Apple Falls Far From the Tree

Jon Markman

Apple (AAPL) has a plan to remake itself. Its new business model is all about leveraging its hardware ecosystem to sell software services. Unfortunately, hardware isn’t what it used to be.

Investors have been grumpy about Apple shares since iPhone sales set records in the middle of last year. Paradoxically, the reasoning then was it couldn’t possibly get any better. So far, that’s true. In fact, expectations were so low going into last week’s earnings report, even terrible year-over-year numbers looked great.

For example, sales in China, once thought to be the engine of future growth, collapsed 33%. Overall revenues fell 15% to $42.4 billion. iPhone sales were down 15%. That was made worse by a decline in average selling prices as its 4-inch retread, the $399 iPhone SE, outsold the iPhone 6 and 6S.

Beyond phones, iPad sales fell for the tenth consecutive quarter. Sales of Mac computers tumbled 11%, the third consecutive decline for that category. And Apple Watch — the product that CEO Tim Cook promised would change the wrist — warranted no more than a few passing thoughts on the conference call despite separate reports pointing to a massive 55% sales decline.

Apple customers have begun keeping their old iPhones longer

However, all of those numbers, as bad as they are, looked fine next to dramatically lower expectations. Cue the short covering rally.

There was a bright spot though, and it’s the key to Apple’s future plans. The subscription business is booming. Apple Music, App Store, Apple Pay and all of the other bits and pieces Cupertino throws under the Services heading are now almost a $6 billion-per-quarter business. Tim Cook promises that by 2017 Apple Services will be a business big enough to make the Fortune 100 all by itself.

That would be amazing. However, investors should be very wary. Apple builds wonderful hardware products people love. In the past, they have been very loyal. However, by all accounts, they’re keeping their beloved iStuff longer or worse, switching to less-costly alternatives. All of the Apple hardware categories are now declining.

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The new business model depends on increasing numbers of new people becoming stuck in the hardware ecosystem and then buying services. To get substantial growth beyond the base, Apple needs sales growth to offset normal attrition. The data says that’s not happening. In fact, sales growth is negative.

This is not just a bad secular trend Apple is patiently riding out. It is building out retail stores in China at a furious clip yet sales are still falling. As Apple loses, China’s Huawei — a conglomerate with global aspirations and with the tacit support of its Communist government — is flourishing. That same Chinese government, by the way, is throwing obstacles in Apple’s way like services bans and dubious patent infringement claims.

In the United States, Apple is fighting a war on two fronts. It’s losing market share at the high end to Samsung’s critically acclaimed, fast selling Galaxy S7 line. At the low end, inexpensive Chinese imports are nipping away at its bottom line. In the past, Cupertino has paid little attention to that part of the market. Those days are over. To make Services gains, it needs to expand the ecosystem. The iPhone SE is a direct response to those ankle biters.

Tim Cook is prone to hyperbole. Cheerleading seems to be part of the job description for modern corporate leaders. He has continually talked about the rate of Android switchers to iOS despite all of the evidence to the contrary. He also recently opined about the growth rate for Apple Watch being on par with the early days of iPhone. Although he’s understandably optimistic about Apple’s future, building a business model based on declining sales growth has never been a great idea.

While it’s tough to bet against the world’s largest company and its pile of cash ahead of a product cycle, reducing exposure into strength is the best course of action right now. Just as investors became too pessimistic about earnings this quarter, they’re likely too optimistic about the prospects for the next iPhone.

Best wishes,

Jon Markman

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