Apple announced that the total number of iTunes account (with credit cards attached) has reached 400 million. This was touted as being the largest collection of credit card accounts for any retailer and I have no reason to doubt it. However, looking beyond the bragging rights, there are more interesting patterns to observe about this asset.
What I plotted was the cumulative number of iPods sold (green), the cumulative number of iPhones and iPads (yellow), the combined devices total (red) and the reported number of iTunes accounts (blue).
The first observation is that the combined total iPhones + iPads have overtaken cumulative total iPods. The iPhone started in Mid '07, more than five years after the first iPod shipped. The acceleration in that product line is still evident while the iPod decelerates gracefully.
The second observation is that the total device count has reached 680 million in the last decade. It's a big number but it is still a number that is dwarfed by the overall device market. Apple is still around 10% of the devices market today. It should give an idea of how many devices could still be sold in the next decade.
The third observation is the ratio between the iTunes accounts and the total devices sold. Since iPods, iPhone and iPads have been dependent on iTunes, the number of iTunes accounts gives a rough indication of active users. Combining active users with total devices sold should give a rough estimate of the number of retired devices. In other words, if we assume that account holders typically use one device then by taking the difference between devices sold to date and accounts at that point in time we should know how many devices have been retired.
Dividing that number of retired devices by devices in use should give us the retirement rate and that is shown in the following chart:
Note that as the iPod was slowing and the iPhone was still a small part of the total, the retirement ratio was increasing. As the iPhone accelerated, the ratio began decreasing and is still decreasing.
Projecting the retirement rate should give us a way of more precisely estimating the addressable market for developers, accessories makers, and other ecosystem participants. Currently that means that about 60% of all Apple's devices sold are still in use. We can tune that figure upward in the next few quarters and make better estimates as Apple releases their shipment data.
The iTunes account data is not just a way to calibrate addressable markets but also a valuable method for measuring device longevity. The distance between the red line and the blue happens to be nearly a constant 8 quarters as shown in the following chart (note change to log scale for the vertical axis).
My thanks to Bruno Ferrari of Exame magazine Brazil for asking the following questions. My answers were written two weeks ago on April 2nd.
Based on financial data of the first fiscal quarter, it is possible to confirm that 2012 will be the best year in Apple's history?
Actually, it's possible to confirm without looking at first quarter data. Every business line Apple has except the iPod is growing and is likely to keep growing during this year. That means that sales will increase over 2011, which was Apple's biggest year. You can see historic sales growth data here:
What are your predictions for the second fiscal quarter?
The iPhone number seems to be higher than consensus. It's aggressive but I'm basing my opinion on the launch of the iPhone 4S in China and the Chinese New Year and new carrier agreement there. Also the iPad will do quite well.
Do you think Apple will hold the iPhone 5 launch to September in order to open 2013 with an extraordinary result?
The next iPhone will launch between June and September. It might be earlier due to the 4S being the "wide end of the egg". Think of the iPhone as an egg rolling down the hill. There is a sharp end and a wide end and the speed of rolling depends on which end is down.
Besides the iPhone 5, which products that Apple could announce in 2012 you think may help them to maintain this extraordinary growth?
I think the iPhone is becoming more predictable. What I'm more curious about is what they will do with the iPod. Apple takes its brands seriously. I am watching the iMac, MacBook and iPod for clues of a re-fresh or replacement as they have aged.
Do you think we will see the “iTv”? Do you think it could be “the next iPad” of technology market?
Apple TV is in waiting mode. It's like an airplane circling, waiting to land. Something will happen but not sure when. Fundamentally, the opportunities are still there but the entertainment industry is very complex. The more complicated it is the more necessary for an entrant is to create a parallel version of it. That takes time.
The building blocks are all there however. See additional thoughts here.
If we analyze the growth of Apple in recent years, it is supported by the launch of new products, especially the iPhone and the iPad. Do you think Apple can lower your rate of growth in coming years since we don’t see in its roadmap new innovative products like a new smartphone or a new iPad?
New products created new growth but iterations of those products also created and will continue to create growth. Of all of Apple's products only one product is not growing today, the iPod. And that is after 10 years in the market and with a "dominant" market share. In addition, Apple has a lot of room to expand internationally and into enterprise and professional sectors.
I do agree that 100% growth is hard to maintain without new products. I believe there might be a few products still waiting for launch. TV is one area (along with game-based entertainment). New user interfaces might be enabling new categories of products. Intelligent assistance and companionship are open problems that software can solve but which have not been productized.
