Understanding The iPhone X's Greatest Risk

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About: Apple Inc. (AAPL)
by: Paulo Santos
Summary

The iPhone X seems off to a great start.

There is, however, a nagging risk. This risk already has showed up on some iPhone X reviews.

Other than this risk, Apple seems likely to miss near term but see higher than expected revenue growth mid term (FY2018).

The iPhone X, whose pre-order window started days ago and whose release happens on November 3, is seeing the expected extreme demand. This demand is obviously driven by some of the most radical design changes the iPhone has seen since the iPhone 6 was launched.

When the iPhone 6 was launched, it drove significant revenue growth for Apple due to the bigger displays which the market had long sought. This time, the major change also is the display, which:

  • Now covers the entire face of the device, except for a sensor notch at the top of the device (when in portrait orientation).
  • Is now using OLED technology, which leads to a more vibrant display with much better contrast (since blacks can be true blacks).

Apple (AAPL), which used to comment on first weekend sales, hasn’t commented on them this year. It’s obvious that the iPhone 8 is off to a weak start. The iPhone X, though, is not. When it came to the iPhone X, Apple said “customer demand is off the charts.” This likely (but speculatively) indicates initial demand for the iPhone X has exceeded initial demand for all prior iPhone models.

However, it had long been reported that the iPhone X would be under constrained supply, so initial demand might itself have been changed by that fact. Customers knew they had to move fast to secure a unit under any reasonable timeline. The pressure (set by the constant news of limited supply) was larger than on any previous launch, and thus likely led to a front loading of orders. Likewise, the iPhone X quickly being 5-6 weeks back-ordered would suffer from the same effect. High demand versus weak supply can expect to quickly extend delivery times.

This is not to say the iPhone X won’t sell tremendously well. Indeed, there are even expectations that it might represent up to 50% of total iPhone orders. When you realize that an entry-level iPhone X ($999) is 42% more expensive than an entry-level iPhone 8 ($699), this becomes very relevant. The same “50% of units” even on an unchanged overall take could lead to an up to 21% increase in value due the higher ASP (average selling price) effect. "Up to" because the difference isn't the same across the range.

Likewise, with the iPhone X sales all falling on Q1 FY2018 or later, it seems a near certainty that when Apple reports, it’s likely to miss Q4 FY2017 expectations (which weren't taken down when the iPhone X got delayed). Guidance for Q1 FY2018 will, however, benefit greatly from the iPhone X late launch, as well as the higher ASPs. So we could be looking at a large miss but very good guidance (with the unknown being how supply constrained the iPhone X will be).

However, with the above considerations being done, I will now explain what the greatest risk to continued high iPhone X demand will be. First, let me say that Apple likely saw this risk and spent a great deal of time making sure it won’t be a factor. However, early reviews seem to indicate that, in spite of such care, it might still be a factor.

The Greatest Risk – FaceID

In pursuing an all-display smartphone, Apple had to do away with TouchID. There were rumors (and leaked prototypes) indicating Apple explored the idea of including a sub-display TouchID or TouchID on the back of the phone. However, Apple ultimately just discarded TouchID, replacing it entirely with FaceID.

Therein lies Apple’s greatest risk. Unlocking and rapidly using the phone is a major part of the experience. TouchID represented a great improvement on that area, which was successfully copied by all Android competitors. A typical user will likely unlock a phone tens to hundreds of times a day. It’s not a time to have trouble doing it.

Yet, there’s the risk that FaceID won’t be entirely smooth. Let me explain why I say this:

  • FaceID uses a technology similar to that used on the xBox Kinect (which was just taken off the market). It projects a dense infrared point cloud, and then uses a ToF (Time of Flight) camera to measure the time it takes for each of those points to be reflected back, thus building a 3D model of what it illuminates and sees.

Kinect infrared point cloud. The iPhone X's will be much denser, since it seeks to cover a much smaller area.

Now, there are a couple of problems here:

  • Not all environments are equally friendly to such a solution. Some environments, like under strong daylight or certain lighting fixtures, produce lots of ambient infrared radiation. The result is that the phone sensor will be less reliable under those conditions. This already was a problem Microsoft warned about when it came to the Kinect, however the Kinect was always sitting on the living room and not walking about outside:

Typically, high-definition cameras need a certain amount of light in order to get the best exposure. Make sure your play space is well lit, but avoid direct sunlight on users and the camera.

  • Both on favorable and unfavorable environments, FaceID will require a specific gesture to put the phone into its “sweet spot” detection area (25-50cm away from the face). This will preclude using the phone as naturally as one with TouchID.

