Apple's Broken Narrative

| About: Apple Inc. (AAPL)

Tim Cook and Luca Maestri had one goal for last week's earnings conference call: convince Wall Street to begin thinking differently about Apple (NASDAQ:AAPL). For the past two decades, the company's success has been judged by hardware unit sales growth, a metric that is now becoming increasingly at odds with the long-term strategy being pushed by Jony Ive. Management now finds itself searching for a new Apple narrative as iPhone sales growth slows. Wall Street has effectively declared the old Apple narrative broken.

Narratives Are Important

Wall Street is ruled by narratives. By coming up with stories, investors and analysts use narratives to understand how companies are performing. When a publicly-traded company reports earnings, the narrative surrounding it plays a major role in how analysts and investors think about the results. This is why a company may report seemingly weak results and yet still have a stock that reacts well. As long as the company performs well in relation to its narrative, Wall Street is in a position to reward management. A company's narrative is the primary way a management team balances near-term demands associated with being a public company with long-term goals aimed at value creation. If a company suffers from a broken narrative, Wall Street struggles to properly judge the management team. The company's valuation suffers as a result.

Amazon (NASDAQ:AMZN) represents a perfect example of how important a narrative can be to a company. While many are quick to point to its sky-high valuation when using earnings multiple metrics, Wall Street has historically judged the company differently, often using either cash flows or a more aggressive form of income to measure management's progress. Narratives also can change on Wall Street depending on a company's performance. Facebook's (NASDAQ:FB) narrative turned from being a social network with a mobile problem to the single-most promising destination for advertisers in the mobile world. For Microsoft (NASDAQ:MSFT), the narrative was about moving away from Windows. It was this change that provided the company room to report deteriorating sales and earnings trends as management put resources into more attractive businesses.

Management teams certainly play a role in nurturing their own narratives, often disclosing certain data points in order to help Wall Street understand the narrative. It is when management teams try to change a narrative without proper explanation that volatility ensues, like when Netflix (NASDAQ:NFLX), back in 2011, tried to split its business in two.

The Old Apple Narrative

While some are convinced Apple has lacked a proper narrative on Wall Street, in reality the company has long been judged as a hardware manufacturer selling personal technology gadgets. Accordingly, its success had traditionally been judged by product sales, specifically high-margin hardware unit sales growth. As long as it reported strong unit sales growth, the Apple story remained intact. The remarkable thing is that over the past 15 years, the company was able to do exactly that, transitioning between a number of products in such a way as to never let the narrative break, despite a few speed bumps.

As seen in Exhibit 1, the Apple narrative based on hardware sales steadily grew from the Mac to the iPod and then the iPad and iPhone.

Exhibit 1: The Old Apple Narrative - Hardware Unit Sales (2000-2015)

Click to enlarge

One of the more amazing business transitions in the modern technology era occurred when Apple introduced the iPhone. In just two years, the former Mac and iPod company became the iPhone company. The company certainly played a role in this transition, going so far as to change its corporate name from Apple Computer Inc. to Apple Inc. in 2007 to reflect the fact that its product line was changing.

Soon after the iPhone was launched, Apple then began selling the iPad, which only helped to boost the narrative of selling lots of devices. Even when the iPad began to face sales trouble, the iPhone's growth was positioned in such a way as to replace any missed iPad sales. Apple's old narrative was all about shipping new hardware, and by all measures, the company was experiencing new levels of success.

Apple's Narrative Is Broken

There are now signs that the Apple narrative is completely broken. The iPad has essentially been written off by investors, with the business having declined by more than 40% since peaking in 2013. Management guidance implies iPhone unit sales will decline this quarter for the first time. Apple Watch shipments remain too small for investors to get excited about, and the Mac is barely growing.

For additional evidence that the company's narrative is broken, AAPL's valuation contains plenty of clues. Apple's stock has had a very difficult past 12 months. After significantly underperforming peers and the broader market in 2015, the shares took another dive following 1Q16 earnings reported last week. Apple shares are now trading like a junk bond, with free cash flow yield exceeding 15%. Either the market expects the company's cash flow to decline substantially within the next few years or there is a fundamental problem with the Apple narrative.

While there is no denying that Apple's earnings growth will slow in the coming quarters, the pessimism priced into the shares would seem to point to investor anxiety over the company's long-term hardware strategy. This type of doubt is representative of a narrative problem. Investors are no longer sure how to judge Apple's results.

Wall Street has already declared Apple's old narrative dead. This is how it can be trading at such a low valuation yet still be the most valuable company in the world. The company's top stockholders have taken it upon themselves to come up with their own Apple narrative. However, there is no one single Apple narrative out there that Wall Street can get behind.