When do you think we’ll stop to see Job’s legacy in Apple new products. And what then?
Jobs' legacy is not in specific products but in how products are built. He also taught the importance of putting products first and markets second (this is, at its base, an artistic principle, not a commercial one). I think that legacy can last forever, if managed properly.
How do you analyze the dividends pay and the buyback made this month?
I wrote some thoughts about it here. I believe the impact will be mostly psychological for investors.
And finally, I was reading at Asymco some analysis of Apple’s share price. Do you think $600 is enough? Do you think in a 1 trillion dollars company in 2014 as some analysts are saying?
The share price depends on the psychology of people. I like to say that Apple is the same exact company today as the one that was priced at $78/share three years ago. When I look out the window of my office I see the same view year-to-year. When I look on my computer screen at Apple's financials I also see the same view year-to-year. I don't know how people can see Apple differently one year to the next. To me it's like looking out the window and seeing mountains instead of the sea.
But this is how markets behave. I can't say what the price will be. It may be $1000 or it may be zero. But the company will not change in either case. It won't change because it does not need to change.
I analyze my performance every quarter to see if there is any pattern of error in my analysis. I devised a scoring method analogous to the grade point average system used in most US schools. You can read about the fourth quarter here.
This quarter I made one public release of data here and a semi-public update on the iPhone shipments here.
The resulting scores for both early and late estimates are shown in the table below:
Overall performance improved with the later estimates but not enough to move the letter grade. In fact, the letter grade of B+ is the same as it was for the fourth quarter.
The best performance was in (late) iPhone prediction and the worst performance was in Mac prediction. The Mac error was due to the relatively strong quarter the year before (which grew over 30%) and the lack of new product introductions. I did not think enough about these two conditions.
iPod error was in the direction of underestimation. The iPod grew better than expected through the average price seems to have dropped.
iPad error was quite modest at 3.4%. We found out after earnings that Apple was supply constrained. They indicated that they will sort out the supply/demand balance in the current quarter.
Gross margin also came in well above estimates, reaching a record high. This is difficult to predict as many factors come into play.
Overall the average error was less than 6% across all categories (late error). This means there was little wrong with the process of prediction. The seasonally adjusted growth for the iPhone and iPad remained consistent. Next, I will look at the scores for all the other public forecasts.
Q: 37 million units of iPhones shipped. When do we run into the Law of Large Numbers? What are the growth opportunities coming up?
A: 37 million is a big number. It was a decent quarter. It was 37 million -- more than we'd ever done before. We were pretty happy with that, but let me give you the way I look at the numbers. As I see it, that 37 million for last quarter represented 24% of the smartphone market. There's 3 out of 4 people buying something else. 9 out of 10 phone buyers are buying something else.
Handset market is projected to go from 1.5 to 2 billion units. Take it in the context of these numbers, the truth is that this is a jaw-dropping industry with enormous opportunity. Up against those numbers, the numbers don't seem so large anymore. What seems so large to me is the opportunity.
What we're focusing on is the same thing we've always focused on. Making the world's best products.
We think if we stay laser-focused on that, and continue to develop the ecosystem around the iPhone, that we have a pretty good opportunity to take advantage of this enormous market.
Q: The biggest opportunity is the emerging markets. Large portion of that is the prepaid market. Apple has done very well but the wholesale iPhone price point is nowhere near what we would expect in the prepaid market. How do you make it more affordable to those markets?
A: Those markets are critical. The smartphone market is projected to be 1 billion units in 2015, 3 years from now. 25% of that is projected to come from China and Brazil. Just two of those markets -- 25% -- obviously those are very critical markets, but there are others as well.
We've been very focused on China. We've had incredible success with iPhone -- we've gone from a few hundred million in revenue to last year with $13 billion. We've been really focused on trying to understand the market there and taking those learnings to other markets. As it turns out, not very many people agree with me on this, probably.
What I see is that there is a lot of commonality in what people around the world want. Everyone in every country wants the best product as it turns out. They're not looking for a cheap version of the best product -- they're looking for the best product.
In the emerging markets there are very big differences in go-to-market. In most of the developed market, the carrier owns most of the distribution. In emerging markets, the retailer has most of the distribution. The whole go-to-market has to be changed significantly. Last year, we covered price points in the subsidized markets from $0 on up. That doesn't translate to zero in the prepaid market, but we're covering more price points there.
