Apple and the EU

Apple and the EU

This morning’s EU action against Apple wasn’t a complete shock — the Financial Times previewed the substance yesterday, though not the amount. Regardless, just as they have in the past claimed expertise of patent law, encryption, automotive manufacturing, or the jewelry market, today everyone who covers tech is suddenly an EU tax expert.

In talking to the reporters who’ve approached me to talk about this today, I’ve tried to avoid diving into that fray. The complexities of the tax arrangements described in the EU press release are dizzying, but represent just a summary of what’s an intricate set of financial arrangements intended to allow Apple to carry out its European tax strategy. None of us not trained in EU tax law should attempt to draw conclusions about the specifics of the accounting structures here. We’re simply not qualified. Apple and the Irish authorities – both of whom obviously have very competent people on staff – have apparently reached different conclusions here from the EU’s staff, and they’re all experts.

But it is possible for non-experts to have an opinion on the reasonableness of the approach the EU is taking here. Apple has acted in good faith throughout, working with the Irish authorities to secure “comfort letters” assuring the company that its behavior was appropriate and conformed to applicable laws regulations in place at the time. The EU now wants to come in after the fact and change the basis on which Apple should be taxed in a key European jurisdiction.

The period in question is 2003 to 2014, meaning that the EU wants to reverse the basis on which Apple paid taxes in Ireland up to thirteen years ago, under agreements that were first made in 1991. If the EU objected to these arrangements then, it should have investigated them then, and not have waited until so long after the fact to look into them. But of course Apple wasn’t nearly as big a target then (or even in 2003) as it is now, and this is where the politics come in.

Apple has, of course, long communicated its approach to this issue. Since its products are conceived and designed in the US, and its software built here, it should pay the bulk of its taxes in the US. It doesn’t consider the current US tax regime favorable, and so has chosen to maintain much of its cash and other liquid assets overseas until such a time as it makes financial sense to repatriate it. But as its investor FAQ on the topic makes clear, it has “previously accrued U.S. taxes related to the income in question.”

This is the key point here — I’ve seen Apple’s European tax strategy described as one for tax avoidance, but this isn’t actually about avoiding paying tax (though it — like all responsible companies — pays the minimum amount possible under applicable laws). It’s about Apple choosing to pay taxes (the full amount due) in the appropriate jurisdiction. Apple will eventually have to pay taxes on the full amount earned in Europe and elsewhere in the world, but it believes that the US is the proper jurisdiction in which to do so. There’s currently a lot of that money overseas on which it hasn’t yet paid taxes, but it won’t escape taxation entirely or indefinitely.

Ultimately, this case — like so many others – comes down to your perspective and preexisting notions. If you’re inclined to believe that big US tech companies don’t pay enough taxes in Europe, this likely confirms that view and makes it official. On the other hand, if you’re more inclined to believe that the EU uses its various investigations as a way to handicap big US tech companies who are more successful than European equivalents, there’s more evidence here for you too. None of this is settled yet, and we’ll have years of court cases before this is decided, but even in the short term I suspect we’ll see lots of non-European companies rethinking their investment strategies for the EU in light of the ruling.

Five Years of Tim Cook’s Apple in Charts

This week marks the fifth anniversary of Tim Cook’s appointment as permanent CEO at Apple – he was appointed CEO on August 24th, 2011. As a result, we’ll no doubt see quite a few retrospectives this week looking back over his time at Apple, and evaluating his tenure. As context for that analysis, I wanted to share some numbers about Apple in the quarter and year before he took over, and compare it with numbers for the quarter and year ending in June of this year. Not all the applicable data sets go back that far – Apple has changed its reporting segments in at least a couple of ways during this five year period, but we’ll mostly try to compare before and after as closely as possible.

Note: here as in all the analysis on this blog, I use calendar quarters rather than companies’ fiscal quarters for analysis for ease of comprehension by those not familiar with companies’ fiscal calendars – hence, Q2 2016 is the June quarter recently ended and reported. Many of the charts shown here are part of the Apple quarterly deck which is available as part of the Jackdaw Research Quarterly Decks Service, which you can read more about here. The underlying data is also available on a custom basis as either a one-off delivery or a quarterly service – please contact me for more information.

P&L measures

Let’s start with the corporate income statement. By any measure, Apple is simply a lot larger than it was five years ago. Here are trailing 4-quarter revenues:

Trailing 4 quarter revenue 560

Revenues in the four quarters before Tim Cook was appointed were $100 billion, whereas in the last four quarters they were over $200 billion. However, as you can see from the chart, it hasn’t been an inexorable rise up and to the right. Revenues grew very strongly in that first period, then began to level off somewhat throughout 2012 and 2013, then spiked following the iPhone 6 launch. And of course over the past year revenue growth has been negative for the first time in many years at Apple. The overall effect is still a more than doubling of total revenue, but the current trajectory is negative. As I’ve written previously, I continue to believe that we’ll see a reversal of this trend in the next few quarters as a combination of factors kicks in, but I’m betting Tim Cook would have rather his 5 year anniversary would have fallen either side of this lull instead of in the middle of it.

Meanwhile, margins have been up and down over time, with a bump in the early part of Tim Cook’s time at the helm, followed by a drop down to slightly lower levels, a steady rise, and then a drop off again:

Trailing 4 quarter margins 560

The ups and downs here largely correlate to overall growth rates for Apple, with higher revenue growth rates driving higher margins for a time as cost expansion takes a while to catch up with revenue growth, only to fall again as growth slows. On operating and net margin, Apple has ended these five years slightly below where it started, whereas on gross margin it’s in more or less the same place. But it’s worth noting that dollar profits are still way up on where they were, and that’s the metric that Apple and its investors are likely more focused on:

Trailing 4 quarter operating income 560

Yes, there’s the same up-and-down pattern, but again operating income on a twelve-month basis is roughly twice what it was five years ago over the past year.

R&D spend has ballooned

The only other line from the income statement I want to zero in on is research and development spending, because there’s been a fairly dramatic change here over the past five years. Here’s total R&D spend in dollars on a twelve-month basis, and spending as a percentage of revenue:

Trailing 4 quarter R and D spend 560 Trailing 4 quarter R and D spend as percent 560

R&D spend was under $2.5 billion the four quarters before Tim Cook took over, but it was almost $10 billion five years later, a roughly fourfold increase. And that’s not just because Apple’s revenue has grown during that time – R&D has actually grown significantly as a percentage of revenue over the same period, going from just over 2% to just over 4%, or almost doubling as a percentage. That’s interesting, because R&D actually fell fairly consistently as a percentage of revenue during most of Steve Jobs’ second stint as Apple CEO, from a peak of 8% in 2001 and 2002 all the way down to 2% just before Cook took over. That’s largely a function of the massive iPod- and iPhone-driven revenue growth during that period – dollar R&D spend rose from around $400 million a year to over $2 billion a year during the same time period – but it’s interesting to note that Cook has reversed the trend and significantly increased R&D spend even above and beyond the rate at which revenue has grown. Interestingly, that 2 percentage point increase in R&D spend is roughly equal to the 2 percentage point drop in margins during the Tim Cook era.

