Investment Conclusion - Avoid/Short Apple (NASDAQ:AAPL)
We believe long-only investors should avoid AAPL, and those that can take short/derivative positions should consider purchasing Out-of-the-Money (OTM) Puts expiring on/after 7/21/17, enough time for the fundamental thesis to begin to play out and be recognized. The core of our thesis is that AAPL has lost its long-standing ability to innovate. In fact, we now believe that AAPL has become an innovation laggard compared to mega-cap tech peers Alphabet (GOOG) (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and even Microsoft (NASDAQ:MSFT), a company AAPL has continuously mocked as a copycat.
For us, innovation is the most crucial element in AAPL's future success and growth - not brand cache, not economies of scale, and not even iOS ecosystem lock-in. Correspondingly, AAPL's lack of innovation suggests ensuing share loss in its core markets (i.e., smartphones, tablets, PCs) that have already ceased growing, as well as an inability to even fast-follow in emerging areas such as voice-driven home assistants (e.g., Amazon's Alexa and Google Now) and augmented/virtual reality.
There are two especially glaring areas where we believe AAPL dropped the ball: a fully integrated TV set and a large form factor touchscreen computer. Deteriorating fundamentals in AAPL's present markets, combined with its failure to enter major new markets, will likely result in single-digit revenue contractions for each of the next three years, as opposed to consensus revenue growth estimates of 6% and 7% for FY17 and FY18 respectively (no FY19 estimates yet). Unless management becomes much more risk tolerant and changes how they make product decisions, we do not see a positive growth catalyst until 5G rollout likely prompts a strong iPhone upgrade cycle in 2020-2021.
In addition to our "end of innovation" thesis, we also want to highlight other data points underlying our bearish AAPL opinion:
- AAPL now has a negative net cash position of $19b and an absolute cash position of $67b (far less than the $100b+ it has had over the last several years), so cash repatriation on any favorable tax terms the Trump administration might extend will not be as positive an event as it would have been a few years ago.
- FY16 (ended 9/24/16) iPhone revenue, which accounted for 63% of AAPL's total, fell 12% from FY15, its first full-year decline.
- The global smartphone market appears to be finally approaching saturation, with an installed base equal to half of the adult global population, and even under-penetrated countries such as India saw only single-digit smartphone growth in 2016.
- Smartphone upgrade periods are now lengthening significantly. During 2009-2014, the U.S. averaged a steady 22.5 months but bumped up to 28.4 months in 2015. The 2016 estimate is 30 months and is forecast to continue to grow in 2017 (Source: Recon Analytics).
- Other AAPL products cannot come to the rescue, including tablets (two consecutive years of sales declines) and PCs (a flat-to-down market where AAPL is also losing market share). The Apple Watch, at <2% of total revenue, is too small to make any top line impact.
We will publish a follow-on to this Brief (our upcoming AAPL CSAR report), with a focused analysis backing our investment conclusion. This piece explains the thematic reasoning behind our call as a prelude to the AAPL CSAR.
AAPL's BIG innovation problem.
We believe AAPL has lost its innovation mojo. Worse, it does not appear that management realizes the severity of the problem, and we see no sign of a change in course to reinvigorate the breakthrough product innovation that has made AAPL the most valuable company in the world. Of course, no corporate fate is set in stone, and certainly not AAPL's, given its history of proving naysayers wrong. AAPL still employs some of the most creative and brilliant minds in tech and is still a leader in the realms of creating intuitive software user interfaces, designing sleek hardware, building and feeding a vibrant developer community, and forging novel win-win partnerships.
Yet, following the 2011 death of Steve Jobs, it seems as if AAPL has turned downright risk-averse regarding product development. Whether consciously or subconsciously motivated, AAPL executives presently appear more focused on tending to the iPod/iPhone/iPad annuity stream, as opposed to taking the risks necessary to create truly breakthrough, innovative products.
Maybe AAPL's executives can no longer recognize and push for product ideas with innovative blockbuster potential. An even more dire possibility: maybe they never developed that skill in the first place. After all, identifying and evaluating the commercial potential of innovations always seemed to be controlled by Jobs. Maybe, without Jobs, AAPL's leadership has become so divided and dysfunctional internally they can only achieve lose-lose compromises, always sacrificing groundbreaking potential for short-term safety and the preservation of inter-departmental harmony.