The paramount thing is the product. It is the focus. Of course distribution, we've recognized the difference there and in purchasing power. Unlike many people, I don't subscribe to the premise that prepay is prepay is prepay. We convinced China Unicom to try to postpay. It wasn't big there but they tried it and it's working really well. It's great for everyone because customer gets cheaper phone and carrier locks in a customer. It's a different way to look at the issue and it's been successful in China.
When Apple introduced the iPod in 2001, when we launched the iTunes Music Store and launched that on Windows, the iPod created a halo for the Mac. For 23 straight quarters we've outgrown the market on the Mac.
The halo that was created by iPod for the Mac, was created in developed markets. It was created in the US, Western Europe, Japan, Australia, Canada. It didn't work nearly to the same level in Eastern Europe, Middle East, Africa, China, Latin America. People were already getting music from their phones. The world changed for us when the iPhone was launched.
The iPhone introduced Apple to millions of people -- our brand -- to people who had never met Apple before. Now, it's interesting to look -- take China as an example -- last year the Macintosh grew more than 100% in China, year-over-year. Not on a big base, but 100% is pretty good. The market grew 10%, so we outgrew the market 10x.
The iPhone is creating a halo for the Macintosh. iPhone has also created a halo for iPad. You can definitely see the synergistic effect of these products, not only in developed markets, but also in emerging markets where Apple wasn't resonant for most of its life.
After the transitional third quarter, Apple's earnings growth returned to an exceptional level. As the following chart shows, earnings growth has maintained above 50% growth since 2009.
Q3 turned out to be a transitional quarter with 52% growth but Q4 proved to be "exceptional" with growth above 100%. This is the third highest rate of growth in the five year span shown. Sales growth was also very near the top of the range, coming in fourth historically.
When looking at the components making up sales, we can see each product line's revenue growth in the following table:
The growth leaders were also the largest product lines in terms of revenue. iPhone and iPad had triple digit growth rates and that translated into the bottom line growth.
Music related products and services which Includes revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party iPod accessories grew at 42%. This is the highest rate during the time frame shown.
Peripherals which Includes revenue from sales of displays, networking products, and Apple TV was next with 29% revenue growth.
The Mac line followed with 22% growth and Software which includes sales of Apple-branded and third-party Mac software, and services through the Mac App Store grew at 7%.
The iPod line continued to shrink with -26% decline.
I used color coding in the table to show the patterns of change and what I note is that the iPhone and iPad lines continue to be exceptionally fast growing businesses. The duration and amplitude of these streaks of growth should be a clear signal about the dynamics of these markets and Apple's role within. Too often, I find, these signals are ignored.
Apple's products are often seen as being priced "at a premium". This is mostly a matter of perception, but in certain categories Apple's products are priced above the industry average (though probably still affordable to sufficiently large populations). As a result, when competitors launch lower-priced products there is a tendency to expect Apple to react and reduce its prices to compete.
This expectation was evident when AT&T had an exclusive on the iPhone. The assumption among many (expressed in comments here as well as elsewhere) was that a switch to multi-carrier distribution would result in a price reduction and consequently a reduction in margins.
It was evident in the iPod and the Mac businesses over the years as prices for competing products collapsed.
It is also evident with respect to the iPad where expectations are that the Kindle will cause a reduction in the iPad price (and presumably in the margin).
However, the data we have from Apple on their pricing shows no concessions to competitive price pressure. The following chart shows the historic prices that Apple was able to obtain for its main product lines:
Over the time span shown (six years) the Mac and iPod saw modest price erosion as would be expected from declines in component costs but there is little evidence that Apple altered fundamental price points (note that these values represent pricing to the channel not to consumers who pay for retail mark-up or discounting/subsidy/taxation).
Similarly, both the iPhone and iPad have held prices very consistently. There is some seasonality as products are launched and there were a few quarters where the original iPhone was priced differently, with operator service revenue sharing lowering the up-front price. But there is a consistency to these products that speaks of a strategy that avoids price-based competition.
In the latest quarter Apple launched a few new price points for the iPhone. With the 3GS and the iPhone 4 and 4S available, Apple had the closest it ever came to a phone portfolio. There was some anticipation that the 3GS price point ($375) would impact the average selling price. However Tim Cook stated that the 4S was the most popular product. Furthermore, the 4S introduced a higher capacity (64GB) which offered a new, higher price point.
As a result, the ASP for the iPhone actually increased to about $660 in Q4. During the launch quarter the iPhone ASP does tend to be higher but history shows that the variance is small. Gifting seasons also affect pricing where the mix shifts to lower priced variants as seen with the iPad and iPod, but again, these are not great changes and entirely due to mix shift. There is no discounting.
