Sifting The Apple Rumors: Television

| About: Apple Inc. (AAPL)
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Any new television products must provide compelling content delivery while meeting Apple's high gross margin expectations.

The low margins of displays and televisions have kept Apple out of the television market.

An Apple 4K television may provide an entry into the TV market with acceptable margin.

An evolved, more capable Apple TV box is more likely to emerge this year.

Amidst all the rumors swirling around the topic of an Apple (NASDAQ:AAPL) television, there is a fundamental mystery in why an Apple smart TV doesn't already exist. After all, most mainstream consumer electronics companies already produce smart TVs, so it's not a matter of technological feasibility. If we understand what has prevented Apple from entering this market, then we can begin to make sense of the rumors and arrive at reasoned expectations for a product that Piper Jaffray analyst Gene Munster has been predicting for years.

There are two basic problems that any Apple television product, whether it be a set top box or a smart TV, must solve:

  1. The Problem of Content

  2. The Problem of Margin

The Problem of Content

Apple has understood for some time that the future of content delivery is the Internet. iTunes is Apple's answer for that. Internet content delivery is disruptive of the traditional audio/video entertainment delivery media of terrestrial broadcast, cable, and satellite. Even Big Media conglomerates such as Comcast (NASDAQ:CMCSA), whose cable operation provides broadband Internet to millions of subscribers, are threatened by Internet content delivery.

It's not that Big Media doesn't know that the Internet is the future. They do. They just want to stall the arrival of that future as long as possible and maximize the return on their investment in the existing broadcast infrastructure. Thus, Internet content delivery is mostly offered as an add-on to an already existing cable or satellite subscription. Cord cutting is not to be encouraged.

Another symptom of Big Media's fear of Internet-delivered content is the fee Comcast recently extracted from Netflix in order to assure sufficient bandwidth for Netflix users. This shows how biased Comcast is in favor of the incumbent broadcast distribution system. Normally, cable operators pay a fee to a content provider such as HBO in order to carry HBO's "channels" (which are just bundles of programming). But Netflix, as a content provider, is required to pay a fee instead.

It is in this difficult context that the recent report by The Wall Street Journal of discussions between Apple and Comcast needs to be taken. The WSJ reported that discussions were underway for Comcast to provide Apple with "managed service" access to Comcast subscribers using an unspecified Apple television service. Given that such a service would directly compete with Comcast's Xfinity on-demand streaming service, I doubt that the matter was even open for discussion. More likely, Apple was in discussion with Comcast for access to content generated by its Universal and NBC business units.

Through Apple TV, Apple has realized that any television product must provide an on-demand streaming experience like Netflix rather than just on-line purchasing and renting like iTunes. Preferably, this streaming service would provide access to live events as well, through providers such as Comcast. Apple doesn't want to build RF tuners or cable boxes or even embed them into televisions, Apple wants to be able to provide all content cleanly via the Internet, managed by a single, consistent user interface. Apple wants to deliver the future.

The Problem of Margin

From the standpoint of profit margin, flat panel displays and televisions are a lousy business. Margins are razor thin and competition is very tough. Samsung's (OTC: OTC:SSNLF) flat panel and television businesses are a case in point. According to their 2013 Q4 results, display panel revenues declined 10% y/y and operating margin was 1.7%. Samsung doesn't break out television operating profit, but television sales constitute 70% of the Consumer Electronics division revenue, which had an operating profit margin of 4.6%.

Apple tends to shy away from low margin businesses, and the margins for televisions have been the most potent deterrent against an Apple television set. Apple knows that there's no money to be made in screens per se. This explains the long delay in refreshing the Apple Thunderbolt Display. After proudly proclaiming the new Mac Pro's ability to drive multiple 4K (3840x2160) monitors, Mac Pro users have been offered only a 32" Sharp 4K display in the Apple on-line store.

Solving the Problems

Any Apple television product must present a compelling solution to both problems. The current Apple TV solves the Problem of Margin by dispensing with the screen. Apple TV provides an incomplete solution to the Problem of Content, which is why Apple keeps adding more channels to it. As a Content Solution, it leaves something to be desired, but its low cost and convenience affords it a niche as a TV accessory.

Are there future solutions that we have yet to see? Yes. At the very least Apple will bring out a next generation Apple TV set top box. Much has also been written about potential gaming capability, and I find the concept of an Apple TV that can run iOS apps of all types very compelling. The current Apple TV already runs a stripped down version of iOS, but a future Apple TV running the full iOS would enhance the usability of many practical apps such as iWork. It would, in effect, be Apple's first non-mobile iOS device.

The catch in this scenario has always been how to provide iOS with the user inputs it needs without a touch screen. Many potential solutions exist, including gesture control, speech, and some form of highly capable remote. In fact, this evolved Apple TV is likely to use all three.

Beyond the evolved Apple TV, which rumors say is likely this year, is there room for an Apple Television? I believe so, but only if it's a 4K (3840x2160 pixels). The reason is that 4K content is unavailable by conventional delivery means. There are no 4K Blu-ray disks. 4K video can't be broadcast over the existing ATSC terrestrial broadcast system, and it will be years before the U.S. adopts a standard that can accommodate 4K. Cable and satellite providers can't broadcast 4K video either without considerable upgrading of their infrastructure, and this would run contrary to maximizing investment in existing infrastructure. For at least the next year, 4K content delivery will be the exclusive province of the Internet.

This is why Sony (NYSE:SNE) has made available a $600 media streaming accessory that can download content from their 4K video store. Although 4K televisions have come down a lot in price (Best Buy (NYSE:BBY) has a Sony 65 inch 4K TV for about $4500), the media streaming device appears to be the profit center.

The dearth of 4K content, and the restriction of Internet-only delivery works in Apple's favor. An Apple 4K television doesn't have to be able to carry the universe of content available to cable subscribers (although it will have HDMI inputs for cable boxes), it just needs to have substantial 4K content on iTunes. Even with relatively slow Internet connections, the Apple 4K TV will be able to download content unattended and store it on its very large hard drive.

By integrating the iOS controller into the television, Apple will achieve the simplicity of use for which it is justly renowned, and be able to justify the premium price Apple products typically command. Apple 4K TV owners won't have to mess with video or audio cables. Setting up the 4K TV will be simply a matter of plugging in the network cable and turning the set on. And the 4K TV will have all the capabilities of the evolved Apple TV mentioned above.

Market Prospects

There are plenty of people who believe that 4K television will flop, just like 3D TV did. I disagree. They ask, why should you pay for something you can't see? Those of us who have spent significant time with our retina display iPhones, iPads, or MacBooks know the answer. Not being able to see the pixels is exactly the point.

4K will eventually supplant HD, although the process will probably take a decade or more. Over this same period of time, Internet content delivery will become dominant, as consumers increasingly abandon the broadcast media approach. Apple 4K Television is a product for the future that if made available soon (as in this year), can begin to woo more customers to the Apple fold.

Although I believe the case for an Apple 4K TV is sound, the chances of it arriving this year are no better than 50/50. Gross Margin for the 4K TV will still be low by Apple standards (25% as a very rough estimate) and the market largely untested. This could doom the 4K TV to another year's delay, as Apple tests the waters with its more capable 4th gen Apple TV.

I don't expect a dramatic near-term impact on revenue or earnings due to either the Apple TVs or 4K television. On its conference call for calendar 2012 Q4 (the first Holiday sales quarter for the third gen Apple TV), Tim Cook revealed that Apple had sold about 2 million Apple TV units in the quarter. This is about the level of sales to be expected for a new Apple television or evolved Apple TV.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.