Why Apple's iWatch will be an iPod

by Mark W. Hibben
6/1/13

Reading into Cook's Statements

Tim Cook's recent appearance at D11 threw gasoline on the fires of speculation about new Apple products, and convinced many observers that a raft of new products, including the much discussed iWatch, was in the works, but Apple's wearable tech in the near future will be evolutionary, not revolutionary.

Given that there hasn't been a new product announcement from Apple since October 23, 2012, it was to be expected that people might read more into Cook's statements than was warranted. For instance, Piper Jaffray's Gene Munster, a long time Apple bull, stated according to Philip Elmer-Dewitt:

"We felt that after viewing the conversation, it seems fairly certain that Apple will launch a television, a watch, and multiple iterations of the iPhone by the end of 2014 as well as a potential new service offering."

A watch by the end of 2014? Given that the Pebble and the I'm Watch already exist as products, I hope it doesn't take that long. In fact, I don't think it will. But Cook made several points about smart watches that bear repeating:

1) There are lots of wearables that do one thing really well. Cook pointed to the Nike Fuel Band as an example. But he said there was "nothing great out there" in wearables that try to do more than one thing.

2) Most young people don't wear watches, since their phones have become their time pieces. In order to convince them to wear a smart watch, it would have to offer an "incredible experience".

The logical conclusion from points 1) and 2) is that current smart watches will have very limited appeal, especially among those not inclined to wear a watch.

Technical Challenges

Offering an incredible experience in a watch is technically very challenging. There are two basic problems: battery life and display size, since being wrist mountable means limiting both. Even then, smart watches tend to push the limits of what people will put on their wrists.

Currently, smart watches tend to be smartphone accessories, allowing the user to view incoming call and message announcements. For the most part, Apple has left iPhone accessories to third parties. Apple needs to do that in order to encourage companies to make accessories and become part of the iOS ecosystem.

Would a wrist mountable, fully fledged iPhone be really cool? Sure. It just isn't feasible right now, or even by 2014. Driving a cellular radio requires a great deal of power, and the battery for the device would be huge. As for a flexible glass, wrap-around display, I doubt that Apple would want to incur the product liability. The display would be easily shattered, producing glass shards in an unfortunately vulnerable area of the human body.

Ingenious Solution

In light of the battery/display size equation, Google Glass appears to be a particularly ingenius solution. The display is actually quite tiny (roughly a 1/4 inch square) so that the power requirement is very small. Through the use of clever optics, the display has a virtual size that appears quite a bit larger to the eye, equivalent to a 25 inch screen viewed from 8 feet away. Minimizing the power requirement of the device while maintaining an acceptable subjective display size is a powerful advantage that Google's competitors should not underestimate.

Mounting the Google Glass display in an eyeglass frame was a necessity driven by the desired physical size of the source display. Whether many consumers will want to wear the devices frequently remains to be seen, but I think Cook may have underestimated the market for the device. He correctly pointed out at D11 that most people only wear glasses when they need to, and want them to be as unobtrusive as possible.

This first generation of Glass is far from unobtrusive, but subsequent generations will become smaller and lighter, inevitably. It's not difficult to foresee a time in the near future when the image projector optics can be concealed behind sunglass lenses, making them easy to wear outdoors or while driving without feeling conspicuous.

The Apple Wearables

Given the growing interest in wearable, smart devices, and the technical limititations on them, what is Apple to do, short of developing an Apple Glass? As an iOS developer, the answer seems pretty obvious: by the addition of software to the existing iPod touch and iPod Nano, they could be given the ability to interact with and display data from an iPhone, since they both have Bluetooth, which is essential to provide a data link between the devices. Apple already provides a host of APIs for developers to do this for third party accessories, such as the Pebble and the I'm Watch.

What is lacking is built in software for the iPods to perform the functions that smartwatches currently perform. It wouldn't take much for Apple to provide this for the iPod Nano, and theoretically, a third party developer could provide this for the iPod Touch in the form of a standard iOS app. Granted, there there may not be much demand for this.