Obviously, we are just speculating here about the reasons for AAPL's innovation funk, but the conclusion holds so much historical precedence that it is almost a cliché. Countless tech companies of all sizes have lost the ability to innovate after the loss of a key founder/CEO. We know this: Steve Jobs did not care about preserving inter-departmental harmony. In fact, time and again, he seemed to deliberately cause discord among his direct reports for effect, sacrificing harmony not just to preserve innovation at AAPL, but to help accelerate it.
To be fair, Jobs was one of the most innovative CEOs ever with an uncanny ability to guide R&D, decide exactly which technologies were ready for prime time, and turn those technologies into products that wowed customers and enhanced AAPL's brand and overall cool factor. Expecting the same pace of product innovation AAPL maintained under Jobs is unrealistic, but we did not expect innovation at AAPL to come to a complete halt, as now appears to be the case.
Although we acknowledge Tim Cook as an excellent executive, we believe his core competencies - i.e., operations and supply-chain management - would make him a much better fit as the CEO of another F500 company. Innovation, vision, and evangelism are not his strongest attributes, and in our opinion, those are exactly the attributes AAPL needs to bring back its innovation mojo.
Under Tim Cook, not only has AAPL not come up with enough new products, it has failed to productize several innovations spearheaded by Jobs where much of the difficult R&D work was already completed. We believe there are a number of compelling, game-changing "products-to-be" currently stuck in the AAPL R&D basement. To be clear, the problem does not lie with R&D and early-product-development teams. Rather, we think that management is simply unwilling to take the chances needed to create the kind of innovative, category-defining products that would prevent a long-term revenue decline.
In press interviews and corporate presentations over the last few years, AAPL execs have given uninspiring and unconvincing reasons why they did not green light products that were eagerly anticipated by analysts, pundits, and loyal customers. An integrated TV set and a large form factor touch-based computer are the leading examples here, and the arguments that AAPL execs have made in support of their decisions feel more like the excuses of an organization content to play defense.
It seems to us as if AAPL execs have forgotten two of the key and interrelated principles behind truly innovative product development:
- The concept of a Minimum Viable Product (MVP) that delivers concrete incremental value to the customer, prioritizes time-to-market, and quickly incorporates feedback from the early adopter customers; and
- parlaying the initial incremental value of an MVP into subsequent product versions that deliver truly transformational value.
To understand and contextualize AAPL's present innovation malaise, we examine two of AAPL's most notable transformational products - the iPod and the iPhone - under the lens of this incremental-to-transformational innovation framework.
Innovation's Own Process: Parlaying Incremental Value into Transformational Value
Our incremental-to-transformational value construct is inspired by Geoffrey Moore's seminal work, Crossing the Chasm that lays out his often-referenced theory on new technology adoption. In Moore's theory, a new tech product - the MVP - does not have to be immediately transformational in order to "cross the chasm" between early adopters who buy technology for technology's sake and the larger population of mainstream customers who buy technology for more practical reasons.
In Moore's parlance, a new tech product only needs to knock down a single "bowling pin," his term for a customer niche with more specific requirements than the overall mainstream.
Knocking down that first pin can then be parlayed into knocking down adjacent bowling pins by modifying/upgrading the product to deliver incremental value to other niches with similar but still different customer requirements. Once a product delivers value to and gains traction in enough niches, it can "cross the chasm" and mainstream adoption takes off. From there, the product can realize the transformational value potential it inherently possessed when conceived.
The iPod and the iPhone are some of the most innovative products ever. (So too was the iPad, though for the sake of brevity, we are leaving that story on the cutting-room floor.) We remember both products for their "transformational value" and the entirely new markets they created. We tend to forget the path they took on their way to becoming the ubiquitous, wildly successful, and transformational products by which we now remember them.
The histories of the iPod and iPhone serve as textbook examples and reminders of how AAPL became one of the most successfully innovative tech companies ever. They also serve as a comparative backdrop for today, illuminating AAPL's loss of innovation mojo.
The iPod Started Incremental…
When the original iPod was released in the fall of 2001, the iTunes store did not exist. In order to load music into the iPod, the customer first took the music CDs they owned and loaded them one after another into their Mac running iTunes software (Windows support came about 20 months later). iTunes automatically copied the songs from the CDs to the Mac, translating their digital format into AAPL's proprietary iTunes format. From that point, the user connected the iPod to their Mac, and iTunes automatically copied the songs from the Mac to the iPod.
Today, that process seems quite awkward and labor-intensive, but it was a big leap forward during a time with 5-foot-tall CD racks and cumbersome CD travel cases. With the iPod, those who wanted to take and listen to their entire music collection on the road could now do so with a single pocket-sized device. The original iPod (including iTunes) is a classic example of an MVP targeted a specific bowling pin. There were any number of features we have come to strongly associate with the iPod that were missing in the original.
