Apple: Hardware Innovation Is No Longer Enough

Aug. 5.14 | About: Apple Inc. (AAPL)


Hardware innovation is far too easily copied in the technology and gadget world today.

The largest opportunity for growth will come from recurring service or fee based revenue streams.

High margin software or fee based revenue streams will offset compression in hardware margins.

The focus on Apple (NASDAQ:AAPL) in the market today is centered around what type of hardware innovation the company will introduce next. Anywhere from the next generation iPhone or iPad, a widely expected iWatch launch this fall, and the long rumored industry disrupting Apple TV. While speculation on these hardware gadgets makes for great fodder for the talking heads, the point in time is either already here or fast approaching, when hardware innovation alone will not be enough to move the needle for Apple. Take for instance the recent report that smartphones operating on the Android operating system now captures close to an 85% market share. These gains have come at the expense of market share loss for Apple. With the smartphone market no longer growing at anywhere near the growth rate experienced just a few years ago, companies will be forced to find hardware growth by converting buyers from one platform to another. It is also unequivocally clear that the smartphone market growth is predominantly at the lower end of the price range, an area that Apple has not made a concerted effort to compete in for a number of reasons. With both the iPad and iPhone, Apple clearly led the way in innovation for product categories that have exploded in popularity. Now dozens of competitors have sprung up, mainly utilizing the Android platform, and shown how devilishly easy it is to make minor hardware modifications and mimic the billions of dollars Apple poured into these products from a research and development standpoint. While imitation may be the sincerest form of flattery, for Apple, imitation is also a formidable foe standing in the way of future hardware growth. Thus the need for Apple to focus on its fastest growing business line, one which is not related to any fancy gadget or gizmo.

Software, Services, and Other Fee-Based Avenues For Growth

Investors might not be aware that in 2013, the fastest growing business unit for Apple was its "iTunes, software, and services" unit as seen in the table below from the 2013 annual report:

Click to enlarge

This non-hardware related category clocked in with 25% YoY growth and was just on the cusp of making up 10% of the total revenue for Apple in FY 2013. The importance of this category should not be understated. There is no question that the operating margin % generated from iTunes, software, and services already does or will far surpass that of hardware revenue in the years to come. This point can be validated by looking at any number of software or service-centric companies who generate substantial gross margin %'s from the time of inception until they become mature companies.

Apple took a first widely chronicled step in the right direction with its recent acquisition of Beats for $3B. It was evident from the beginning and made clearer by subsequent organizational changes that the purchase of Beats had very little to do with the hardware side of the business. Apple was buying talent capable of monetizing a recurring revenue stream in music licensing. Instead of paying a gargantuan premium to buy a $5B market cap company such as Pandora (NYSE:P), Apple chose to buy a smaller company with the belief that it should easily be able to surpass what companies such as Pandora and Spotify offer today. Consider that Apple recently revealed the company has 800M iTunes accounts, and you realize that Apple already is sitting on its very own gold mine, one which the company has acknowledged it will begin to mine a little more actively.

Potential Growth From Non-Hardware Markets

It would do most knowledgeable Apple investors a disservice to delve too deeply into all the various avenues for growth outside of hardware that Apple logically could see to explore. Streaming music, cloud services, streaming video, expanded advertising, health monitoring, mobile payments, and the list goes on and on. The key is understanding just how big the recurring revenue, services, and fee-based market could be for Apple.

Apple starts with 800M potential iTunes accounts, most locked and loaded with credit card information, and ready and willing to purchase songs, apps, or other miscellaneous services today. Morgan Stanley estimated that Apple generated $3.29 in revenue per active credit card account during Q1 2014. This is a paltry number when you consider that tens of millions of subscribers pay anywhere from $8 to $10 per month for subscriptions to Netflix (NASDAQ:NFLX), Amazon Prime (NASDAQ:AMZN) and Spotify for example. You also have the holy grail of fee income, notably from credit card processing fees, which should Apple manage to crack this market would be worth unimaginable fortunes. The key for investors to realize is that Apple has the foundation to enter any of the aforementioned markets while adding very little the cost structure already in place at the company. Certain markets involve licensing content or paying for infrastructure to host additional data in the cloud while others such as processing fees for credit card transactions would not even move the needle in terms of additional SG&A costs.

I fully believe the market underestimates the potential top and bottom line growth from non-hardware opportunities. The below table is an example of the additional revenue Apple could generate by monetizing different %'s of its current iTunes account holders with a service or services costing $10 per month:

It should not be a pipe dream to believe that in the very near future, Apple could be monetizing $10 per month from up to 400M users across the world. A just as likely scenario is that the company monetizes a higher amount from a higher value service offering covering a smaller number of accounts. It is not hard to believe at all that Apple already has the infrastructure in place to generate almost $50B in revenue from software, services, or other fee-based product offerings.

The Final Takeaway

Apple will likely continue to be a leader in hardware innovation, but the company is fighting what over time will become a zero sum game. Hardware margins will continue to compress, markets will continue to mature, and the ability to grow revenue will more and more become predicated on converting Android users to the Apple platform.

Apple needs to ensure that it does not allow Android to monopolize the low-end smartphone market. As evidenced above, the opportunity for growth will come from converting users of the Apple platform into other recurring revenue service streams. While there are certainly millions of iTunes account holders using an Android smartphone, there are also hundreds of millions of potential iTunes accounts holders to be converted. Without exposing these users to Apple hardware, it will be infinitely harder to bring these users into the fold and generate recurring revenue streams from them. I am not arguing for hardware to be a loss leader, but I am advocating for Apple to make a more concerted effort to compete against Android considering that platform now has ~85% market share.

The upside for Apple in finding new ways to monetize its user base is in no way shape or form priced into the current outlook or expectations for the stock. The downside of attempting to break into some of these nascent markets is negligible. While most wait with bated breath for the specs of the next gadget, that Apple announces, the real move for the stock will come from the company developing ways to monetize its user base with recurring revenue streams.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.