Clearly what Apple needs is an iPod Nano even smaller than the previous generation, which was wearable on the wrist. This is perfectly doable, although all day battery life may not be happening. This Even Smaller Nano (what's smaller than Nano?) would have robust iPhone interface and display capabilities, along with the usual iPod features, but wouldn't be marketed as a watch. It will simply be wearable, as the iPod shuffle is now, and Apple will probably leave it to third parties to come up with wrist straps for it.

It's not clear what this new iPod will be called. Just introducing another iPod, even one with the capabilities of current smart watches, is unlikely to excite investors or fans, but I think this is what we have to look forward to from Apple in the coming months, a series of evolutionary products.

The first signs of this new iPod will appear at WWDC, when Apple rolls out iOS 7, which will contain enhanced APIs for iPhone accessories, and the new iPod may even be debuted at WWDC. Whenever it appears, I don't expect the reaction by Apple's critics to be particularly kind. It won't be nearly revolutionary enough for them. The new iPod will not be the catalyst that Apple investors have looked for in the iWatch, and Apple's shares are likely to stay in the $400-$450 range until the product announcements Apple has promised for the Fall.

 

The Big Battery Bet of Elon Musk

by Mark W. Hibben
5/31/13

Alleviating Range Anxiety

Now that the afterglow of Tesla's profitable Q1 has faded, many are questioning the long term viability of Tesla. Tesla's share price has gained over 90% since their earnings report on May 8, largely on the strength of sales of 4900 Model S sedans in the quarter, better than the next highest selling electric vehicles, the General Motors Volt at 4421 units and the Nissan Leaf at 3695.

Tesla has stated the expectation that it will sell about 20000 Model S sedans this year, and that's a good pace, but it begs the question what happens when current demand in the U.S. is satisfied. Tesla's current approach seems to be to boost demand by addressing concerns about travel range and battery life. At D11 yesterday, Elon Musk pre-announced the rapid expansion of the "supercharger" stations that can charge a Tesla Model S with supercharging capability to about half capacity in as little as 20 minutes. Musk promised 80% coverage of the U.S. by 2014 and the ability to drive from Los Angeles to New York in a Model S.

As long as you don't mind stopping for that 20 minute break every 265 miles or so. This is the EPA estimated range of the Model S with the larger of two battery options, which pushes the price of the Model S to $79900 before tax credits. A Model S, equipped with the smaller battery and shorter EPA estimated range of 208 miles, will still set you back $69900 before credits.

Targeting the cars at the luxury market was a necessity for Tesla, given its commitment to a fully electric vehicle with decent range. The battery packs alone cost about $24000 and $34000 for the smaller and larger sizes respectively. Wrapping an economy car body around those battery packs wouldn't have worked, since Tesla would have ended up with a cheap looking car that cost $50000.

Moving up market allowed the batteries to be a smaller part of the total purchase price of the car, and allowed Tesla to exploit the novel quiet and turbine smoothness of electric drive to appeal to luxury car buyers. The result was a luxury car for the eco-conscious elite, but it won't really make Tesla a successful car company.

Duplicating the Tesla Formula

Part of the problem for Tesla is the age old one of competition. The formula of putting an electric drive train into a luxury car is easily duplicated, and General Motors is about to do precisely that with the drive train from the Chevy Volt. The Volt is an innovative car that combines a primary electric drive train with a gasoline engine generator to take over when the batteries are depleted. The generator allows a smaller, less expensive battery pack to be used in the Volt, with consequently shorter EPA estimated battery range of 38 miles.

The Volt drivetrain is a compromise solution designed to maximize the benefits of electric drive while minimizing the inconvenience and added cost. The sticker price of the Volt is $39145 before tax credits. The gas generator relieves range anxiety, but makes the car seem less eco-friendly, and the Volt hasn't won many fans, despite its relatively quiet drive train.