Yet, the iPod delivered significant incremental value to a specific niche - Mac-owning music lovers who travel. Based on the incremental value delivered to that niche, AAPL sold about 600,000 iPods in the 14 months following its initial release in October 2001. That was a considerable achievement given the historical context: The telecom/dot-com bubbles had just burst, 9/11 happened two months before the iPod's release, and AAPL did not yet possess nearly the brand appeal it did by 2010.
iTunes makes the iPod Transformational
In April 2003, AAPL introduced the iTunes Store, enabling customers to buy music for the iPod online. In our opinion, that is when the iPod jumped from incremental to transformational. Building on the initial traction gained by providing substantial incremental value to a comparatively small - but dedicated and vocal - customer base of Mac-owning, music-loving frequent travelers, AAPL could then justify a bump in R&D to expand the addressable market (e.g., to develop a Windows version of iTunes).
The iPod's initial traction also helped AAPL's negotiating position when it forged the deal with the record companies necessary to make the transformational iPod + iTunes Store combination a reality. We will admit that AAPL was aided at that time by the music industry's fear of illegal downloading, still spooked by the brief but tremendous success of free music downloading site Napster. With this combination of strategy, timing, and luck, AAPL parlayed the iPod's initial incremental value into truly transformational value delivered to the much larger mainstream.
By coupling the iPod to iTunes and the iTunes Store, AAPL successfully created portable music-playing devices that were not only far superior to any alternative, but completely revolutionized how people bought and consumed music and massively disrupted the structure of the entire music industry.
The iPhone Started Incremental…
We believe the iPhone is an even more powerful example of an MVP that initially delivered compelling incremental value and was then parlayed into delivering transformational value. In doing so, AAPL disrupted yet another entire industry: mobile handsets. Like the original iPod, the original iPhone, released in June 2007, lacked many of the features that drove its mainstream adoption, with the biggest missing piece in our opinion being the complete lack of third-party applications.
Some might argue that the iPhone's multi-touch interface created transformational value, and a case could be made for that. After all, deciding whether the value that a product delivers is "transformational" or "incremental" is highly subjective, with the difference often bordering on the merely semantic. However, even if one is convinced that multi-touch was the iPhone's transformational element, we believe it was certainly not transformational from the get-go.
We believe that the full realization of the multi-touch interface and the transformational value it carried was the result of a superior ability to browse the Web anywhere, anytime. That multi-touch-driven mobile-browsing capability was only truly realized with the 3G version of the iPhone released a year after the original. In fact, we would argue that, although it was compelling and one could get a glimpse of its transformational potential when connected via Wi-Fi, multi-touch browsing on the original 2G iPhone was too painfully slow to offer even much incremental value.
We argue that the original iPhone's key incremental value was simply integrating an iPod with a mobile phone. That, along with a good dose of residual "Think Different" brand cache, enabled AAPL to sell enough of the first iPhone to justify its investment. Some may have different recollections, but we remember clearly that, following the disastrous integration of "iPod functionality" with Motorola's Rokr phone, many die-hard and vocal iPod customers were chomping at the bit for a product that combined the two devices they loved most and wanted in their pocket at all times.
An Aside: Former Smartphone Competitors
Though it may seem odd now, in 2008, many believed the smartphone market tide would raise all boats. Most thought that both Research in Motion (BBRY)-of Blackberry fame-and Nokia (NYSE:NOK)-with its 35% smartphone market share -- would piggyback the iPhone success and continue to grow. After all, the prevailing wisdom was that RIM's Blackberry had a lock on business users and its loyal customers would never give up their physical keyboard for an on-screen one.
Similarly, most assumed NOK would continue to dominate the more price-sensitive end of the market due to scale, brand, and tight relationships with telcos worldwide. However, if one saw the inherent transformational value of the iPhone as a platform for "mobile computing apps", the challenge for RIMM and NOK was clear. Sensing that their ability to catalyze and feed third party software developers would be crucial for both NOK and RIMM, we (well, actually only one of us at a previous firm) engaged in a cursory due diligence project to determine the magnitude of their challenge to attract and keep third party app developers to both NOK handsets running the Symbian operating system and RIM handsets running its BBOS platform.
The interviews we conducted in early 2009 convinced us NOK and BBRY were likely in trouble. With NOK, developing apps on Symbian required:
- Fluency in Symbian C++, an altered and more-difficult version of standard C++, itself having a steep learning curve;
- That individual applications be tweaked significantly for each phone/device; and
- An "almost manual" debugging process with only marginally helpful tools, most from the 1980's.
