This piece was initially published on Andrew’s Substack, Field Day.
This week, longtime Apple analyst Katie Huberty at Morgan Stanley discussed her views on Apple entering the car market. She argues that Apple will eventually build its own ‘Apple Car’ with differentiated hardware, software, and services. I agree and here’s why:
Getting hardware + software + services right is easier said than done. Apple is one of a few companies that consistently deliver excellent hardware + software + services. This rare competency has driven success with iPhone and will likely do the same with Apple Car.
A quick look at three case studies reveals an obvious pattern: Incumbents are replaced when new market entrants get the combination of hardware + software + services right.
1. Apple – iPhone – Smartphone Market
During the iPhone launch keynote in 2007, Jobs quoted Alan Kay’s insight from 30 years prior:
“People who are really serious about software should make their own hardware.”
Embedded in Kay’s insight is the primacy of software. If the objective is to build great software, then dedicated hardware should also be built. And the primacy of software is why smartphone hardware makers struggled to compete with Apple — not the other way around.
Software drives the experience and hardware needs to get out of the way.
Notice how great software makers remove buttons from the hardware, solving for those features with great software instead.
Apple started to deliver exceptional services with the launch of the App Store a year after the iPhone’s release. It was a natural extension of a large and growing user base using iPhone hardware and software.
More than a decade later, the Services category represents about 20% of Apple’s revenue. Clearly, Tim Cook has fully embraced Kay’s insight and Jobs’ vision. More specifically, Cook has extended Jobs’ hardware + software paradigm with the addition of services.
In response to a question from Katy Huberty, in fact, during the company’s Q1 2021 earnings call, Cook said:
“The kind of things that we love to work on are those where there’s a requirement for hardware, software and services to come together because we believe that the magic really occurs at that intersection.”
2. Peloton – Bike – Fitness Equipment Market
Peloton could have delivered a good product with nothing more than an app. Born three years after the advent of the App Store, most fitness equipment makers were already shipping bikes with built-in phone and tablet holders.
Users were watching Netflix as they biked, and fitness equipment makers were leaving profitable revenue from their own content on the table. It was quite literally right in front of their faces.
In the spirit of Alan Kay, Peloton aimed to deliver a superior software experience so they built their own hardware. And while subscriptions only represent about 20% of Peloton’s revenue, the software and content is what differentiates the hardware offering and drives the entire value proposition.
I recently had the opportunity to try a Tonal and my takeaway was that Peloton will likely deliver a superior strength machine. The Tonal hardware is great, the software is good, and the service (content) is also pretty good. But Tonal seems to lack that magical trifecta of great hardware and great software and great service (content). The software and content are so difficult to execute well, it’s important to fully appreciate the rare combination.
3. Tesla – Model S – Automotive Market
In 2010 Tesla became the first US automaker to go public since Ford’s IPO in 1956. Tesla fundamentally reinvented the car as a combination of hardware + software + services to displace legacy automakers.
Early Tesla drivers noticed that it was “just a big screen.” The Model S hardware seemed built around a software experience first and foremost. The wisdom of Alan Kay strikes again.
Tesla has earned dominant market share among electric vehicle makers with superior hardware and software. Now, services (FSD subscriptions, robotaxi services, and Tesla insurance) are a natural extension.
Thoughts on Apple Car
Apple’s CarPlay may be the best counterexample of why Apple will succeed if and when they make their own car. Software alone is not enough, but software married with hardware married with services elevates the user experience.
Another relevant quote from Tim Cook, also in response to Katy Huberty’s question on the Q1 earnings call:
“We ask ourselves if we can do something better. If we can deliver a better product. If we can buy something in the market and it’s great and it’s as good as what we can do, we’re going to buy it. We’ll only enter where we have an ability to do something better and therefore make a better product for the user.”
Taking the full context of Cook’s response into consideration, transportation is an obvious area of opportunity for Apple.
- Tesla has proven that the user experience in a car benefits from the tight integration of hardware + software + services. This truth will be increasingly important as the market transitions to electric, autonomous vehicles, and offers more opportunities for automakers to provide related services.
- The market is huge and the nature of the product leaves room for several big players to succeed. At Loup, we’ve estimated that the global market for new passenger cars is about $1.7T annually, not including services. Cars are an outward expression of someone’s identity, much more so than a phone, for example. This leaves room for a wide range of brands to thrive, even if Apple appears to be late to the party (like they did with smartphones).
- Can Apple “do something better”? In theory, Apple’s track record of executing complex combinations of hardware + software + services suggests that the company can indeed deliver something better in the car market. In practice, this is the crux of a trillion dollar question.
Paraphrasing the Cook doctrine outlined above, Apple will only enter the market once they believe they can win, once they have an unfair advantage. In my view, it’s more a question of ‘when?’ not ‘if?’.