The evidence I see is that Apple does not change pricing but rather stakes out a specific price point as resonating with consumers given their positioning. They then doggedly stick to it. Competitors tend to exploit open price points or try to position with specs on the same spots Apple occupies. That's not a game I observe being played by Apple.
Imagine it's late 2005. Apple's fiscal year just ended and they reported their performance. You're an analyst whose job includes forecasting the company's performance for next year. This is a weighty responsibility. Your forecast will be blended with those of your peers and used as a "consensus" average. That consensus for the next year will be used to measure the current value of the shares in a ratio called the forward PEG or Price/Earnings/annual earnings Growth. You are supplying the earnings and hence growth forecast while the market offers a price. As a stock is meant to measure future earnings, your forecast is a crucial and frequently cited figure about whether a stock is priced fairly.
There is some comfort in knowing that there will be many others who will offer such a forecast and your contribution is thus not the only way investors can calibrate the price. However, you should think hard about what you are predicting as it also will reflect your skill in predicting such a visible company.
Apple just had a tremendous two years. 2004 and 2005 saw EPS grow at 274% and 337%. This is largely due to the runaway hit iPod. Given all that is known about the company, what will you put forward? While you're at it can you also forecast two years forward, namely provide a growth forecast for 2006, 2007 and 2008?
Here is what you and your cohorts publish as a consensus:
You go with a 13% growth for 2006, 15% for 2007 and 5% for 2008. The chances are, you reason, that the iPod will not carry the company's growth much longer. The competition is sprouting all over and Microsoft is rumored to be launching its own music player.
It makes sense to be conservative and offer a modest growth of 13%. At the same time you can rate the stock a buy as it is still growing. The stock just doubled in the last 12 months and the law of large numbers says that growth cannot last at the same rate as we've just seen.
It's now late 2006. Apple just closed out another big year. Contrary to your forecast last year, the company grew at a rate of 46%, more than three times faster than you expected.
It turns out the iPod still has some legs and the company's Mac business seems to be growing. Looking forward you take your 15% growth for 2007 and increase it to 20% and suggest 16% for 2008 and 32% for 2009.
There are rumors of Apple getting into the phone business.
It's now late 2007. Apple just launched the iPhone and even though it was available in limited numbers on one carrier for one full quarter, the company still turned in an amazing 73%. Again more than three times faster growth than you forecast. What do you do about 2008?
It might make sense to increase the previous 16% estimate to 17% but since there is a real estate bubble brewing, the 32% growth for 2009 should come down to 22% and defer that growth out to 2010, dialing in 27%.
It's now late 2008. Apple closed out another huge year. 73% growth was once again more than triple your forecast of 17% growth. It's clear that the iPhone is a huge hit.
However, there is a credit crunch and talk of a huge recession, even depression looming. Apple is a luxury/premium brand and it is unlikely that those expensive products will sell well into these "macro headwinds". You predict a decline in the earnings of 13% in 2009, inline with many other tech stocks. You are optimistic however that 2010 will be a year of recovery and predict 18% increase from recession lows followed by a more reasonable 11% growth in 2011.
It's now late 2009. To everyone's surprise, Apple grew through the credit crisis. It turned in 34% growth (vs. your predicted 13% decline). The success is hard to believe but the iPhone had a lot to do with that. There are new competitors coming and the recession has proven resilient. With unemployment still high you predict 2010 will still be a tough year. You go with -14% growth for 2010 and postpone recovery out to 2011 with 24% "bounce". Longer term you see 2012 as a flat year, with Apple earnings shrinking slightly by 1%.
2010 ends with Apple achieving 67% growth. Shocking relative to a -14% growth forecast. But then again, Apple launched the iPad and who could have thought that was a hit? Apple achieved growth throughout the recession and it looks like it might keep going. Your 2011 forecast of 24% looks weak so you increase it to 25%. The 2012 decline thesis is abandoned in favor of 16% growth and, given the likely competition in smartphones, you tone down growth in 2013 to 6%.
It's November 2011. The company turned in 83% growth. It's more than three times faster than your forecast. Some people are suggesting that Apple may have a lot of headroom with the iPhone and iPad but the law of large numbers is what it is. The company became the largest by market cap in the world and Android is gaining huge market share. However, in deference to their strong recent performance you increase the 2012 forecast from 16% growth to 24% growth. 2013 goes from 6% to more than double: 13% and 2014 is when growth begins to slacken, though still a healthy 8%.