As for developing for the Blackberry, the consensus was that it was basically a non-starter. One developer with whom we spoke literally just laughed when we asked about development on the Blackberry, not even dignifying the question with a verbal response. - Samadhi Partners
The demand for this iPod + handset combo, frequently voiced by AAPL fanatics and some general consumers alike in 2005 and 2006, now seems forgotten. However, we firmly believe it was the incremental value of the iPod + handset combo, along with a good dose of residual "Think Different" brand cache, that enabled AAPL to knock over its first bowling pin to the tune of five million iPhone customers within the first year of its release.
An SDK and App Store make the iPhone Transformational
With a base of five million users by which to attract developers, AAPL did two things in the first half of 2008 that truly marked the iPhone's jump a little later from incremental to transformational: First, it released the iPhone Software Developer's Kit (SDK) in March 2008. Second, it launched the app store for the iPhone in July 2008. Not only did AAPL open the iPhone to third-party application development, it built an unprecedented end-to-end environment and toolset making it possible to build fully featured apps within weeks.
Demonstrating the ease of iPhone app development, over 800 apps were developed and ready for download in the three months between the release of the SDK and the launch of the app store - an elegantly constructed storefront, accessible right from the iPhone, that drastically reduced the friction between buyers and sellers of apps.
Together, the iOS SDK and the app store enabled AAPL, extending Geoffrey Moore's bowling analogy from Crossing the Chasm, to knock over a huge number of bowling pins without significantly increasing its level of effort. More specifically, by making iOS apps so easy to build and sell, AAPL enlisted an army of third-party developers so large that soon there existed at least one compelling application to match the desires of virtually any iPhone customer.
By the end of 2008, AAPL sold an additional seven million iPhones and third parties contributed approximately 6,700 new apps. iPhone users cumulatively recorded more than 400 million app downloads in 2008. The exploding growth of the iPhone community attracted even more apps and developers, which, in turn, attracted more iPhone customers, initiating one of the most remarkable and lucrative feedback loops in tech-sector history: Users attracting developers, developers making apps, and apps attracting more users, ad infinitum. By 2009, despite the grave economic uncertainty of the times, AAPL had successfully built a revolutionary product that created transformational value.
Please forgive us for the history lesson, but we felt it was a necessary backdrop to explain why we think AAPL has lost its innovation mojo. Now, let's look at two product ideas - the integrated TV set and the large form factor touchscreen computer - that share the following four characteristics: 1. AAPL has already completed most of the difficult R&D work to turn these ideas into products, 2. each holds the potential to be truly transformational, 3. the Total Addressable Market (TAM) for each is large enough to significantly improve AAPL's top and bottom lines, and 4. there exists significant risk of high-profile failure.
Punting the TV Set
In Walter Isaacson's biography of Jobs - which, for reference, was published shortly after the subject's 2011 passing - Jobs expresses unabashed zeal about the R&D progress AAPL had already made in creating a truly integrated, flat-screen TV. Isaacson writes:
"[Steve Jobs] very much wanted to do for television sets what he had done for computers, music players, and phones: make them simple and elegant. 'I'd like to create an integrated television set that is completely easy to use,' he told me. 'It would be seamlessly synced with all of your devices and with iCloud.' No longer would users have to fiddle with complex remotes for DVD players and cable channels. 'It will have the simplest user interface you could imagine. I finally cracked it.'"
To be clear, the above-described product is wholly different than the current AAPL TV product, which, in our view, is not much more than an overpriced iPod with an HDMI interface. The "integrated television set" envisioned by Jobs has not been brought to market even after six years from that conversation. Per a May 18th, 2015 article in The Wall Street Journal, AAPL is said to have given up completely on the idea of a television set sometime during 2014, although this was never officially confirmed or denied by AAPL.
We found the arguments offered against an Apple TV set in the article particularly curious, if not laughable (text bolding added for emphasis):
"Apple had searched for breakthrough features to justify building an Apple-branded television set, those people said. In addition to an ultra-high-definition display, Apple considered adding sensor-equipped cameras so viewers could make video calls through the set. Ultimately, though, Apple executives didn't consider any of those features compelling enough to enter the highly competitive television market, led by Samsung Electronics Co."
Virtually every aspect of how we control our TVs has been begging for a complete re-think and re-design for what seems like decades now, including confusing, easy-to-lose, hard-to-use remote controls, as well as the notoriously counterintuitive, awkward, and sometimes downright infuriating software interfaces to control the basic functions of the TV. In our view, AAPL is simply not telling a credible story in suggesting that there are no features it could add to a television product that would be compelling enough for success in the market.
