer complaints regarding the purchasing process in its App store. The company has been criticized for making it too easy for children to make unauthorized purchases from their parent's credit cards. Apple also recently settled a $32 million lawsuit with Federal Trade Commission in this regard.
I believe with this new feature Apple's revenue could be impacted both positively and negatively. Although it would increase the number of the users that would have access to the app store, the revenue from the paid apps could both increase and decrease. Some families would spend more money on the apps knowing that they can all share it, while those families who used to shell out money to download the same apps for all of the family members may cut the spending.
In addition to a number of new products offering in iServices, Apple will also be launching new hardware (and hardware refreshes) this fall. Both of the expected hardware launches this fall are of immense importance to Apple. While iPhone for many years now has been the company's revenue driver, iWatch will determine Apple's innovation capability going forward. Apple has an opportunity to take share in now slower growth smartphone/ tablet market with its large screen phone and new services.
The Most Rumored About Wearable iWatch
Although there are many smart watches in the market at the moment, none has the "wow" factor to attract significant sales. With the widespread rumors of Apple launching an iWatch and because of the company's history of reinventing products in a way that competitors haven't been able to do before, it makes everyone look forward to the launch. I believe that the overall value generated by a smartwatch would remain unclear until a company having as impressive marketing skills as Apple and a user base as loyal as Apple, makes it seem indispensable. As without people feeling the need to wear the watch again, which they left because of the ubiquitousness of smartphone, the smartwatch would be just another faddish wearable that people will eventually forget. So it isn't just a matter of utility but also fashion, which is going to determine the revenue-generating ability of iWatch.
In order to make the product popular among masses, Apple can make it "aspirational" for users by making it a fashion-forward and celebrity endorsed object of desire and once it establishes its niche at the high end of market, transform it into an attainable luxury, just like the strategy the company used to attain its huge iPhone user base.
Although the company has delayed its smartwatch launch compared to competitors, I believe that Apple is in the middle of deploying an impressive brand strategy that will make the smartwatch in general and iWatch in particular ubiquitous in the high end retail environment as well as in the popular culture. Moreover, the product would also generate the promised utility like contextual information and health and fitness. RBC Capital Markets estimates that iWatch (priced between $175 to $225), which could either connect to a smartphone or even incorporate health tracking capabilities, could add $10 billion revenues for Apple, and as much as $3.0 in EPS. Again this is significant.
Finally The Big Thing - iPhone 6
Apple is expected to launch iPhone 6 in coming fall. The rumored iPhone 6 is expected to be launched in two models, a smaller phone with 4.7 inch screen and a bigger phone with 5.5 inches screen. Both models are expected to be slimmer with faster A8 processors and high resolution cameras. According to businessweekly, Apple's mass production of 68 million iPhones, which is nearly twice the initial order for iPhone 5 will commence this month.
Despite the huge forecasted demand for iPhone 6, I think that the high end smartphone market growth is slowing. The high end market is highly saturated and largely in its replacement cycle with an expected flat unit growth through 2015. In addition, the company is also facing a great deal of competition from other vendors as they have incorporated the most high end specs at low prices. Moreover, the company's growth in high-end may be further constrained because of the volume guarantees offered by Sprint (NYSE:S) and Verizon (NYSE:VZ) that are beginning to expire.
The company is also facing stiff competition from rival Samsung (OTC:SSNLF); both have a stable share in high end market and will likely protect their installed base by innovating at high end to maintain their market share. Samsung, I think, has a slight advantage in vertically integrating components as it has a long history of making unique and innovative components for phones such as memory, application processors, image sensors, and displays. However, I expect both these companies to continue to offer the cutting edge technologies such as bendable screens and faster processors with lower power consumption.
While larger screen, faster processor, improved camera might not be game changing features in iPhone 6 but Apple boasts an operating system on mobile devices that has no rival and that has existed for a long time. Few companies have done as much to bring consumers' attention to the benefits of having a high-quality OS as Apple has and that will continue be the differentiating factor between Apple and the rest.
I think the market is underestimating Apple's upcoming services, software, and hardware innovations. While the larger screen iPhone will accelerate the replacement cycle as the current iPhone users will have a much stronger incentive to upgrade to larger screen phones, the upcoming iWatch and iServices product should also help accelerate growth and expand margins. Looking at the sheer volume of new product in pipeline and Apple's history of successfully entering new product categories makes it a great time to take a bullish position on this innovation powerhouse.
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