After a tumultuous multi-year stretch that included massive unit sales declines, declining average selling prices (ASPs), and deteriorating margin trends, the iPad business has turned a corner. The combination of improving upgrade fundamentals, less severe iPad mini sales declines, and a stronger iPad lineup with the iPad Pro and accompanying accessories have positioned the iPad category that much closer to stabilization. The worst is likely over.

The iPad's Early Potential

The iPad shot out of the gate like a rocket in 2010, instantly becoming the best-selling new Apple product in history. Considering that the iPad was an entirely new category positioned between an iPhone and MacBook, many were caught off guard by how consumers embraced the new form factor. As seen in Exhibit 1, initial iPad sales were nearly three times as strong as initial iPhone sales. Consensus even began to think the iPad would end up outselling the iPhone over time. Needless to say, iPad optimism was riding high. In just 10 quarters on the market, Apple sold 100 million iPads. It took Apple 16 quarters to hit the same milestone with iPhone.

Exhibit 1: iPad and iPhone Unit Sales Post Launch

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The Turning Point and Dark Days

In November 2012, just two and a half years after launching the original iPad, Apple unveiled the lower-cost 7.9-inch iPad mini. The goal was simple: Prevent Android competitors from gaining traction under the iPad's price umbrella. Apple did not want to see a repeat of the 1990s all over again. This time it would be in the tablet space where Android would become the new Windows.

While the iPad mini was well received with many in the press calling it the "real" iPad, the device ended up representing a turning point for the iPad business. After what appeared to be a very successful 1Q13 holiday season for the iPad thanks to the mini, Apple reported its first decline in iPad unit sales just two quarters later. Since then, the iPad business has experienced a brutal three-year stretch.

The iPad's dark days had arrived. Heading into 2015, the iPad line consisting of iPad mini and iPad Air looked dated and out of place within Apple's evolving product line. This led many to conclude that the tablet may simply be a less attractive product category going forward in a world dominated by large-screen smartphones. In addition, iPad marketing just didn't seem to contain much of a punch. Many of the iPad use cases profiled could be handled just as well, if not better, with an iPhone. Unsurprisingly, iPad expectations turned remarkably low.

In 2013, Apple sold 71M iPads. Apple's 3Q16 marked the 10th consecutive quarter of iPad sales declines. Apple is now on track to report 46M iPad unit sales in FY16. As shown in Exhibit 2, this significant 35% drop in sales, spread out over number of years, has given the iPad a very ominous sales trajectory.

Exhibit 2: iPad and iPhone Unit Sales Trajectories Post Launch

iPad Problems

There have been a number of factors put forth to explain the iPad's troubles. I suspect much of the iPad's difficult stretch over the past three years has been due to two overarching reasons:

1) Peak iPad Mini. As shown in Exhibit 3, the iPad mini form factor has experienced a more significant sales decline than its larger 9.7-inch sibling. According to my estimates, the iPad mini is responsible for approximately 70% of the iPad's overall sales decline since 2013.

The iPad mini form factor bore all of the competitive headwinds associated with larger screen smartphones, much more so than its 9.7-inch screen iPad sibling. I suspect the iPad mini initially benefited from interest in and curiosity for an iOS device that was bigger than the 3.5-inch and 4-inch iPhones at the time but smaller than the 9.7-inch iPad 2 and 3. Meanwhile, the iPad mini's low price and feature set positioned basic video consumption as a leading use case. This distinction meant that the iPad mini upgrade cycle was basically a myth. When an iPad is used for nothing more than video watching, there is little to no incentive to upgrade.

Exhibit 3: 7.9-Inch iPad vs. 9.7-Inch iPad Unit Sales (TTM)

2) Longer Upgrade Cycle for 9.7-inch iPad. If 70% of the iPad's decline is due to the iPad mini, the remaining 30% relates to 9.7-inch iPad owners holding on to their iPads for more than two or three years. The iPad upgrade cycle is more like four to five years. The iPad 2, released in 2011, still represents 15% of iPads in use today. This elongated upgrade cycle meant that the 9.7-inch iPad would not follow in the steps of the iPhone, a device that saw sales benefit from a very short two-year upgrade cycle for years. Apple continued to do fine selling iPads to new customers. However, the lack of iPad upgraders meant it was that much harder for Apple to report year-over-year iPad sales growth.

