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Prior to the third quarter earnings report I discussed a part of Apple's balance sheet related to tangible assets (Plant, Property and Equipment). In a series of three posts I covered the Land and Buildings (data centers and campuses), Leasehold Improvements (store investments) and Machinery, equipment (tooling and factory equipment as well as servers.)

The data shows that there is a consistent pattern of investment in pursuit of strategic goals: extending reach into distribution through stores, extending services through cloud infrastructure spending, and extending control over the supply chain. One story that still remains largely untold is how much does Apple know in advance what it will spend.

In other words, can we tell if Apple can anticipate demand and does it plan its expansion well in advance?

For an answer, the 10 K report comes in handy. Published only once a year, this document shows some data that is not present in any other public release. For example, Apple makes forecasts for capital spending.

But first, an update.

Since the last discussion on PP&E, Apple reported third calendar quarter data. The 10K offers the details on how much was spent in the last quarter. Leasehold improvements increased by 240 million, a new record high. That might have gone into the 30 new stores opened in the quarter but it also signals more openings and renovations still to come.

Land and buildings did not see any significant increase ($31 million).

Machinery and Equipment growth was explosive. Over $1.1 billion was added to the value of those assets. The previous high was $868 million in Q1, presumably getting iPad and iPhone production ramped. The total for Q3 is about half of what was spent in all of 2010. The chart below shows the three items:

The increase in M&E foreshadows increased device production so, while not very precise, it gives an idea that volumes are expected to be substantially higher in the following quarter. More about this when I make my forecast.

Now I want to focus on Apple's ability to forecast its own production. As I mentioned, once a year, Apple predicts its CapEx. That prediction is broken down further by Retail expenditures and M&E+Real Estate. Let's look at Retail first.

The following chart shows three bars: a previous year's forecast (from the 10K), reported expenditure (from the next 10K) and my own running estimate based on asset value changes.

If we consider the forecast as a "budget" for the next year, what can be observed is that the spending was closely "within budget".

Going by reported expenditure, the company was within 1% of expected budged for store spending in 2010 and 2% in 2011. It underspent for the years 2006 through 2009, though again, but modest amounts.

What this suggests to me is that store roll-outs are predictable for Apple. The costs involved are also quite predictable and things seem to be happening on schedule. The retail expansion is a steady slog.

The next chart does the same comparison but with Machinery and Equipment and Real Estate.

Here the story is different. The company has typically over-spent what it forecast.

Here are the "deficits" for this asset class by fiscal year:

• 2006: 154%
• 2007: 68%
• 2008: 0%
• 2009: -30% (surplus)
• 2010: 47%
• 2011: 18%

This suggests that unlike retail, production for Apple has been far less predictable and that the predictions for spending were mostly lower than actuals. It might imply that production was higher than expected as well.

What this analysis suggests overall is that although production (and spending) are increasing, the rate of increase is a bit higher than what Apple expects a year in advance. Some of that might be due to increased costs, but some may be due to changes in capacity.

Note the iOS unit production "wireframe" bar chart overlaid on the expenditure chart. As with quarterly data, the yearly (fiscal) production ramps remarkably consistently with M&E expansion.

Looking forward, the company predicts $8 billion in PP&E, exactly twice what it forecast last year. Retail expansion is forecast at $900 million an increase of 50% and "Infrastructure" (M&E) increase of 110% to $7.1 billion.

Knowing that Apple tends to over-spend on M&E, we can assume that they will at least double spending on machinery and equipment. Knowing further that increase in M&E spending correlates to iOS device production (see chart at left noting the inset scale marked with 150 million units), it implies that iOS device production is set to continue growing at the same rate it always has: 100%.

Analysts have to count things in order to measure value. It sounds easy but it can be tricky. As I pointed out with PCs vs. iPads, if you count an iPad as a PC you can get into a lot of trouble with your clients. But if you don't you end up directing them away from confronting an existential threat. Only very rarely is a market report published in contradiction to widely held sustaining beliefs. More often than not analysts bow to the source of their paychecks and in so doing show their rear end to the truth.

This comes up again now with respect to how to count tablets. Consider that there is little difference in architecture, software or design between an iPhone and an iPad. They run the same OS, use the same microprocessors and have similar communication methods, inputs and sensors. However they are considered completely different products and counted as part of separate markets. The only physical attribute that differs is the screen size. So we have to conclude that the size of the screen is a huge determinant factor in deciding whether a product is a tablet but not a smartphone (or music player).

But what about tablets themselves? Their screen sizes vary widely. A 10" screen is certainly a tablet device, but a 4" screen certainly isn't. Where is the boundary exactly? It seems that a 7" device is still a tablet but a 5" may not be. The Dell Streak 5 device is presumably not a tablet. The arguments then descend into an arbitrary definition of tablet based on whether it fits in one hand or in a bag of a certain size.

