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Apple's Potential New Product Categories: Living Room Or Wearable Computing?

|Includes:Apple Inc. (AAPL)

A good article in February 2012 from Macrumors (citing an article from the NY Times and the "law of large numbers") discussed Apple's revenue conundrum: Thanks to the iPhone and the iPad Apple grew its revenue like a small start-up despite being one of the companies with the highest market caps worldwide.

The mentioned article highlighted that Apple's astonishing growth in recent years was largely achieved thanks to its two "new" product categories, the iPhone and the iPad - while maintaining historically high operating margins compared to all its peers in the IT and consumer electronics sector:

(Image Source for both charts: Macrumors.com)

Without these two product categories Apple would have "only" grown like a "normal" company (see second chart, yellow bars). It can even be argued some of the other product categories (iTunes store) would have contributed less revenue without the introduction of the iPhone and iPad. Therefore, the Macrumors article already concluded in its headline:

To Beat the Law of Large Numbers, Apple Must Expand Its Product Line

With Apple stock touching 700 USD in September of 2012 (and some analysts already talking up price targets of 1000 USD and above) both bullish analysts and over-optimistic stock holders began to speculate which "new" markets Apple could target next.

On one hand, this makes sense. It is highly likely (because of the law of large numbers and simply market saturation) that AAPL will not rise back to its highest levels unless Apple enters new product categories. In about two to three years, the iPhone and iPad enter saturation mode and "only" get replaced in most countries - with significantly less "net new" buyers after 2015 shopping for their first smartphone or tablet.

On the other hand, few analysts took a step back and contemplated hard if it makes sense for AAPL to enter these markets. Most analysts seem to think (given Apple's homerun success in recent years) that any new product category would be another "automatic winner" from Apple - and for AAPL in terms of revenue growth and consistent high gross margins.

Two widely rumored candidates for "new" product categories from Apple are TV sets and smartwatches:

A. Apple iTV set and ecosystem (I will label this iTV below so as not to confuse this rumored product category with the current, existing Apple TV box sold at 99 USD)

B. Wearable computing devices (for example a smartwatch)

The iTV rumors have cooled down somewhat and rumor focus has shifted to wearable computing devices recently. One possible reason: Some interesting new products and prototypes were created in segment B. recently (Pebble Smartwatch, Google Glass...).

I will argue that there's a stark distinction between these two categories A. and B. in terms of market potential for AAPL.

I will argue that Apple has much to lose in category A. and much to gain in category B. Let's start with category A.

A. Apple iTV? Why Apple's iTV would endanger Apple's operating margins

Doesn't Apple have a magic touch? After all, it disrupted the entire smartphone market dismantling the two companies dominating it until 2007 (RIMM/Blackberry and Nokia). Why shouldn't this possible in the TV market? After all, Apple stock rose (and many AAPL analysts issued bullish notes) in 2011-2012 thanks to the iTV rumors.

In my view, AAPL stockholders should be thankful Apple did not enter this market up to now. I will give five reasons:

1. TV Gross Margins And Logistics Issues. Consumers can buy any Apple Hardware product and walk home with it (the only exception being the rather heavy MacPro, but this product has been marginalized in Apple's revenue results). A good example is the current Apple TV box the size of the "hockey puck". An iTV (TV set) on the other hand would have a screen size of at least 40'' to 42''. There is a trend in many countries for TV sizes at 46'' or even above 55''. Shipping these huge iTVs over from Asia (shipping&handling, logistics, storage at Apple retail, potential logistics for repairs at Apple stores or online) will create pressure on gross margins. Just ask FedEx, UPS or other shippers: How many iPhones can you ship for the price of one large iTV?

2. Longevity And Low Turnover in TV Sales. Most TV sets are only replaced when they break down, every 5 to 10 years. In countries with high purchasing power most households already own a HD Ready or Full HD TV (sometimes more than one). Smartphones or tablets on the other hand get replaced much more frequently (every 2 to 4 years). Apple will get lower revenue from iTV. In addition, smartphones and especially tablets were "white spaces" while TV is a heavily saturated market segment with many households owning more than one TV set.

