In Tim Cook’s letter to Apple investors, he attributed the shortfall in revenue on numerous factors. The two standout factors were a slowdown in China and more worryingly, a shortfall in the expected number of upgrades across all markets. For investors, the main area of concern isn’t the fear of Apple’s impending doom, but rather the uncertainty around their future. A miss of this magnitude may suggest a lack of understanding of their current place in the market.

Undoubtedly, part of the problem is due to their exposure to macroeconomic factors. However, I do not want to dwell on the impact of the Chinese market, there are many detailed investigations of Apple’s challenges and equally the potential for success. What I feel is worth some additional analysis, is the shortfall in upgrades. This, more so than the issues in China, can be completely attributed to the decisions that they have made. Which will shed some light on the strategic halfway house, that I believe they currently find themselves in.

iPhone upgrades

iPhone revenue came in at $52 billion down from $61.1 billion year on year, down not only on the high of 2017 but 2016 as well. This Quarter was the first since Apple stopped announcing unit sales, but with the increase in average selling price of the iPhone year on year, it is fair to say that there has also been a fall in unit sales. Despite falling sales, their active install base rose from $1.3 billion to $1.4 billion and on the earnings call, Tim Cook highlighted that two-thirds of iPhone purchases in China were their first. It is clear that Apple still has mass appeal and holds a large amount of brand loyalty amongst their customers. Their main issue is the growing difficulty in encouraging existing iPhone users to upgrade at the rate they used to.

Some of this may be due to the iPhone experiencing an “S” year. The latest iPhone is not a significant change design wise, which could be prompting iPhone buyers to delay spending. There is evidence that Apple’s customers, especially in Asia, view the iPhone as a luxury product. With the launch of the iPhoneXS, in which changes are not externally visible, customers may have decided to wait for a more eye-catching model¹. This could be a major issue as innovation in the smartphone market could be slowing down.

This is linked to the ”good enough” principle. For many customers, the newer generations of iPhones offer no additional functionality that tangibly improves everyday experiences. At the end of the day, excluding overall performance, the experience of using an iPhone has not really changed in the last 4-5 years. This is not from a want of trying, Apple’s recent keynotes have spent a great deal of time emphasising VR and AR capabilities, but besides a few niche use cases they have failed to capture the imagination of their consumers or developers.

On the software side, after years of neglecting their OS on older hardware, their latest operating system (IOS12) has improved the performance of all previous iPhones considerably. Another performance gain arose from, Apple’s battery throttling fiasco last year. Where Apple revealed that they had a released a software update that reduced the performance of the phone when the battery had aged to prevent shutdowns. It was the best technical solution however, due to a lack of communication of the issue, it resulted in Apple releasing an unapologetic statement. They subsequently announced a discounted battery replacement program for all iPhones. Aside from the financial cost, this program increased the awareness amongst the market of the way a declining battery impacts phone performance, in addition to the relatively low cost of replacement. For many, who would have seen significant boosts in performance from a combination of new software and batteries, they may feel like they have no reason to purchase the latest iPhone.

For most people the newer generation of iPhones offer no additional functionality that tangibly improves everyday experiences.

These factors paint a bleak picture for the future growth of not just Apple but the smartphone market as a whole. One could argue, that the relentless upgrade cycle was always unsustainable. Apple had stumbled unto the perfect product. The iPhone instantaneously became an essential product and was able to be rapidly innovated on year after year. It is easy to accuse Apple of being caught unawares, but for those that have been paying attention, Apple had set in motion the steps to reduce their reliance on the iPhone.

The shift to services

In the 2018 Q3 report and ensuing earnings call they spent a significant period of time highlighting their growing services revenue. It was clear that Apple was attempting to piece together a convincing narrative. Revenue from services has continued to grow with Q4 seeing 10.9 billion up from 9.1 billion the previous year.

This revenue is quite diverse. Services from apple all started with iTunes, which later expanded to the AppStore, in addition to the more recent music and cloud storage offerings. These services have been mostly limited to apples existing customers. However, more recently there has been a change in the exposure of these services. Airplay now works with smart TV’s not produced by Apple. Similarly, there has been a shift in Apple Music to work on a greater number of platforms. Apple is starting to democratise their service to larger audiences. Which suggests that they want to see their services business to expand to new customers.

There is also the rumoured Apple video platform, predicted to launch later this year. In which Apple seems set to take on the likes of Netflix and Disney. They have reportedly spent over a billion on original programming. Time will tell whether this venture will be successful, but with the amount of capital, Apple is investing it will most likely have a sizeable impact the market in the short term.

While all of these factors are outward indicators, most firms have an internal indicator as for where they see their growth coming from, job listings. The job listings that have increased the most (As of January 2019) are AI engineers, backend/infrastructure engineers and media/marketing, all of which hint at an increased focus in services and or software.