This begins to sound academic. Why should it matter what size is or isn't a valid tablet? Buyers are not in the market for screen sizes. They are in the market for products that can be hired to do jobs or address pain in their lives. So as far as consumers are concerned, these categories are meaningless. If you want to design something you'd better segment according to jobs to be done.

However, buyers are not the target audience for the analyst. Nor are product designers (hopefully anyway.) Part of the reasoning of offering market research is that it presumably helps ecosystem participants (vendors, developers, retailers, etc.) decide where to invest their time and money. They are the target audience. They don't spend their lives reading tech blogs. For them it's important to understand "which way the wind is blowing" and that's where an analyst should be helpful with data.

But then if we are to measure ecosystems, we have more difficulties.

The iOS ecosystem is pretty well understood. Apple publishes the number of devices it sells and the number of apps on its store and downloads, etc. We can assume Microsoft will do the same with Windows 8 as they do already for Windows in general.

For Android, it's a challenge. Google measures activations, but that may not cover the actual units sold. Google admits that it does not know how many Android devices are sold or even how many are for sale. It's in the nature of open source that it's not controlled and hence not measurable.

But analysts still try. Consider the estimate that about 27% of all "tablets" shipped are Android. That's not something Google helped with. Google can report the number of activations of a certain version of the OS, but they themselves don't know what the device looks like or what size screen it has. A device vendor can put any version of Android on a device of any size. To find out how many tablets run Android, you need to try to estimate "bottom up" by adding the output from various vendors.

However, it's clear that a large number of these devices are not exactly Android. Consider what  Kevin C. Tofel writes for GigaOm:

I asked Strategy Analytics to clarify both of those points and received the following email response from Neil Mawston, the analyst who wrote the report: ”Yes, the press release refers to shipments, not sales. All sub-versions of Android are included. Yes, the B&N Nook Color tablet is included in the tablet figures.”

So the B&N Nook is counted as an Android tablet and part of the 27% share of Android. But Google itself does not count the B&N Nook as an Android tablet. It's not something that can even use the Android brand. From Google's own documentation:

We define an "Android compatible" device as one that can run any application written by third-party developers using the Android SDK and NDK. We use this as a filter to separate devices that can participate in the Android app ecosystem, and those that cannot. Devices that are properly compatible can seek approval to use the Android trademark. Devices that are not compatible are merely derived from the Android source code and may not use the Android trademark.

In other words, compatibility is a prerequisite to participate in the Android apps ecosystem. Anyone is welcome to use the Android source code, but if the device isn't compatible, it's not considered part of the Android ecosystem.

So to summarize, whereas the Nook is counted as an "Android tablet" it...

• cannot be called an Android device without violating the trademark
• may or may not compatible with Android Apps
• does not include Google Services like Google Maps
• cannot license the Android Market client software or brand
• is not considered to be a part of the Android ecosystem by Google

All this is also true for the Amazon Kindle Fire and whatever Baidu, Alibaba and other Google competitors will be selling. Furthermore, Google can define compatibility and therefore what "being Android" means arbitrarily and can change that definition at will. It can even withdraw compatibility on the basis of business priorities.

It matters because these devices might end up very popular (see Amazon's reporting of Fire's pre-orders in its quarterly earnings call) and in aggregate could even be the majority of "Android tablets".

The result is that most analysis of the Android ecosystem (and by comparison, all mobile ecosystems) depends on classifying as Android devices those that compete with Google, and indeed, with Android. For the purpose of assessing value, growth and opportunity for third parties such reports fall short.

So what should be done?

The solution is simple: Count as Android devices those that are allowed to be called Android as per Google's own definition. It makes clear that developers can reliably sell their software through the Android Market. It makes clear that those devices are designed to use Google services and it makes clear that those devices are not designed to compete with Google.

Those devices which are using "derived" Android source code and are not compatible (as per Google's definition) and are not allowed to be called Android by their vendor should be called something else. Maybe "Android-like" or "Android derivative" or "Non-Google Android" or just "Other".

Last quarter the iPad had unit growth of 166% with revenue growth of 146%. The iPad is selling more than twice the (also rapidly growing) Mac. The two product lines are shown below:

A big reason the Mac is still growing is that it now consists of 74% portables and the MacBook Air and Pro products are still largely unmatched and have a near monopoly in their target price.

The Mac's average selling price has remained remarkably steady for three years.

But more importantly the iPad and the Mac both outgrew the PC market. Taken as OS X vs. Windows, the growth rates were 27.7% vs. 2.5%. If iOS is included along OS X, Apple grew its "computer" shipments at a rate of 99%.

The following chart illustrates the growth rates for Windows, Mac and Apple as a combined OS X/iOS.

The Windows platform still ran on 82% of PCs sold in the quarter with iOS taking second with 10.5%, OS X third with 4.7% and Android at about 3%.