3. Apple's Business Model At Risk: TV Hardware Is A Commodity. Name TV manufacturers that don't bleed money? At the moment, only Samsung comes to mind and it is barely in the black in its TV segment. Most competitors from Japan lose money year after year and even contemplate leaving the TV market (Sony, Sharp, Panasonic). TV sets look the same to the average consumer. Most people don't care about 3D and higher resolution (4K or 8k) content. In short, I can't think of any lasting competitive advantage in TV hardware. This is vastly different from Apple's entry in the smartphone market, Apple's iPhone was truly a breakthrough back in 2007 - even before an SDK was made available in 2008. In today's TV market, competitors already have innovative features, some of them even feel gimmicky at this point:

- Voice and/or gesture control (Samsung, Microsoft Kinect and others)
- 3D TV without the need to wear glasses (Toshiba)
- 4K TV sets at "reasonable" price points, currently as low as 5k USD! (Sony, keep in mind the first Sony 4K TV set sold for 25k USD in 2012)

One can only assume the next Playstation 4 and Microsoft Kinect/XBox bundles will further improve voice and gesture controls. In addition, many features the TV industry cooked up in recent years (interactivity on Blu Ray, 3D content...) have been commercial failures. The average TV consumer looks both conservative and very price sensitive. There are AAPL competitors who thrive on such razor-thin margins. The best example is maybe AMZN, in particular the Amazon Kindle: Basically AMZN is giving away hardware at cost to make money later on with content sales and tying customers to its eco-system. But will Apple and more importantly AAPL shareholders support this revenue model? AAPL and AMZN operating margins are very different for a reason...I doubt the analysts lusting after an iTV introduction would be comfortable with a "razor and blades" business model.

4. TV/On Demand Content Delivery Issues. Internet providers will likely balk at Apple offering live HD streams over the Internet. In some countries, monthly bandwidth caps prevent companies from offering HD TV streams over IP. In on-demand content Apple has powerful competitors with a headstart (Netflix, Amazon Prime, YouTube...). It can be argued that Apple already serves the on-demand market with the Apple TV and iTunes. Should Apple choose the traditional delivery model there would be many regional issues (different cable standards worldwide etc.), this would run contrary to Apple design philosophy. Apple is between a rock and a hard place - the current TV landscape is a mess of differing standards and regulations in Asia, Europe and the US. The new "clean" and global delivery method (IP TV) is still unreliable and creates bandwidth and monthly cap issues.

5. Content Cost and Bargaining Issues. Will TV stations and rights holders with exclusive content turn their back on existing partners or bargain for higher prices? Will Apple get the "interesting" or exclusive content as a new entrant? The bidding wars (for example between Netflix and Amazon Prime, Google will enter this market soon with YouTube) for content show that this is not a high margin business. Bargaining power mostly lies with the content holders in this area. One current example is Apple's rumored iRadio service taking months of negotiations with music rights holders - and in TV/video content Apple doesn't have the online market dominance and bargaining power it (still) enjoys in music/audio content.

Conclusion: Apple should not create an iTV set and stick to improving its "hobby offering" in this segment, the Apple TV box at price points between 49-99 USD. Low price points below 100 USD are ideal for "impulse buy" in consumer electronics.

Improving the current Apple TV offering could be achieved in many areas;

One significant improvement on the content side would be to simply buy out a competitor like Netflix (NASDAQ:NFLX) thanks to Apple's huge net cash position. Given Apple's history of only buying small companies it is highly doubtful Apple would spend around 15 to 20 billion USD on NFLX (assuming an upside of 30-50% on the current NFLX stock price). Also, NFLX may be dominant in the USA, but only recently entered the Nordic markets in Europe and is virtually inexistent in Asia.

Another significant improvement would be to finally allow app creation on Apple TV boxes both for existing app developers (huge existing ecosystem of iOS developers) and professional content holders (each TV station could basically become an app - with personalized TV advertising options for each viewer and seamless iPad/iPhone integration for additional information and interactivity, the latter is commonly referred to as "second screen").

On the hardware side, there were minor rumors that Apple could buy a small, high-end TV manufacturer such as B&O, Loewe or Bose. Bose for example created an interesting audio/video combination with its "Videowave" system incorporating surround sound directly into the TV set. Given the small sales it is doubtful this technology (even if marketed by Apple) would be enough of a unique advantage for consumers to choose a premium iTV manufactured by Apple over any commodity Full HD/4k/3D TV from the competition.

Another wild rumor that has been out for some time was a partnership (or even more) between Nintendo and Apple - even this unlikely alliance would be achievable with an improved Apple TV box with no need to manufacture a TV.

To summarize, Apple can - and should, in my opinion - achieve both a better user experience (SDK for iOS developers, more content deals, "appification" of TV stations with personalized content and advertising, iPad/iPhone as second screens) and increased market share in the living room with improved Apple TV box revisions - without creating its own TV set. The large screen is "dumb" in this scenario, it just displays audio or video provided wirelessly or via an HDMI cable by the Apple TV box.

This strategy is also less risky.

The market opportunities for Apple in wearable computing will be discussed in a forthcoming Instablog article.

It will be argued that Apple enjoys much better opportunities (market dominance and potential operating margins) in this category B.

Stocks: AAPL