Can apple make the transition?

Currently, Apple has an over 60% margin on their existing services. These margins are driven partly from the very nature of the services business. Unlike physical goods, services have much lower marginal costs² so that they grow increasingly profitable at scale. This makes it an extremely appealing area of focus. A move to services is one that makes sense on the balance sheet but to what extent can apple successfully make the transition?

A company like Google has clearly aligned incentives to create services. Google is driven by the benefits of collecting as much data about its users as possible, which they are then able to leverage to sell more targeted advertising. On the consumer side, their users trade their data for services that are using the data they provide to constantly improve. Google is so effective an extracting value from users data, that they offer a large proportion of their services for free.

Apple, on the other hand, may have mixed incentives. They have previously employed their services as a way to differentiate their hardware. A large part of their success can be attributed to their tight integration with their platform, which helped them to reduce friction³. Apple has fostered a user-focused culture that is fixated on the quality of their experiences.

Despite their lack of clear incentives, there are a number of factors that are hugely beneficial to apple. The Apple brand holds a huge weight in the market. The success of their products has built a fiercely loyal customer base that is willing to pay a premium on services/products. Despite not offering superior services or value for money, their customers value the tight integration with the Apple ecosystem. They are able to further drive service growth because of the power that they hold over their customers by being able to control the defaults on their platforms. Products like Apple Music and Apple Books have benefited hugely from being the default app.

Furthermore, they will be able to use their scale to continue to grow the value and number of services that they offer. This would create further opportunities to bundle these services into a single package similar to Amazon Prime. Not every consumer assigns the same values to the individual services in the bundle, but in a large bundle that doesn’t matter; the differences in the individual values average out. If a seller can accurately predict the average value a subscriber is willing to pay for all the services in the bundle, then it can set a price just slightly below that value and extract the maximum value possible from its audience.

Privacy

One thing that is antithetical to this shifting strategy is Apple’s stance on privacy. Apple has prioritised privacy on their devices often to the detriment of their services. One such area is in their use of machine learning. Unlike their competitors, Apple focuses on utilising on device learning on pre-trained models, rather than amalgamating all of its users’ data and feeding them into their models. Similarly, they have been very strong on their stance on tracking user actions.

When evaluating a firms strategic approach it is helpful to distinguish between actions which are aligned to the companies business model, therefore, are “free” and those which are chosen despite their contradiction to their business model so that they incur a cost. With a focus on hardware, Apple’s stance on privacy so far has been “free”.

If they are to move to services, the cost of this approach would not be immediately felt but could severely hamper them in the long run. The gathering of data affords an organisation a cyclic advantage. Wherein more data provides the ability to improve their services, this generates more active use, which results in more data and so on and so forth. Apple stance on privacy has most likely reduced the efficacy of Apple’s services but for many of Apple customers⁴ who value their privacy, this may have given them an incentive to choose apple’s services.

Will the strategy be successful?

Success can be boiled down to two main questions.

• At what point are consumers willing to trade their privacy and integration for improved services?

• With the focus on privacy can Apple keep up with the rate of improvement of their data advantaged competitors?

Apple is betting that they will be able to create services that can surpass the data advantages of their competitors, or at least capture the segment of the market that is willing to trade off quality for privacy and integration.

Returning to the good enough principle, it may be possible that the gap between Apple and its competitors will not lead to any groundbreaking functionality. This would enable Apple to continue to remain relevant in the market. However, when it comes to software services, where innovation can be deployed instantly with the push of a button, this principle holds far less weight.

There are possible cultural ramifications of a move to services. Apple has built a culture that is secretive, segmented and specialised. This culture allowed it to thrive in the waterfall style delivery needed in the world of hardware. Their secretive culture has even led them to hire some of the leading business minds to build their own internal business school.

Contrastingly in software services, collaboration and openness are key traits. Successful services companies develop their products iteratively are not afraid to release works in progress. Their approach to collaboration extends beyond their walls as they readily form partnerships. One such example is a company like Netflix who readily publish their learnings and talk openly about their challenges.

Microsoft tries to find pockets of unrealised revenue and then figures out what to make. Apple is just the opposite: It thinks of great products, then sells them. -Ex-Apple employee

Their former CEO, Steve Jobs spent his final years cementing his vision for Apple, hiring the best and the brightest all creating a robust framework to ensure the apple he created would endure. Cultural change is hard to achieve, however, it is born in success. If Apple is successful in services it may be at the cost of their advantages in hardware. Equally, if they fail to succeed it will be in part due to the culture that Jobs created.

Apple is on a path to delve deeper and deeper into services. With their plunge, they aim to take an even bigger bite of our digital lives. It remains to be seen how rewarding or damaging this will be for Apple in the long run but in the short term Apple have a clear pathway to growth.

By Damilola Payne