Even though Mac OS X grew faster than the overall PC market for 20+ quarters, its market share is still below 5%--lower than what the iPhone has been able to obtain in the far larger mobile phone market.

That share has grown from 3.2% in the same quarter of 2008 but it's still a very slowly changing landscape.

However, if we include the iPad, Apple begins to not only grow very rapidly, it moves up sharply in terms of ranking among PC vendors.

Last quarter's 16 million OS X and iOS tablets brought it into second place behind the 16.6 million PCs that HP sold. That was enough to give Apple 15% share vs. 15.7% for HP. Over the last three years Apple has gained nearly 12 points of percentage of share.

The other vendors mostly lost share but the most affected were the smaller OEMs. HP lost 2.6 points, Acer 3.9 and Dell 3.4. However "Other" lost 10.5 points. Lenovo is the only major vendor to gain share (+4.48 points).

What's interesting about this pattern is that whereas in the phone business "others" is a rapidly growing group of companies, in PCs the smaller vendors seem to be suffering. They still make up about 30% of the market but that's down from about 40% three years ago.

In contrast, "Other" went from 15% to 24% of the phone market in the same time frame. Part of the explanation is that the entry of the iPad took the wind out of the "low end" netbooks and other cheap PCs. Consumers migrated low-end usage to a product re-built around those jobs.

In the mobile phone market, the disruption is in the opposite direction: communication is moving rapidly up-market from real-time voice to latent messaging and from storage consumption to broadband consumption. The companies being rewarded today in the phone business are those who are leading the charge to new markets.

In other words, on the PC, we are witnessing low-end disruption. On the mobile phone we are witnessing new market disruption. The irony is that the low end PC and the high-end mobile are very nearly the same thing but the industries, channels and incumbent business models are very different.

Apple's Cash and Marketable Securities has been the focus of attention for many year now. It has now reached $81.6 billion equivalent to a value of $86.8 per diluted share. Currently each share is worth about $393 making the enterprise value $306/share or 11 times last twelve month's earnings.

The division of liquid cash and cash equivalent asset types is shown in the following chart.

The company added $5.4 billion to its cash reserves during the quarter and now keeps two thirds of that outside the US. Long-term securities (bonds mainly) are now also about two thirds of total. Both of these ratios have increased this year. Some of this shift may be explained by changes in the strategy employed by the CFO/treasurer, but there is another set of assets that has changed dramatically and may explain the change in cash allocation.

I've written about the PP&E assets and their dramatic increase, but the "Acquired intangible assets" have also had a huge increase in the last quarter ($2.3 billion). Much of that is attributed to the acquisition of Nortel's patents.

Unlike cash, these assets can be considered an "investment" by the company. They are expected to (but may not) return value to shareholders in excess of the average cost of capital. Therefore, they demonstrate that some of Apple's capital is being "put to work" rather than resting idle as many suggest. Apple is buying patents and companies and intellectual property. $12 billion worth so far.

Whether they will be a good investment, we cannot tell, but the allocation of capital to non-cash assets is already significant and has grown more quickly than cash. They have, in fact, more than doubled in a year and quadrupled in two.

In Apple: For What It’s Worth Jeff Matthews asks a question "about the most disturbing pattern coming out of Apple’s earning release: the measly 1% year/year revenue increase at Apple’s retail stores".

He notes that prior to the drop, Apple stores were growing at 36%. Such a huge drop quarter on quarter seems suspicious and he thinks something is happening.

Something is happening.

To find out what, let's start with the revenue from Retail that Apple reports[1]

 

 

The concern is with that low growth between calendar Q3 last year and this year. That is being contrasted with the growth in the previous quarter (Q2) of 36%.

When seen as a chart, the explanation for a big change in growth is perhaps easier. The third quarter of last year was a boom for retail and the quarters that followed were more-or-less similar in sales level.

With this perspective, it's clear that there was a surge in sales during the last year which did not repeat this year.

But what's the cause for this pattern? If we know the cause can we predict if retail sales growth will increase or decrease?

Consider the following compound chart:

The chart shows three different quantities.

1. The original retail sales values in "hollow" bars
2. The growth in those values year-on-year (in a line chart)
3. A "proxy" candidate for retail growth explanation: the sum of US phone activations and in-store CPU units sold as a stacked bar chart.

The choice of proxy includes the blue bars which Apple reports as in-store "CPU units" and the US phone activations[2] coming from AT&T and Verizon[3].

We can see now that there is a strong relationship between iPhone sales growth and store sales growth. The Mac business is growing but not in the bursty way that iPhones are growing. The growth of US iPhones matches the growth in (US mostly) Apple retail. This should not be a surprise.

The bursty nature of iPhone means that store growth varies just as dramatically. I highlighted that during the period of Q4 2008 to Q1 2010, Apple store revenue grew at an average of 7.3% but following the "big bang" of the iPhone 4 launch they grew at 79% over the subsequent five quarters (because the comps were easy).

