Quick Thoughts: AAPL – Pay No Attention to the Unit Sales Behind the Curtain!

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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November 5, 2018

Quick Thoughts: AAPL – Pay No Attention to the Unit Sales Behind the Curtain!

  • With unit volume flatlining YoY in 4QFY18 and heading into a tough 1Q19 compare, investors are correct to presume that AAPL’s new policy of not reporting device unit sales is a cover for a likely decline in iPhone units in FY19 and beyond.
  • AAPL’s bet seems to be that ASP increases can more than offset declining units to drive sales growth and margin expansion going forward. This elasticity is hard to predict and very vulnerable to the economic environment.
  • The installed base of iOS devices continues to grow as older devices are remaining active longer, because original buyers wait to upgrade and second-hand devices are sold in the used market. This can drive services growth in the near term, but declining new unit sales are a very bad omen.
  • The long-term narrative is about pulling ever more spending from the loyal base via higher device prices, accessory devices (e.g. Watch, AirPod, TV, etc.) and services (e.g. App downloads, Apple Music, iCloud, etc.). We are concerned that the water will begin drying up sooner rather than later.

“The number of units sold in any 90-day period is not necessarily representative of the underlying strength of our business. Furthermore, a unit of sale is less relevant for us today than it was in the past given the breadth of our portfolio and the wider sales price dispersion within any given product line.”

Luca Maestri – CFO Apple, 4QFY18 Earnings Conference Call 

With that, Apple announced that it would no longer be releasing unit sales numbers for its iPhone, iPad or Mac products, prompting a nearly immediate 4% hit to the company’s shares in after-hours trading, beyond the 3% thrashing they were already taking in reaction to the published guidance for the holiday quarter. The meaning of this self-imposed blunt trauma seems unambiguous. Apple doesn’t want investors looking at the unit volumes of its products because those numbers are likely to be disappointing. The just reported 4Q18, which featured two new flagship iPhones shipping in volume, eked out negligible 0.4% YoY unit growth against a year ago compare when users were still waiting for the November release of the iPhone X. The 29% revenue growth in the quarter was all iPhone pricing – the $1,000 X along with a few weeks of the $1,200 XS Max did the trick. The 1QFY19 compare will be much, much more difficult, as evidenced by the less than confident guidance for less than 5% YoY revenue growth in a quarter buoyed by the long-awaited product refresh for the iPad and MacBook product lines.

Apple will simply report revenue and costs for each of its device product lines – iPhones, iPads, Macs and “Other” (e.g. mainly Apple Watch, AirPods, and such). Management seems to be betting that price increases will more than offset declining units, and that the associated effects on margins will be a pacifier to investors more than a bit put off by this decision. This depends on the price elasticity of the average Apple user. Loyalty is one thing, but cash out of pocket is another, particularly if we see the economy weaken anywhere in the world that matters to Apple. It is hard, even for a company as sophisticated as Apple, to accurately predict price elasticity above the range of known data. Micro-economic theory is clear that higher prices ought to mean declining revenues at some point. Are we there yet? Tim Cook and Company will find out along with the rest of us.

Meanwhile, management would rather we look at the installed base of Apple devices, which is still growing despite the flat unit sales of new devices. This is happening because the average iPhone user is hanging on to his or her phone longer and longer. Moreover, many unwanted phones end up on the vibrant secondhand market, not always replacing an even older model. This arithmetic keeps new phones sold higher than old phones permanently retired, and thus, the installed base keeps growing. This is good for services and accessories, which care not whether the phone is new or gently used and rise with the installed base and the willingness of existing users to increase their spending on these things outside of their phone upgrade cycle. Thus, new phone unit sales can be dead flat and services revenue can rise 17% as they did in the just reported quarter.

This is not as good as it sounds. The whole market for smartphones has been decelerating for years as penetration into the global population wealthy enough to afford one has saturated and as innovation in the devices has become less compelling by the year. Faster processors, better cameras, higher resolution screens – Feh! The older models were already good enough. This is clear in Apple’s unit sales trend line as well – smoothing out that bump from a few years ago, when they finally decided to capitulate to the world’s taste for larger screens, iPhone sales have been decelerating along with the market. Now that we’ve hit flat (and not against a crazy compare, like in 2016), there is reason to expect the trend line to continue into declines. This ripples down into the used market as well, and eventually, Apple will find itself facing flat in their installed base as well.

So, if Apple’s installed base of loyal iPhone users is going to plateau, the strategy seems to be to get all these consumers to contribute ever more toward the health of its Cupertino masters. Currently, Apple has more than 1.3 billion devices in active use – iPhones, iPads and Macs included. Presuming that most iPad and Mac users are also iPhone users, and that there are plenty of users that have at least tripled up, lets presume for the ease of math that there are a billion distinct Apple users (although we suspect that the number is smaller than that). FY 2018 sales of $266B divvied up by those billion users is $266 per user per year, including spending on phone upgrades, services and other products. For Apple to continue to grow its revenues against an installed base that is in sight of its peak, that number is going to have to keep going higher.

Step one: raise prices. In 4QFY18, the ASP of an iPhone was up 28% YoY driven by that $1,000 piece of electronic bling, the iPhone X. For FY19, Apple has doubled down with the iPhone XS Max, which tips the register at $1,200 to start, along with the still $999 iPhone XS and the $799 XR. This is the bet on price elasticity, and maybe it works for a while longer and maybe not.

Step two: push services. Apple’s $38B services segment contains quite a few things. It has the 30% tax on app revenues (e.g. upfront payments, subscription fees, in-app purchases, and advertising, subject to some negotiation) generated from apps downloaded from its app store. It has payments from some app partners included as platform defaults – Google alone is believed to be paying ~$3B to be the Search provider. It has the money earned from Apple Care service, including the $29 battery replacement program ending this December. It has Apple’s own subscription services, such as Apple Music, iCloud, and Apple TV. Services revenues have been growing at a 17% clip, but slower than that if you consider service dollars per Apple user. To get this number higher against that flattening active base, Apple is pushing new subscription services – i.e. Apple Music, an Apple TV enhanced by original shows, a content subscription platform for media partners willing to cough up the 30% cover charge, and others. We’d feel better about this leg of the strategy if Apple were better at creating and operating services businesses. Even with the enormous advantage of default app status and free trial periods, and those enormous fees paid by rivals, Apple’s branded services offerings have had tepid uptake.

Step three: Sell accessories. If you have an iPhone, you really NEED and Apple Watch … and AirPods … and an Apple Homepod … and an AppleTV box … and so on, and so on. An issue here is that the upgrade cycle for most of these items is far longer than the phone itself (except for AirPods, which get lost on a 4-month cycle), so the list of $400 add-ons needs to keep growing. Still, this is the most promising element of the strategy – Apple is REALLY good at designing desirable electronic bling.

Of course, all this is predicated on keeping those billion users loyal as you annually deluge them with price increases, push offers for meh-services, and dangle those luxury accessories in front of them. Apple has historically only revealed its installed base numbers from time to time. Given management’s decision to stop disclosing unit volume numbers, we doubt that they will be entirely forthcoming about the installed base either.

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