Quick Thoughts: Apple – Go Big or Go Home

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–           The big screen iPhone 6 and 6+ should pull upgrade sales sharply forward, even at a higher average price point than the 5S, yielding 15%+ sales growth from iPhone for AAPL’s FY15.

–           The Apple Watch is beautiful and chock-a-block with technology, but lacks a compelling use case at a price that will stretch the wallets of users already saving for an iPhone 6 upgrade.

–           Pay has uniquely integrated HW and SW for mobile payments, and has a coalition of banks, card nets and merchants, but users get little benefit and the revenue potential for AAPL is small

–           AAPL is positioned for strong iPhone 6 driven results in its 1HFY15, but we do not expect the Watch to be a repeat of the surprising iPad phenomenon. Growth worries will return in 2H.

In a super-sized version of its annual fall ritual, Apple CEO Tim Cook to the stage at the Flint Center in Cupertino to unveil two highly anticipated new iPhone models, a mobile payment solution called Apple Pay, and the company’s first new product category in four and a half years, the Apple Watch. The content of today’s presentation was hardly a surprise given bloggers and the tech press have been publishing leaked photos of the new iPhone as well as commenting on deals between Apple and payments networks in the weeks leading up to the event. Apple’s move into wearables has long been speculated, given the company’s hiring spree of executives from the luxury goods industry over the past year, though the alleged “iWatch” leaks turned out to be no more than fan boy renderings for a future product that is likely not yet in production.

Leaks about a significant U2 performance turned out to be accurate, as the band closed the show and announced that its newest album would be distributed for free to iTunes users. Still, the most exciting news for most Apple users was the company’s capitulation to modern smartphone tastes. Steve Jobs loved to talk about how the iPhone was the perfect size for the human hand, and even as recently as 2012, the company was still publically mocking the big screen Android models. No more mocking – the 5.5 inch iPhone 6 Plus is officially bigger than the original Samsung Galaxy Note that started the whole Phablet phenomenon.

The iPhone 6 and its larger sibling the iPhone 6 plus represent a true refresh for the product without gimmicky features. Though Apple’s Phil Schiller blasted through the iPhone unveil quicker compared to previous launches, the features and enhancements available in the latest generation are more than incremental. While screen sizes are obviously bigger, Apple has boosted resolution and kept the fidelity of the retina display at 326ppi for the iPhone 6 and increased 401 ppi pixel density for the larger iPhone 6 plus phablet. Instead of the rumored sapphire displays, the new phones get an ion-strengthened glass front that’s more than likely Corning’s latest iteration of the Gorilla Glass that it had invented for Steve Jobs and the original iPhone.

The guts of the phone feature the new 20-nm A8 processor, which Apple claims is not only faster, but also more efficient delivering sustained performance without causing heat. Apple’s demo of a video game produced by the ironically named startup “Super Evil Mega Corp,” showed off its “Metal” processing framework to exploit hardware accelerated graphics and the quality is close to late generation consoles like the PS3 and XBox 360. Also inside the phone is the M8 motion co-processor which is used to power sensors like the new barometer that was added to the phone to measure changes in elevation. Moving down the bill of materials, Apple has also included updated baseband and wireless semis. The new LTE chipset will work with 20 LTE bands and offer carrier aggregation to make speeds up to 150Mbps possible, while the new Wi-Fi chipset supports the 802.11ac standard which was approved in January.

Apple flexed its muscles to slap wireless carriers with support for WiFi calling, initially in conjunction with T-Mobile in the US and Everything Everywhere in the UK. As for camera, Apple hasn’t budged from 8MP sized sensor since its 2011 launch of the iPhone 4S, but has made some enhancements to the sensor borrowing technologies used in expensive DSLR cameras such as “focus pixels” and “phase detection” to enable faster autofocus and better image processing.  It’s also included image stabilization for video recording and also boosted 1080p HD capabilities to record at up to 60 frames per second. At lower resolutions it can now record at up to 240 fps to allow for slo-mo video. Despite the impressive value added software features, the 8MP camera and sensor are still incremental changes.