In the latest quarter the growth dropped as there was no launch of a new iPhone to top the big bang of a year earlier. Even so, store revenues actually increased by a slight amount.

Knowing that the comp with the year before was so tough the surprise isn't that the growth slowed, it's that there was any growth at all.

If iPhone as a cause for growth in retail is to be believed, then how hard can it be to forecast retail growth in the future?

---

Notes:

1. Apple does not submit this information to the SEC but reports it (exclusively I believe) during the earnings conference call. Transcripts are available on seekingalpha.com but fortunately they are recorded as well by Gary Allen at ifoapplestore.com.
2. I used US data for the iPhone as most of Apple stores are in the US. The global pattern is similar.
3. I had to estimate Verizon units used during the last quarter as they have not been reported yet. I used a similar ratio between AT&T and Verizon as for the last quarter.

In his recent posts Horace took a look at Apple’s fixed assets and their development over the recent years. He also tested the hypotheses that Apple is making investments into machinery & equipment on which iOS devices are produced by overlaying iOS volumes with preceding changes in property, plant and equipment (PP&E).

The question that has arisen is: Are Apple’s investments in PP&E extraordinary?

To answer, I have compiled the capital expenditures (CapEx) for our previously established peer group [1].

But first we need to clarify what CapEx include and not include. CapEx includes investment into property, plants, equipment, office furniture, larger IT hardware and in some cases patents; CapEx do not include investment into long-term marketable securities or other long-term financial instruments, acquisitions or capitalized R&D. Furthermore, CapEx are gross values and are not net of any sold equipment [2]. CapEx are largely depending on a company’s business model and strategy. For example if you are a manufacturer you need equipment to operate, if you are a software company or a retailer, your business will not be capital intensive.

As the second calendar quarter of 2011 is the latest quarter for which all companies have reported figures, we will take a look at last twelve months’ (LTM) figures from Q2/2011 backwards. The following stacked bar chart shows the combined CapEx of our peer group:

 

The combined capital expenditures of our peer group for the LTM CQ2/2011 have outpaced even pre-crisis levels of investments and, combined, account for $34.7 billion. Samsung, a diversified manufacturer of IT hardware and other equipment, has invested more than $11.6bn with Google ($5.1bn), HP ($4.4bn) and Apple with $3.4bn following in line. While Google’s CapEx mostly account for its infrastructure of server farms and other IT hardware, HP’s CapEx mostly account for IT hardware it leases to its customers [3]. In absolute terms, Apple takes fourth place in CapEx spending for the last twelve months ending in CQ2.

Since the business model and sales magnitude varies largely in our peer group, we can also take a look at a common measure to compare CapEx intensity by dividing CapEx by sales achieved in the same period. For the last twelve months we can depict the following chart:

 

The average of the peer group accounts for 4.4% of CapEx over sales. Samsung’s and Google’s business model are clearly more capital intensive, while Apple’s CapEx ratio of 3.4% is below the peer group average but above some of its peers like Nokia, Dell, LG, HTC or Motorola Mobility. Interestingly, capital intensity of HP, Apple, Sony, Microsoft and Amazon is at a comparable level of around 3.4%.

As noted before, business models and strategies are significantly different among companies in our peer group. However, while Apple’s CapEx intensity is not extraordinary, Apple’s CapEx in absolute terms are among the largest in it this peer group and have grown constantly throughout a five year period.

Is this a good thing and why does it matter?

CapEx by itself does not tell us much. We still do not know in what companies specifically invest as financial regulations do not require detailed CapEx accounts. We know that even if a company is not growing assets they need to be maintained, upgraded and replaced – this spending is also called "Maintenance CapEx". Everything else can be called "Expansion CapEx" associated with new product launches, entry to new business area or geographies or expansion of (manufacturing) capacity.

Therefore, Expansion CapEx is closely linked to expected organic sales growth in the future. So let’s go ahead and link CapEx ratio of the previous years with the sales growth of the following year. The following chart shows the cumulative average growth rate (CAGR) over the last four years versus the average of CapEx/sales ratio of the four last preceding years:

 

We can see that high CapEx efficiency has been achieved by Amazon, Apple and HTC with sales growth rates of 33-47%. RIM reached similar revenue growth but with higher CapEx intensity. Google and Samsung with high CapEx intensity have only reached modest growth rates. Dell, HP, Microsoft and Sony have not grown significantly but have close to average CapEx intensity.

We cannot state that CapEx in absolute terms have been extraordinary for Apple, but we can witness that with below average CapEx/sales ratio Apple outgrew in absolute terms Dell, LG, Microsoft, Nokia and Sony and has grown close to the revenue size of Samsung and HP in the last four years.

