Apple: 'Single Product Company'... It's Not The iPhone

Summary

• Someday, the iPhone will be disrupted by an even better user interface. We are still long Apple despite this expectation.
• Services is targeted to double in the next four years. But even longer term, we believe it will be more important to Apple than the iPhone.
• The services ecosystem is the "single product." The iPhone, iPad, Mac, Watch, TV, and HomePods are accessories. Hardware is a means of accessing the real product.

We believe Apple (NASDAQ:AAPL) is a "single product company," but that product is not the iPhone.

Someday, the iPhone will likely get disrupted by a new user interface, probably related to augmented reality (AR). But we don't think this will impact Apple as much as some might expect because the iPhone is not the true product people are buying.

We see the services ecosystem functioning as the single product. All the hardware, including the iPhone, are accessories that give access to the ecosystem.

The ecosystem of services is much harder to disrupt. It is made of so many components, developers, and partners. It provides so much utility for so many people. Even if the way we access it changes, the ecosystem will continue to provide an incredible experience.

But coming back to the current reality of iPads and iPhones to access the ecosystem. We see iPhone demand remaining flattish over the next couple of quarters, and then seeing a catch-up period when the next iPhone launches. And we expect iPad demand to bottom in 2017 with a five-year refresh cycle starting in 2018, as the 2013 iPad Air becomes a legacy piece of hardware.

A Single Product Company

It has come to our attention that Apple is viewed by some as a "single product company." We believe Apple CEO Tim Cook sees that opinion becoming more widespread, coaxing him to make comments like:

"Our Services revenue topped $7 billion, and it's well on the way to being the size of a Fortune 100 company. We're very happy to see the deep level of customer engagement with the Apple ecosystem across all of our services." - CEO Tim Cook 2Q17 Earnings Call

And

"Demand for AirPods significantly exceeds supply, and growth in Beats products has also been very strong. In fact, when we combine Apple Watch, AirPods, and Beats headphones, our revenue from wearable products in the last four quarters was the size of a Fortune 500 company." - CEO Tim Cook 2Q17 Earnings Call

Services Nearly A Fortune 100 Company

In the last 12 months, Services has generated revenue of $26.5 billion after eight years of growing at 20% CAGR. Services include digital content and services (iTunes, App Store, iBooks, Apple Music), AppleCare, Apple Pay, licensing and other services.

Currently, Capital One Financial (COF) bookends the Fortune 100 list with $27.5 billion in revenue. Kraft Heinz (KHC) at 106 is close to the same revenue as Apple Services. While notable companies not far away are Facebook (FB) at 98 and Nike (NKE) at 88.

In the 2Q17 earnings calls, CFO Luca Maestri reiterated:

"Our goal is to double the size of our Services business by 2020."

If Apple can achieve this goal, it could eclipse Coca-Cola (KO) in revenue, assuming Coca-Cola stands still for four years (-5.5% y/y in 2016)

Other Apple Hardware A Fortune 500 Company

Apple's Other Products generated revenue of $11.5 billion in the last 12 months. It has stayed in this range for a number of years as products come in and out of fashion (i.e. iPod, Apple Watch, Apple TV). This includes sales of Apple TV, Apple Watch, Beats products, iPod and Apple-branded and third-party accessories.

ABM Industries (ABM) closes out the Fortune 500 list with $5.145 billion in revenue. Apple's Other Products at $11.5 billion would be closer to the Fortune 250. Biogen (BIIB) at 248 is close to the same revenue as Apple's Other Products. Other notable companies nearby include Estee Lauder at 253 and Toys "R" Us at 244.

iPhone Is Not "The Single Product"…

iPhone ranks in the top 12 on Fortune as a standalone product, just ahead of Amazon (AMZN). And iPhone made up 63% of Apple's revenue in 2016.

We get it.

Many people see iPhone as the product Apple will succeed by or fail because of.

And we don't disagree. But hear us out.

…The Ecosystem Is "The Single Product"

As important as the iPhone is to Apple, the iPhone is just a popular accessory. Arguably, something will disrupt the smartphone someday. People will instead use something else to access the Apple ecosystem, perhaps an augmented reality user interface.

Source: Minority Report

How much time would you spend with your iPhone if you had no Wi-Fi, no data connectivity, and no apps?

Now think about all the great synergies you get when you have your iPhone synced with your Mac, your iPad, your Apple Watch, your Apple TV, your Apple CarPlay and soon your Apple HomePod.

All these pieces of hardware are simply accessories to connect you to the ecosystem of functionality. The ecosystem is what improves your life, and the ecosystem is what makes Apple's hardware products so great. Hardware is an enabler. No doubt, the ecosystem became what it is today because of hardware, like the iPhone, but the focus has changed.

Apple gives you the choice of how you want to interact with the ecosystem. While we have seen people with iPads on the street taking photos. The result has so far been that most people choose an iPhone.

Source: ExtremeTech

Since 2010, over 1.1 billion iPhones have been sold with 215 million or 20% of those sold in the last 12 months. iPad has not fared as well. Since 2010, Apple has sold about 360 million iPads. The gap in the number of units sold is interesting even despite the iPad selling at 70-80% of the price of the iPhone.

Many would say the upgrade cycle for consumers is longer, but why is it longer?

Our iPad Story

At home, we have one iPad. It's an iPad Air from 2013. It has been nearly four years since we bought it. We use it mostly to browse the web, play Candy Crush (we're on level 1268), but by far we watch YouTube on it the most. We used to use it for FaceTime, but the quality of the camera is no longer comparable to our newer iPhones, so we are willing to give up size for quality. We only use the iPad a couple of hours a day, so the battery is more than sufficient. The iPad never leaves our flat, so running out of power is never an issue.

