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We believe the investing view on Apple is shifting to Apple as a Service. The news that Netflix is leaving the App Store is somewhat expected, given the company began testing alternatives to the App Store last summer. The move is a fractional negative to earnings, along with a psychological headwind to investors embracing the theme of Apple as a Service. That said, we believe Spotify is the only other brand at risk of leaving, and the Apple as a Service theme is intact.
- Netflix leaving the App Store only affects new subscriptions, therefore, the financial impact on Apple will be de minimis (0.07% of Apple’s overall revenue and 0.14% of earnings. Details below).
- You’ll still be able to watch Netflix on Apple devices.
- Spotify (the only other brand strong enough to leave the App Store) has also been testing ways to avoid paying Apple for new in-app subscription purchases by forcing customers to visit mobile sites for subscription sign-ups.
- Outside of Spotify, we think the risk of further defections is low. The value of the App Store for developers is app discovery and conversion. Loss of new subscribers due to additional sign-up friction will force most apps to continue offering subscriptions through the App Store.
- The real risk is losing revenue from in-app purchases, but given the walled garden nature of iOS, it’s unlikely that in-app purchases can be enabled off-platform. This means that Epic Games (Fortnite), which has paid Apple roughly $100m this year, will likely continue to pay Apple the required 30% of in-app purchases.
- We estimate that, over a 4 year period, an average subscription app will pay Apple 19% of its revenue.
- The Google Play store is at more risk, as evidenced by Epic Games’ decision to launch on Android without the Google Play store.
Apple’s Deal with Developers
Apple keeps 30% of an in-app subscription over the first 12 months and 15% in each of the following months. Assuming a 4-year subscription life (which is about where Netflix is today), Apple takes 19% over those 4 years. For in-app purchases, Apple keeps 30%.
Apple’s recent decision to end unit reporting is evidence of Apple’s latest reinvention — into a services business. It will take time, but this change lays the groundwork for future AAPL multiple expansion. Six months ago we introduced our view of an upcoming investor paradigm shift from Apple as a hardware company to Apple as a Service. We are now in the midst of a four step transformation process: from news to knee-jerk to indifference to enlightenment.
One of the many skills that propelled Apple’s rise to a $1T market cap has been its ability to reinvent itself. From Mac to iPod to iPhone, the company has gone through several significant reinventions. Its next reinvention is beginning, as Apple transforms both its hardware and software businesses into a single unified service.
History of Reinvention
In the fall of 2005, Jobs referred to the launch of the iPod Nano as a “heart transplant,” because it would wipe out the iPod Mini at the peak of its success. The company has done even more aggressive “transplants” throughout its history. One of the clearest examples is Apple’s transition from the iPod growth story to the iPhone growth story. The change seems obvious in hindsight, but to purposely cannibalize one of the greatest innovations of all time (iPod) by entering a complex product category (mobile phones) entirely new to the company, with massive established players (Nokia), was perhaps the biggest gamble the tech industry has ever seen. This kind of reinvention, multiple times over the lifespan of a long-living company, requires lots of foresight and even more humility. Apple has never stopped saying “we can do even better.”
Apple has a great track record when it comes to reinvention. It’s built into the company culture. The annual product refresh cycle that the company has mastered over the last decade exemplifies many smaller-scale annual reinventions. As a result, when it comes time to make these large business transitions, the company is well practiced.
The Next Reinvention
Apple’s next reinvention does not involve product replacement; rather, it will require a shift in mindset to consuming Apple products as a service. This takes multiple forms:
Over the past several months we’ve written about a shift in Apple investment thinking to Apple as a Service. To date, the view has been slow to take root as evidenced by AAPL’s recent sell-off due to supply chain concerns. It’s clear that most investors’ mindsets are still centered on an iPhone unit-dominated story, but we believe that will change over the next two years.
- Historical data supports the view that underlying business performance is not correlated to unit sales.
- A unit of sale (i.e. iPhone) is less relevant today than it has been in the past.
- Google search activity for iPhone is increasing, a positive sign for demand.
- The Street is overreacting to supply chain concerns; drawing insights from the supply chain is more of an art than a science.
Apple as a Service Defined
Apple as a Service is the notion that the company is transitioning from primarily manufacturing and selling devices to maintaining and satisfying a large and growing customer base with ever-improving hardware and an increasing portfolio of software services.
New Reporting Methodology
Apple’s most concerted effort to shift the mindset of investors and analysts to Apple as a Service came during the Sept. quarter earnings call when the company announced it will no longer report hardware units numbers. This, rightfully, raised some questions, but the rationale, which we laid out here, suggests that investors should take this transition seriously.
Apple’s Justification of New Reporting
When asked to explain the reason for not reporting units, CFO Luca Maestri said:
“When you look at our financial performance in recent years, take the last three years, for example, the number of units sold during any quarter has not been necessarily representative of the underlying strength of our business. If you look at our revenue, given the last three years, if you look at our net income during the last three years, if you look at our stock price here in the last three years, there’s no correlation to the units sold in any given period.
As you know very well, in addition, our product ranges for all the major product categories have become wider over time and therefore, a unit of sale is less relevant for us at this point compared to the past, because we’ve got this wider sales price dispersion, so unit of sale, per se, becomes less relevant.”
Data Supports Luca’s Rationale
1: Underlying business performance is not correlated to unit sales.
The chart below shows the y/y unit growth of the iPhone, Mac, and iPad compared to revenue growth, earnings growth, and stock price by quarter since 2014. Unit growth metrics are solid lines and financial performance metrics are dotted lines. Note the disassociation between the two after the vertical line that marks three years ago (Sep-15).
Apple reported its results for the Sept. 2018 quarter essentially in line with expectations and gave guidance for Dec. quarter revenue 2% below Street expectations. Shares were down 5% after hours but fell further to ~7% on news that the company is adopting a new reporting methodology and will no longer break out hardware unit sales for iPhone, iPad, and Mac. Here are our thoughts:
- The new reporting methodology is Apple’s attempt to get investors to think of their entire business as a service (including hardware).
- This move should not be a surprise, given Apple’s efforts over the past four years to encourage investors to look more at its Services segment and, separately, to measure the iPhone on an annual basis rather than quarterly.
- It will likely take a year for investors to embrace the new reporting methodology.
- Ultimately, this is a good thing for Apple investors. The new reporting method will force the Street to think about Apple’s business as a stable and growing service, which should yield a higher earnings multiple in the long run.
New Reporting Is Frustrating, but a Good Thing Long-Term
While the move should not come as a surprise, the elimination of reporting unit metrics for iPhone, iPad, and Mac is significant—the Street obsesses over them. Unit metrics have made it easier to model Apple’s traditional hardware business, but Apple is no longer a traditional hardware business.
For the past eight quarters, the iPhone, which accounts for about 2/3 of revenue, has been growing units in a range of -1% and +5%, with an average of 1%. We attribute 90% of iPhone stability to existing iPhone owners upgrading and 10% to market share gains. This 1% average unit growth rate is, by definition, stability. Conversely, if iPhone units were less predictable, investors should demand the company continues to report units.
Apple has earned the right to ask investors to determine its value based on the two most important metrics – earnings and revenue growth. Understandably, investors and analysts will be frustrated over the next year, but will eventually gain confidence that Apple’s mix of loyal customers and product innovation will drive sustained revenue and earnings growth.