---

Notes:

1. Excluding Lenovo (not reported) and Acer (extra-ordinary low numbers reported, to be investigated), Motorola Mobility figures only available for the last six quarters
2. Minor differences may occur due to local Generally Accepted Accounting Principles (GAAP)
3. HP assumes ownership of these assets and rents them to the customers who in turn have a smaller balance sheet and can run IT hardware CapEx through the income statement as lease expenses

Last quarter I was wrong because I thought Apple would throttle production of the iPhone 4 in the fourth quarter post-launch. "The reason growth would moderate was that Apple slowed production of the old model in order to switch out to the new model--we saw the same thing happen with the slowdown in iPad 1 and transition to iPad 2."

As a result I seriously under-estimated iPhone volumes in the second quarter (FQ3). That failure led me to question whether the theory I was using in forecasting was still valid. When it came time for a new estimate I hesitated.

I had to choose whether to apply the old seasonality theory or to assume that the game had changed and that the product would now grow organically.

The first assumption would put the iPhone growth at 100%+ while the second would place it in the 60% to 80% range. I decided to dial in a figure somewhere in between at 90% but I’m not very confident in this

The result was an over-estimation by almost the same error as that of the previous quarter. Most of the other product lines were accurately predicted, but again, as a always, the whole forecast rides on the iPhone.

So where does that leave the theory?

I now believe that the iPhone behaves far more consistent with the original theory. Namely that...

1. Overall production capacity is increasing at approximately 100%/yr.
2. There is significant seasonality due to production ramps as the product is updated on a yearly cycle. These cycles are tuned to reach maximum throughput during the US holiday period. I discussed this theory here.
3. Demand is practically unlimited and is throttled by both production schedule and distribution agreements

The first point is not controversial. The iPhone continues to grow at triple digits rates. The second quarter's 142% growth and the first quarter's 113% growth more than makes up for the 21% of the third. Fourth quarter promises to be exceptionally strong with management clearly guiding for a blockbuster.

The point of contention was number 2. If we look at the following chart, we can observe that it still holds:

Each new iPhone launch was preceded by a quarter where units went down sequentially. The same has happened with the iPad for the one tradition we've had so far.

Regarding the third point, Balance sheet analysis shows that investment in manufacturing process equipment installation slowed in the March quarter. That was not matched by a decline in the June quarter sell-out however it does correspond with a slowing in the September quarter. Using the PP&E line is something I'm still exploring but it does seem that there is support for the theory.

Mea Culpa

I made an error in abandoning my theory. I thought I had discovered an anomaly that made it invalid. I was wrong. I read too much into the late in cycle boom. I bought into the notion that the product was in a new pattern of behavior--due to expanded channel or broader portfolio. This was a mistake.

Footnote

• There was one other bit of data that was offered to us which we ignored. At the 4S launch Tim Cook gave us a warning. He announced that 250 million iOS units had "just been shipped". After the announcement it turns out that the total was around 254 million. This came up in comments on this blog. I noted that if the number is correct I should shave 13 million off my iPhone number. I even went into my model and adjusted it to see the effect. I did not "correct" my estimate as I felt that this new data could be disguised and not meant to signal to us. This was another error.

At the Open Source Business Conference in March 2004 Clayton Christensen gave a presentation. It's available as an audio file for download here: Clayton Christensen | Capturing the Upside. I strongly recommend listening to the whole thing because it's the quintessential Disruption lecture.

It has relevance in many areas of analysis, but when I was trying to think of a way to characterize the potential for Siri I recalled one particular passage that I saw as almost clairvoyant. Seven and a half years ago, Clay said:

... the next time you go to a computer superstore, go to the voice recognition software shelf and pick up a box there that’s called the IBM ViaVoice.  Now don’t buy it, but just look at it!  They have a picture of the customer on the box, and it’s an administrative assistant who is sitting in front of her computer wearing a headset speaking rather than word processing.

You think about the value proposition that IBM has to be making to this woman.  She types 90 words a minute.  She is 99% accurate.  If she needs to capitalize something, she just instinctively presses shift and cruises through.  And IBM has to say, “No, don’t do that anymore.  I want you to put this headset on and teach yourself to speak in a slow and distinct and consistent manner in complete sentences.  If you must capitalize, you must pause, speak the command “capitalize,” pause, speak the word you want to capitalize, pause, speak the command “uncapitalize,” pause, please be patient, we are 70% accurate, this will get better we promise.”

This is not an attractive proposition to this customer.  And IBM has -- I’ve not worked with them at all, but as I understand it -- they’ve spent maybe $700 million trying to make voice recognition technology good enough that it can be used in that market.  This is a very difficult technical hurdle to surmount. Meanwhile, while they are investing that aggressively, Lego comes up with these robots that recognize “stop,” “go,” “left,” “right,” and the kids are thrilled with the four word vocabulary, and then "press -- or -- say -- one" kinds of applications take root, and now directory assistants ask you to say the city and state and so on, and much simpler, and an interesting market is emerging.