GM is about to transplant the heart of the Volt into its Cadillac ELR coupe, which will be available in early 2014. As far as I can tell, there won't be any performance enhancements to the drivetrain for the ELR, just a much nicer interior and an exterior that is, well, more attention getting than the Volt.

Whether the ELR will be a success remains to be seen, but it demonstrates that the major automakers aren't going to leave Tesla alone. Tesla needs to bulk up with a broader range of models and an under $30000 electric car.

Pitfalls of the $30000 Electric Car

The Nissan Leaf illustrates the pitfalls of trying to build an affordable electric car. The leaf uses basically the same battery technology as the Volt/ELR and the Tesla S: lithium ion batteries. In order to keep the cost down, the Leaf just uses a smaller battery pack and a lower power electric motor.

Whereas the base Model S has a 302 hp motor, the Leaf has a 107 hp motor. And the range of the Leaf is 75 miles. The sticker price of the base Leaf is commendably low at $28,800, but the Leaf is the proverbial Second Car that no one will really want to drive.

Clearly a Leaf-like Tesla would be a complete non-starter. At D11 Elon Musk was asked what it would take to build an electric car for about $30000. He estimated that it would be possible in about 3-4 years. When pressed about what it would take, he said that such a car would require further design optimization, be 20% smaller, and have an order of magnitude greater production volume.

His answer was perhaps a little disengenuous, since he knows full well that the cost problem centers around the batteries and range capability. Lithium ion batteries are used in everything from cell phones to the Boeing 787. They're already in high volume production, so there isn't really much additional economy of scale to be realized. The batteries just don't store enough energy per unit weight. Musk also knows that researchers have developed a new class of lithium ion batteries with about 4 times the capacity of the current generation.

A Battery Quantum Leap

The impact of such batteries will be truly remarkable, if they prove practical to mass produce. Imagine a Tesla Model S with a range of 800 miles, or a low cost Tesla with a range of 300 miles where the battery pack only cost $9000 rather than $34000. Until recently I would have thought that such a quantum leap in battery technology was decades away.

Until I read a paper by a research group at Northwestern University, led by Harold Kung. In the dry unsensational language of science the group described how they had solved the main technical problems in fabricating this new battery and presented the measurement results that proved that it would provide the 4x energy storage while having long life. Getting both properties had always been the fundamental problem. And their results were not a fluke, since another group working on a somewhat different approach has essentially duplicated the Northwestern results.

How long will it take to get the new batteries into production? You guessed it. Three to four years.

 

Is Netflix still a Good Investment?

by Mark W. Hibben
5/27/13

A Remarkable Run

Netflix shares have been on a remarkable bull run, up over 300% since 8/1/12, and the shares have added almost half of that since the start of the year. Investor sentiment continues to be bullish, and the P/E is a stratospheric 518.7.

Yet there are doubters. Rocco Pendola wrote a pair of scathing articles about Netflix: "Netflix: The Biggest Empty Promise Since Enron?" and "Netflix News So Absurd I Couldn't Make it Up". In the articles, Pendola vents his mystification at the run-up, but stops short of recommending a sell.

Positive views of Netflix, such as a recent post by fellow blogger Salvatore Mattera ("Netflix's Battle with HBO Could Change TV Forever") tend to focus on the service itself rather than financial metrics. As a streaming video service for a fixed monthly fee, Netflix has no equal, and continues to add subscribers, with domestic streaming membership up 25% y/y in Q1 at 29.2 million. And Netflix is producing it's own content, the latest being a fourth season of Arrested Development.

Do these advantages make Netflix a good investment? Not necessarily. One question investors should ponder is what the return will be on the investment Netflix is making in new content. Lacking detailed insight into the cost structure of Netflix, especially the production costs of the new shows, Return on Invested Capital (ROIC) may offer the best insight.