The cash hoard grows

The other major corporate financial metric that’s worth a quick look is cash. Apple’s cash and investment assets have grown enormously over the past five years, as the two charts below show:

Cash metrics 560Cash metrics two quarter only 560

The starting and ending totals are easier to see in the second chart, but the steady growth is perhaps easier to see in the first. Regardless, Apple ended calendar Q2 2011 with a total balance of cash and investments of $76 billion, while it ended Q2 2016 with a balance of $231.5 billion. In other words, it has added over $155 billion to its coffers over this time. Meanwhile, an increasing proportion of this cash and investments has been held overseas – the percentage was 63% five years ago, but was 93% at the end of Q2 2016.

Of course, the other cash-related metric worth noting during the first five years of the Cook era is the way Apple has been using that cash to pay dividends and buy back stock. Steve Jobs famously refused to pay dividends, but around a year into his tenure, Tim Cook instituted both these programs to return cash to shareholders. As of April of this year, Apple said it had “returned over $163 billion to shareholders, including $117 billion in share repurchases.” That makes the increase in its overall pile of cash and investments all the more remarkable.

Unit shipments are up for iPhone, less so for other products

One of the most interesting things to look at in regard to the last five years is what’s happened to unit shipments for Apple’s three major product lines. The long-term trend is shown in this first chart:

Trailing 4 quarter unit shipments 560

Again, we’re all familiar with the trajectory of iPhone sales over recent years, so let’s be brief here. It’s worth noting that Tim Cook’s appointment coincided with the decision to move the launch date for new iPhones from June to the Fall, with the iPhone 4s launching in October of 2011. That explains the flat part at the beginning of the iPhone chart above. Following that shift, though, the iPhone saw strong growth in 2012 and 2013, but began to flatten out, only to spike in late 2014 and into 2015 thanks to the iPhone 6, then slumping a little in late 2015 and the first half of 2016. But again, it’s worth looking at the total numbers here. Apple shipped 69 million iPhones in the four quarters to Q2 2011, and shipped 214 million in the most recent four quarters. That’s a massive expansion of Apple’s business here, despite the recent lull (shipments peaked at 231.5 million on a twelve month basis in Q4 2015).

It’s also interesting to note that Apple has shipped 859 million iPhones during the Tim Cook era, compared with just 130 million in the pre-Cook era. In other words, roughly 87% of the almost one billion iPhones Apple has ever sold have been sold during Tim Cook’s time as permanent CEO.

What’s almost more interesting, though, is what’s happened to Mac and iPad sales, which performed roughly the same in the most recent quarter as they did five years ago:

Unit shipments for two quarters 560

As you can see, both Mac and iPad sales were up just a few hundred thousand on those from five years earlier, despite the doubling of iPhone sales over the same period. As the earlier chart shows, for iPads that’s because sales first grew significantly, peaking at 26 million quarterly and 74 million over twelve months in Q4 2013 and falling since.  Mac sales, too, have had better quarters than the most recent one, though the peak was not  much higher than today. Both products are due for something of a rebound in the coming quarters, as new Mac are (hopefully) finally introduced and the iPad Pro trend continues to help sales. And it’s worth noting that 300 of the roughly 330 million total iPads sold to date have been sold under Tim Cook, along with almost 112 million Macs.

Of course, we don’t have official shipment numbers for the Apple Watch, though there are various estimates out there. But it would be inappropriate to skip over that product entirely – it was the first brand-new product introduced in the Tim Cook era, and likely sold around 15 million units in its first year on the market. That’s a much faster run-rate than the iPhone, but down a little at this point on iPad sales in their first year. But it’s interesting that, as Tim Cook marks his five year anniversary, we’re seeing another product whose launch timeframe is being moved from the first half to the second half of the year, causing something of a lull in sales in the meantime.

A changing mix of segment revenues

All that movement in unit shipments obviously flows through to product revenues too. The revenue split by segment has changed fairly significantly over Tim Cook’s tenure. Apple’s financial reporting by segment has also changed over the last five years, with the iPod no longer separated out as its own reporting line, the Accessories bucket being merged with iPod, Apple Watch, Apple into “Other Products” and “iTunes, Software, and Services” becoming just “Services”. In the chart below, I’ve collapsed these segments for comparability:Revenue split by segment 560

The iPhone, which was already a very significant portion of Apple’s overall revenue, has only become more dominant over the past five years, rising from 45% of revenue in the twelve months to Q2 2011 to 64% in the year to Q2 2016. But other components have also risen or fallen – iPad has dropped from 16% to 9% and Mac from 20% to 11%, while the combination of iPod, accessories, and various other hardware products has dropped quite a bit too. The only other segment that’s risen as a portion of the total during this time – despite the rapid growth of iPhone revenues – is Services. An increase from 9% to 10% of revenue doesn’t look like much, but it’s much more impressive when you look at the dollar amounts instead:Trailing 4 quarter Services revenue 560

What’s now the Services segment has grown from under $10 billion in the twelve months to Q2 2011 to well over $20 billion in the most recent twelve months, with the trajectory actually steepening in recent quarters. Yes, it’s still just 10% of total revenue over the past year, but it’s actually Apple’s fastest-growing segment at the moment.

The other interesting thing to look at in the context of segment revenue is the difference between unit shipments and revenue performance, which is driven by changing average selling prices (ASPs). You can see it a little in iPhone revenues:

Trailing 4 quarter iPhone revenue 560By now, that iPhone trajectory should be familiar, but it’s worth noting the growth – from just over $40 billion on a twelve-month basis to $140 billion. It’s subtle, but the 3.1x growth in shipments has translated into a 3.5x growth in revenue, and that’s largely down to ASPs. Here are average selling prices on a trailing 4-quarter basis for the three major product lines at the beginning and end of Tim Cook’s first five years – note that because of changes in reporting structures I’ve used Q3 rather than Q2 2011 as the starting point here:Trailing 4 quarter ASP 560

As you can see, iPhone ASPs have risen over the five years despite the increasing maturity of the product and the introduction of two cheaper models (the iPhone 5c and more recently the iPhone SE). Mac ASPs have dropped, but only slightly, while iPad ASPs have dropped fairly significantly, driven by the launch of the iPad Mini in 2012 and the increasing tendency to keep older devices in the lineup for longer at lower prices. But something interesting has been happening to iPad revenues in recent quarters, even as shipments continue to fall year on year:

Trailing 4 quarter iPad revenue 560

This flattening of revenues, and the growth this past quarter, has been driven by the iPad Pro, which has raised ASPs considerably. iPad ASPs bottomed out at around $415 a year ago, but were $490 in Q2 2016, up $60 from Q1, putting them back at late 2012 levels.



