Apple’s Services Narrative
On January 2nd 2019, Tim Cook released a letter to investors to announce a revised (lower) revenue guidance for Apple’s fiscal 2019 first quarter, which ended on December 29th 2018. This is the first time Apple has lowered revenue guidance in more than two decades. The new guidance is significantly lower than the initial projection and caused the share price to drop. Apple is attributing the miss to the US â€“ China trade war and the weakening economic growth in China. This bad news came after Apple announced that it will no longer report unit sales volumes for its hardware products â€“ a sign that the company does not expect unit sale to continue to drive growth, making investors jittery.
As big as Apple is, with more than US$ 265.6 billion in revenue in 2019, the iPhone still represents 62.8% of the company’s income, and as successful as the iPhone has been (arguably the most successful consumer product ever launched), Apple’s dependency on a singular product for the bulk of its revenue has always been a cause for concern for investors. Macroeconomic conditions and changing consumer taste have always been the primary risks for any consumer products, but the iPhone has been relatively immune to these risks and has had an unprecedented decade of dominance. The iPhone captures about 87% of the profit margin of the entire smartphone industry. Nonetheless, all good things must come to an end. As the iPhone market has become saturated (the number of units sold has been largely flat in the last three years â€“ see Figure 1), Apple must find a new engine of growth.
Figure 1: iPhone units sold by the years.
If you can’t sell more units, just charge more.
To extract more revenue, Apple has been increasing the average selling price (ASP) of its devices. Since the iPhone has many skews (different screen sizes, memory, models, etc), we can calculate the ASP by dividing the net iPhone sales by the total units sold. The numbers are shown in Figure 2 below. Apple is clearly flexing its pricing power and testing customer loyalty. Despite increasing the average selling price, number of units sold has remained flat in the last three years â€“ iPhone’s customers are not very price sensitive.
Figure 2: Number of iPhone sold remains flat despite the increasing price.
The Services Narrative
But Apple cannot raise prices forever. Moving forward, the company must generate a new engine for growth. Apple believes its services business can be this engine. In addition to its hardware business, Apple has its services business, which includes Digital Content and Services (iTunes and App store), iCloud, Apple Care, and Apple Pay. See Figure 3 for the breakdown.
Figure 3: Apple’s different businesses.
Apple has been emphasizing its services narrative for several quarters now. It continues to tout record revenue from the services business unit. In 2018, the Services business unit grew 24% to over US$ 37 billion. Nonetheless, this represents only one fifth of the revenue generated by the iPhone. See Figure 4. For services revenue to match the iPhone global revenue, it has to grow an additional US$ 129 billion. Considering that iPhone’s global install base is about 728 million (as of April 2017), this means Apple, without expanding its user base, must extract US$ 177 from each user per year, or about US$ 15 per user per month. This is not too far fetchedâ€¦
Figure 4: iPhone vs Services revenue.
How will Apple achieve this?
- The App Store: In the App store, Apple is a rent seeking monopoly. It forces apps to enable payment through the app store and takes 30% cut from any in-app purchases. For subscription services, Apple charges 30% for the first year, and 15% thereafter. That means, for many subscription based companies (such as Netflix, Amazon prime service, etc), Apple takes a significant cut. Some well known companies are pushing back on this practice however. Netflix has killed in-app subscription on Apple hardware to circumvent this fee. Users now have to make payment via Netflix’s website.
- Apple Music: Apple charges US$ 9.99 per month per user for this service. Previously, in an attempt to sell more HomePods, Apple limited the availability of its music streaming service to its own smart speaker. But this strategy has failed. So, in an effort to drive further adoption, Apple announced that it is now enabling its music streaming service on Amazon’s smart speaker platform.
- Apple Pay: The service is operational in 16 countries, and was used more than a billion times in Q3 2018. This means that it was on a 4 billion transaction run rate in 2018. It is unclear how much revenue Apple is generating from this service however, as the company does not disclose this data.
Despite the rapid growth and its massive potential, the Services strategy will face an uphill battle. In addition to the aforementioned risk of established companies bypassing the App store payment, Apple faces significant risks in China. This risk comes from the Chinese government’s protectionism policies. In recent months, the App store has seen a slowdown in new game approvals. On the payments front, Apple Pay faces multiple challenges from other players (PayPal in the US, PayTM in India, and WeChat in China to name a few). And on the music streaming sector, the company is battling its chief competitor, Spotify.