I bet maybe the next place it takes route is in chatrooms because the kids don’t spellcheck or capitalize anyway, and they would rather speak than type.  And maybe then the next application would be, when you see these stubby fingered executives with their BlackBerrys trying to peck out emails, and their fingers are four times the diameter of the keys, they’re only 70% accurate.  If somebody gave them a voice recognition algorithm that really didn't have to be very good so that they could speak their wireless email rather than peck it out, I bet they’d be thrilled with the crummy product.  And ultimately, as it takes route in these new applications, it may get good enough that we can do word processing with it, but it’ll be a long time.

The thing that strikes me about Siri is how "crummy" it is. It's trying to be an intelligent assistant but it's not nearly good enough. Many have called it "toy like". It was so uninteresting that there was minimal coverage of it after the keynote launch. One can almost forgive the cynics. It was "yet another feature".

However, it does seem to be good in a very limited set of tasks. It is something you can hire for some minor jobs that you'd rather not do. Basic calendar booking, context aware search and a few delightful surprises. But it's not trying to be much more. It's not trying to be a typist. It's not trying to be a companion. It's not trying to be smarter than you and make you redundant. It's only trying to help lubricate your life. This is what makes it so exciting.

Like the example of the toy robot that delights the child, Siri delights with simple competence. It's not profound but as Clay points out in his talk, it's a necessary first step. What must follow are many more steps. Siri must get better. And because it will have at least 200 million users, I'm betting it will. So over time it will take on more tasks and will eventually help us in ways that we cannot yet conceive possible today. This is just like the introduction of the capacitive touch screen. Popularizing the touch screen has led to experiences with phones and tablets which we did not think possible four years ago.

But it takes time. Like any truly useful breakthrough, it takes a long time to mature. And also like any disruption, the potential of Siri is rooted in four principles:

1. Humble early goals which it accomplishes well
2. A large population of enthusiastic adopters who give it sustenance
3. Plenty of headroom in improvement giving it areas to grow into with positive feedback
4. A patient sponsor who makes a stable living

There's no magic to it. In fact it's banal. These are only the principles that every parent uses to raise a child.

 

In the last two posts (How much does an Apple store cost?, The down payment on iCloud) I discussed two line items in the PP&E asset class on Apple's Balance Sheet. In isolation, the data is interesting as it gives us an idea of the cost structure of stores and facilities being developed to sustain its current business model. In aggregate, it provides insight into Apple's strategic intent.

To complete the picture, I will look at the third asset: "Machinery, equipment and internal use software." It's the yellow line in the chart below:

It's plain to see at first glance that it's the most significant asset. What does it represent and what conclusions can we draw about Apple's strategy?

Before I begin, I should make clear what this asset represents and what it does not represent. These expenditures cover equipment used in production. They do not include components used in the production nor loans to suppliers for purchasing equipment. These are fixed assets that can be depreciated on a schedule and have specific tax treatment as a result. These are, in plain language, instruments used for producing things to be sold. They are things Apple owns.[1]

Using the same method as in the other asset analyses I took a measure of the sequential change in that asset over the time period and tried to see if there is a correlation between that spending and some other measure of output from the company.

Here is the sequential change chart since the end of 2005:

I noted that the pattern seems to relate closely with the increase in shipments of iPhones. More specifically, iOS devices. To test this I overlaid the overall volumes (with estimates of product types) of iOS shipments. This is a modified version of the chart published here.

There is a broad similarity. But again, as in the other analyses, the spending on assets typically predates the "output" from that asset. As we saw in land and buildings, the operational start of a facility may happen many quarters after the purchase is made. Similarly, stores open some time after the spending on fitting them out.

So it is with Machinery and Equipment. If we time-shift the output one quarter to account for spending before production we have a better fit (note the change in the title with "Q-1" indicating that the dates for the iOS shipments are offset by 1 quarter to the left).

We can even take the analysis further by breaking the spending and output into Phases corresponding to specific product cycles and introductions.

Phase 1: The original iPhone

Spending on M&E prior to the iPhone launch began two quarters in advance of sales. The following chart reflects this delay. Note that the M&E payments are marked with quarters ending six months earlier than the shipment schedule. Note also the scale (red denoting the M&E spending and black the units shipped). I also separated the two product types  (iPod touch are my estimates, iPhone numbers are published by Apple).

This Phase corresponds to the first "bump" in the expenditure chart but offers more detail. There is an evident relationship between the "input" expense and the "output" of units shipped.

The cost of Phase I was $408 million.

Phase II: The iPhone 3G series

Phase II covers spending from the quarter ending March '08 to December '09 and production from September '08 to March '10.