As the following chart shows, look ahead one year accuracy has not been all that great, but you are at least consistent. In any case, everything you based your decisions on showed remarkable consistency with consensus. You're just reflecting common sense.
Note:
Though the numbers are all real, the narrative is fictitious. I suspect however that the truth is actually stranger than this fiction.
Guessing the next Apple product has become the parlor game of choice for a whole generation of technology journalists and analysts. The premise of the game is that given a track record of breakthrough products, there is always another one just around the corner. Being the one to predict this next breakthrough product creates credibility and demonstrates the domain knowledge of the predictor. If the prediction fails to materialize there is consolation in dismissing the actual announced product as disappointing, unsophisticated or, worst of all, uninteresting.
Most often, these guesses are as much a reflection of the analyst as they are an analysis of the company. Too many predictions are designed to impress or demonstrate the imagination or knowledge of the predictor. They typically anticipate a giant leap of functionality, power or market re-structuring. They envision revolution not evolution; a cutting of the Gordian knot not a polishing of ugly rocks.
Yet nearly all of Apple's launches have been sustaining improvements in existing products, technologies or platforms. To name just a few:
The iPad is an evolution of the iPod touch
The iPod touch is an evolution of the iPhone
The iPhone uses OS X and Objective C from the Mac
OS X came from NeXT
The app store market model came out of the iTunes store
The iTunes store came from iTunes which came first to the Mac as a media sync tool for the iPod
etc.
John Gruber explained the process last spring as it relates to many of Apple's launches. Although the iPhone did introduce a new user input method and experience that takes consumption in a new direction, its building blocks were there for all to see for many years. The iPhone is a natural evolution of the computer with a handy little "Phone" app.
Likewise, the iPod came seemingly out of nowhere but by watching the original launch you see it as part of a "media hub" strategy that envisions the Mac as a personal server. The very products which ended up disrupting the Mac/PC began as extensions of their victims.
You can trace the DNA of almost all of Apple's products to previous products. If Apple did not have these foundations, the slow-motion revolutions would not have happened. Rather than a deliberate big bang, Apple's disruptions are the result of a discovery process. A test, iterate and improve loop. This is why they seem obvious after the launch but also why they seem to be such an anti-climax.
Therefore, the challenge of predicting Apple's next product should be tackled not only through an act of imagination but by carefully projecting the current products and understanding where they can evolve.
So it is that I approach the question of Apple's TV disruption. My working assumption about the next Apple TV is that it already exists. It's none other than the existing Apple TV, improved.
Here are the clues or hints I noted:
It uses iOS and the hardware from the devices that run it. It originally ran a PC architecture and shared a kernel with Macs.
It has been integrated with iTunes media stores (with the notable exception of the iTunes app store)
It has begun to introduce channels other than downloads (ESPN, Wall Street Journal) thus establishing its own distribution for traditional content
It is a global product, depending only on the Internet protocols and independent of the balkanized cable standards
Through AirPlay it is integrated with Macs and Apple devices.
Through display mirroring, iOS devices can use the TV as an external monitor and can even change their own behavior when doing so
This last point is intriguing. I have not seen discussion of this feature, but if using an iPad 2 or iPhone 4S with iOS 5 and an Apple TV with the latest software updates it's possible to have an iOS device become a controller for TV-based game experiences. Developers are already using the API. When using a pinball game with screen mirroring, the device becomes a controller while the action takes place on the big screen. Switching display mirroring off bring the action and control back onto the small screen. There are still problems with lag and the processors are over-taxed on high frame rates, but the APIs are already there for developers. (I could also mention the potential of new a Bluetooth standard for better wireless response).
What these signals point to is Apple defining the TV as an iOS portfolio product. This means integration with iTunes, including an app store. This, in turn, means unleashing developer/creative talent through new monetization opportunities. This means new user experiences in discovery. This means FaceTime-like communication through the TV. This means many other things but mostly it means that the TV will be a platform product.
The only challenge is a (currently lacking) smooth interface. Perhaps that's where voice comes into the picture. But whether that is built-in at the next rev of the product or not is not the story. The story is going to be the sustaining improvement in the original Apple TV. A wonderfully asymmetric product begging to be ignored. A product that because of its apparent lack of success, effectively hides all its secrets in plain sight.
I began thinking carefully about Apple in 2005 when the stock was priced at around $55/share. I remember that the events which made me consider Apple in a different light were the launch of the iPod shuffle and the launch of the Mac mini. Both moves signaled to me that the company was serious about competing with non-consumption. At that point I thought that the company was a potential opportunity as an investment.
