Apple's (NASDAQ:AAPL) product line got some new additions and updates at the WWDC event starting Monday, June 5th. Other Contributors have already examined the newest member of the Apple family, HomePod, in some detail. However, I did want to talk about how investors should measure the success of Apple's event in terms of tablet competition, and what I am looking for to become optimistic again on Apple's tablet ambitions.
Consumption, Not Creation
Last March, I wrote an article laying out my views on the future of the iPad line. I argued the point that content consumption, not creation, was the key market for tablets and that Apple should shift its pricing strategy and product design philosophy to reflect that. As evidence, I cited the increasing success of Amazon's (NASDAQ:AMZN) Fire line of devices.
Readers will know I have been regularly monitoring the state of the tablet market since then. Amazon's success continued, with sales more than doubling year-ago levels throughout the 2016 model year. Meanwhile, Apple's iPad has continued to struggle.
Because of my repeated arguments that Apple's tablet strategy needs fundamental revamping, I am often accused of being an Apple perma-bear. That is not correct, as I've noted positive developments in its iPhone and Services line. I simply have continuing questions about its tablet strategy, which in my opinion have never been answered.
Apple (Quietly) Recognizes Need To Shift
Apple has not been idle in the tablet space, of course. In addition to the regular updates and refreshes of the product - which now includes the new 10.5-inch iPad Pro as well as Mini, the 12.9 Pro and the original 9.7-inch product - Apple also took a small step towards Amazon when it decided to launch a new 9.7-inch model for the lower price point of $329. In exchange for slightly downgraded specs, Apple delivered an almost 20% price cut.
Apple's price cut on its iPad line should be recognized as a reaction to the success of Amazon Fire, and this has been generally acknowledged by analysts, though curiously most of them aren't mentioning Amazon by name. Instead, Apple's decision has been cast in terms of a lower-priced tablet market in general, as if it was many companies seeing booming sales in low-priced Android (NASDAQ:GOOG) (NASDAQ:GOOGL) tablets instead of only one. Also referenced repeatedly is just the general need to keep the product moving in a declining tablet market.
That is certainly all true, but as I've noted for over a year now it ignores that not everyone in the tablet market is declining. Focusing on providing affordable devices featuring near-premium (i.e., just below top level) specs continues to yield growth even as the overall market has declined. Amazon has been far and away leading that trend, despite a somewhat disappointing start to 2017 where it reportedly only held sales steady rather than growing them. But in a market that overall declined 20% Y/Y even that is impressive.
Double Back Or Double Down?
I agree with others on Seeking Alpha who have already noted that Apple's price cut decision in March will likely result in lower gross margins on iPads but higher Service revenues. There is dispute over whether this is a good strategy or a bad strategy, but little dispute about what the strategy is.
This is a variant of the strategy I proposed last year, cutting prices and making up for it with expanded digital content sales post-device sale, just as Amazon has. With WWDC, the question was whether Apple will take further steps down this road, or double back and return to trying to boost revenues through the sale of ever-higher end iPad Pros with higher prices.
With the launch of a 10.5-inch iPad for a $150 premium, we have our answer. And I am still not sure it is the right one. But I have said my fair share about what Apple's strategy should be already, and it's Tim Cook's opinion that counts. So assuming that the already announced $329 iPad and new services (Apple Music, plus the ongoing rumors about originals and other content deals) are the closest Apple is willing to get to a consumption strategy, has it done enough to meet the Amazon challenge?
I believe that there are three areas that investors should focus on to get a sense of whether Apple is transitioning its tablet strategy with appropriate speed, and whether it is primed to reverse its tablet sales decline. The three key areas for tablet competition on the "consumption wing," going forward are hardware, software/ecosystem, and content.
Hardware: More Needs To Be Done
While I recognize that Apple's price cut and Services growth approach represent a partial embrace of the strategy I proposed last year, I still see Apple's current hardware approach to tablets as sub-optimal. In my opinion, the price cut does not go far enough. Apple's tablet prospects will brighten considerably if it takes further price-cutting action.
At the time I wrote my original article last year, Amazon was only selling a non-HD tablet for $50. An HD version of Fire still cost $150, almost half of the $400 iPad was selling for. And yet Amazon still managed to soar back into the top tier of the tablet market, while Apple and Samsung (OTC:SSNLF) sales stagnated.
Fast forward another year, and Amazon has through two product refreshes cut the price of an HD tablet all the way down to $80. In other words, the lower-priced vendor has cut prices almost 50%, while Apple has cut them only 20%. Relatively speaking, Apple is actually falling further behind Amazon in price and value, although of course iPad remains the premium market option of choice for those who are willing to spend that high.
Last year, I said that an iPad at $199-299 should be enough to restore Apple's iPad sales growth and open up new digital content sales opportunities. That estimate was based, at least in part, on the idea that Amazon was still charging three figures for actual HD, which reduced the pricing pressure on the higher-performance iPad somewhat. Since iPad really is a superior product in many ways, and since you had to pay $150 to get HD anyway, I thought Apple could maybe get away with charging $300 for its HD (Retina) tablet.