First of all, since when has AAPL shied away from jumping into a market dominated by incumbents with long histories? A strong argument can be made that portable music players, music stores, and mobile handsets possessed more daunting competition than an AAPL TV set would have faced in 2013 or even today for that matter. To be sure, TV-set market-share leader Samsung (OTC:SSNLF) possesses several advantages that make it a formidable competitor: An extensive global distribution network; design and manufacturing processes honed to ensure very high quality at low cost; and, perhaps most significant, vertical integration for many of the most critical, high-cost TV components such as the flat panel display, the LEDs and OLEDs in the display, DRAM, and image processors.
However, Samsung is not known for user-friendly, intuitive software interfaces; slick hardware design; innovative ergonomics; or, frankly, much of any truly breakthrough innovation in consumer electronics (Samsung is, however, an innovation standout when it comes to physical layer technologies, components, and semiconductor manufacturing). Core competence and innovation in these areas are supposed to be AAPL's calling cards, and it has used them to successfully battle Samsung and minimize its advantages in other areas, most obviously and importantly in smart phones.
Samsung also does not possess AAPL's massive developer community, let alone a knack for building and feeding such a developer community. Last, and perhaps most importantly, Samsung does not possess AAPL's brand, which features a core cult of tens of millions of global members, most of whom fall into the highest-income, least-price-sensitive demographic. AAPL's cult-member customers jump at the opportunity to buy virtually any product AAPL proclaims to be the next big thing, and the television, in our opinion, would have been no exception. In fact, after the 1994 retirement of Sony's legendary and truly ground-breaking founder/CEO, Akio Morita, it is hard to call any TV maker "innovative," particularly compared to AAPL.
Jobs was unambiguous in his belief that a change was needed in how we controlled our television. Our conversations with former AAPL execs and with key AAPL-supplier employees made it clear to us that Jobs had a particular solution in mind: he wanted to integrate Siri, AAPL's voice recognition software, with the TV. Critics will cite two main problems with using Siri as a TV control mechanism, as opposed to its original purpose of answering open-ended queries:
The first is the potential for too many voice recognition errors. People might not mind repeating general questions to Siri, but a high error rate for basic television control commands would be highly frustrating.
The second is what would be an intolerably long response time. Once the audio signal of a user's verbal command is properly translated into words, a long delay would follow if Siri were to operate the way it does normally, which is to send recognized words as text via the Internet to Siri's knowledge servers in AAPL's data center, looking up and retrieving the command corresponding to the words, and sending that command all the way back to the TV for execution.
AAPL's Difficulty with Difficulties
These two issues would not have been difficult to overcome at all. AAPL could have created and installed a "subset" version of Siri with a vocabulary limited only to relevant television control commands, programming titles, and a few selected content descriptions of the available programming (e.g., genre, actors, the director, season, etc.).
That vocabulary could easily fit into less than 1GB of solid-state, NAND Flash storage in the TV and goes a long way toward alleviating both the recognition accuracy and delay problems. A limited vocabulary would substantially improve voice-recognition accuracy, and storing that vocabulary locally on the TV set eliminates the need to send the voice commands via the Internet and back for word-to-meaning resolution.
With the substantially larger circuit board real estate on a TV compared to an iPhone, AAPL could have employed the latest Digital Signal Processors (DSPs), throwing a lot more processing power directly at the task of voice recognition. Finally, a TV set has the necessary real estate to employ larger, more accurate microphones, also improving voice recognition accuracy.
When Siri debuted on the iPhone 4 in 2011, its voice recognition error rate was ~18%, high but tolerable for general queries. By employing the previously mentioned "TV Siri" with its subset TV command vocabulary, the latest DSPs, larger mics, and other advances that AAPL could have made between 2011 through 2013, we believe an integrated AAPL TV set launched in early 2014 could have achieved a voice recognition error rate of less than 5%.
By comparison, today's leading voice recognition systems (e.g., Siri, Google Now, Amazon Echo, and Microsoft's Cortana) can now attain word recognition error rates at or below 5%, and that is for the entire universe of vocabulary for general questions, not the comparatively limited command and content-related vocabulary TV Siri would have required.
