The results are in. Actually, they’re not in. And that was a major problem yesterday for Apple.
You see, the company had to do something they almost never do. They had to revise their earnings guidance.¹ Downward. The stock was halted. Yikes.
Today, the stock is down nearly 10%. Tens of billions of dollars have been shaved off of Apple’s market cap, literally overnight. The company is now the 4th most valuable corporation in the world. That sounds like a great thing until you remember that until recently, it was the most valuable company in the world — and for much of the past several years, this was the case by far.
Yesterday was a nightmare scenario for any public company. But it’s almost unfathomable that this happened with Apple. For years and years, this is the company that not only beat their earnings guidance (not to mention Wall Street’s expectations) quarter after quarter, they crushed them.²
I mean, this is the company which celebrated becoming the first trillion dollar company just this past August. What a difference a few months makes.
Tim Cook’s letter to shareholders on the matter is fascinating. On one hand, he makes a very simple case: chalk it up to China. A bad economic situation exacerbated by a trade war has created a perfect storm of sorts, undoubtedly for many companies operating in the country. Yet many U.S. companies don’t operate in China the way that Apple does. It’s their third-largest market. So yeah, this was always going to hurt.
On the other hand, all of that could have been explained in one or two paragraphs. Cook’s letter is nearly 1,500 words long.
I offered up some initial thoughts in a tweetstorm on the matter yesterday (embedded below), but it’s worth diving a bit deeper into what’s going on. Or actually, just zooming out a bit, to summarize. Because to me, the interesting bits are about what’s going on with Apple beyond the China situation.
While the bad miss on the quarterly revenue and the revised statement surprised me, the underlying issues that Cook hints at do not. They point to something we’ve known for years: it was always inevitable that the law of large numbers would catch up with Apple. More specifically, with the iPhone — perhaps the greatest product from a business perspective in history. And that appears to have happened. Finally.
Two paragraphs in Cook’s statement stand out to me:
In addition, these and other factors resulted in fewer iPhone upgrades than we had anticipated.
This is a big deal. Almost mentioned as an aside; love it. And:
While Greater China and other emerging markets accounted for the vast majority of the year-over-year iPhone revenue decline, in some developed markets, iPhone upgrades also were not as strong as we thought they would be. While macroeconomic challenges in some markets were a key contributor to this trend, we believe there are other factors broadly impacting our iPhone performance, including consumers adapting to a world with fewer carrier subsidies, US dollar strength-related price increases, and some customers taking advantage of significantly reduced pricing for iPhone battery replacements.
Again, there’s the weaker-than-expected iPhone upgrades data point. But with a bit more detail this time.
Starting at the bottom, the battery replacement point is sort of wild. Not the point itself, but that Cook would include it. I mean, how big of an impact could that possibly have on the bottom line? If you believe Cook — and he later reiterated this point on CNBC — quite a bit. And that’s why it’s crazy that he included it in the statement. Because it points to one of two things:
First, it suggests a favorite conspiracy theory about the company: that they degrade the batteries on purpose to make more money. I don’t actually believe this, but a lot of people do. And when no less than Tim Cook now highlights such a stat in this context, who can blame them?
Second, and more likely, the battery replacement issue suggests that many people are no longer upgrading iPhones because they’re now “good enough” and everyone is more than happy to just pay a bit more for a better battery.
Obviously, neither of these are good scenarios for Apple. And I’m honestly not sure which is worse!
Continuing up the paragraph, we get to the part about “US dollar strength-related price increases” — yes, this is Apple complaining that the price of their products are too high! That’s funny, but it’s also serious: they are actually acknowledging there may be a price ceiling for the iPhone. This was, I believe, part of the premise of the “$1,500 iPhone” (the most expensive variety of the iPhone XS Max) — to test such upper boundries, like velociraptors testing electric fences. Consider it tested! And they’ll remember!
And then there’s the real standout part of the paragraph: “consumers adapting to a world with fewer carrier subsidies”. Once again, this translates into English as: we pushed the price of the iPhone too far. And whereas before, such prices were obfuscated by things like carrier contracts, that world is shifting. And Apple hasn’t shifted fast enough or strongly enough to account for this. More on this in a bit.
Two other key takeaways from the statement: just how many times Cook mentions Apple’s Services business, and the continued talk of Apple’s installed base of active devices. Unsurprisingly, these are directly related. Apple continues to grow their base to… upsell them services.
