For consumer electronics companies, the Holy Grail is a “new category” -- fresh, unexplored territory rich in the opportunity to sell millions of new devices and billions of software downloads. A new category also gives companies the opportunity to deepen their “ecosystems” -- the interlocking suite of devices and services that keep consumers in a happy garden where they contentedly graze on the products of a single company. Apple (AAPL) and Google (GOOG) have been the most successful thus far, together dominating the new category created by the launch of Apple’s iPhone in 2007.
It’s hard to overstate the technological and social significance of the arrival of the smartphone era. Both commerce and social life are being reshaped by these devices in profound and unpredictable ways. The arrival of the smartphone has meant that computers, after long gestation in the form of mainframes, PCs, and laptops, have become genuinely personal and easily portable. This means in turn that the possibilities for the transformation of human life that computers have always represented are now being realized with exponential acceleration. The smartphone -- the first example of a portable universal supercomputer -- is already the iconic device of the 21st century.
We pointed out in this letter on January 29 that ultimately we will interact with our personal smart devices (and through them, with the entire cloud) not through a discrete controller that we hold in our hand, but through augmented reality. That will mean the integration of our physical surroundings with a projected layer of holographic images, with which we interact gesturally. Our entire perceptual sphere will become the field within which we interact with our device. This will be the kind of system of which GOOG’s now-defunct Glass project was an embryo. We think GOOG, as well as AAPL, Microsoft (MSFT) , Facebook (FB) , and others, are all pursuing such technology. When it will arrive, we don’t know. You could call it the “omega point” of personal computing, where the physical world we inhabit is blended seamlessly with the cloud.
However, there will be other stopping-points before we arrive at that future. Those stopping-points will involve the manufacture and sale of billions of devices. Even the “commoditization” of smartphones is a relative affair; with two billion smartphones currently in use, analysts estimate another two billion will be sold by the end of the decade. Of course, the saturation is greatest in the most technologically and economically developed countries, especially in North America, Europe, and developed Asia. However, saturation is still relatively far off in the developing world -- in India, China, the rest of developing Asia, much of Latin America, Africa, and most of the Middle East. New manufacturers of cheap devices such as China’s Xiaomi may seize much of that market share. Telecom infrastructure build out still presents opportunities, as the stream of data becomes larger and the pipes carrying it likewise need to expand -- with India being a particular case in point. Narendra Modi’s emphasis on infrastructure and his desire to bring rural Indians into a manufacturing economy suggest that both smart device penetration and telecom infrastructure build out could accelerate in India over the next several years.
Smart Devices -- New and Smaller
So even though we are headed toward a future where “the device” as a discrete object you use your hands to interact with will disappear, a lot of devices are still going to get made and sold before we get there. We have now seen two disruptive devices from AAPL -- the iPhone and the iPad. We’d like to observe that many analysts believed at the time of their launch that these devices would be failures, and that they would not secure wide adoption. Instead they have ushered in fundamental changes in human behavior and spawned new global systems of commerce and communication.
The smartphone -- a candy-bar sized block of semiconductors in a case with a touchscreen -- will not be the last form that personal smart devices take before they disappear into augmented reality’s world of seamless integration. Billions of devices will be made and sold, and they may not look like smartphones.
All of this brings us to the “bridge” between the smartphone in your pocket and the all-embracing world of augmented reality that’s coming -- and that bridge is wearables.
On Monday, Apple (AAPL) revealed details about the much-anticipated Apple Watch. Apple Watch is another Apple product that has analysts questioning its viability. Indeed, some of the specifications of the Watch were a disappointment. Users had hoped for a comprehensive suite of sensors that would give it robust functionality in health and fitness monitoring; the announced device will have some but not others (for example, a heart rate sensor, but not a blood pressure sensor). The apps that would give you or your physician advance warning of a heart attack or stroke are still, sadly, just hopes for the future.
However, we believe that the Apple Watch will be a success for AAPL, and we also believe that, like the iPhone, it will blaze a trail that other device manufacturers will follow. In fact, in this case, other manufacturers have already produced wearables like the Apple Watch -- including Samsung, LG, and Lenovo.
However, AAPL’s design is likely to make a difference -- and adoption of the Apple Watch will pave the way for competitors. Perhaps those competitors will ultimately take most of the share in terms of devices sold, as AAPL’s competitors have done with smartphones. But we see several trends that will protect AAPL:
1. AAPL is an extraordinarily valuable brand, and the release of a very high-end edition of the Apple Watch is a symbol of AAPL’s association with status and luxury. No one expects AAPL to sell many of its $10,000 gold Watches -- but those watches underline the appeal AAPL products have to consumers. Some analysts expect the Apple Watch to sell 30 million units (mostly the cheaper Sport model) in 2015. AAPL’s brand appeal and its well-cemented reputation for top-quality hardware mean that it is becoming as much a luxury brand as a tech brand -- and it is a luxury brand that is accessible to the mass of global consumers.
2. The upcoming release of the Watch already had app developers working feverishly. The launch of the Watch will, like the launch of the iPhone itself, encourage the development of a host of applications that we need, but don’t at the moment know we need. In short, the Watch will deepen the AAPL ecosystem -- especially as future Watch models incorporate more advanced sensor functionality.
3. We think that the incremental ease of use of the Watch will draw users. Push notifications will become easier and smoother to interact with; we think users will be happy to leave their iPhone in a pocket or briefcase or purse, and interact with their Watch. This promises to be an especially effective synergy with Apple Pay, which will now become accessible to Watch owners whose older iPhone lacks near-field communication and Apple Pay functionality. We continue to believe that the Apple Pay rollout will ultimately prove to have been a watershed in the adoption of mobile payment systems.
Investment summary: All stocks are subject to correction. However, we believe that AAPL is attractively priced relative to its peers and continuing to demonstrate that it has a finger on the pulse of consumer demand. We also believe that the launch of AAPL’s smartwatch could mark the true advent of wearables as a significant new category in smart devices. Note: GIM owns AAPL for some clients.
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