Doing a double take of our iPad story, we understand that everyone doesn't use their iPad the same way as us. But one thing in common is the battery life. Even if you take your four-year-old iPad out with you all day, you will probably come home with enough power to watch a cooking video for dinner.

Our iPhone Story

An iPhone is a completely different story. I have had two iPhones in the last 4.5 years; my current setup is an iPhone 6s in space gray, which I got at the end of 2015 in the batch that had the battery issues. As a result, I have a "new" battery in my almost 1.5-year-old iPhone, but my next refresh could be longer than average because of the battery change.

My first smartphone and first iPhone was the iPhone 5, which I got in late 2012. The last six months with my iPhone 5, I suffered with a battery that would only last half a day and shut down suddenly when it reached 30% on the battery bar.

We're not telling you this because we want to give a bad review of Apple's products; on the contrary, we want to demonstrate that one of the reasons iPhones are refreshed by consumers more often than iPads is because of the battery.

A brand new iPhone or iPad connects the user into the Apple ecosystem in different but very similar ways, giving access to apps and files. Full-day usage of either product should not be an issue for new hardware. But an iPhone's battery will see diminishing life below a usable threshold faster than an iPad. This is simply due to the size and usage difference.

9to5Mac did a poll with 14,980 votes on how often people upgrade their iPad. Over 40% upgrade "less often than every three years," with about 7% maybe upgrading annually.

Source: 9to5Mac

We have a similar story with our Mac Air from 2012. But you get the point. We are still using it, but we are starting to see the battery life diminish. Almost time for a new one after five years.

iPhone Refresh Cycle Less Than Half As Long

Customers just want to get access to Apple's incredible ecosystem of apps and services. They can do that with a number of products, but so far they have chosen the iPhone by far.

The iPhone is strategically positioned with a smaller battery that has just enough power as a new product, for a full day of heavy usage.

With hardware upgrades coming with a premium price and often appealing to the early adopters, the majority of people will delay an upgrade until their current phone is causing them more headaches than providing value. For many, that means the battery is dying before they get home, they are tethered to a wall all the time, or attached to a power bank. The beauty and coolness of an iPhone are lost at this point.

This has meant that the iPhone has had a refresh cycle of 1-3 years. This compares to longer battery life products like iPad and Mac which have 4-5 years or more to give.

With the new iPhone "Plus" versions getting bigger batteries, we could see upgrade cycles on these Plus versions extending a bit longer.

Of course, there are many other reasons people choose iPhones like portability, capability, usability, etc.

What does this mean financially?

First on the Ecosystem

Apple's ecosystem is a hidden asset in its Services revenue line. Services has grown at 20% CAGR for the last eight years, and Apple's goal is to double the revenue between now and 2020, which implies a 19% CAGR. Through the first two quarters of 2017, it has posted 18% y/y growth consistently, with the App Store growing at 40% y/y in 2Q17. We think the Apple Pay Cash Card could add a billion dollars to the bottom line in a few years as well. See our article Apple Bank.

On a top-line basis, Apple Services may never eclipse hardware products due to the difference in margin profiles. But we believe in the long term, Apple Services will mature into the largest contributor to the bottom line for Apple. Hardware has already just become an accessory to the functionality of the Services ecosystem.

iPad

Apple reached peak iPad in 2013; this is year four since then. After two quarters in 2017, iPad sales are down 17% y/y. A sign that this may not be the refresh year. But arguably 2018 will be pushing the boundaries of the five-year-old iPad Air's capabilities. We're forecasting 2017 iPad units to decline by 12% y/y to 40 million iPads. However, in 2018, we expect the trend to start reversing as the five-year refresh cycle starts to take hold.

At the end of the day, we still believe there is a time and place for an iPad in the house. We don't always want to turn our computers on, but we want a bigger screen as well.

Note: Units in thousands. Green bars are author's forecast

Source: Author, Apple

We see Mac units holding steady in the middle of a 15-20 million unit range for the next two years as well as they have over the last six years.

iPhone

We see iPhone as a mature product now. This year, we expect some purchase delays will limit the unit growth.

"It's that there are more rumors floating and more press articles and mentions of new things, and when that happens, a percentage of people delay. And so, yeah, we see a piece of that. That probably affects us more in China than other places because there's a tendency there to buy the latest thing." - CEO Tim Cook on CNBC

But with an expected 10-year anniversary of iPhone in the fall/winter, 2018 should see a lift from delayed upgrades. Though a potential supply shortage could limit the upside. Given the maturity of the iPhone and the already short refresh cycle, the relative impact is expected to be minimal. We forecast 1% y/y unit growth in 2017 to 215 million units, and 5% y/y unit growth in 2018 to 227 million units, as the majority of new iPhones will fall into fiscal 2018.

Note: Units in thousands. Green bars are author's forecast

Source: Author, Apple

Wrap Up

Apple is a "single product company," but that product is not the iPhone. It's the services ecosystem. When the iPhone and smartphones are disrupted by a new user interface like AR, we will still be long Apple because the ecosystem is a huge moat in our minds.

The ecosystem of services is much harder to disrupt. It is made of so many components, developers, and partners. It provides so much utility for so many people. Even if the way we access it changes, it will continue to provide incredible utility.

Apple's ecosystem is a hidden asset in its Services revenue line. Services are targeted to double by 2020, implying a 19% CAGR. Apple Services may never eclipse hardware products in revenue, but we believe in the long term, Apple Services will mature into the largest contributor to the bottom line for Apple.

We think the Apple Pay Cash Card could add a billion dollars to the bottom line in a few years as well. See our article Apple Bank.

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Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.