Can Shifting to a Services Business Model Help Apple Rebound?
- By John Kinsellagh
One of the pivotal questions concerning Apple Inc.'s (AAPL) future growth prospects, prompted by the 20% drop in its share price since late October, is whether a company whose identity has been inextricably wedded to the iPhone can squeeze more revenue out of its existing base of customers with an integrated service offering package. In light of the weak demand for the company's flagship product in India, that question now has special significance. Apple suffered a rout in one of the last untapped markets for smartphones.
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Apple posted revenues of $1.8 billion from India for the current year, which is less than half of what it had hoped to capture. The experience in India is a foreboding sign and should prompt the company to implement its services integrations with alacrity. What does the iPhone's recent unwelcome reception in India tell us? Consumers, particularly first-time smartphone buyers, in new or fertile markets are no longer willing to pay a premium for Apple's product when another phone with comparable features can be had for far less.
Some security analysts believe it will be easy for Apple to supplant the lost revenue from declining iPhone sales by leveraging its existing customer base.
Operating margin projections untethered to reality
Ivan Feinseth, an analyst withTigress Financial Partners, believes Apple will be able to monetize its large existing customer base of iPhone users and, by 2020, double its service revenues from its current level of $50 billion. Jeffries analysts also buy into the rapid revenue from services scenario, projecting inordinately high margins from increasing sales from Apple Music, iCloud storage and App Store downloads.
Jeffries anticipates the App Store can achieve $32 billion in revenue by 2023.This revenue model presupposes a 19% compound annual growth rate for the next five years with an 80% growth margin. For Apple Music, Jeffries expects a 34% annual compound growth rate. Lastly, Jeffries cut its price target from $265 per share to $225 and expects earnings per share to double through 2023 to $22.19 a share.
To call these analysts' projections optimistic would be an understatement.
Enterprising investors should ask, what is the factual basis for the heady growth projections from Apple's service offerings? Benjamin Graham repeatedly stressed the importance of incorporating qualitative factors in determining a stock's intrinsic value. There are several qualitative factors that present hurdles for Apple as it tries to reinvent itself. An analysis of these qualitative factors alone should give one pause before accepting the exaggerated projected growth rate for Apple's service offerings.
An analysis of the chart below is instructive. Apple's operating margins have been declining steadily since September 2015, from 30.5% to 26.7%. as of Sept. 25. Even though revenue increased from from $230 billion in October 2017 to $265 billion this past October, operating margins, price-earnings ratios and the stock's price all declined in tandem. These numbers cast serious doubt on the projections made by those analysts who now anticipate a miraculous, rapid acceleration in operating margins. It is highly dubious that Apple will be able, in the span of one year, to now achieve these astronomical projected operating margins from its service offerings.
Challenges for Apple as it tries to supplant lost iPhone revenue
A question arises: Will Apple see subscription services earnings that grow substantially or merely an incremental increase at the margin? The projected earnings growth rates seem inordinately high when one realizes that many existing Apple customers are already are plugged in to the integrated Apple device and OS ecosystem.
These customers have been making purchases from the Apple store and Apple music for years. Where else is the subscription services growth going to come from sufficient with which to achieve the revenue projections for the next 12 months? What additional services can Apple provide existing and new customers that will make a compelling monthly subscription services offering that can replace lost iPhone revenue?
Even if Apple offered its monthly subscribers a new iPhone at a reduced price at the expiration of a specified period, who would want to pay for such a bundle if changes to new iPhones are going to be merely cosmetic? This package sounds like the cable offerings that forced consumers to pay for something many rarely use: a landline. This type of bundle is what caused many to cut the cord.
What about the much-touted Apple original content offerings? This won't provide salvation as the endeavor has been stuck, for the most part, in the planning or preparatory phase. To date, Apple hasn't announced any compelling additions to its existing array of services. As iPhone sales continue to plummet, time is of the essence.
Given the difficulties in trying to change business models on a dime, the price targets calculated by many security analysts are simply not rational.
There doesn't seem to be any offering that would propel the company out of its current rut sufficient to replace the lost revenue from depressed iPhone sales. Part of the problem with relying on the potential of its subscription business is that Apple may have waited too long to get it up and running concomitant with the decline in iPhone sales. It were as if CEO Tim Cook wanted to hold these plans in abeyance until such time as every last drop of operating margins were extracted from its traditional number one revenue provider.
Apple's overriding problem is it has not had any groundbreaking product or service since it rolled out the Apple watch in 2015. Apple, known for introducing some of the world's most revolutionary products, has an innovation problem. With the exception of the Apple Watch, the company hasn't released anything of consequence that isn't a mere incremental iteration of one of its existing products.
Apple will need to transform its identity with consumers
The other risky part of Apple's strateg is that it is counting on increased revenue to extract a premium on some of its existing products, such as the MacBook Pro and its top of the line iPhone. It is far from certain how profitable this endeavor will be and whether this strategy will be able to yield any type of substantial revenue.
Increasingly, the company's fortunes will be tied to its ability to switch its business offerings and, more importantly, its relationship with consumers. The question would be different were there plans for a groundbreaking product. In the absence of new innovative products, the entire fortune rests with its ability to convert its identity with its existing base of customers, long acclimated to viewing Apple as a company that makes "cool" and useful electronic devices.
The difficulty for Apple in the short to intermediate term is that its shift to a radically different company needs to transpire with alacrity. Cook spent far too much time eking out every drop of revenue from the company's flagship device. Sales are going to continue to drop dramatically and Apple is ill prepared currently to roll out a services package that can replace lost revenue from slowing iPhone sales.
Microsoft (MSFT), by comparison, began its shift to a cloud-based subscription service back in 2013, when CEO Satya Nadella joined the company. Five years later, Microsoft is reaping the rewards of a forward-looking business strategy. What has Cook been doing for the past five years to prepare for the ineluctable demise of the iPhone?
The company can no longer count on its reputation as a one-time innovator and leader in integrating its OS system with applications and its hardware products. Regardless of the by now hackneyed applause of Apple automatons in the auditorium during its annual developer conference, the company's sales pitches and power point presentations can't obscure the fact some of the new, much-hyped features touted have long been available on Windows OS or Android.
Apple exults in the retina display in its MacBook line of laptops, yet some Windows machines, costing far less, can match the resolution. Apple is going to find that consumers will no longer be held captive to its familiar marketing strategy. In short, the once ubiquitous cult of Mac users is slowly dissipating.
Apple currently has a Peter Lynch value of $151, a Graham number of $77.61 and a Piotroski F-Score of 6.
Before they accept some of the rather posh valuations, enterprising investors should take pause and examine the substantial turnaround challenges Apple faces, as well as the likelihood of the company's ability to achieve its subscription services goals.
Disclosure: I have no position in any of the securities referenced in this article.
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This article first appeared on GuruFocus.
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