Apple has made two changes in the past week related to steering, most recently making it easier for media app developers to build a direct payment relationship with the user. The first change was news worthy and the second was investor worthy. There will likely be more changes to come, given it will likely take years to define the long-term app store policies for the tech industry. The bottom line, Apple and other tech companies will likely have to make further app store policy concessions, and investors will largely look through these developments given once the company anniversaries changes, app store growth rates should return to pre-regulation levels.
The App Store is financially important
I approach the question about the impact to Apple’s model by framing how much of Apple’s business is directly related to apps. For starters, the Services business accounts for about 20% of revenue. I believe apps account for about a third of Services revenue, or about 7% of total company revenue. Since Services gross margin is double the company average, it’s appropriate to model apps account for about 14% of total profits. Based on Apple public filings related to the Epic trail, I believe media related apps account for about 15% of app revenue, or 1% of overall revenue, and games account for the vast majority (70%-80%) of app billings (based on fillings from the Apple v. Epic trial). I believe it’s wise to anticipate that eventually gaming apps will also be allowed to steer toward off-platform payments.
Users will likely stay in the garden
A fundamental question is whether Apple users will continue to transact in the walled garden if they have an option to transact directly with the app developer. Our belief is the vast majority of users will stay within the Apple payment and app ecosystem because it’s more secure and easier. Developers should favor transacting within the garden because paid customer conversion will be higher given the ease of payment Apple enables.
Even if the take rate bends, growth will return to the App Store
I believe the 30% and 15% take rates will hold for the next five years plus. If I’m wrong, and Apple has to lower its take rate, it will create a one year headwind to the Services segment growth rate. This is a similar headwind Amazon experienced when it was forced to start collecting taxes on all sales. The path is predictable: growth dips in the first year after the change, then steps back up to a level similar to where it was before the change. Investors understand this dyammic and will likely largely give Apple a pass on any further changes to app store policies.
For twenty years, the team at Loup has had a pulse on technology and a point of view on how that tech will change the world. The cutting edge of that change is frontier tech, driven today by AI, fintech, robotics, autonomous and electric vehicles, and virtual/augmented reality. We provide exposure to these themes through our partners at Innovator Capital Management. For more information click here.
Why Frontier Tech?
Frontier tech represents the forward-most edge of understanding and achievement in technology. By definition, what is frontier today will not be frontier tomorrow—it is dynamic. These are the technologies with the greatest opportunity to create value for investors.
Loup Frontier Tech Benchmark
Here is the Loup Frontier Tech Index performance update as of August 31, 2021:
What’s on our minds this month
Two Chinese companies, Baidu and Huya, represent about 9% of the Loup Frontier Tech Index. These stocks have traded down significantly year-to-date as investors braced for regulation around gaming, along with a confrontational posture from the Chinese government toward tech companies. The recent clarity on gaming rules, which prohibit students in China from gaming Monday through Thursday, was positively received by investors given the unknown around impending regulation is now known. Over the last decade of following Chinese internet companies, we’ve seen a pattern of initial investor concern around regulation, followed by six months of relief as the details are clarified. In the years ahead, we expect this cycle to continue and we believe the long-term potential in China outweighs the risks.
Separately, Affirm Holdings (4.5% of the index) signed a deal with Amazon. Shares moved up about 40% on the news.
Changes to the Loup Frontier Tech Index
GXO Logistics (NYSE: GXO). The only change this month was swapping XPO Logistics with GXO Logistics, which was a spin-off from XPO. GXO is an intelligent warehouse management business that will build into the robotics fulfillment theme. The company’s two largest customers are Apple and Nike, managing their fulfillment operations.
Top 10 Holdings (Weighting as of August 31, 2021)
- Harmonic Drive Systems Inc, 4.79%
- Snap Inc, 4.72%
- Baidu Inc, 4.55%
- Affirm Holdings Inc, 4.49%
- HUYA Inc, 4.38%
- SK Hynix Inc, 4.35%
- GXO Logistics, 3.89%
- Unity Software Inc, 3.40%
- Lumentum Holdings Inc, 3.21%
- Pegasystems Inc, 3.19%
Weight by Theme
- VR/AR – 39.5%
- AI – 19.5%
- Robotics – 14.5%
- Fintech– 16.0%
- EVs/AVs– 10.5%
The Loup Frontier Tech Index tracks the performance of publicly traded companies developing frontier technologies including, but not limited to, AI, fintech, robotics, autonomous and electric vehicles, and virtual/augmented reality. We’ve licensed the index to Innovator Capital Management. For more information click here.
Register for our next Tech Roundtable with the Loup team, a quarterly webinar to discuss the latest in frontier tech.