But I also remember that many people at the time thought that the stock price was too expensive. At $50, the company was much more expensive than the year before. The stock started 2004 at about $11/share. The reason it had climbed so much was that the iPod began to be a real world-wide growth phenomenon. Buying Apple was buying into the iPod and many said the price was unsustainable given such a strong dependency on fickle consumer tastes. It was a much riskier proposition than that of competitors like Dell and HP which made product for reliable buyers like enterprises.
Indeed, by 2006, the shine was off. In the first half of 2006 the stock collapsed from $85 a share to $50, a fall of 40%. It was becoming clear that with mobile phones taking on more music playing features, the iPod was not going to be a big story for long. What's more, Apple had just announced that they were switching to Intel for the Mac product line. Investors saw just how vulnerable the company still was and considered that the Mac brand was in jeopardy as it transitioned to becoming a Windows-friendly machine.
However, in 2007 the company's value recovered with the introduction of the iPhone. Suddenly there was a new product to drive sales. Nobody knew by how much or how but there was a sense that the iPhone was enough to keep Apple from oblivion.
Yet, again, in early 2008 the company lost 40% of its valuation. In a rather inexplicable period following the launch of the MacBook Air, the company's shares went into free fall. Inexplicable because the company continued to deliver solid growth with 2008 calendar quarters showing between 32% and 155% EPS growth.
Then the recession came. It caused another 40% share price collapse. Growth slowed to a range of 11% to 61% during 2009. As the marco "headwinds" blew over, by the end of 2009, with the help of a lukewarm response to the iPad, the company's value recovered to its 2007 level. In the mean-time its earnings more than doubled.
It may not appear to be the case, but throughout this volatile period, the investment thesis remained fairly constant: Apple is a rather small collection of product bets. Owning Apple meant riding the iPod or the iPhone or the iPad as waves of growth. As soon as one growth wave was seen to start to fade, investors would say the same thing: Apple is done.
The chart below shows just what that looks like in terms of product contribution to gross margin.
The investment thesis is the same today. I've had dozens of conversations with fund managers and if anything, it's even more about betting on products. The iPhone and the iPad make up such a large part of profits that the company seems to be nothing but those two things. So if there is any hint that those products might slow down, the stock is sold off.
What intrigues me about this investment thesis is not whether the signals of growth are interpreted correctly or not, but rather that an investor in Apple in 2006 was considered perfectly rational valuing Apple as an iPod company as much as an investor today is perfectly rational valuing Apple as an iPhone company. Why would anyone buy Apple for any other reason? There is no evidence that Apple can be anything more. Any fund manager positing a different point of view would surely be limiting her credibility.
The consensus is that the value of future, unknown products is zero. Not only that but the probability that there will be any products at all is equally zero. Not only that but whatever Apple does to create new products is not perceptibly valuable. The company is simply the sum-of-the-product-parts and nothing more. Cash flows from current products can easily be shown to be more than the current valuation so even these products are deeply discounted. If and when a new product shows up, it will be considered and maybe if it shows promise, the stock will reflect that, briefly.
A corollary to this investment thesis therefore is that the process of product development at Apple is worth nothing. It does not matter if the company has shown an ability to disrupt and to create new categories. The past is not a predictor. The value of the company is a discounted cash flow of current products--discounted for the odds of commoditization, which are seen to be quite high. A new hit product is a windfall, a winning lottery ticket. Something that you cannot count on.
Think about that in a different context. That's like valuing Pixar on the box office revenues of its current movie. If Cars 2 is not beating records, Pixar is suddenly nearly worthless. The fact that Pixar repeatably creates blockbusters would be seen as meaningless. The way they built a reliable pipeline with predictable cost structures for movie-making is not interesting.
However, the fact is that Pixar did not get acquired on the basis of the last hit it made. It was acquired for its system of production. This can be confirmed not only by the price paid but by the fact that the organization was not folded into the Disney machine. It stands alone and is given autonomy. So at least in the movie making industry, predictability is seen as valuable.
So why is Apple not valued as a process company?
I think the answer lies in the lack of understanding or belief in a theory that predictable success in product development is possible. Until and unless an explanation is available that persuades a majority that Apple is as much a hit factory as Pixar then Apple without the products will intrinsically be valued at zero.
The premise of the stock market today is therefore that being innovative in technology is meaningless. Innovations are valuable but there is no such thing as an innovation process. If there was such a thing then we could measure it and put a number of its value. Until then innovation is nothing more than a spin of the roulette wheel.
