Is Apple TV a Viable Replacement?

As of the end of last year, roughly 132 million DVD players have been sold in the United States since the device's debut in the late 1990s. Over 10 million of these players were sold in 2007 alone, notwithstanding the advent of the Blu-Ray and HD-DVD formats. At its height in 2003, DVD sales reached close to 22 million units annually (U.S.). If Apple (NASDAQ:AAPL) is able to dominate the video market with the Apple TV, as it conquered the digital music market with the iPod, Apple could potentially add an additional $2 to $4 billion a year in "surreptitious" revenue from sales in the United States alone.

Apple has been, and continues to be, quite secretive regarding the number of Apple TVs that are in circulation. Apple neither discloses a total unit sales figure for the device, nor does it announce the amount of revenue it receives from Apple TV sales. All we know is that Apple currently uses the subscription method of accounting for Apple TV revenue, much like it does with the iPhone.

But instead of allocating a separate line item for the Apple TV on its financial statement, Apple simply records the revenue under one line item called "iPhone and Apple TV"—leaving the relevant observer completely ignorant as to both the monetary and market impact of the device. This has led many Wall Street pundits, investors and financial analysts to fully understate the potential influence the Apple TV might have on the video market.

Investors should view this as a positive for more than one reason. First, by leaving the financial public in the dark, Apple has all but eliminated potential headline risk commonly associated with the inauguration of a new digital product. Both sell-side analysts, and the financial press, thrive in writing negative fluff pieces focused on the understandable and unavoidable set-backs that occur whenever a new device is introduced into the market place. The Apple TV, like the iPhone and the iPod, probably started off with relatively low sales figures. If Apple reported those figures, then the headlines, instead of focusing on blow out earnings, might have read: "Apple drops 5 points in after hours on lower than expected Apple TV sales." By leaving everyone in the dark, neither Apple nor its investors have to deal with such nonsense.

Secondly, if the Apple TV does begin to dominate the market place, Apple will find itself in the advantageous position of being able to frequently post upside surprises to its revenue. While the Apple financial community focuses on iPod, iPhone and Mac sales, the Apple TV would continue to fly under the radar as it posts stealthy but significant sales revenue to the largely ignored deferred revenue category. Additionally, by being secretive regarding the Apple TV, management gives Jobs & Co. the option of blindsiding the market during one of its MacWorld or WWDC conferences by announcing staggering sales figures of which the market might have otherwise been aware.

For all we know, the Apple TV could be making considerable ground even as I write this article. Last week, Apple announced that iTunes has become the world's most popular online movie store as it sells and rents over 50,000 movies per day or a little over 18 million movies per year. That's with a catalogue of only 2,000 movies. With a huge customer install base for movie downloads already set in place, the Apple TV 2.0 can already be taking off.

Yet, while Apple has made significant inroads in its campaign for occupancy of the living room with its Apple TV Take 2, the Apple TV still has a long ways to go from being the perfect alternative to DVD players.

There is a lengthy laundry list of easily fixable issues that Apple needs to address before the Apple TV can be considered a viable replacement. Some issues touch on practical considerations, while others focus on the convenience of the end user. Knowing the genius of Steve Jobs, Apple is probably working on most, if not all of them:

1. Where's the TV Tuner and HD-DVR? One of the most complained about issues regarding the Apple TV is its lack of a basic TV Tuner and an HD-DVR. By adding a TV Tuner and a DVR, the Apple TV will probably become the best alternative to any current set-top box on the market today. It will allow the end user to interface the Apple TV software conveniently with his or her television programming. By offering Cable TV shows, such as HBO, through iTunes, the DVR + TV Tuner might even obviate the need for a subscription to Cable for some users. Yet, it will be really crucial for Apple to successfully interface its Apple TV software with its tuner capabilities. This might require a complete revamp of Apple TV's current software. A big annoyance with the Apple TV is having to switch to "video 2" every time I want to watch a downloaded TV show or movie. Having a TV Tuner and a DVR would create the maximum convenience for the end user. It will allow the user to channel surf, record a TV program and download a movie from a large catalogue in iTunes all through the same set top box. This is very key. If Apple could get over the legal hurdles to do so, it would also be vital to allow users to sync its DVR recorded content with his or her iPod/iPhone.
2. Wireless Syncing and Streaming with the iPod Touch & the iPhone. As a practical matter, I could always take a DVD I rented from Blockbuster (BBI) or Netflix (NFLX) to a friend's house to watch on his or her DVD player. But with downloaded content, this is not so easily accomplished. I would have to copy the iTunes movie onto an external hard-drive from my computer, add the video to my friend's iTunes account on her computer, authorize her iTunes to be able to play my content, and then she would have to have an Apple TV to play the movie on her television set. After watching the movie, my friend would have to delete the digital copy, and I would have to unauthorize her computer from playing my content. Clearly, this system causes major headaches for even the technologically inclined, not to mention for those individuals who have a hard enough time understanding how to load their iPods with music. An obvious and clever solution to this problem is to allow wireless streaming between the end-user's iPhone/iPod Touch and any Apple TV. That way, one could load his or her movies on his or her iPhone and take them to a buddy's house to watch on the telly. This would also further solidify the Apple ecosystem of the iPod-iTunes-Apple TV. Moreover, one is more likely to be carrying his or her iPhone than a DVD, thus allowing the end user to be able to spontaneously watch their downloaded content at a friend's house. Wireless syncing would also be a huge plus, but it is not as necessary as being able to stream content. It would be great to be able to download a movie through Apple TV and wirelessly sync that movie to one's iPhone. Yet, more importantly, it would do Apple well to allow users to plug in their iPods/iPhone to their Apple TV to pull content directly off of the set-top box. That way, if one has DVR recorded content, he or she would be able to download it onto his or her portable device.
3. iTunes Expansion, DVD Extras, Subscription Services and HD Content. Apple TV's potential for success is only as good as the catalogue of movies and TV shows offered in iTunes. The Apple TV cannot be considered a viable replacement of the DVD player without the full catalogue of movies. Yet, in all fairness, Apple is slowly, but surely, building its iTunes catalogue with movies and TV shows daily. Still, iTunes movies currently contain no DVD extras, which severely limit the content available to the end user. Apple needs to make all of their movies available for both purchase and rent in HD quality, insert the extras found in DVDs and increase the storage capacity on the Apple TV. Moreover, the Apple TV would be even more attractive if Apple offered its users a wider range of service by creating a Netflix-like subscription service along with its a la carte offerings it already sustains.
4. Maybe a Blu-Ray Player? Another idea that I have come across is the notion of adding a Blu-Ray player to the Apple TV. I remain skeptical about Apple going in this direction for a number of reasons. First, while the inclusion of a Blu-Ray player might help make the Apple TV an attractive option with the HD crowd, the idea of including a Blu-Ray player defeats the fundamental purpose behind the Apple TV—making video content available to the end user in the quickest most convenient way. The whole concept behind the Apple TV is an attempt to put an end to the physical medium for music, television and movie content. Secondly, Apple's HD medium should try to compete with Blu-Ray. By adding a Blu-Ray player, Apple is helping itself defeat its own HD format.
5. Allow DVD Ripping in a DRM Protected Format. Once again, if Apple could get over the legal hurdles of permitting its customers to do so, Apple should allow the end user to rip their DVD catalogue in DRM-protected files so as to allow the end user to make a quick and easy transition to the Apple TV. For those who have huge DVD catalogues, there is a high incentive to stick with the physical medium. Blu-Ray would have a difficult time surviving if its players were not compatible with DVDs. In the same way, it would behoove Apple to take steps in the direction of helping their customers make a smooth transition to virtual content. One way or another, the Apple TV will be better off if iTunes customers do not have to pay twice for the same content.
6. Better Remote Control. For anyone who has an Apple TV, this is self-explanatory. Apple needs to develop a much better remote control for the Apple TV, especially if it decides to add an HD-DVR and TV Tuner. A touch screen one perhaps?

Disclosure: I own long term 2009 and 2010 call options in Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.