What everyone’s missing in Apple’s earnings drop

Apple’s iPhone sales declined for the first time since 2003. That’s the bad news, and judging from the pundits, the sky has started to fall on Apple’s halcyon days. One analyst goes so far as to say that “the only thing that is plainly clear concerning Apple is that it has saturated the market with its legacy, hardware products and largely achieved its total addressable market.”

The truth, however, is very different.

What this analyst and others seem to be missing is that the future for Apple’s iPhone business has less to do with hardware and more to do with services. While Apple will always generate huge sales (and profits) from its hardware sales, its second largest revenue-generating category in the quarter was “Services,” or things like App Store sales, Apple Music, and Apple Pay. Each of these businesses is soaring, and isn’t dependent on stratospheric sales of devices to grow.

We are all doomed!

Source: Screen shot from Seeking Alpha

No one should have been surprised by Apple’s Q2 earnings miss. Back in January the company reported the softest revenue growth since the iPhone was introduced in 2007, and warned that Q2 revenue would decline for the first time in 13 years. Analysts wrung their hands at the time, but waited to go into full-scale panic until after Q2 results hit.

Not that Apple is alone in this. According to Strategy Analytics, global smartphone shipments declined for the first time ever, dropping 3% to 334.6 million devices from 345 million devices. Apple’s contributed 51.19 million iPhones to the slide, down from 61.17 million units a year earlier.

ZDNet’s Jason Perlow challenges Apple’s future, arguing that headwinds from developing economies like China mean “a meteor is heading right for… [Apple, forcing it to cede the market] to the Huaweis, the ZTEs and the Xiaomis of the world, the big commodity producers.”

Despite the fact that Apple has shown time and time again that it can sell upmarket, and grow that upmarket pie, Perlow may be right.

But where Perlow’s analysis goes awry, as with many other onlookers, is in this statement: “Like the PC industry before it, the smartphone/mobile device industry has become so mature that there isn’t much new that can be done.” In fact, there is “much new that can be done.” It’s just that the new runs on the phones, or on servers that connect with the phones over wireless networks. That’s where the big bank in the sky will shower Apple again.

The Apple services force awakens

While Apple’s iPhone shipments keep slowing, use of them keeps accelerating. Apple characterizes such use as “engaged” users, i.e., those who have purchased a service (movie in iTunes, app from the App Store, and so on) within the last 90 days. In Q1 the number of “engaged” Apple customers grew 25%, generating $5.5 billion in Services revenue, which was up 15% year over year.

In Q2, those engaged customers spent even more, with Services revenue at its highest ever amount, climbing 20% to $6 billion. As Apple CEO Tim Cook detailed on the earnings call, App Store revenue also jumped 35% to top Q1 2016’s all-time record, and Apple Music has finally reversed quarters of decline to nab over 13 million paying subscribers. (Even so, I’m steering clear of it for now.)

Here’s where things get interesting. According to Cook, to really get a read on Apple’s future you need to decouple devices from the services that they enable:

The Services business is powered by our huge installed base of active devices, which crossed 1 billion units earlier this year….[T]hose 1 billion-plus active devices are a source of recurring revenue that is growing independent of the unit shipments we report every three months. In fact, the purchase value of services tied to our installed base was a record $9.9 billion in the March quarter, up 27% over last year, accelerating from the 24% growth rate we reported in the December quarter.

One of the most promising Services that Apple offers, one that I personally have started to use daily, is Apple Pay. Cook extolled the success of Apple Pay: “Apple Pay is growing at a tremendous rate, with more than five times the transaction volume of a year ago and 1 million new users per week.” That 5X increase in transaction volume meshes well with what Cook reported in the Q1 earnings call: “In the second half of 2015, we saw a significant acceleration in usage, with a growth rate 10 times higher than in the first half of the year.”

Oh, and as if Apple weren’t profitable enough, its Services business shows “a profitability that is higher than company average,” according to Apple CFO Luca Maestri.

In short, the question isn’t whether the iPhone era is over. It’s not, and things like the Apple Watch will buttress and augment it. But we need to stop making a fetish of device sales when the services powered by those devices increasingly command center stage. In this area Apple is making real progress, and it’s only just beginning. Importantly, no one else – not Samsung, not Google, not Facebook – is creating a similarly rich services ecosystem for which consumers are happy.

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