Generally, ROIC should be higher than the cost of capital. If it is, then the company is increasing its value by the difference between the ROIC and its cost of capital. In the table below I give the ROIC for Netflix and other companies that are competitors or future competitors (courtesy the Wall Street Journal):


Netflix

Amazon

Apple

Google

ROIC (%)

1.03

-0.38

42.84

15.88

P/E for 2013 Q1

788.8

-2908

10.08

27.03

I've included the other companies for comparison because they already distribute video content through online stores and therefore have the necessary infrastructure (massive server farms) and software capabilities to provide a subscription streaming service like Netflix. Amazon even offers a Netflix-like subscription service through Amazon Prime as well as rental and purchase content. As I discuss below, Apple and Google may join Amazon in this "hybrid" approach.

Netflix isn't the worst in ROIC, but its 1% ROIC is well below its current cost of capital. In February 2013 Netflix issued $500 million in Senior Notes at 5.375% interest.

Future ROIC Performance

Even though Netflix doesn't perform particularly well in ROIC at the moment, it could be argued that Netflix is growing so fast that eventually ROIC will improve. This is true, but there is a caveat: if operating margin stays constant, then ROIC doesn't improve enough to matter. Operating margin, currently a meager 3%, is critical for Netflix.

To illustrate how critical operating margin will be to future ROIC performance, I put together a simplified spreadsheet model to calculate ROIC based on three scenarios:

1) Idealized 2013 Q1: a point of departure that represents ROIC performance without some one-time only charges. Together with the quarterly interest on the new 5.375% Senior Notes, these pretty much wiped out the operating profit of $32 million. ROIC is calculated as Net Income (after taxes)/Invested Capital.

2) Future performance, constant margin: assumes a doubling of revenue, but operating margin is still 3%. ROIC increases to 2.41%.

3) Future performance, constant operating cost: once again, revenues double, but operating costs are held essentially constant. ROIC increases to 13.63%.

In fact, the prospects for the constant operating cost scenario are dim, since Netflix operating costs have historically grown at a pace equal to or greater than revenue growth. But even in this scenario, the company's value doesn't really catches up to its price, and its P/E of 60 is still quite a bit higher that the other companies I listed.

Future Competition

Achieving a competitive ROIC will only become more difficult as better funded competitors introduce subscription streaming services of their own. If we include online rental and purchased content, then Netflix already has significant competition for the consumer's online entertainment dollar from the companies listed in the table.

Amazon hosts the Netflix domestic streaming service through Amazon Web Hosting, so they clearly have the technical capability to compete with Netflix. Amazon has also started offering as part of its Amazon Prime service ($80/year) unlimited streaming of selected movie and TV titles. While the web interface is primitive, the Amazon Instant Video app for iOS works well, and Instant Video is also available on other devices such as Sony Blu-ray players. On the Sony, Instant Video allows the watching of Amazon Prime titles as well as renting or purchasing many other titles available for download.

This hybrid approach is probably the future for online content providers such as Google and Apple. Google has already started experimenting with the subscription model through YouTube subscription channels and has a lucrative content store in Google Play that could also host a subscription service. In Q1, Google made about $1 billion in revenue from Google Play (including all goods and services).

Google also announced a subscription music service at Google IO called Google All Access. Clearly Google is interested in the subscription content provider model. With an audience of roughly 750 million Android device users, many using the Netflix Android app, a Google subscription video service would help Google improve monetization of its Android devices, a high priority.

Apple also appears well positioned to offer a subscription streaming service if it so chooses. The iTunes segment generated $4.1 billion in revenue in 2013 Q1, and it reaches beyond Mac OS and iOS with the PC version of iTunes. With roughly 500 million iOS users, Apple has a ready market for a subscription video service. Such a service would undoubtedly be integrated into iTunes for a "hybrid" service of unlimited streaming, rentals, and purchases.

So far, Apple has been content with the rental/purchase model, but this may change with the arrival of an Apple Television. An iTV just cries out for a subscription service in order to ensure that the iTV is (almost) always showing Apple-provided content.

Opportune Profit-taking

Given the enormous run-up of the stock and the vulnerability of Netflix to competition, I think it's time to cash out of Netflix. You might miss out on a little additional upside, but you'll be glad when the Netflix bubble bursts.