Regional trends and the rise of China

One of the most dramatic changes at Apple in the Tim Cook era has been the rise of China as one of its two major markets. Here, again, unfortunately, we’re thwarted a little by a change in Apple’s reporting a few years back, in which it eliminated Retail as a separate segment and rolled it into the individual regions, so we’re going to use Q4 rather than Q2 2011 as our starting point, and for comparability we’ll use Q4 2015 as the end point. As such, we’re measuring a four-year rather than five-year period, but the changes are still very visible. Here’s the share of Apple’s revenue by region at those two points in time:Apple revenue by region 560

As you can see, Greater China has increased massively as a proportion of revenue over this period, going from 10% to 24% of revenues, while every other region has shrunk in percentage terms. In Q4 2015, Greater China contributed the same percentage of revenue as Europe. Looking at the dollar amounts is again helpful – here’s actual revenue by region for those two quarters:

Apple revenue in dollars by region 560

It’s worth noting first that every region has grown during these four years, but Greater China has clearly grown far faster than any other region, from $4.5 billion to over $18 billion during this time. That’s massive growth, and I’d say it’s one of Tim Cook’s great achievements during his tenure. It’s also clearly something he hasn’t given up on, given his recent frequent visits to China and the investments in Didi and in an R&D center to be built there. It’s also worth looking at operating income by geography, because here too China has made a significant contribution:

Apple operating income by region 560

Retail is far more international

I want to close out with Apple’s retail business, which gets less attention in Apple’s official reporting than it used to, since Retail has been wrapped into the regions, but is as important to Apple’s strategy as ever. And Tim Cook has been instrumental in expanding the Retail footprint, especially overseas, though Retail has also been the focal point of arguably Cook’s biggest blunder as CEO – the appointment of John Browett to run the business. However, Angela Ahrendts’ appointment seems to have more than made up for that mistake.

Here are a couple of charts about Apple’s retail footprint:

Retail stores by geography 560 Split of Apple retail stores by geography 560

At the end of Q2 2011, Apple had a total of 327 retail stores, of which 270 or 72% were in the US. By the end of Q2 2016, Apple had 488 stores globally, of which 218 or 45% were now overseas. Tim Cook’s time as CEO has seen Apple stores opened in seven new countries across four continents:New Apple Retail countries 560But of course it’s also seen a massive expansion in the number of Apple stores in China, which had 36 stores as of the end of July, up from single digits when Tim Cook took over.


I’ve deliberately made this more of a factual post than an evaluation of Tim Cook’s tenure – as I said up front, this week will see lots of this sort of stuff, and I’ve already talked to several reporters doing their best to sum up five years of work in a few hundred words. But I think it’s worth noting several things here, some of which I’ve mentioned in the text:

  • Apple under Tim Cook has sold far more iPhones and iPads than it ever did under Steve Jobs – 87% of total iPhones sold and 90% of iPads ever sold. Though Steve Jobs launched these products, it was always Tim Cook who ensured the supply chain met demand as well as possible, and it’s been Tim Cook who’s overseen the massive expansion in that supply chain over the last five years as the scale has grown to something unprecedented.
  • Tim Cook has made the decision to increase Apple’s spending on research and development not just in dollar terms commensurate with revenue growth but actually doubling it as a percentage of revenue during his tenure despite the massive growth in revenue. That reversed the trend under Steve Jobs, and the increased investment in R&D is roughly equivalent to the drop in margins during this time – Cook has made a massive bet on R&D and by implication on future products.
  • Cook has made China a special focus, and this focus has paid off in a big way, with a roughly fourfold increase in revenue from Greater China and an equivalent increase in operating income. Greater China has grown from 10% of revenues to roughly a quarter, and Apple’s retail footprint there has also grown dramatically. That growth in China has been a major contributor to Apple’s overall growth in the last five years, and Cook clearly remains committed to China as a focus for Apple as evidenced by his recent investments there. He’s begun to talk more about India and its potential, but I remain skeptical that India can be much more than a rounding error for Apple over the next few years.
  • Only one entirely new hardware product has launched under Tim Cook, and yet we have almost no official data to go on to evaluate the performance of the Apple Watch so far. Opinion remains divided about how to evaluate the Watch, but I’m on the side of those who considers it a modest success in Apple terms and a smash hit in the context of the market into which it was launched. Like the iPhone the year Tim Cook took over, it’s going through an interesting transition as its release moves from the first half to the second half of the year, but I suspect that like the iPhone in late 2011, the Watch is due for big growth in late 2016 and beyond.
  • I suspect the transformation we’ve seen in Services, driven largely to date by the App Store and latterly by Apple Music, is just the start of what we’ll see under Tim Cook. He’s already hinted several times at additional services to come, and TV is an obvious focus here. But I also think some of the rhetoric about Services has been overblown – it’s still only 10% of revenue, and unlikely to grow massively past that point unless Apple decouples services from its devices, which I think would be a mistake.

Perhaps one of the most significant contributions Tim Cook has made at Apple can’t be seen in any of these charts, because it’s about the changes to Apple’s culture that have happened under his leadership. The increased openness, best exemplified by the frequent interviews Cook and other executives now regularly grant to various publications (and even podcasters), is one element of this, though Apple’s secrecy about future products remains as tight as ever. But an increased sense of social responsibility, especially as regards the environment and contributions to social causes is another major change. This doesn’t have a direct financial impact, but it’s made a positive contribution nonetheless, and no evaluation of Cook’s tenure would be complete without a recognition of that fact.

Nougat Launch Highlights Android’s Slow Rollout

Google today released Android 7, codenamed Nougat. What this means in practical terms is that owners of recent Nexus devices can download and install the new version immediately, while the vast majority of Android device owners have to wait patiently for the update to be available for their device. This seems like a good time to revisit some of the stats around Android version adoption to put all this in context, because the reality is that it’ll likely be almost two years before even 50% of the base has access to the features in Nougat, while Nougat itself will likely never get above 40% penetration of the base.

For earlier posts on this topic, see:

Although those past posts have largely focused on the implications for developers, this time around I want to focus a little more on the implications for users.

Overview of Android version adoption

If you’re reading this, you’re likely familiar with how Android rollouts work, but here’s the process in brief:

  • Google finalizes and releases a new version
  • Device makers, who have had access to beta versions, work on customizing that final version to run on their various devices, incorporating their own software customizations, user interface elements, and so on
  • In the vast majority of cases, that updated software is sent to mobile carriers, who also have to spend time testing and approving the update
  • Once the device-specific version is approved by the mobile carrier, it is made available to users of that carrier.