The question, we suppose, is whether a voice-driven interface for a TV set would have represented enough incremental value for a successful MVP. We believe the answer is a self-evident and resounding "YES." For those who need a little more convincing about there being enough potential customers for such a voice-driven MVP TV set, we provide some anecdotes in the sidebar, "On the State of the Human/TV Interface." Any similarity between these anecdotes and real-life events is purely coincidental… Those already convinced of the latent demand for a new way to control the TV may skip this sidebar.
Aside: On the State of the Human/TV Interface
Unlike the apparent opinion of AAPL execs, we believe there are many people who would see substantial incremental value in a TV set product featuring a well-designed voice-driven interface that could interpret and execute direct, verbal commands and perform content searches. The people who would be ideal candidates to buy such a TV set, even if it were an MVP, might fall under the following hypotheticals, including anyone who has ever…
…used one of the unbelievably obtuse, counterintuitive, remote-button-driven Electronic Programming Guides (EPGs). (To this day, EPG's continue to adhere to a rigid structure that was standardized way back in the 1980s.)
…felt the aggravation of navigating a maze of pointless Yes/No toggle screens, infinitely nested drop-down menus, and circular jump commands just to turn on closed captioning but without changing the default language from English to Mandarin.
…taken almost ten minutes to fat finger and search for "I Just Remembered That I Still Know What You Did Last Summer III" using the remote's cramped arrow buttons and a painfully small, on-screen, "select-a-letter" grid.
…hurled the remote against a TV screen after scrolling through 1,000+ channels desperately trying to catch a sporting event before it ends, such as, for example, the overtime finish of the UVA vs. Hopkins NCAA lacrosse playoff game that was one of several simultaneously broadcast NCAA lacrosse games from Divisions I, II, and III, including both women's and men's playoffs and being supremely frustrated because the EPG program descriptions are all cut off from view in "scroll mode," forcing you to stop at each channel entry and hit that tiny "more info" button, which, of course, you eventually miss, hitting the adjacent button that returns the TV to the Pay-Per-View movie watched, Paris Hilton's 2008 classic The Hottie and the Nottie, officially making you the laughing stock among the coworkers you invited over that day. - Samadhi Partners
Of course, with any product innovative, laggard, or retro, strong execution on one or two key features is always necessary for success. In this case, strong execution might entail the addition of a mechanism to visually recognize a set of predefined hand gestures, which might be less intrusive to other viewers in the room for common commands like volume control. It would totally make sense for TV Siri to be able to switch to "general query mode," which would essentially be the same Siri as the one running on one's iPhone.
Further, it might be a good option to keep this more generalized version of Siri turned on and recording 24/7 to accelerate the improvement of its voice recognition and language-learning algorithms and to be able to differentiate between different family members' voices-just like Amazon Echo can do today.
This leads us to what might be the most problematic aspect of AAPL's swing-and-miss in the TV space. Like AMZN's Echo, TV Siri could soon have been tweaked and expanded to serve any number of non-TV functions, including the ability to play content from iTunes, order content from the iTunes Store, or run immersive, multi-media language learning applications-all by just talking. Given that the TV remains the physical centerpiece of most living rooms, an AAPL TV set running Siri could have served as a critical first step towards introducing home AI.
This still-nascent home AI market-presently dominated by competitors Google, Amazon, and Microsoft, among others-is estimated by Grand View Research to explode to $12b by 2024, up from less than $1b this year, and we think that estimate is likely quite low. So, coming full circle, we feel that AAPL management's apparent fear of failure, manifesting in the decision not to pursue Jobs' vision for an Apple TV set, has now placed the company dangerously behind in the home AI space.
The Touch-Screen "Desktop" - Scooped by Microsoft?
Another idea that has never seen the light of day at AAPL is a fully-featured computer with a large (i.e., >15 inch/38 cm) multi-touchscreen interface. Unlike the television, the concept of a multi-touch computer has been publicly and officially rejected by two different AAPL executives. First, on October, 16, 2014, Craig Federighi, AAPL's Senior VP of Software Engineering, claimed the following on CNET:
"It's really fantastic that at AAPL we build prototypes around all sorts of ideas. We certainly explored the topic deeply many years ago and had working models. But we decided that it really was a compromise. For a device that you hold in your hand like a phone or tablet … we think touch is at its best. And, we wanted to build, and have built, a really deep experience around a "multi-touch first" user interface. Grafting touch on something that fundamentally was designed around a precise pointer really compromises the experience."
More recently on November 14th, 2016, Phil Schiller, AAPL's Senior VP of Worldwide Marketing had this to say about multi-touch on Mac:
"We think of the whole platform. If we were to do Multi-Touch on the screen of the notebook, that wouldn't be enough-then the desktop wouldn't work that way."
