Apple as a service company?

Last week, when Apple (NASDAQ: AAPL) reported its much-anticipated December quarter earnings, CEO Tim Cook provided a key update on the health of the Apple ecosystem – as of January 2018, there were 1.3 billion active Apple devices worldwide, an increase of 30% over two years ago. The healthy growth of Apple’s global installed base, and the implications that follow, helped mitigate the disappointment of the iPhone X, which has thus far failed to ignite a new iPhone “supercycle”.

On the conference call, Mr Cook was at pains to emphasise the importance of Apple’s installed base over the company’s quarterly reported unit sales.

“What I think is important, I think the active devices are hugely important and that’s the reason that we released the number two years ago and the reason that we’re releasing that again today. That number speaks to the strength of the product, the loyalty of the customer, the strength of the ecosystem and so we do put a lot of weight behind that and it obviously also fuels the services business.

“So I have long believed that a 90-day clock on unit sales is a very surface way to view Apple. I think that the far bigger thing is to look over a longer period of time and customer satisfaction and engagement and number of active devices are all a part of that.”

This marks a continued shift in strategy by a company whose philosophy has been (and still is, for the time being) to sell quality hardware differentiated by software at an attractive margin. Since Steve Jobs retook the reins in 1997, Apple has been the most successful technology company in selling hardware at a premium, propelled by its vertically integrated model and closed ecosystem that ensured control over all aspects of the product experience.

At the time Jobs revolutionised Apple with the iPod and the world with the iPhone, smartphones were all but non-existent. Apple’s control over the entire technology stack, plus Jobs’ keen eye for product design and experience, allowed the company to dig a massive moat around itself at the top of the smartphone mountain.

Today, however, global premium smartphone penetration has reached saturation point and the business of selling more smartphones at higher price points every year appears to have run its course. According to IDC, worldwide smartphone shipments declined -6.3% in the December 2017 quarter, with particularly notable declines in China and the US due to elongating replacement cycles. We can see this in Apple’s own data – a 30% increase in the installed base when unit sales over the last two years were roughly flat suggests a greater percentage of switchers and less replacement units (and a growing second-hand market, as Cook pointed out).

Apple’s shifting focus to Services in recent quarters is understandable for at least two reasons: firstly, to deflect negative attention away from the stagnant iPhone business; and secondly, Services is a scale business that better lends itself to a horizontal model rather than Apple’s vertical model, but Apple’s global installed base is now such a size that the company can generate attractive growth just by increasing the monetisation of active devices within its closed ecosystem.

Apple’s Services revenue growth has accelerated in recent quarters and years driven by the growing installed base, and reached an annual run-rate of $34 billion in the December quarter. This is good news, as Services gross margin is estimated to be almost 1.5 times the iPhone gross margin. While the company does not break down Services revenue, we estimate that most of the revenue is from App Store commissions and Google search payments, with a material contribution from Apple Music’s 36 million subscribers as well.

The most important question for us at Montaka is whether the trajectory of Apple’s Services growth can be maintained. Leaving aside AI which has limited practical application in and of itself, two of the biggest developments in consumer technology are connected-everything and augmented reality (AR). While Apple has been slow to address the connected home opportunity with its (arguably underwhelming) HomePod, Apple’s control over the entire technology stack from camera to processor to operating system gives it an advantage in consumer AR apps. We expect this to be an ongoing source of growth for Apple’s Services business as AR adoption rises, and a more native form factor for AR remains years away.

Overall, we believe Apple represents attractive value at the current share price, especially with the recent market correction. It is well understood that smartphone replacement cycles are elongating as hardware innovations become more marginal, but the market is unduly concerned about a smartphone supercycle (or lack thereof). With 1.3 billion active devices globally and a collection of the most valuable customers in the world, Apple is well positioned to continue growing in the long term regardless of how quarterly smartphone shipments develop.

Montaka owns shares in Apple (NASDAQ: AAPL)

DH5_2155Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.