For this Phase the time shift is only one quarter but there is a quarter's worth of spending that is initiated prior to any shipments. I chose to demarcate this Phase to cover production for both the 3G and 3GS as they probably shared a lot of common equipment. Some spending on new production lines however still had to happen as volumes increased during 3GS production.

Note the scale change from the first Phase. Whereas the maximum in Phase I spending was around $150 million per quarter, the peak is nearly twice as much in the second Phase. The peak output is 5x higher.

The cost of Phase II was $1 billion.

[I had to guess whether the Sep 09 and Dec 09 M&E spending was for 3GS or whether it was to prepare for the ramps in the new products about to be launched in the third Phase.]

Phase III: The iPhone 4 and the iPad

Phase III begins with spending prior to the launch of the iPad 1 (March '10) to the last quarter (ending June 2011). Coupled to this is production starting in quarter ending June '10 and ending in the last quarter.

Note that due to the time offsetting on production, the output from the spending on the quarter just ended will not be known until Apple publishes their shipments for the June quarter (scheduled for October 18th).

The relationship between pre-dated spending and production one quarter later holds quite well. There is a "surplus" of spending in December 2010 but that could be seen as the ramp being prepared for the second iPad.

Phase III cost is $3.7 billion so far.

Note again the change in scale from the previous two Phases. Peak M&E expenditures are around $900 million per quarter while production peaks at around 35 million units. This is a tripling of spending coupled to about a doubling of output.

Observations

The data suggests spending on equipment is correlated with the volume of production of its iOS devices.  However, Apple is understood to be a company that outsources its production and does not "own" its own factories. Claiming that it keeps equipment used in the production of iOS devices on its books is an extraordinary claim.

I make a further claim that the scope of spending itself is extraordinary.

The following chart shows the three asset classes discussed in the three latest posts relative to each other (quarterly change in asset value).

In How much does an Apple store cost? I noted that the spending on leasehold improvements of $2 billion over a few years is significant and sustaining and largely asymmetric to competitors. You can see that spending in the grey bars above.

In The down payment on iCloud I noted that spending on Land and Buildings is significant and sustaining to iOS but not on a scale many can match. Those costs are shown in the blue bars above.

If, as I claim here, the yellow bars show the spending on Machinery and Equipment used in the production of iOS devices, then the commitment Apple has made to controlling production is even higher. In December 2010, M&E expenses were 50% higher than the spending on the data center and the new Cupertino campus put together.

The M&E assets have cost a total of $6 billion. The Apple stores have cost $2.3 billion and land and buildings $2 billion.  In other words, Apple's machinery and equipment is worth much more than all its buildings and stores put together.

Compared with what Apple spends on other fixed assets, M&E is spectacularly significant.

In the twelve months ended June, Apple will have spent $2.9 billion in M&E to manufacture 118 million iOS devices. To put that in perspective, Nokia, which manufacturers a large (if not majority) of the 340 million phones it sells, expects full year 2011 capital expenditures of $1.1 billion.

Correcting for amortization and depreciation and deducting some spending on Mac M&E, it's very likely that Apple spent twice as much as Nokia on the instruments of production for one third the number of devices.

Conclusions

It may be too early to draw conclusions from this analysis. The claims should be debated and the claims should be tested, but I can suggest some tentative strategic implications.

Last December I wrote that I thought Apple should use its capital to own the means of production for iOS. I reasoned that device supply was its biggest deficiency and that perhaps ownership would allow them to become better at it.

Indeed, Apple has used capital to ensure it has better control over the supply of components and to also perhaps ensure capacity of production of those components.

But this analysis shows that Apple has gone much further toward integrating its value chain. It suggests that a large part of the tooling in its supply chain is owned by Apple. It suggests that those tools are put out of reach of its competitors.

The implications could be profound but given the length of this post, I'll leave that discussion for another day.

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Notes:

1. Some of the capital expenditures were also allocated to servers or "information systems hardware, software and enhancements." From the Annual Report 2010:
   Capital Assets. The Company anticipates utilizing approximately $4.0 billion for capital expenditures during 2011, including approximately $600 million for retail store facilities and approximately $3.4 billion for product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software and enhancements.

Apple loves to talk about its stores. They do it in every conference call, keynote event and SEC filing. There is a monotony with the repetition of how many they have and how many they are building and how pretty they are. They start to seem like commodities.

But if they were commodities why aren't there any other networks of successful "vendor stores"?

The answer is partly in the odd integrated business model Apple maintains asymmetric to every other modular technology provider. Apple seems to want to control the relationship with the buyer. It's also partly in the uniqueness of design, an obsession with the brand. But still, that does not explain why can't it be copied.

The answer is in the economics.

To understand the cost of developing an Apple store, we turn again to the balance sheet. Fortunately for us, Apple reports details of a particular asset called "Leasehold Improvements." It's a substantial asset worth over $2.3 billion in the last statement. It represents "alterations made to rental premises in order to customize it for the specific needs of a tenant."