And touch on the desktop, he says, would be a disaster:
"Can you imagine a 27-inch iMac where you have to reach over the air to try to touch and do things? That becomes absurd."
He also explains that such a move would mean totally redesigning the menu bar for fingers, ruining the experience for those using pointer devices like the Apple Pencil or the mouse:
"You can't optimize for both … It's the lowest common denominator thinking."
Over the last few years, there have been a few other expressions by members of AAPL management, both directly quoted and referenced by the press and pundits, pointing to how awkward and tiring it would be to have to continuously reach "up" (or in Schiller's own words, "over the air") to a monitor to execute commands or manipulate objects on the screen. Essentially, one of AAPL's primary arguments against the touch-screen desktop has been ergonomic. This ergonomic problem is largely solved, however, by simply being able to position the screen flat or at a shallow angle on a "surface."
In fact, AAPL seemingly figured this out already. In 2010, AAPL filed a patent for a mechanism (EU filing number: PCT/US2009/050168) whereby adjusting the angle of the screen of a computer automatically changes "the mode of input." When the screen is vertical, the operating system remains in "mouse input mode." When the user adjusts the screen angle below some user-set threshold, the operating system switches to touch input mode.
So, in our view, two things are evident from this patent filing:
First, it is obvious to those inside AAPL, not to mention many in the field of human-computer interfaces, that a full-fledged, touch-driven computer is only ergonomically viable at flat or a shallow angle on a desk surface. In this light, Federighi's and, especially, Schiller's objections that a touch-driven interface would be awkward and tiring ring hollow. More than hollow, it sounds almost disingenuous, as if the real reason for not pursuing a touchscreen Mac or a beefed-up iPad equivalent were more related to internal politics rather than a sincerely held belief about the future of computing.
Second, it shows that someone inside of AAPL actually came up with what seems to be a reasonable solution to the "can't optimize for both" problem (i.e., both mouse and touch input modes).
Maybe we are blowing AAPL's resistance to a large form factor, touch-driven computer out of proportion. We fully understand that companies often file patents without ever productizing them. Further, we admit there is something decidedly "Apple-esque," or more appropriately, "Jobs-ian" about Schiller's aversion to that "lowest common denominator thinking." We too think Jobs would not have been fond of a "dual mode" operating system, regardless of how slick a mechanism is employed to automatically switch between modes.
The difference, however, is that we believe Jobs would not have abandoned touch, which, along with voice recognition, represents the future of the human-computer interface. Instead, Jobs would have killed the mouse, and he would have made a big damn deal about doing it too. The ad script almost writes itself: "The company that ushered in the era of the mouse and killed the command line is now ushering in the era of touch and killing the mouse."
In our opinion, AAPL should have made this move at least two if not three years ago. The technology for acceptably priced 15inch/38cm touchscreens has been ready since 2013. With a little price/performance extrapolation with Moore's Law as a rough guide, AAPL could have easily anticipated when large form-factor touchscreens would be ready for prime time.
What is more, given AAPL's expertise and track record in ergonomics, user interfaces, and making an entirely new computing context relatively easy for developers to quickly create compelling applications, it is hard to believe AAPL could not have made a touch version of OS X to go with a new line of "TouchMacs" by the end of 2014, or the end of 2015 at the very latest.
Yet, here we are in 2017 with no indication that AAPL is even close to launching a touchscreen Mac. At minimum, AAPL could have developed a "Pro" version of iOS running on a beefed up, large form factor iPad. And, if you were wondering, today's iPad Pro is not nearly beefed up enough to run apps where serious creative work is done.
To be fair, the iPad Pro does have fans among some creative professionals, mainly those who spend a lot of their time in the initial ideation and sketching phases of the content creation workflow. The creative professionals who are satisfied with the iPad Pro see it as an accessory, not a replacement, for a full-fledged Mac that can handle the most processor/memory intensive and collaborative phases of the content creation workflow.
Perhaps AAPL is simply biding its time before it releases an iPad with the processing/memory muscle running a correspondingly powerful, revamped version of iOS so that creative professionals of many types can use it to handle the entire creative workflow, from ideation to finished content. The problem is that, in our opinion, AAPL does not have the luxury to wait. The most shocking thing about AAPL's inaction regarding touchscreen computing is the fact that it appears to have been scooped by Microsoft with the Surface line in general and the Surface Studio in particular.
Released in October 2016, Surface Studio is an ergonomically well-designed, high-end 28-inch touchscreen desktop with a full 90° range of motion (flat to vertical) aimed at the most loyal core of AAPL's customers: creative professionals.