The end result is a very slow rollout of new Android versions, when compared with, for example, Apple software releases, which are instantly available to all users everywhere on day 1, or even Microsoft’s Windows updates, which are available to consumers immediately at launch (although business users likely have to wait for their IT departments to approve and push out updates).

The history of what this process looks like in practice from a user adoption perspective is shown in the chart below:

Android Versions Overview 560px

I’ve grouped released into the major dessert-denominated categories so as to simplify things here. As you can see, there’s a clear pattern early on which morphs over time:

  • Early on (2009-2011), adoption quickly spikes to rates in the 60-70% range, falling gradually over time
  • Over time, the time to hit this milestone lengthens, but peak penetration remains similar (2012-2014)
  • More recently, peak penetration drops significantly, to around 40%, while the drop off happens more gradually too.

Let’s drill into all that a bit more. But first, a quick note on the quirks of how these versions have been released in the past. The chart below shows the gap in months between Android version releases, which has varied greatly over time:

Android Versions Months From Last Release 560pxEarly on, major new (“dessert”) releases showed up  every few months, with the C, D, and E releases following particularly quickly on each others’ heels, while the F-J releases came slightly less quickly, and the most recent releases have occurred a little either side of a year apart. It’s worth noting that the H release, which isn’t in the chart above, was for tablets only, while the I release converged the smartphone and tablet flavors, and also that the K release (KitKat) took a very long time to follow Jelly Bean, which as a result had that much more time to build a substantial base. This will be important context as we look at some of the trends below.

Peak penetration has fallen dramatically

To start with,  peak penetration rates – i.e. the maximum penetration of the Android base – have fallen dramatically with recent releases, as shown in the chart below:

Android Versions Highest Percentage 560pxThere are a couple of anomalies here, which mostly relate to the quirks of release timing and other details I just referred to. But in general it’s very clear that earlier releases hit peak penetration rates in the 60-70% range, while the two most recent releases have hit maximums of 41% and 36% respectively (Marshmallow hasn’t peaked yet).

Time to peak penetration is long

One of the reasons for the lower peak penetration rates is likely that adoption as a percentage of the base has been that much slower. The time taken to reach peak penetration has lengthened since those early days, despite the fact that peak penetration rates are lower. The chart below illustrates this:

Android Versions Months to Peak 560px

The pattern here is marred by a couple of outlier data points – notably the Gingerbread release, which took an unusually long time to reach peak penetration for an early release, and the Lollipop release, which did so quite quickly. But the trend is generally upward – early releases mostly took 10-12 months to hit their peak rates, while later releases have mostly taken 14-18 months to do so. That means releases often don’t peak until after a new version is released.

This is particularly striking right now, when Nougat is being released, but its predecessor Marshmallow is currently only the third most widespread version of Android, behind the two previous versions. The top version is actually the version from two years ago, while the next most popular version is the one from three years ago.Android Versions Ranking August 2016 560px

Put another way, the version of Android Google “released” in October last year is currently outranked by the version released in July 2012, as well as the versions released in October 2013 and November 2014. And of course that will be the case for the Nougat version too for the foreseeable future.

The user perspective – 18 months for the average user

As I mentioned up front, I’ve often focused in these analyses on the developer perspective – after all, targeting a base which is fragmented across so many different versions is tough. But Google has addressed that fragmentation at least in part over the last several years, and that path has been well trodden both by me and by others. Today, I instead want to focus on the user perspective – what does all this mean if you’re an Android user?

I think a useful way to think about this is how quickly a majority of Android users can expect to be able to experience the features and functionality in a new version of Android after it’s launched. The chart below shows how long it takes versions of Android to reach 50% penetration of the base from launch. Because recent versions have peaked before hitting 50%, I’ve included the combined total for that version and the subsequent version (which of course also offers those features):

Android Versions Months to 50pc 560px

As you can see, from the Eclair to Gingerbread releases, it took a year or less for new versions to reach 50% of the base. But the ICS release took 18 months to reach that milestone together with Jelly Bean, which itself took just a little less time to reach 50% on its own. And the KitKat and Lollipop releases took over 18 months to reach 50% of the base.

In other words, the average Android user can expect to wait over a year and a half (and probably six months from the release of the subsequent version) to be able to use the features in a new version of Android. If you factor in the months from when a new version is demoed on stage and announced at I/O or before, it could easily be two years before many users see these features.

No wonder Google appeared to de-emphasize the core features in the N release of Android at I/O this year. The core features of Android N for smartphones got just 14 minutes of stage time in the nearly 2 hour keynote – compare that to an hour for iOS at WWDC. And that makes sense if most users won’t see those features for two years.

But of course from a developer perspective it also applies to things like the VR features in the new version of Android, which also require new devices. The addressable market for Daydream on Android will be tiny for the foreseeable future – if Nougat adoption follows the path of the two previous releases, it can hope for roughly one-third penetration of the base in two years.

Uncovering the Reasons for T-Mobile’s One Launch

T-Mobile today announced its latest Un-Carrier move, Un-Carrier 12. The crux of the plan is new unlimited plans under the T-Mobile One brand. The headline from T-Mobile is about simplicity and unlimited for everyone, but the upshot of this new pricing is that the base price for postpaid at T-Mobile just went up quite significantly. And the reason for the move is that Un-Carrier is losing momentum and T-Mobile needs to boost growth again.

The context – slowing growth

I’ve written about this a little bit in the past, but here is the context: T-Mobile is losing momentum with its Un-Carrier moves. Two key metrics – postpaid phone net adds and porting ratios from other carriers – have both been falling.

The chart below shows postpaid phone net adds on a quarterly basis, with one line for each year, so you can see how each quarter compares to the year-ago quarter:

TMO phone net adds 560px

As you can see, the 2016 quarters so far are below Q1 and Q2 in 2015, while Q2 was also below 2013, and Q1 was below 2014. In 2015, every quarter but Q2 was below 2014 net adds. So there’s a very clear trend now that T-Mobile is adding fewer phones each quarter than a year earlier. If you strip out the exceptional Q2 2014, when phone net adds dipped, the trend is now clear for a year and a half.

Moving to porting ratios, which T-Mobile reports on its earnings calls, the trend there is fairly clear too. It reports porting ratios against each of the other three major carriers, as well as an overall porting ratio most quarters. An average of the three individual carriers’ porting ratios tends to track fairly closely against the overall porting ratio, so I’ve included that in the second chart below to fill in some gaps:

TMO porting ratios 560px

TMO porting ratios overall 560pxThat second chart is probably the easiest one to read, because the trend is so clear. The overall rate peaked in Q3 2014 at just under 2.5, and has fallen since to under 1.5. Against individual carriers, the biggest change in the last two years has been Sprint, whose troubles two and three years ago allowed T-Mobile to capture massive numbers of subscribers, but whose recent improvements have made that cherrypicking much harder. I’ll stop here with the context, but it should be clear by now that T-Mobile is having less and less success with adding new customers and winning subscribers from competitors as time goes on, as its various Un-Carrier moves offer diminishing returns.