The following chart shows the change in that figure quarter-over-quarter.

Can we tie these expenditures directly to stores? I overlaid the number of stores opened in the same quarters as the expenses in the following chart:

There does not seem to be much correlation. But if we consider that spending happens before a store opens and shift the openings forward relative to expense by one quarter we have the following:

This is a very consistent pattern. The rise and fall in expenses is matched by the subsequent rise and fall in store openings. We can even see how stores seem to be getting more expensive with the amplitude of the waves increasing relative to the amplitude of the openings.

So if we are looking at store costs, just how much does one cost?

Over the time period illustrated, Apple opened 220 stores and spent $1.9 billion in fitting them out. That's about $8.5 million per store. It's been increasing so it's probably closer to $10 million lately.

That's an interesting figure by itself, evidence of how profitable they must be. But I turn the question again to competitiveness and the lack of response in kind.

The data shows that if a company wanted to duplicate this effort they would need to commit to spending at least $2 billion. And that's just for "fixing up" the sites. This figure does not include the lease itself, the cost to operate (including the tens of thousands of employees) or the inventory within. It also does not include the value of choosing the right locations (though maybe a follower could simply choose to locate in the near proximity to an Apple store.)

So assuming a competitor (e.g. Microsoft) did commit to this spending, how would they recover it? I'll keep this question rhetorical, but the hint must be in the unique way Apple is integrated as a business.

Balance Sheets are not typical targets of focus in software or services or "high tech" companies. Except for Cash, there are usually not much in terms of assets for analysts to contemplate. With outsourced manufacturing, even hardware companies don't maintain depreciable assets on their books.

Apple, as usual, is different. It turns out there is a lot there and there's a lot to learn from what's there. I've looked at the Cash and Long Term Securities in the past but in the next few posts I'll dive into fixed (non-current) assets. Specifically Apple's Property, Plant and Equipment.

Apple Inc. has selected North Carolina as the location for a new data center and will invest more than $1 billion in the project over nine years, Gov. Bev Perdue announced

via It's Official: Apple iDataCenter to North Carolina » Data Center Knowledge.

When Apple committed to the North Carolina data center in mid-2009 the iPhone was two years old. Only 26 million iPhones had been sold to date (about as many as Apple now sells every quarter.) Clearly if the commitment was on such a scale there must have been a plan. A big plan.

We don't know for sure if NC was used last week or whether it was handling only part of the load, but let's assume it was. What I want to think about is how much iCloud would thus cost and hence what would be the cost for alternative providers of such a service. That analysis might let us determine if "cloud" forms a substantial barrier to entry for competitors.

Beside the public statement above (which may have been designed for political benefit) can we find any evidence of what Apple spent on data centers? That's where the PP&E line comes in.

The following chart shows the Property, Plant and Equipment asset in Apple's Balance Sheet.

 

Each line represents a particular type of asset and its value at a particular point in time. I will now pay attention to the blue line, Land and Buildings. I'll look at the other lines separately.

Note that each line represent current value so it does not say directly what was happening in the quarter. However, if we look at the change q/q for a particular line we get how much new spending occurred in the quarter for that particular asset.

This change in Land and Building asset value is shown in the following chart:

Going back to 2005, there were minimal changes. Perhaps there is some significance in the $250 million spend in early 2006 or the nearly $78 million spent in Q4 2008, but there is a definite significance to the massive spending that occurred right after the NC commitment was made.[1] Some of that payment also included the old HP campus in Cupertino. "Local real estate experts said HP’s asking price may have been $300 million or more, but they also said the final amount may have been less."

There is also a clear cut-off on that spending at the end of 2010.

The total spending during this time adds up to nearly exactly $1 billion. If we subtract $250 million for the Cupertino expansion we still have $750 million that must have gone into NC.

Note that the original statement quoted above was $1 billion over nine years. We can see that Apple spent $0.75 billion in one year. On the building alone. This is why I consider this a down payment. It does not include any of the equipment in the plant. It does not include the cost of operation (incl. labor) or any development costs (R&D). In fact, it does not include any of the funds that would be part of the nine year commitment.

What this level of spending implies is that iCloud (and Siri and iTunes) are expensive. They may seem ephemeral and even trivial as services, but they require a staggering commitment few can make. Apple made that commitment and they made it early on, before the first quarter billion users were even on the horizon.

If platforms are moving from local to distributed and if value moves from selling things to "getting to know you" and if that knowledge requires infrastructure control then the number of companies that can participate in the market shrinks dramatically. Not only in terms of who has the capabilities, but who could even afford to acquire them.

The invoices Apple pays are shown above.

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Notes:

1. Apple's retail stores are not included in these figures as Apple leases them. The cost of the stores will be discussed in a separate post.