Pricing for the iPhone is consistent with Apple’s tiered approach and users finally get a break from Apple on memory, which has been a significant source of margin for phones equipped with more capacity. For $299 and a two year contract, users now get 64GB of space on the iPhone 6 versus the 32GB for the same price in previous versions going back to iPhone 4 in 2010. As expected, the 5.5-inch iPhone 6 plus is priced at a $100 premium to its 4.7-inch sibling. Unlike last year’s iPhone 5c, likely considered a debacle in Cupertino, there was no lower tier phone released this year with previous versions of the iPhone 5S and 5C offered at reduced prices. Keeping older versions of iPhone on hand not only boosts margins, but also drives sales in emerging markets where Apple is deemed a luxury and aspirational brand. Lower priced iPhones drove sales of the category in the two most recent quarters with ASPs at $596 and $561 respectively versus a flagship model starting ASP of $650. Going into the holiday quarter, we expect iPhone ASPs to pop up closer to $650 given anticipated upgrades to larger handsets in developed markets. eMarketer for instance estimates that some 35% of current iPhone owners plan on upgrading in the next six months.

Next up was the Apple Pay mobile wallet. Here, Apple hopes to succeed where many others, including archrival Google, have failed, leveraging its unique control over both the hardware and software for its primary platform. With the iPhone 5S, Apple had introduced its TouchID fingerprint sensor, offering a tool for biometric authentication tied to a “secure enclave” in its iOS software that isolated the encrypted identification data on the phone. The iPhone 6 and 6 Plus add a Near Field Communications (NFC) chip – Apple would have preferred to use Bluetooth LE for Pay, but issuing banks (JPM, C, COF etc.) refused to support it, believing that it gave Apple too much control over the payments architecture. With the banks on board, Apple gained the support of the major card nets, V, MC and AMEX, and signed on a list of merchants, most of whom have already installed NFC gear and support most of the other existing contactless initiatives.

While Tim Cook roasted other mobile wallets for trying to solve payments with business models rather than user experience, Apple’s solution likely won’t yield much business for itself, given the payments networks and issuers will still control the payments process. A rumored 15-25bp payment for fingerprint “credit scoring” to Apple would not amount to very much revenue given likely transaction volumes, and the benefit could easily be passed through to merchants to give them incentive to support Pay.  Given recent concerns about Apple and Consumer Privacy with last week’s celebrity photo breach, Apple’s Eddy Cue was careful to note the solution will not store card information in the phone nor transmit purchase data to Apple noting that “Apple doesn’t known what you bought, where you bought it, and how much you paid for it.” With the mobile payments space in recent years characterized as a turf war between payments networks, issuers, merchants, mobile carriers, and technology companies, Apple’s willingness to sustain the status quo, eschewing a chance to attack interchange fees or exploit customer purchase data, puts them in a favored position with the current payments chain.

A year from now, with 30-40M iPhone 6 and 6 Plus users in the US, Apple Pay could be the mobile payments breakthrough for which the industry has been waiting – IF Apple can get a majority of those consumers to use it for a good chunk of their credit transactions. First, this will depend on gaining widespread acceptance by retailers. Apple has an interesting start, with announced merchants like Bloomingdales, Disney, Macy’s, McDonald’s, Nike, Petco, Staples, Subway, Toys R Us, Walgreens, and Whole Foods, representing some 220,000 locations, along with Apple’s own retail operations. Apple Pay is also supported by a number of Apps, including Groupon, Major League Baseball, OpenTable (recently acquired by Priceline), Panera, Sephora, Starbucks, Target, and Uber. Still, there are also many major national retailers that are NOT participating, in particular, the 88 merchants involved with the Merchant Customer Exchange (MCX) payments initiative, like Walmart, Target, Best Buy, CVS, Lowe’s and others, which requires its members NOT to participating in alternative e-wallet programs like Apple Pay. It would seem that consumers will be juggling multiple payment options, including good old mag stripe credit cards, for a long time.