T-Mobile One – simplicity at a cost

T-Mobile is selling simplicity here – that’s the headline. It will have one plan going forward, and that plan will be unlimited, with a pricing structure that’s extremely easy to understand. In the context of recent pricing moves from competitors, that’s admirable, and attractive to customers. Unlimited is the simplest message of all, and has huge appeal in the peace of mind it provides.

However, this change is coming at a significant price premium. T-Mobile’s current plans start at $50 for a single line, with 2GB of data.  A second line at that price costs $30 additionally, for $80 total. A third line is only $10, so $90 in total, and the same pricing continues for additional lines. Let’s compare this to the new pricing which will be offered from September 6, which will be the only pricing available for new customers:

TMO One Pricing 560px


The headline here is that, for the plans at 2GB and 6GB per line, the new pricing is more expensive, while for the plans at 10GB and the Unlimited plans, the new pricing is the same or cheaper. That’s significant, because T-Mobile says their most popular plans are the 6GB and 10GB plans, so a good chunk of their customers would be paying more on this plan, while many others would be paying roughly the same or slightly less. This helps to explain why T-Mobile says it doesn’t expect a meaningful change to its ARPU.

But of course for new customers, the starting point is now $70 rather than $50, meaning that the entry point for new customers has gone up by $20 for a single line. Put another way, competitors who previously matched T-Mobile’s entry pricing now undercut it by $20 (and Sprint has just launched new pricing today). So, even though the headline is all about simplicity and the gift of unlimited, the reality is that customers coming in at the low end will end up paying more than they would have before, and potentially more than they would at competitors.

The reason for the shift to unlimited

Here’s the rub, though, with this whole thing: T-Mobile introduced BingeOn, its video throttling strategy, a year ago. That did two things: it made it much more economical for T-Mobile to offer bigger and unlimited data plans, because it cut bandwidth usage dramatically; but it also meant that many customers who would otherwise have been on the standard trajectory of ever increasing usage pushing them into ever bigger data buckets instead went backwards. The same consumption of video suddenly drove far lower usage. The result is that T-Mobile doesn’t have the same driver of ARPU that almost every other carrier does, because it kneecapped data growth.

There’s an analog here with what happened with all the carriers a few years back when it became clear that voice and text usage were no longer going to grow as they had in the past, while data was going to continue to grow rapidly. At that point, the best move from a financial perspective was to move away from metered voice and text, because there was no longer upside for charging for every bit of usage, and instead only downside as usage dropped. On the other hand, it made sense to begin metering data and move away from unlimited plans, because that’s where the usage growth was, and where the future revenue opportunity would be too.

What T-Mobile is doing here is finding an alternative way to move people to higher tiered data plans even though they no longer need to. The appeal of unlimited is such that people will move to it even if they’re not close to hitting their current data cap, just for peace of mind. It’s even more likely that a T-Mobile customer would actually need to move to a higher plan when you consider that T-Mobile has offered Data Stash, which allows customers to roll over a data allowance over many months.

The cost of unlimited

T-Mobile made much today of the fact that its network was designed for unlimited, and that competitors’ networks were not. But that’s really another way of saying two things: T-Mobile is far smaller than its two major competitors, and so has far fewer customers on an national network, using far less data in aggregate; and with BingeOn, it’s reduced the data usage associated with video consumption by about two thirds.

But it’s not really about the network per se – it’s about the cost. Unlimited customers (for the most part) don’t actually use dramatic amounts of bandwidth in the average month. It’s likely that many of them would fit fine in the 5-20GB buckets offered by the carriers. But suddenly taking the limits off all customers risks significant increases in usage because it changes behavior dramatically, and that could incur significant costs in increased data capacity. So that’s a high-risk move, and it’s why most carriers don’t do this.

But anyone can offer unlimited if they price it right, which is why you see T-Mobile pricing it at roughly the same price as 10GB plans under its previous options. It’s also why streaming video up to 4K costs an additional $25 per line per month. There’s a cost to unlimited, and if it’s truly unlimited rather than being throttled to 480p, it costs more. This is really just a question of pricing, but that’s why T-Mobile’s pricing is going up here – it’s not magic, just economics.

A sign of confidence

The other thing that’s going on here is that T-Mobile is getting more confident in the performance of its network. One of the interesting facets of pricing in the US mobile market is that pricing power largely depends on perceptions of network performance. This is why Sprint can run campaigns offering 1% worse performance than Verizon at half the price and yet doesn’t see a massive influx of customers from its competitor. Network quality, but more importantly perception of network quality, requires certain carriers to charge less for the same services in order to win customers, while other carriers can charge more on the basis of their perceived better network quality.

Both Sprint and T-Mobile (and especially T-Mobile) have been increasing the quality of their networks in recent years, and perception on the T-Mobile side is finally starting to catch up with reality. It’s absolutely a sign of the company’s increased confidence in both its actual network and perceptions of its network that it’s willing to raise prices at this point. It clearly feels like it’s more able to compete with the big guys on network, and so can move its pricing more in line with theirs. That Sprint instead focuses on that 1% difference and 50% lower pricing is a sign that it’s not there yet, by a long stretch (leaving aside the wisdom of highlighting the worse performance of your network in national advertising).

Cord Cutting Continues to Accelerate in Q2 2016

One of the data sets I maintain is a database on the major cable, satellite, and telecoms operators in the US and their pay TV, broadband, and voice subscribers. As such, each quarter, I dig through those numbers and churn out a bunch of charts on how those markets are performing, and one of the posts I do each quarter is a cord-cutting update. Here’s the update for Q2 2016.

TL;DR: Cord-Cutting Continues to Accelerate

This is going to be a longish post, in which I’ll dive into lots of the detail around what’s really happening in the US pay TV market. But the headline here is that cord-cutting continues to accelerate, a trend that’s been fairly consistent for quite some time.

Here’s the money chart, which shows the year on year growth or decline in pay TV subscribers across all the publicly traded players I track:

Q2 2016 Cord Cutting 560px All Public Players

As you can see, the trend is very clear, with a consistent pattern from mid 2014 onwards of worse declines each quarter (except Q4 2015), culminating in this a loss of around 834,000 pay TV subscribers at the end of Q2 2016 compared with the end of Q2 2015. As discussed in more detail below, these numbers include the positive growth Dish has seen from its Sling TV product, which has added around 800,000 subscribers over the past year or so. Without those subs, the picture looks even worse.