Almost all valuation models for Apple assume it's a hardware company. The modeling algorithm for hardware is simple:
For each year in near future
For each product line
Compute contribution
Determine company value by summing contributions and multiplying by a P/E ratio
The major difficulty is in predicting the growth of each product line. This is difficult because buyers can be fickle. Companies employs all sorts of tools in order to secure repeat customers but if switching costs are low, the company can crash in value. For this reason, analysts pick various ways to predict device sales. Some choose to index each product on production (channel checks), demand (customer surveys,) or even on a top-down share of total (market research on growth of whole market and assumptions of share).
Although simple and convenient, this model does not probably match the way Apple is managed. The company does not build hardware products to sell and forget. It builds platforms which are best seen as sources of recurring revenues. Users are incentivized to continue buying devices. iCloud, iTunes and other Apple properties are expressly designed to that goal--and they are not cheap to run. So, the company must see the world through a different set of lenses than the default model shown above.
To think about the business like they do, we need to put the data through a similar set of lenses. I began with a modest proposal last month to value each user as a source of recurring revenue. Now it's time to expand on this method.
The following chart shows the recurring revenues per user by product and the current and possible future size of user bases.[2]
Revenues/yr/user are bars with the left axis and the User bases are various colored circles indexed with the right axis.
The assumptions that went into the data are as follows:
Device life span is as per previous article linked above
User base growth for 1 year is: Mac 20%, iPhone 80%, iTunes 10%, iPod 30%, iPad 100%
User base growth for 2nd and 3rd years (recurring): Mac 20%, iPhone 50%, iTunes 10%, iPod 20%, iPad 80%.
The Revenue per user is assumed constant
Note that the user base growth figures are lower than the product growth levels seen historically. Obviously, the model is highly sensitive to these growth assumptions so they need to be scrutinized and tested rigorously.
Nevertheless, as a straw-man proposal, the recurring revenues for all these products[1] is shown in the following chart:
Once the income is estimated, we can take that value and assume a profit margin (net) and then multiply the earnings by a multiple. Using a 20% net margin and 12x P/E yields the following chart.
(I added an assumed level of cash in green.)
This model would imply that the company today could be valued at $208 billion on the basis of its installed base alone. That value would be about $323 billion in one year and $620 billion in three years. Dividing by the number of shares outstanding (935m this year increasing at 2% a year) yields a share price of $222, $339 and $629 by mid 2014.
These values can be considered "lower bounds" on valuation since they assume income from previously secured customers. The speculative part of investment would be based on what the future bases will look like (so, for example, if one believes these assumptions, the $629 figure could be considered a target to be discounted to today).
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Notes:
Excludes Software, Peripherals, non-iOS devices, and any other service revenue.
My thanks to Robert van Apeldoorn, journalist for Trends Tendances Magazine, for asking good questions. My responses are reproduced below. The article (in French) is titled "Nokia a trop écouté les réseaux télécoms" and can be found in the June 23rd edition of the magazine along with more details in the article "Comment Nokia peut-il renaître?".
-About your post “Does the phone market forgive failure”, that puts forward the idea that all mobile device vendors experiencing losses never really recover… It seems that this possible “rule” is more severe than in the computer industry. If Digital Equipement, Compaq, WordPerfect did fail, IBM and, yes, Apple, did survive failure and rebound strongly. Do you think that there is a difference between the industries? What makes the failures more lethal in the mobile device market ?
The observation is unique to the mobile phone market and even there it's only an observation not a rule. It could be that Nokia will be the first mobile phone company that will recover from severe crisis, but history shows it to be very unlikely. I try to shed some light on the reasons why it's unlikely and what makes the mobile phone market so unforgiving. I think much of the problem rests with the fact that mobile phones are sold indirectly, through intermediaries who are amplifying both success and failure. A company like Apple was able to recover in the computer industry because it launched new products like iPod which could be sold directly to consumers. It had to convince the consumer and only the consumer. Having to convince a distributor, retailer, value added reseller, operator and consumer would be much more difficult. These intermediaries are "institutional" buyers who are risk averse and have low tolerance for untested ideas. Institutional buyers need to think about dealing with other people's money not just their own so they are doing the right thing from their point of view.
Nokia needs to persuade first operators, then distributors and then consumers that its new products are great (even though maybe the old ones were not so great.) That's tough. Apple works in the other direction. It creates consumer demand then "sells" that demand to the intermediaries as needed.