Even if Apple cracks the code to get consumers to really use mobile payments and establishes a sustainable critical mass of merchants, we believe financial terms are likely negligible in the context of Apple’s massive sales and profits. Even if Apple gets as much as a 25bp cut on $100B in transactions, the $250M fee cut is still under 2% of Apple’s revenue and not a significant driver of growth. If Apple got the same deal on the full $4.3T spent on cards annually in the US – a fantasy given that Apple has only 44% share of US smartphones and gaining 100% share of a customers credit transactions is impossible – the fee would represent some $10.9B, still too small a number for Apple with its $170B+ in revenue to be meaningful for growth.

Finally, Tim Cook had his “One more thing moment” when he took the wraps off the long rumored iWatch, which is simply called the “Apple Watch.” Apple’s poaching of luxury goods executives from the likes of Burberry and Yves Saint Laurent, and most recently famed designer Marc Newson were tell-tale signs the device was coming. Cook spent some time introducing the product and its features focusing on the user interface which is driven by a watch dial Apple has dubbed the “digital crown” as well as a touch screen. While light on tech specs during the presentation, Cook turned to a Jony Ive video explaining the design and styling of the Apple Watch which features a sapphire glass display, a tiny water resistant S1 system on chip, Taptic sensor engine, infrared and LED sensors, accelerometer, small speaker, and inductive charging. Ive also revealed the Watch will come in two sizes, with three options for coating including stainless steel, aluminum (aka Sport), and 18-karat gold (aka Edition) along with a couple color options for each coating. Narrating the six options for watchbands, Ive was obviously more in his element than last year when he helmed a video describing the “unapologetically plastic” iPhone 5C. After the eloquent video, Cook called on Kevin Lynch to give the Watch demo. Ironically, Lynch is the former Adobe executive responsible for Flash, which is the same multimedia technology panned by Steve Jobs in a letter made public in April 2010. Lynch is now Apple’s VP of Technology, and took the audience through some of the features of the Watch, which requires pairing with an iPhone. While some of the default watch faces look novel, the watch is light on apps given the few demoed were developed in secrecy with partners like Twitter, City Mapper, American Airlines, and BMW.

Aside from the flashy video and demo, Apple only announced a starting price of $349 and availability in early 2015, a similar lag between introduction and launch with the first iPhone which took nearly 6 months to bring to market from initial preview. The Apple Watch is a beautiful piece of engineering, and the fanboys will queue up for theirs after the holiday season, but it is unclear how much growth could come from it given its price point. An iPhone 6 on contract and the cheapest Watch model will set you back $548 together. The flashier options will clearly cost a LOT more.

The Apple Watch packs in a LOT of functionality – a battery of sensors, NFC, wireless charging, a scroll wheel, a touch screen, voice commands, etc. – but Apple is a bit fuzzy on the use cases. For a company that claims to deliver solutions to user problems, it is not at all clear what burning need the Apple Watch fulfills. Is it fitness? Fitness trackers and apps have had limited success, appealing primarily to the very fit and the very sick, with most of the rest of the population quick to lose interest. Is it payments? It’s not clear that a swipe of the wrist is any more convenient that a swipe of a phone (or a swipe of a credit card for that matter), and certainly not enough more convenient to justify the price. Home control? The market is so fragmented poorly penetrated that it will take many years for this to be a meaningful driver of watch demand.

I think the application is fashion. Like a fine Swiss watch, the supposed functionality of the product is secondary. The gold plated Apple Watch Edition will probably cost thousands of dollars and Apple could sell enough of them to make a difference as the product ramps. Still, unlike a fine Swiss watch, it is unlikely that the Apple product will last long enough to be passed down to subsequent generations, and demand may be limited to the very rich willing to drop a few grand on a product likely to be obsolete in a couple of years. Even the lower price models may be a stretch for most of Apple’s customer base – the Watch has no subsidy attached to stimulate replacements and upgrade. Still, Apple has surprised us before delivering a product before a compelling use case was obvious and many investors will be wary of making the mistake of underestimating Apple twice in five years. The Apple mystique, and the strong sales of the iPhone 6, will likely keep the stock going for another quarter or two.

For our full research notes, please visit our published research site.

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