Though creative professionals are a small niche, they have been central to AAPL's success historically. We believe creative professionals serve as canaries in the coal mine and listening to them reveals insights into AAPL's creative, innovative soul. When AAPL was at its lowest point in the mid-90's and its existence as an independent entity was in jeopardy, creative professionals stayed loyal, stubbornly hanging on to the Mac platform even within Windows-dominated enterprises.
AAPL, in turn, gave back, prioritizing features this niche customer base was asking for and focusing its limited developer support funds specifically on those that produced applications for creative professionals (e.g., graphics, drawing, publishing, video/photo editing, music production, etc.).
It's Time to 'Think Different' - Again
We believe that creative professionals were an early key behind AAPL's resurgence. After Jobs took over in 1997, AAPL launched its award-winning "Think Different" ad campaign that, in effect, likened its creative professional customers to many of the most revered and innovative icons of the 20th century (Albert Einstein, Bob Dylan, Jim Henson, Richard Feynman, etc.).
The campaign accomplished three key goals that set the stage for AAPL's unprecedented corporate comeback from during 2001-2010: 1. it paid homage to its creative professional customer base, essentially thanking them for their loyalty, and, in turn, strengthening their dedication to the brand; 2. it celebrated and amplified the "cool nonconformity" of creative professionals who use AAPL products; and 3. it implied that anyone who thought of themselves as "a rebel," even if they were not a creative professional, should consider a Mac-the creative professional bowling pin knocked down the pins of the broader consumer market.
Fast forward to today and one sees numerous signs that AAPL did not just lose its innovation mojo, but that MSFT has stolen it, at least in terms of touch computing. The entire Microsoft Surface line, which admittedly experienced an awkward, slow start, is indeed now attracting creative professionals at a decent clip. Further, it seems that many of these professionals never even tried to use the iPad for professional content creation.
Most are not abandoning the iPad for the Surface. Rather, they appear to be mostly abandoning the Mac for the Surface, indicating not merely a preference for a particular "digital sketching accessory" but a migration to a completely different computing platform to handle the entire creative workflow, from ideation to finishing touches.
Regardless of whether the Surface Family is taking share from iPads or Macs, the numbers are surprising and telling: In the first three quarters of 2016, total Surface revenue was up 18% y/y to $3.1b, while iPad revenue fell 5% to $13.5b and Mac revenue fell 13% to $16.1b. What is more, these numbers do not include Surface Studio sales that went on sale in November and of all Surface models, Surface Studio is the most squarely targeted at creative professionals.
We firmly believe AAPL has opened the door wide for MSFT and potentially others to take the lead and define the future of touch computing, which represents, along with voice recognition, the future of the human-computer interface. This misstep specifically, and more generally, AAPL's overall innovation problem is certainly not a matter of resources as it is for many tech companies pressured to make more risk-averse product development decisions.
Ultimately, AAPL's innovation problem lies with CEO Tim Cook whose core competencies lie solidly in the realms of operations, logistics, and supply-chain management. Without Jobs' innate ability to define AAPL's innovative future, maybe Cook is relying too much on the consensus of his several direct reports.
Unfortunately, consensus decision-making is usually anathema to innovation. This is especially true when a CEO is trying to determine consensus among several strong-willed leaders all vying to be, at least, the visionary leader of the largest company in the world.
It is even more true when this consensus is being arbitrated by a CEO without the vision or tech chops necessary to call out his direct reports when they obfuscate, exaggerate, and manipulate. These issues occur with ambitious, capable humans in any organization. However, now that AAPL is the most valuable company in the world, the bar is much higher, especially for investors anticipating continued growth for AAPL.
We believe that AAPL can fix its innovation problem if either Cook resigns or if Cook appoints someone to be transparently and unequivocally responsible for the vision and product decisions of the company. However, we are not in the management consulting business and realistically, do not see that kind of move happening any time soon.
This Samadhi Brief is part of a larger series on AAPL, that includes Alerts, Company Scenarios and Research (CSAR) reports, and Thematic Industry Fundamentals (TIF) sector reports.
Disclosure: I am/we are short AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This information is intended as an informational newsletter only. No investment advice is offered. Samadhi Partners, a provider of equity research services and newsletters, is a commonly-controlled affiliate of Samadhi Capital Partners that offers a long/short and long-only fund. Samadhi and/or its affiliates may have positions in stocks mentioned and/or traded in these names as of today. I am/we are long GOOG, AMZN, FB, NOK, MSFT.