Read on for more in-depth analysis of these numbers and the trends behind them. Reporters who would like further comment or anyone who would like to know more about our data offerings can reach Jan Dawson at jan (at) or (408) 744-6244.

Avoiding false trends with a proper methodology

I’ve lost track of how many headlines I’ve seen over the last couple of years which posit that cord cutting is somehow slowing down off the back of a small number of providers’ quarterly results. This poor analysis is usually based on several key mistakes:

  • Focusing on quarterly net adds rather than annual changes – this is problematic because the pay TV industry is inherently very cyclical, historically doing much better in the fourth and first quarters of the year, and doing worse in the late spring and summer months, reported as part of Q2 and Q3. You have to compare the same quarter in subsequent years to see the real trends.
  • Focusing on one or two big players, instead of the whole market. One of the key trends that’s emerged in recent quarters is that the larger and smaller players are seeing quite different trends, so fixating on the large players alone is misleading.
  • Focusing on one set of players, such as the cable companies. Though “cable TV” is often used as a synonym for pay TV in the US, it’s not a useful one when it comes to doing this kind of analysis. Cable, satellite, and telecoms players are seeing divergent trends when it comes to pay TV growth, and you have to look at all sets of players to get the full picture.

On that basis, then, I focus on year-on-year change in subs, and try to cast the net as wide as possible when it comes to players. My analysis includes all the major publicly traded cable, satellite, and telecoms (CST) providers in the US, of which there are now 17 in my data set, ranging from AT&T/DirecTV at over 25 million subs to Consolidated Communications, with just 112,000. The only major player now missing from this analysis (following the acquisition of Bright House by Charter) is Cox, which has around four million subscribers. In some of the charts below, you’ll see estimates for Cox included.

Trends by player type

So let’s stark to break down that chart I showed at the beginning, to see what’s happening behind the scenes. First off, here’s a chart that shows the year on year subscriber growth trends by player type: cable, satellite, and telecoms:

Q2 2016 Cord Cutting 560px by player type

This chart illustrates perfectly why focusing on just cable operators is utterly misleading – they’ve actually been having a better time of things over the past two years, but largely at the expense of the major telcos, who have seen plunging growth during the same period.

A tale of two groups of cable companies

It gets even more interesting when you break cable down into two groups, large and small companies:

Q2 2016 Cord Cutting 560px large and small cable

As you can see, what’s really been happening is that the four largest publicly traded cable companies have been doing much better over the last two years, while the smaller ones have if anything been doing worse. A large chunk of that improvement by the large companies comes from Time Warner Cable’s impressive turnaround during 2014 and 2015:

Q2 2016 Cord Cutting 560px cable by company

However, Comcast has also had a meaningful improvement over that same period, moving from 200k net losses year on year to positive net adds in the last two quarters. Legacy Charter has also had a slight improvement, while Cablevision has been largely static.

AT&T and Verizon have shifted focus elsewhere

The rest of the market is dominated by two large satellite companies and two large telcos, but the story here is really about the shift in focus away from TV by the telecoms guys. In AT&T’s case, it’s about a shift towards satellite-delivered TV, while in Verizon’s case it’s about slimming down its wireline operations and shifting focus from TV to broadband.

The transformation at AT&T over the last two years has been dramatic. Since the announcement of its plans to acquire DirecTV in May 2014, AT&T has seen plunging net adds in its U-verse TV business, while post-acquisition net adds at DirecTV have been skyrocketing:

Q2 2016 Cord Cutting 560px ATT DirecTV

This is part of a conscious strategy at AT&T to shift its TV focus to the platform with better economics, in addition to its cross-selling and bundling of DirecTV and AT&T wireless services. The net impact is still a loss of subscribers across its TV business as a whole – around 250k fewer subs at the end of Q2 2016 than Q2 2015 – but the economics of the subscribers it’s keeping are way better than for the subs it’s losing.

Dish is suffering, despite Sling TV

The other major satellite provider, Dish, is seeing worsening rather than improving trends, despite its ownership of over-the-top TV service Sling TV. It reports Sling TV subscribers as part of its overall pay TV numbers, through they’re markedly different in many of their characteristics, but even so it’s seen subscriber losses increase dramatically this quarter. The chart below shows Dish’s reported subscriber losses in blue, and adds estimated Sling TV subscriber growth in dark gray to show what’s really happening to traditional pay TV subs at Dish:

Q2 2016 Cord cutting 560px Dish and Sling

As you can see, the year on year change in traditional pay TV subs at Dish looks a lot worse when you strip out the Sling subscriber growth. The company lost almost a million pay TV subs on this basis over the past year, a number that appears to be rapidly accelerating.

Of course, we’re also including Sling subscribers in our overall industry numbers, so it’s worth looking at how industry growth numbers look when we strip out the same Sling subscribers from the overall pay TV numbers (with the Sling reduction this time shown in red):

Q2 2016 Cord Cutting 560px pay TV plus Sling

As you can see, the picture here worsens quite a bit too, going from a roughly 800k loss to a 1400k loss over the past year. The trend over time is also even more noticeable and dramatic.

Broadband may be the salvation for some

We’ve focused this analysis on pay TV exclusively, but many of these players also provide broadband services, and these services have grown to the point where they now rival the total installed base for pay TV. Indeed, a number of the larger cable operators now have more broadband subscribers than pay TV subscribers. This is another area where the larger cable operators are outperforming their smaller counterparts, as shown in the chart below:

Q2 2016 Cord Cutting 560px broadband and TV

Besides those smaller cable operators, the other company that will fare worst from cord cutting is Dish, which we’ve already discussed. Though it has a few hundred thousand broadband subscribers, it’s not remotely competitive in this space on a national basis, and as TV subscribership continues to fall, it will struggle to make up the difference in other areas, increasing pressure for a merger or acquisition that will allow it to tap into the broadband market. DirecTV, of course, now has the AT&T U-verse and wireless bases to bundle with.

Recent M&A leaves six large groups in control

Lastly, I want to touch on the recent merger and acquisition activity. We’ve already mentioned AT&T and DirecTV, but there have also been two other bits of consolidation: the creation of the new Charter from the combination of Charter, Time Warner Cable, and Bright House; and the acquisition of Cablevision and Suddenlink by French company Altice. It’s interesting to consider the scale of the groups formed by these various mergers in the context of the rest of the industry – these are now the six largest publicly-traded groups in the US pay TV market:

Q2 2016 Cord Cutting 560px Biggest groups

AT&T comes out on top, bolstered enormously by the DirecTV acquisition, while Comcast remains close behind despite not having been involved in the recent mergers (despite its best efforts). The new Charter comes in third, Dish in fourth, and then Verizon and Altice are way behind with a very similar number of subscribers a little under 5 million. After that, in turn, the companies get much smaller, with Frontier next at 1.6 million pay TV subs (including over a million recently acquired from Verizon), with no other publicly traded companies with over a million subs. And of course privately-held Cox is again excluded here, but would come in around the same size as Verizon and Altice.