This has been a key narrative for Apple for the past couple of years now. And in 2018, it was clearly elevated to a main talking point time and time again. The reason why is obvious: growth. Services is the one area Apple can rely on for not just some growth, but for big growth. It’s also an area Wall Street happens to find sexy at the moment. See also: Microsoft’s turnaround.
The problem is that as good as the Services business is becoming for Apple, it’s unlikely to replace the iPhone as the key cog of Apple’s overall business anytime soon.³ And this means Apple is unlikely to grow as a whole anytime soon. Sure, there may be some quarters of growth here and there, but as this current situation makes clear, the era of unabated growth is over.
The iPhone has simply been too good of a business. And it’s hard to see what tops it. Certainly in the near term. If Services is to carry Apple in the future, it will likely be only after years of relatively stagnant iPhone revenue growth mixed with a rising overall market. In other words, time and the broader world will have to catch up. And then Apple can have their “Microsoft Moment” — a services-based resurrection of growth.
By the way, this seems like a much more likely scenario for Apple than say, a pair of AR glasses, or even a car product eclipsing the iPhone business. I wouldn’t sleep on Apple Pay, but Apple buckets that under Services as well!
All roads lead to Services for Apple, as Cook makes pretty clear in his statement. And if you’re looking for growth — which Wall Street always is — look no further:
Our non-iPhone businesses have less exposure to emerging markets, and the vast majority of Services revenue is related to the size of the installed base, not current period sales.
Services generated over $10.8 billion in revenue during the quarter, growing to a new quarterly record in every geographic segment, and we are on track to achieve our goal of doubling the size of this business from 2016 to 2020.
Again, growth simply thanks to the installed base. And did he mention there’s also growth in Services in China? Yes, yes he did:
Our results in China include a new record for Services revenue, and our installed base of devices grew over the last year.
But the path to this Services future isn’t quite as straightforward as Cook makes it seem. Apple’s history has been selling excellent hardware coupled with great software at fantastic margins. The Services themselves are a mixed bag, at best. If this is the key area of growth for the company, and they’re not truly great at said Services, there’s a risk of rot from within.⁴
Going back to the post-carrier-contracts world, another seemingly telling part of Cook’s statement:
We can’t change macroeconomic conditions, but we are undertaking and accelerating other initiatives to improve our results. One such initiative is making it simple to trade in a phone in our stores, finance the purchase over time, and get help transferring data from the current to the new phone. This is not only great for the environment, it is great for the customer, as their existing phone acts as a subsidy for their new phone, and it is great for developers, as it can help grow our installed base.
This is fascinating! Cook is basically making a case for the end of buying phones at full price each year and instead, a world in which you pay Apple in perpetuity to constantly get the new iPhone. This is — wait for it — a service! The name is even right there for the taking: iPaaS — iPhone as a Service.
And it’s a service Apple already has, in the form of the iPhone Upgrade Program! Unfortunately, it’s not a great service right now — I’m a member — as it’s largely outsourced to a third-party, Citizens Bank. Cook is suggesting that Apple is going to put a lot more emphasis here. Which makes a lot of sense, both to help continue to obfuscate the true price of the iPhone, but also to keep that all-important base of users locked in.
It’s also Apple’s most interesting inroad to an “Apple Prime” offering. That is, an all-encompassing suite of services you pay Apple for — just like Amazon Prime, with all that offers from an Amazon-perspective.
I had thought it was going to be a longer road to get there simply given how much Apple would have to charge for it to make sense if they’re going to include an iPhone each year. And Apple clearly thought this would and should take longer as well! But Cook’s comments — “undertaking and accelerating” — suggest a more robust iPaaS is now a priority.
An easier path would be Apple Music, mixed with their forthcoming TV offering, the new subscription news offering, alongside some iCloud storage space, no doubt. Maybe even Apple Care? But to be truly differentiated and to be meaningful to Apple’s bottom line, I think you need to throw Apple’s core, their products, into the mix. Which sounds great. But again, expensive.
All of the above points to a rocky year ahead for Apple, but also a pivotal one. The transition from the iPhone company to a Services company is now officially underway. It is clearly happening earlier than Apple had planned. How will Apple adapt to this new era?
Apple has skirted the “law of large numbers” by continuing to grow the iPhone business. And there’s undoubtedly still more room for growth — especially in places like China. But what about other products?
The time has come to answer such a question.