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Can Apple Build Its New Empire on Services?

October 31, 2018

Apple (AAPL) is not happy being a boutique high-end marketer of smartphones, tablets, laptops, smartwatches and other products. It knows that the real money is made not on products, but on the behind-the-scenes services.

Telecom companies, including Verizon (VZ), AT&T (T) and T-Mobile (TMUS) in the American market and many others around the globe, earn vast subscription fees for wireless voice, data and other services that are delivered via Apple products.

And thanks to Apple acquiescing, Alphabet’s Google (GOOGL) reaps revenues from Apple’s users via Google’s mapping, search and other services that are on Apple’s products.

Apple isn’t too happy about all of this revenue missing its coffers. In fact, its CEO, Tim Cook, did a bit of a rant last week while speaking at a European Union (EU) privacy conference in Brussels about companies making their dime on his company’s devices. Mr. Cook lambasted companies for harvesting data for advertising and other revenue streams while at the same time not bringing up that Apple is paid fee income for access to its products by those same companies.

Cook is trying to convince the stock market that its services will be the foundation for its new empire of a company. Apple wants more customers locking themselves into Apple-land for their music and other content as well as for search and other services that would bring needed revenue growth for a company that is seeing slowing expansion in unit sales for its core iPhone products.

To get more services revenues, Apple needs a bigger universe of Apple users. And for the past ten years, Apple’s iOS operating system remains a very small piece of the mobile pie for handheld devices. It’s only about 11% or so of the global market, and aside from a few blips has remained well below 20% of the market. This compares to nearly 90% for Google’s Android operating system. Android is the market, and that’s where service revenues are operating, with Alphabet and plenty of other companies cashing in while Apple just sits there.

Apple needs a bigger universe, with more iPhones, iPads and other devices in the hands of customers. But rather than licensing out its iOS to other companies, Apple keeps to itself. And rather than slicing product costs to drive more unit sales and conversions from Android to iOS, Apple takes the short-term view of raising prices, focusing on average sales prices (ASP) over unit sales.

Now, granted, it has rolled out some newer iPhones that are slightly lower priced than its flagship iPhone X with its four-figure sticker price. The new iPhone XS and XS Max shipped recently, along with its cheaper XR. But the XR is still a very pricey phone, despite being a cheaper model in comparison.

And the market for smartphones is slowing down. According to a survey by the privately-held HYLA Mobile, which offers exchange and trade-in services as well as recycling for mobile devices, American consumers are holding on to older smartphones longer. Currently, the average hold on a device by customers is running at 2.83 years, which is up 18.41% over just the past two years alone. This means that phone companies, including Apple, can’t rely on upgrades being as frequent as they have been.

On Thursday, November 1, after the market close, Apple will release its fiscal fourth quarter results. This quarter, much like its third quarter results, tends to be softer for unit sales and device revenue. Apple depends more on its fiscal first quarter’s holiday sales, followed by the second quarter catch-up.

Given my analysis of supply chain and assembly company information, the fourth quarter should be about the same, with the potential for a small gain in unit sales and revenues from its phones and devices.

The company did finally wake up, and it did something to improve its laptops while making some tweaks to some tablet products. This might help sales in coming quarters. But with tablet and laptop sales being small fractions of iPhone unit sales, it will take a lot more to build up its universe with these product offerings.

Services for the third quarter were 17.93% of overall revenue, compared to 56.15% for iPhones, with laptops, tablets and other products including watches making up the rest at 25.93%.

Services revenue share is up from the same quarter from last year, when it was at 16.00%. And in dollar terms, it increased by 31.41% quarter over quarter. But if you follow the previous quarter, it only improved by 3.90%, and that’s been as Apple has supposedly been ramping up its efforts to offer and sell more services.

The bottom line is that Apple designs aesthetically nice products even though the heavy engineering work is done by its suppliers. And it has a nice base of customers who would be hard-pressed to convert to Android. That makes for some reliability in its services revenues.

But reliability isn’t a growth story. Apple might make for a good consumer stock if it managed to pay out more than its current dividend of 73 cents, for a yield of only 1.37%. And it could easily do that for shareholder value, given the payout ratio of only 26.00% and its major cash hoard.

But if it wants to get the growth narrative going from services, it needs to amp up the numbers of users. This means slashing product prices and licensing its iOS for other makers to build its universe so it can get more services revenues.