Now, with Fire HD so much cheaper, Apple probably has to get to the lower end of that range. With Apple currently not offering a single tablet below $300, not even in the Mini line, this seems to me a potential weakness. As I noted last year, most people find even older tablet designs perfectly adequate for all the tasks they actually want to perform on a tablet. Apple's elaborate content creation kit, which adds significantly to device costs, is not needed by a large portion of the tablet customer base.
Regardless of exactly how far Apple needs to or decides to downgrade the kit on its tablets, it needs to get the price low enough to make the upgrade from Fire to iPad a good value for those who may not use tablets for content creation, only for consumption. That is almost certainly at a price a good deal lower than it is now.
Software: Apple Leads The Industry
Apple's software position is much stronger. First, one of the changes less noted by analysts in March, Apple's iTunes will finally allow cross-category streaming of rented titles. This capability, long since implemented on Amazon Fire, will allow someone to rent a movie on an Apple TV and then finish watching it on their iPad on the way to work the next morning. Previously, you could only finish watching rented content on the same device you started it on, an utterly ludicrous limitation in the modern era of integrated ecosystems.
This change removes one of the last real pain points in Apple's iOS software for tablet usage and content sales. Software engineering and integration with hardware has always been a relative strength of Apple. Aside from this basic flaw, finally rectified, Apple software has never really been the subject of many complaints. And unlike Apple TV iPad already had a Prime Video app, so iPad buyers were not locked out of one of the most popular streaming services in the world today.
With this basic pain point finally addressed and Apple's reputation for hardware-software integration remaining well-deserved, Apple maintains its position as a company known for software that "just works." With WWDC revealing Apple's next generation of software updates to keep it in the front of the pack, Apple's tablet software should remain a strength going forward.
Content: Show Us The Deal
This brings us, finally, to content, where most of the next wave of profits in tablets is likely to be found. At one point, Apple was seeking to join the long list of tech and telecom companies offering a full-blown package of live-streaming cable-TV channels. But repeated delays finally led Apple to abandon that approach. While Apple does not need to sell cable-TV specifically, it needs to identify some large swath of TV content it can sell through its tablets with a subscription product, much like Apple Music. It has not yet done so, but reports suggest that perhaps it is getting close.
Reports are now that Apple has abandoned the idea of a traditional bundle and is trying to persuade TimeWarner's (NYSE:TWX) HBO, Starz and Showtime to help it create a premium-only bundle. These channels normally go for a combined $35. Since HBO gives half of its $15 monthly subscription fee to cable distributors, it could get Apple most of the way to its customary 30% cut by itself, and the other two would only have to chip in $1.50 each.
Of course, HBO might not feel like being quite so generous and insist that the others carry their fair share of the load, but regardless, the point stands that unlike traditional bundle channels, premium networks and digital disruptors like Apple start much closer together in negotiations than cable-TV providers do. They are accustomed to setting their own price, direct to consumers, and then sharing a portion of the proceeds with a partner company which facilitates billing, hardware and technical support - exactly the way Apple already runs its Services division, including iTunes and App Store.
A $35 subscription year-round would yield $420 per year in revenue - more than the $329 the new affordable iPad model sells for. With Apple taking a 30% commission on digital sales and iPad selling for gross margins in the low-mid 30s - unlike iPhone in the high-40s - that means that digital content sales on iPads generate gross margins little less than the underlying device. In other words, Apple could basically sell a second tablet's worth of content through the first tablet, just with this one content bundle. And unlike the tablet, the bundle could conceivably keep selling year after year.
Apple doesn't have to announce a premium channel package, specifically. I analyze that specific scenario because that is the most recent report we have of what Apple's content strategy is leaning towards. But it needs to announce some sort of content package that it can both start selling quickly and generate substantial revenue off of. If it doesn't it will not be able to cut prices low enough on its hardware to boost sales while still keeping the division overall as profitable as it is now. I do not see the pressure from Amazon and other "content profit, not hardware profit" companies abating.
By far, the single most important question investors should ask themselves now that Tim Cook has wrapped up the WWDC is whether Apple will make a significant content announcement, either pertaining to premium cable channels, sports, or some other major content category, that would spur substantially higher digital content purchases through iPad as well as through the Apple TV.
Also bearing monitoring is any further progress towards a lower selling price for iPad's new slimmed-down model. Software is also important but Apple already has the lead here and there is little reason to think it won't keep it, so there is little to watch for.
As I said before, I consider Apple overall to be a strong company with several well-performing divisions. The return of Prime Video to Apple TV may well create another strong division at the company before long. I was, however, disappointed at the direction the company has chosen to take for its iPad line and I think investors should keep a close eye on the company's content moves to determine the future progress of the product line.
Disclosure: I/we 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.