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  • KPB & Co Research

In previous articles we explained why we think that leveraging payments is the best way for Apple (NASDAQ:AAPL) to grow its business in the face of declining iPhone sales revenues. The foundation of our arguments rested upon the fact that there are few industries globally that provide the scale that would allow the company to replace iPhone sales, and that the company already have the Apple Pay product line and the install base that allow them to readily access the market. On March 25, 2019, the company introduced a new suite of service businesses that they expect to double service revenues by 2021, one of which is a credit card. In this article we look at how this card came about, and the value proposition to customers.

How This Card Came About

The Apple Card is a fusion of capabilities that two companies are extremely good at and one company is growing into. This is not the first time that Apple has pursued consumer finance, but it is the first time it is doing it this big. Apple has had financing options for Apple products for well over 8 years. Today, the company has financing services such as the Fair Market Value Lease - a deal where an organization leases Apple's products with the option to upgrade every 2 to 3 years and possibly buy the equipment outright after 3 years, the 10% Purchase option - where an organization leases the product with the option to buy the product at the end of the lease term for 10% of the original cost, and the $1 purchase option - where the organization leases the product with the option to renew or purchase the product at the end of the lease term for 1 dollar. The company also has had consumer financing options such as the 0% interest for 24 months. Apple has been dabbling into consumer and business finance but why has the company gone this big into credit cards ?

They have to Find a Way to Earn a Return on Cash

Apple has more money than ideas, and so consumer finance is a natural way to earn a good return on capital. Generally, we are very skeptical when consumer product companies go into consumer finance as it usually doesn't ends well, and it usually implies that the company cannot find enough investment projects within its circle of competence that would earn a reasonable return on money invested. We are also skeptical because of the fact that many consumer product companies go into these areas to their detriment, remember GE Capital that was eventually spun off into synchrony financial after a disaster in 2008.

Last fiscal year Apple generated approximately US$77.4Bn in cash just from operating the business, of that amount the company re-invested US$14.8Bn back into the business to "keep the lights on" leaving them US$62.6Bn that they have no idea what to do with. Add to this crazy money, the roughly US$237.1Bn that they have in cash & equivalents and short term investments stored in some bank account somewhere. So in the end Apple has roughly US$237.1Bn in unencumbered money that is growing at US$62.6Bn every year, and they have limited avenues in which to put this money to use. Give it to us Apple we can take care of it. Anyway to be fair to Apple, they tried a few things such as buying by stock - they bought back US$72Bn last year, buying marketable securities - they bought US$71Bn last year, and paying dividends - they paid out US$13Bn last year. In any event, most of the activities that Apple has tried are low return activities in the sense that they are places to park money until they can come up with a true idea. This leads us to the purpose of credit cards.

With the Apple Card and Apple's 1.5Bn handsets distributed globally, the company is able to lend out a portion of the cash hoard that is currently sitting idle earning between 0% and 2.5% return. According to Apple in its regulatory (10-K) filings:

The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 2.16%, 1.99% and 1.73% in 2018, 2017 and 2016, respectively.

The average credit card purchase interest rate is approximately 13.0%, roughly a 10% percentage point gap between what Apple earns today on its cash versus lending it out to customers. As such, Apple has the potential to earn an additional US$10 to US$20Bn in income less administration fees. Though the company has not divulge the interest rates, nor the terms of the deal signed with Master Card and Goldman Sachs, we can assume that the roles and responsibilities will be shared according to the capabilities offered by all the parties involved. Goldman Sachs will provide analytics for credit approval and scoring, Master Card will provide the backend for transaction processing and administration, and Apple will be the interface between customers and the credit management process. This structure is similar to other deals, such that between Walmart, Master Card and JP Morgan. Each of the third parties in the Apple deal will take their share of the pie in fees.

What is in it for the Customer

Apple has unveiled a range of benefits that will provide value for the customer, and may give many financial institutions a run for their money. The card will have no late fees, annual fees, nor international usage fees which is something that many banks thrive off today, and many consumers hate. Given that apple has over a billion handsets worldwide there will likely be quick adoption in the USA as they roll that out, and the quick adoption will likely extend to international markets soon after. Many have been arguing that the cash back rewards aren't all that great relative to what is out there in the market today, but I am pretty sure that few if any provides real cash as opposed to credit that is severely restricted in its use. Apple has gone to great length to express the fact that people will get real cash that is not limited in some ways by something explained in the fine print, if this is the case this is a massive shift and do represents a big competitive threat to banks.

The customer will also appreciate the approach taken to turn over control of their data to them as opposed to banks and other third parties. The approach Apple is taking is one where no independent third party uses the data to perform analytics as all the analytics is done on the phone on the go. In the context of today today's world, where consumers are sensitive to privacy, and where Apple has proprietary control over the handset, this is a valued add capability that can be matched by only a few players in the world. Certainly, it is very difficult for any bank to match this value proposition without significantly changing their business model. In addition, the Credit Card App represents a platform that can deliver additional value added services to the end user, such as tracking personal finances through analytics, personal financial strategies suggestions through artificial intelligence, or other asset management service recommendations such as mutual funds, lines of credits, and insurance. Finally, Apple is the number one brand on the planet, most young people will want to get the Apple card simply because it is the cool thing to do, don't forget appearing to be cool is a benefit in and of itself.

In concluding, Apple's entry into the credit card space is a potential game changer for financial services. This is a game changer more so because the level of fin-tech adoption by traditional banks has been very limited thus far. Most banks have not given themselves a chance to develop the capabilities that allow them to provide additional value added services on mobile. As such, Apple's entry into the credit market will likely lead to "hurry come up" responses and Apps that can in no way compete with the quality of service that Apple can deliver. Furthermore, Apple already has proprietary control over the handset which gives them enormous design, execution, and go to market advantages, something that no single company is able to match.

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