These intermediaries (which Steve Jobs famously called "orifices" to the market) amplify the success and failure of a company. For a long time after a product may lose favor with consumers, it will still be sold out of momentum of the channel. But it works the other way as well. If you're out of the channel, getting in is much harder even if the product may have favor with consumers. This is Microsoft's problem with Windows Phone. Surveys show that it's well liked by users, but because Microsoft relies on a long chain of intermediaries, it's still very hard to get started. Microsoft (and Nokia) rely on momentum to carry them once they get some traction and they plan to spend a lot of money ($ billions) to ensure they get some traction.
-You are absolutely not optimistic at all about the Microsoft partnership (see “in memoriam” post). What could be the best solution? To enhance Symbian platform? Go for Android? To create a new market with a new kind of device (cf book “How new ideas can win fast”)? Or to go back in the tire business ;-) ?
I only observe and record data and then try to have a theory of why it happens that way. The empirical data shows that Microsoft has been very unsuccessful with mobile. Their partners seem to all have failed and the list is long. So the question is why. Is it just bad luck? Is there something wrong with management? Is it that perhaps there is a failure in strategy or business architecture? All these are possible hypotheses but I believe the problem is that Microsoft has chosen not to integrate products and to rely on intermediaries at a time when that strategy leads to uncompetitive products. One can understand why they went with this strategy: They believe the scale of the market is so large that they cannot address it like they did with Xbox (building their own complete solution). However, that also means that they are likely to be uncompetitive during the time when integrated products/ecosystems are still not good enough and can iterate more quickly to capture the market. This was true for the iPod where Microsoft tried to license technology to device makers. It was true during the time of Windows Mobile when Microsoft's OS could not compete with either Blackberry or Symbian and it may still be true today with iPad which redefined what a computer could be.
-What and when, precisely, Nokia did fail to understand how to be remain the market leader and innovator?
I think the answer goes beyond the failures in execution or software development. Being late or sloppy with Symbian evolution is a symptom not a cause of the failure. What Nokia failed to understand is that software and data-oriented products would be built and sold and valued differently than voice-oriented products. Nokia listened very carefully to its best customers, the operators. Operators saw data as a sustaining improvement to their core business and steered Nokia into building "voice-plus" products. Every technology that came out of the laboratories was used to enhance the phone *as a terminal* in a network. Nokia never framed the product as a computer using the network as an accessory the way modern smartphones are valued (or if they did as with Maemo, it was a half-hearted effort). Users today are glued to apps and local media storage and see network access as a necessary inconvenience. The network is only valued in terms of being available.
The re-framing of the device from being a terminal to being the center of user's focus is the "disruption" which is sweeping aside all the incumbents in the phone space. They all did what was expected of the best managers: they listened very closely to their best customers. That also leads to blindness when the industry itself is being ripped apart by disruptive forces.
-In many aspects, Nokia developed many innovations (email on the phone, music store, smartphone with applications, tv on the phone,..). I remember visiting a Nokia exhibition four or five years ago, in Nice, with a broad and incredible new services range that I almost never see on the Belgian market. Many of the innovations were related (dependant) to a deal with telcos, as network device vendor. Blackberry (RIM) or Apple were more successful. Is it because they had nothing to sell as network device vendors ?
This is answered by the previous answer as well. All of Nokia's services were designed to help operators improve their business. Operators were the best customers and they ensured Nokia would sell large volumes. But consumers did not see it that way. When a competitor came with an alternative, consumers defected en masse. By then it was too late to change the strategy. It takes years. Nokia still perseveres with this operator-first strategy. Elop continues to say they will do what operators need first. The first thing he did when on the job was visit every major operator. The decision on Windows Phone was based on whether operators saw it as a viable third alternative to the iOS/Android duopoly. Strategy is a matter of priorities not capabilities.
-How is the Nokia strategic problem perceived in Finland ?
The problem is very deeply felt in Finnish society. Nokia was a source of pride for the country and also a large employer both directly and indirectly. I think the impact is felt more psychologically than financially. There was a sense of betrayal when Symbian was publicly "terminated". Many people criticize present and past management, but I think that anger is misplaced. The failure of a company rarely comes from the failure of character or intelligence. It's usually a failure of being too rational, too reliant on best practices. What Finns need is a dose of independence in thought and a re-assertion of their willingness to take risks.
The Finnish character is one of independence and perseverance in face of adversity. If Nokia loses its independence then it will need to deal with a lot more adversity. I believe however that innovation will continue. Case in point: Rovio, the maker of Angry Birds is a Finnish company.