This is a market increasingly dominated by large players, and that’s a trend that’s likely to continue, with Altice publicly suggesting that it intends to roll up more of the smaller assets. The four largest groups already own 78 million of the roughly 91 million owned by the publicly traded companies we’re tracking here, and the six large groups have 87 million between them. The rest of the market is becoming less and less relevant all the time, and as we’ve already seen has been suffering worse from cord cutting too.

Google’s Increasing Reliance on its Own Sites

After a couple of weeks on vacation, I’m still playing catchup with some of the tech earnings reports that came out while I was gone. Today, I’m tackling an interesting aspect of Alphabet’s earnings, which is the increasing dominance of ad revenue from Google’s own properties versus revenue from third party sites as a proportion of its total ad revenues. The charts I’m using here are largely taken from the Alphabet deck in the Jackdaw Research Quarterly Decks Service, which you can sign up for here. We also discussed Alphabet earnings along with those of other major tech companies on this week’s Beyond Devices Podcast.

Some quick definitions

First off, some quick definitions. Google divides its ad revenue into two categories:

  • Google websites – this includes all revenue from Google’s own websites, including AdWords revenue that is generated on, advertising revenue generated on YouTube,  and advertising revenue generated from other Google owned and operated properties like Gmail, Finance, Maps, and Google Play.
  • Google Network Members’ websites – this includes AdSense,
    AdExchange, AdMob, All DoubleClick-related revenues including DoubleClick Bid Manager revenues, and Other Network products including AdSense for Domains.

Within the core Google segment, these two divisions plus the “Other” category make up the entirety of revenue, and ad revenue from these two sources makes up 90% of Google segment revenue.

Very different growth rates lead to increasing dominance by Google’s own sites

These two segments have been growing at very different rates over the last several years, with Google’s own site revenue growing much faster than its Network Members’ ad revenues, as shown in the chart below:

Google ad segment growth Q2 2016 560px

Though there have been a couple of brief periods (in 2009-2010 and 2012) when Network revenue grew faster than Google website revenue, the pattern has otherwise been fairly consistent: Google’s revenue from its own sites has grown faster. Over the last three years, the gap has been significant – Google website revenue is up 74% over that period, while Network Members’ revenue is up just 17% over three years. That leads to a business that’s increasingly lopsided in favor of Google’s own sites:

Google ad revenue split Q2 2016 560px

In Q2 2016, Google sites passed 80% of total Google ad revenue for the first time. That’s up from 70% in 2011, and 60% around 2006.

Paid clicks growth is the driver

The reason for this discrepancy becomes abundantly clear when you look at the ad metrics Google provides. Every quarter, it reports growth in the number of paid clicks and the cost-per-click (i.e. price) for both the Google sites business and the Network Members business. These numbers bounce around quite a bit, but I find it’s often helpful to index the numbers to a certain point in the past to see the longer-term trends. The chart below shows these figures indexed to the quarter two years ago, Q2 2014:

Google ad metrics Q2 2016 560px

As you can see, there’s a stark contrast between the two businesses here. Let’s start with the number of paid clicks:

  • Google sites paid clicks are up 61% over two years (the number was 67% last quarter)
  • Network paid clicks are at 98% of where they were two years ago, and this number has been relatively flat over that whole period.

Google says that growth in clicks on its own sites has been driven by a combination of growth in the adoption of YouTube engagement ads, improvements in ad formats and delivery, and expansion of products, advertisers and user bases across all platforms, particularly mobile. There simply aren’t similar drivers for the Network business, which Google obviously doesn’t control as directly, and which is in some ways much more mature.

Looking at the cost per click:

  • Google sites CPC in Q2 2016 was only 76% of the CPC for two years earlier
  • Network CPC was 95% of two years earlier, and again this number has been relatively flat over the period, with modest growth in the first year, followed by slight shrinkage since.

The reason for the falling cost per click on Google’s own sites is largely due to growth in YouTube engagement ads where cost-per-click is lower than on Google’s other platforms, as well as changes in property and device mix, product mix, geographic mix, and ongoing product changes, with a smaller impact from currency exchange rates. Some of the same factors drove the modest recent decline in Network CPC as well.

Traffic Acquisition Costs and margins

This all matters a great deal for a couple of reasons, the second of which we’ll come onto in a moment. But the single most obvious reason is that the economics of ad revenue from Google’s own sites is radically different from the economics for Network sites, and that’s because of how Google pays for traffic. On third-party sites, Google pays out most of the revenue to the site owner, whereas on its own sites it keeps the vast majority of the revenue. Google breaks out the traffic acquisition costs (TAC) for both these segments, and the stark differences are shown in the chart below:

Google TAC by segment Q2 2016 560px

As you can see, in the Network business, Google pays out at a rate very similar to the economics of the major app stores, at about 70% of revenue. For its own sites, however, Google’s TAC is a fraction of that, at around 9% in Q2 2016. These payments go to the sources of traffic to Google’s various websites, principally makers of browsers including Apple’s Safari which feature Google as a default search engine.

Interestingly, Network TAC had come down quite a bit for several years, but has recently spiked back up a little, though it’s been within a range from 67-71% for the last five years. Conversely, Google’s TAC for its own sites has been steadily rising, as its cut of revenues under various placement deals has been shrinking. With competition from Yahoo and Microsoft in particular rising over recent years, Google has had to pay more to retain its prime placement in various browsers.

Regardless of the recent changes, TAC remains far higher for third party sites than for Google’s own, though that’s not to say that this somehow translates directly into margins. Obviously, Google’s other costs for running its own sites are much higher than its cost for running ads on other people’s websites. But I suspect the increasing dominance of Google’s own sites as a source of ad revenue is driving the steady improvement in margins we’ve seen over recent years.

The downside of all this

Let’s turn now to the second reason all this matters. Though I’ve just said that the increasing dominance of Google’s ad revenues by money from its own sites is likely good for margins, there’s a downside here too. The problem with this dominance is that Google has to be responsible for essentially all the growth itself, largely by growing its direct audience and finding ways to sell more ads at higher prices. As we’ve already seen, YouTube has been a huge help here in recent years as monetization has really taken off, but I wonder how sustainable that growth will be over time. Google is already attempting to drive revenue through alternative business models like YouTube Red and other subscriptions, and I suspect we’ll see more of this.