What these “couple of problems” amount to, is a potential hassle. As I said above, I expect Apple to have thoroughly tested the device and somehow came to the conclusion that it was perfectly usable even under those challenging conditions for the phone.

However, some of the first few reviews seem to indicate that this potential issue will still be a hassle. These reviews happened for a very short time (24 hours), and yet the users already noticed the problem – under a longer usage period, it’s likely that the hassle could build up to be a real annoyance. For instance, take TheVerge's review (bold highlight is mine):

In my early tests, Face ID worked well indoors: sitting at my desk, standing in our video studio, and waiting in line to get coffee. You have to look at it head-on, though: if it’s sitting on your desk you have to pick up the phone and look at it, which is a little annoying if you’re used to just putting your finger on the Touch ID sensor to check a notification.

...

You also can’t be too casual about it: I had a lot of problems pulling the iPhone X out of my pocket and having it fail to unlock until Apple clarified that Face ID works best at a distance of 25 to 50 centimeters away from your face, or about 10 to 20 inches. That’s closer than I usually hold my phone when I pull it out of my pocket to check something, which means I had to actively think about holding the iPhone X closer to my face than every other phone I’ve ever used. “You’re holding it wrong” is a joke until it isn’t, and you can definitely hold the iPhone X wrong.

...

I took a walk outside our NYC office in bright sunlight, and Face ID definitely had issues recognizing my face consistently while I was moving until I went into shade or brought the phone much closer to my face than usual. I also went to the deli across the street, which has a wide variety of lights inside, including a bunch of overhead florescent strips, and Face ID also got significantly more inconsistent.

Some reviewers went to a great extent in testing FaceID in the dark, or with all kinds of disguises. However, TheVerge was the one which was actually smart enough to test it under bright daylight, and thus a regular use case where the sensor is the most challenged. Testing FaceID indoors is likely to be much less problematic (with exceptions).

Of course, it’s not like Apple wasn’t aware of this potential problem. It’s not a coincidence that Apple set the sensor to use IR spectrum around 940nm (bold is mine):

I eventually found a pair of sunglasses of mine that it could not penetrate. Apple says that the IR spectrum around 940nm is crucial to Face ID’s ability to function, so sunglasses that block this are an issue. That’s because the light spectrum that it uses is completely invisible to the naked eye. If you unlock in the dark it works perfectly, but no one sees anything coming from the phone — just for the record.

Source: Techcrunch.com

You see, that IR Spectrum band is actually one that’s suppressed under daylight due to water vapor (H2O) absorption in the atmosphere, so Apple was pretty smart as usual:

However, this absorption can vary with cloud cover, humidity, incidence angle and whatnot. So there’s still enough variability that can probably produce annoyances like those experienced by TheVerge.

What Happens If It Turns Into An Actual Annoyance?

Initially, the demand for the iPhone X will certainly not be a function of such worries as the ones stated above regarding FaceID. The new design and beautiful display should overwhelm anything else, though total demand might be somewhat contained by the much higher price.

However, over time, if FaceID turns out to be an annoyance under the described conditions it could be enough of a factor for iPhone X to fade out faster than it would, otherwise. This, in turn, could be a factor for H2 FY2018 Apple sales.

However, I must say that while short-term (Q4 FY2017) Apple revenue expectations seem too high, given the weak iPhone launch, the opposite seems to be true for Q1 FY2018 expectations and indeed FY2018 as whole. This is so because:

  • The iPhone X delay will backload sales into FY2018.
  • The iPhone X ASP is so much higher (42% higher if we compare entry prices) that if it attains a 50% share of iPhones sold, it alone would likely increase the value of iPhone sales by as much as 21% (also considering the entry price on the iPhone 8 is higher than in the past, too). Now, FY2018 revenue expectations stand at a growth of “just” ~17.4%, so this factor alone can mean two-thirds of Apple’s sales (iPhone sales) would already be exceeding the expectation for the whole company by a large margin even on flat iPhone unit sales.

Conclusion

There are several conclusions to be drawn here:

  • Apple is likely to miss Q4 FY2017 revenue and earnings expectations when it reports earnings.
  • Apple is likely to hike Q1 FY2018 revenue and earnings expectations if it has adequate iPhone X supply to meet demand.
  • FY2018 revenue expectations seem too low if the iPhone X attains 50% of all iPhone units sold. This is so even if total iPhone units sold would remain flat, just on the ASP effects alone. As a result, Apple FY2018 revenue expectations seem too low.
  • However, if FaceID turns into an obvious annoyance (under daylight) the iPhone X demand could ultimately fade faster than usual for an iPhone, after a strong start. Initial reviews seem to indicate this might be a real problem, but this remains to be confirmed.

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.