2-5-18 2:47 AM EST | Email Article
By Christopher Mims 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (February 5, 2018).

Contrary to popular belief, Apple isn't a hardware company. Nor is it a software company. Apple is, fundamentally, an ecosystem company -- one that, with the help of millions of developers world-wide, has created a vast web of software and services that run on its 1.3 billion active devices.

Apple revenue has been dominated by the iPhone, but thanks to the services side of its business, the company is proving to be more durable than any single iPhone generation.

The trouble is, as Apple increasingly emphasizes device prices over volumes for revenue gains, it confronts a fundamental tension -- between charging people more for hardware and, simultaneously, more for services to access through it.

The former puts profit margins ahead of prevalence, while the latter emphasizes maximizing the number of gadgets in customers' hands.

The iPhone's average selling price rose in the most recent quarter, but unit sales were down. Meanwhile, evidence mounted that more people are holding on to their older iPhones. If any company can figure out how to continue increasing revenue while selling fewer phones, it's the Colossus of Cupertino -- but it might require a fundamental rethinking of how Apple charges for its goods and services.

Just as Chief Executive Tim Cook predicted in 2016, Apple has increased revenue from its intangible services into a Fortune 100-size business. In the 2017 calendar year, Apple reported $31.15 billion in revenue from services including Apple's music (both downloads and subscriptions), video sales and rentals, books, apps (including in-app purchases, subscriptions and advertising sold by Apple), iCloud storage and money Google pays Apple to be the iPhone's default search engine.

Another way to think of it: Apple is on track to take in about $26 a year in revenue from each of its 1.3 billion active devices. By contrast, Facebook brings in advertising revenue of about $25 a year for each of its more than two billion users. (Users in the U.S. and Canada, Facebook's most lucrative ad targets, are each worth $26.76 a year.)

Mr. Cook says by 2020 he wants Apple's services revenue to double from its 2016 level. Between now and then, if revenue from iPhone sales holds steady or declines, which would be a natural consequence of people holding on to their devices longer, then growth in services could become the primary driver of Apple's overall revenue growth -- or even the one thing that keeps it from declining. Services, and the millions of developers and thousands of companies behind them, are the reason the iPhone is so sticky, says Horace Dediu, an Apple analyst and fellow at the Clayton Christensen Institute for Disruptive Innovation.

The iOS economy

While the majority of the world's smartphones are powered by Android, Apple remains strong in the U.S. and other high-value markets. Compare Apple with Microsoft's 1990s dominance of the personal computer, Mr. Dediu says. "Once Microsoft established this juggernaut situation with Windows and developers and apps built on top of Windows, you couldn't move it." Even a federal antimonopoly lawsuit couldn't harm Microsoft's market share, he says.

While Apple counts only its share of app-store purchases and subscriptions in its services revenue, the totality of the "iOS economy" is much bigger, Mr. Dediu says. World-wide, people now spend $40 billion a year on apps for Apple devices. As of this year, that is more than they spend on movies at the theater, he adds.

When iTunes was king, the bulk of Apple's services revenue was music and movie downloads; with the arrival of the iPhone, it soon became apps. As Apple rolls out more gadgets, its services revenue will continue to diversify. Analysts believe Apple's coming HomePod and Watch have the potential to drive subscriptions and other spending. Take the example of AirPods: People who own them are more likely to subscribe to a music service, including Apple's, because AirPods make it easier and more convenient to consume audio content, says Ben Bajarin, an analyst at market-research firm Creative Strategies.

Hardware is hard

The remarkable thing about Apple's services revenue is that in general it goes up, quarter after quarter.

Contrast that with Apple's hardware revenue, which is highly seasonal and dependent on whether Apple is releasing a new iPhone that quarter. Without services -- which represented a record 16% of Apple's fiscal fourth-quarter revenue in 2017, when hardware sales were relatively low, and 9.6% of revenue in its most recent quarter, which included the launch of the new iPhones 8 and X -- Apple's money machine would be a good deal more erratic than it is.

Recent declines in the number of iPhones sold reflect how global demand for high-end smartphones appears to be saturated.

In a market where everyone is battling for existing customers, Apple is contending with competitors like Google, which gives away its Android OS to earn money on ad-supported services, and Amazon, which ropes in customers with low-cost electronics and Prime memberships. To keep expanding its services revenue, Apple will have to continue to sell (and care for) older models of iPhones, which could eventually mean lower margins on hardware.

An iPhone subscription

One way for Apple to resolve the hardware-versus-services tension would be to roll them into one giant subscription, Mr. Dediu says.

Apple already offers an upgrade program, where users can pay off an iPhone after 24 months or trade it for a new one after a year. Imagine a service where you simply subscribe to a regularly updated iPhone, Apple Watch, AirPods or some subset of these devices. Mr. Dediu estimates that for every Mac or iPhone, the average Apple customer spends on average a dollar a day on hardware plus services. A customer would spend more for a premium version -- say, for a new MacBook Pro and an iPhone X -- but calculating the annual value of such a customer should be straightforward for a company like Apple.

Throw in health monitoring, an iCloud subscription, Apple Music, Apple's original programming and more into a cable-television-like bundle, or a la carte, and Apple could go from being a hit-driven company to one that throws off predictable, consistent, subscription-based revenue. Think of it as Apple Prime.

Write to Christopher Mims at christopher.mims@wsj.com

 

(END) Dow Jones Newswires

February 05, 2018 02:47 ET (07:47 GMT)

Copyright (c) 2018 Dow Jones & Company, Inc.
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