But as long as Google is so heavily dependent on revenue from its own sites, it’s going to have to find new sources of revenue which it owns, which might well drive it to make acquisitions (Twitter, perhaps?) and organic investments in new properties. That may be challenging over time, especially as more and more online activity takes place on mobile devices, where there’s simply less room for ads. Better targeting and more lucrative formats like app install ads should help offset that a bit, but it may still be tough to sustain over time. Though Alphabet and Google’s recent results have been very positive, there is here still the core of a bear case against continued growth along the same lines.

Instagram Stories and Copying Competitors

Instagram today engaged in what was arguably one of the most transparent rip-offs of a competing company’s product in recent memory, as it launched Instagram Stories, apparently a clone of Snapchat’s Stories feature, right down to the name. In response, I’ve seen some people saying that such feature copying is actually good for users. Though I think I understand what those people are saying, those words need quite a bit more context. Here is some.

Steve Jobs and stealing

The reality is that copying at some level has always been part and parcel of the tech industry. Steve Jobs famously said in an interview for a 1996 TV show:

Ultimately it comes down to taste. It comes down to trying to expose yourself to the best things that humans have done and then try to bring those things in to what you’re doing. I mean Picasso had a saying he said good artists copy great artists steal. And we have always been shameless about stealing great ideas.

I’ve seen that quote interpreted in a number of different ways, but it’s important to understand what it does and doesn’t mean. Picasso likely didn’t originate the quote; TS Eliot did, as follows:

One of the surest of tests is the way in which a poet borrows. Immature poets imitate; mature poets steal; bad poets deface what they take, and good poets make it into something better, or at least something different. The good poet welds his theft into a whole of feeling which is unique, utterly different from that from which it was torn; the bad poet throws it into something which has no cohesion. A good poet will usually borrow from authors remote in time, or alien in language, or diverse in interest.

In this original version of the quote, Eliot implies that there’s an important difference between imitating and stealing. The imitator merely apes the original (often badly, thereby actually degrading it), while the thief takes it but makes it his own by improving on it. It’s very similar to the definition of fair use under copyright law: if you create a fundamentally new work, your use of the work of others is fair game, whereas mere copying is not. But the point here is that there has to be some improvement on the original – some standing on the shoulders of giants, one might say – in order to qualify.

Users can benefit from copying

Do users benefit from such copying? It’s arguable that they do. If someone finds the absolute best way to do something, it’s to some extent ridiculous to do it another way. The introduction of graphical user interfaces for computers are a good example here – the GUI was so clearly better than the command line for most users that it would have been nonsensical not to embrace it. Almost all progress in technology builds on what’s come before, just as in science. Ignoring the advances of others is simply bad practice.

There are limits, and Instagram has gone too far

The problem here, though, is twofold. Firstly, this only applies to the kind of “copying” we’ve outlined above – that which improves on something that came before, rather than simply aping it. And secondly, the baser sort of copying can quickly become circular and stifle innovation if not counterbalanced by real innovation by all companies in a market. Companies have to drive their own new, differentiating features in addition to borrowing the best invented elsewhere. The problem with what Instagram is doing here is that it’s so barefaced and unashamed, while not exhibiting any of the positive characteristics of what Eliot and Jobs referred to admiringly as stealing.

There’s essentially nothing in Instagram’s appropriation of Stories which builds in a meaningful way on Snapchat’s implementation and makes it something new and different. Right down to the name and somewhat unintuitive interface, Instagram seems to have literally stolen the whole thing. That’s problematic, because it’s a lot more like the sort of IP violation that Asian (and particularly Chinese) device makers have engaged in over the last few years. There’s really nothing to admire here except possibly Instagram’s sheer brazenness.

I think it’s inevitable that services that occupy similar spaces in the broader communications and content markets will end up building feature sets that look very similar on paper. But that ought not to mean that they also look similar when implemented in apps. That smacks of laziness and a lack of imagination, which is a shame from a company like Instagram, which has fostered real innovation in the past.

Quick Take on Fitbit Q2 2016 Results

Fitbit released its results for Q2 2016 today, and the market seems to be responding pretty positively in the short term. However, based on the numbers reported today, there’s not a lot of reason for cheer – the positive reaction seems to be at least in part about the company’s forward guidance. Here are some quick thoughts and charts on the numbers for Q2.

Growth continues to be slower

One of the big issues facing Fitbit is slowing growth. The chart below shows both year on year revenue growth and unit shipment growth, and as you can see both have dropped precipitously from its heyday in 2014 and early 2015 in percentage terms. Fitbit Growth Q2 2016Now, neither of those numbers is in negative territory – revenue growth was still almost 50%, while shipment growth was about half that. But both are down considerably over the past, and seem to be flattening out. In pure dollar terms, growth has also been lower than in the past. That’s likely a sign of a maturing market and an increasingly saturated one for Fitbit.

Marketing costs continue to rise faster than revenues

The fact that growth is still ticking over decently is largely a result of rapidly rising sales and marketing spend, which has been climbing faster than revenue for some time now:
Fitbit costs as percentage of revenue quarterlyFitbit costs as a percentage of revenue trailing 4 quartersAs you can see, sales and marketing spend on a trailing 4-quarter basis has risen from 10% of revenue to 20% over the past three years or so. That kind of rise is hard to sustain over time, but it’s probably inevitable as Fitbit has to fight harder and harder for each additional sale.

The other problem is that S&M spending isn’t the only cost category that’s been rising as a percentage of revenue – both R&D spend and general and administrative spend have been rising too. For the last several quarters, Fitbit has been touting the percentage of its employees that work in R&D – the number has now reached 59%, or 863 employees. Though such an investment in innovation is admirable, the combination of these three growing cost categories is squeezing margins. Together with some temporary issues driving up cost of revenue, these various increases are causing margins to drop to almost zero, from operating margins in the 20s and 30s two years ago:

Fitbit margins Q2 2016

The US still dominates

The US still dominates Fitbit’s global revenues, with around three quarters of the total. EMEA is the only other really significant region today, with around 15% of revenue. The APAC region took a dive in Q2, apparently because a major Australian distributor is going out of business, but this just highlights the lack of diversity outside the US. APAC revenues including Australia fell 54%, while APAC revenues excluding Australia apparently grew 98%. Fitbit regional revenues Q2 2016This suggests that Australia absolutely dominates APAC revenues, and that the one distributor in turn dominates Fitbit’s sales there. It needs more diversity geographically as well as among distributors if it’s to continue to grow overall.

The silver lining

If there’s good news, it’s that Fitbit continues to dominate the specialist fitness wearables space. To be sure, the Apple Watch has begun to achieve similar scale at a radically higher price and with a much broader offering, but when it comes to dedicated fitness devices, Fitbit continues to lead the market. And despite the slowdown in its growth, it is still growing. That it’s able to achieve this even as both cheap Chinese alternatives and expensive upgrades from Apple come into the market is a testament to what it’s built. But I continue to believe that Fitbit will struggle to recreate its past combination of very high growth and good margins going forward.