Signs of Improvement

Just as it seems like people have completely written off the iPad business for good, signs are beginning to appear that point to improving iPad fundamentals. In fact, I suspect the iPad's dark days are already over.

Better Upgrade Fundamentals. The average age of iPads in use now exceeds three and a half years, as shown in Exhibit 4. This is one of the best developments for the iPad business in years. At the current rate, the iPad business is close to hitting its natural upgrade cycle cadence, likely in mid-2017 to early 2018. I estimate there are approximately 225 million iPad users out in the wild. Assuming the average iPad upgrade cycle extends out to five years, this means that Apple would have approximately 45M iPad unit sales per year just due to existing iPad owners upgrading their devices. Meanwhile, Apple is on track to report annual iPad sales of 45M units for 2016. This number includes both iPad upgraders and customers new to iPad. This suggests that Apple's iPad business is very close to approaching a natural sales run rate at which the combination of upgrades and sales to new users will lead to roughly flat sales growth year-over-year.

Exhibit 4: Average Age of iPads in Use

One announcement from WWDC provided much credibility to the theory that the iPad upgrade cycle will top out around five years. iOS 10 will not be compatible with the original iPad, iPad 2, iPad 3, and iPad mini, iPad models that are six, five, four, and four years old, respectively. This means there will be approximately 65M iPads that will not get the latest iOS release. That is a very significant number of iPads. While it's wrong to conclude owners of those iPad models will rush out and buy a new iPad as a result of not getting iOS 10, it does provide a few clues as to how Apple is thinking about an iPad's useful life before turning into an inferior experience: between four and five years.

Less Severe iPad Mini Headwinds. With the iPad mini contributing to 70% of the iPad's overall sales decline in recent years, there is evidence that the period of massive iPad mini sales declines is coming to an end. Given current iPad mini sales, there is simply less room for the device to register the same kind of sale declines seen in the past. Accordingly, overall iPad sales will benefit from no longer having a massive iPad mini sales headwind. For example, in 3Q16, the iPad mini likely represented less than 20% of total quarterly iPad sales. While I remain confident that we have seen Peak iPad Mini, I do not expect iPad mini sales to go to zero. The device represents one of the low-cost entry-level devices for the iOS ecosystem, which will appeal to millions of consumers each year.

Stronger iPad Lineup. The 9.7-inch and 12.9-inch iPad Pro and accompanying Apple Pencil and Smart Keyboard accessories represent the iPad's future. One consequence of iPhones becoming larger and MacBooks becoming smaller was that the old iPad line felt stale and out of place. Apple needed to shift its iPad strategy to the high-end, as detailed in my article, "Finding iPad's Future," from August 2015. This would be the opposite of the iPad strategy kicked off with the iPad mini at the end of 2012. Not only do the Pros serve as the first genuine iPads worth upgrading to for existing 9.7-inch iPad users, but they also give Apple a much better story to tell in terms of marketing. Apple's latest iPad commercial demonstrates this as Apple is explaining the iPad in a whole new way. The iPad is no longer the product that exists between a smartphone and laptop. Instead, the iPad is a computer.

iPad Sales Stabilization Is Near

As a very early sign that all of these positive developments are coming together, Apple just reported the best quarter for iPad unit sales growth in 10 quarters, highlighted in Exhibit 5. The 9.7-inch iPad Pro launch certainly played its role. While sales are still declining, on a revenue basis, the iPad business registered its first year-over-year increase in 10 quarters. This is the clearest sign in years that iPad is approaching stabilization.

Exhibit 5: iPad Unit Sales Growth

Even though iPad sales declines will likely continue for a few more quarters, the probability that the iPad business will see significant sales declines from current levels has been reduced. Meanwhile, ASP and margin trends look to have long-term tailwinds as well. Looking ahead, the 40M sales milestone is the leading candidate for a natural sales run rate for the iPad business. This means that iPad sales would have to fall another 10% before reaching that level. To put that decline in perspective, Mac sales have declined more than 10% for the past two quarters. While the days of strong 30-40% unit sales growth will likely never make a return with iPad, it's clear that the iPad will soon enter a new stabilization phase. The dark days for the iPad are over.

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