A New Narrative

Apple management appears to be ready to push a new narrative on Wall Street. With management's revenue guidance implying iPhone unit sales will decline 10-15% and iPad sales will fall another 15-20%, it is clear the company is entering a period of slowing hardware unit sales growth. While it is still possible for growth to return, it is in Apple's best interest to focus on establishing a new narrative. The company has a base of more than 650 million users with loyalty that is unmatched in technology. There is value found with this user base, but management needs a new way to explain it to Wall Street.

Management is positioning the reoccurring nature of its services revenue as the critical piece of a new narrative. In an attempt to strengthen its services story, management used last week's earnings report and conference call to introduce new disclosures meant to get Wall Street to focus on business metrics other than slowing hardware unit sales growth. The company disclosed that there are one billion devices that have engaged with Apple services over the past 90 days. In addition, management introduced a new services revenue total called Installed Base Related Purchases, which reflects the total amount spent on content and services in the Apple ecosystem, including the revenue remitted to third-party app developers and certain digital content owners. Exhibit 2 highlights management's first attempt at forming a new Apple narrative that moves beyond hardware unit sales.

Exhibit 2: Apple's First Attempt at a New Narrative

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Whereas in the past, Apple's earnings contained one of the more straightforward reports in tech, with investors simply checking a few sales numbers to make sure the company was on track, it issued a supplemental packet with 1Q16 earnings - a sign of a more complicated narrative being formed.

While some have classified this new narrative as "Apple, the services company," management likely has a different goal by focusing on services revenue. Since Apple still makes 95% of its operating income from hardware sales, management is likely trying to get Wall Street to think differently about its existing user base. One way of doing that is to emphasize how financially lucrative the user base can be by looking at the amount of money the average Apple user is spending on services such as iTunes, the App Store, Apple Music and Apple Pay.

"Apple, the Services Company" Narrative Problems

Management faces an uphill battle trying to position Apple as a services company. Wanting Wall Street to focus on services revenue makes sense on paper, because services revenue is one of the few Apple income line items still growing. Instead of talking about numbers that are declining, focusing on the only thing driving growth seems practical.

However, by talking up services revenue, management is moving away from the company's strength at the intersection of hardware, software and services. Positioning Apple as a services company also would mean that its competitor list just got a lot longer, with a slew of new players, including Facebook, Netflix, Spotify and Hulu. This comparison seems highly problematic for Apple, since the company is known to have limited resources, and to not have a new narrative built around one of its strengths is questionable.

Ingredients for a Successful Luxury Narrative

When thinking about a successful new narrative for Apple, it is important to focus on a few key ingredients.

Growth. This may seem obvious, but it is important to point out that growth is a crucial element in any Wall Street narrative. Apple management needs to find the right kind of variable that can effectively demonstrate growth over time. Along those lines, one metric stands out as something to monitor: relevancy. For management to remain successful in the future, the company needs to remain relevant. One way of including relevancy into a new narrative is to focus on metrics such as time spent on Apple products or amount of money spent on Apple products (notice management moving down this route last week). Engagement levels may also represent a useful metric to measure relevancy. A metric that may seem important, but contains incredible risk for building a narrative around, is user base. For a company that has taken on a much more refined strategy built around luxury themes, championed by Jony Ive, Apple's success is likely not aligned with the need to constantly expand the user base over time.

Hardware. The company's strength is hardware, and a long-term narrative should include hardware in some respect. Considering that its mission statement revolves around coming up with new products, hardware is very important. Instead of focusing on hardware unit sales growth, Apple could look at adoption rates within its user base as a metric to monitor. If there is evidence that a new hardware product, such as Apple Watch, is seeing steady adoption within the Apple user base, the takeaway could be that the company is succeeding with its mission statement. This metric would also go a long way in validating Apple relevancy and user loyalty.

A Personal Technology Company

A long-lasting narrative for the company needs to reflect ideals pushed by Jony Ive. There are signs of a refined Apple strategy playing out in nearly every product category. Apple is pushing much farther and faster at the high-end of each market (iPhone Plus, iPad Pro, the new MacBook, Apple Watch). Given a user base of more than 650 million people, the company is showing a willingness to hold the line on margins and, instead, build the intangibles surrounding the Apple brand. Management is now in a position to turn slowing iPhone unit sales growth into a strength by moving past a broken narrative on Wall Street and, instead, building a new narrative for Apple. By focusing on relevancy and engagement levels, in addition to user adoption rates, success will be measured by management's ability to come up with new products that people love: the one metric that will determine Apple's long-term success as a personal technology company.