- KPB & Co Research
With Apple's stock price bouncing 6% since the release of its Q1 of FY-19 results, we think investors are getting a bit overly optimistic about the near term prospects of the company. For Q1 of FY-19, the company recorded a 5% decline in revenues relative to the same period a year earlier, driven by a 15% percent decline in its flag ship product. In our opinion, the decline in iPhone sales reflects the inevitable cycle that all consumer products go through (we covered the Apple product cycle in previous articles ). As in the case with the iPod, iPad, and Mac there was a period of double-digit sale growth, but as the market matured sales growth levelled off and then began to decline. The damage has not been only on sales, but also on margins. In Q1 of FY-19 Apple's gross profit margins declined 1 percentage point, a trend we have been seeing for a while now. Investors are a bit optimistic about the 19% growth in the services business, which offset some of the decline in the hardware business. While the growth in services is good we think that for Apple to become a serviced based company, they would have to declare war on all businesses currently operating in their domain, and re-think how they approach research and development. The company definitely has the cash to do it, and to some extent the market power, but it is more difficult than it would appear at first glance, and it certainly cannot be done quickly.
Apple's services business can be subdivided into 6 categories: 1) streaming of music and tv shows, and rental or purchase of movies through the iTunes store, 2) purchase of Apps or purchase of in-App content through the App Store, 3) the purchase of e-books from independent publishers through the Book Store, 4) the purchase of Apps for the Apple TV through the TV App Store, 5) the storage of music, photos, contacts, calendars, and other stuffs on iCloud, and 6) Apple pay which facilitates purchases using Apple devices. For Apple to get the additional lift in sales needed to offset declines in the iPhone business, they will surely have to dominate areas in which they are not currently vertically integrated. To boost the service business beyond the current US$37Bn, and to offset the decline in the iPhone, the company would have to dominate the payments industry, overthrow all incumbents in music streaming, and go heavily into original movie content and online gaming. All the other services line have already matured.
Music Streaming Industry IS Tiny, Risky, Crowded
For FY-18, Apple generated approximately US$166Bn in sales from iPhones and services revenue of US$37.2Bn. Data from IFPI indicates that the entire music industry globally was US$17.3Bn in 2017, growing for the third time that year, after seeing 15 consecutive prior years of decline. The digital streaming component was only US$6.6Bn. In this industry you have the likes of Spotify (157Mn active users, 71Mn paying subscribers), Amazon (100Mn prime subscribers), Sound Cloud, radio companies such as iHeartMedia (271Mn active users), Pandora Media (80Mn active users), and others. When you put these numbers into context, it becomes abundantly clear that even if the entire music industry was absorbed by Apple it still would not be enough. Apple's 1.4Bn install base of devices, and 900Mn iPhone install base counts for nothing as it relates to music unless the entire market grows substantially. Furthermore incumbents in this industry are getting more vertically integrated and are establishing direct engagement with both content creators, and end users, which somewhat counterbalances Apple's power in distribution. For example, Spotify has built out it's Spotify for Artist Platform that we believe is second to none in the race for engagement with the artist community. They provide analytics, tour scheduling, and content release management for content creators. They are also organising concerts for their subscribers using the same artist pool available at their disposal. Don't believe us watch this video, while you do recognize that Apple is nowhere near this stage, and that this makes it difficult for Apple to sidestep third-party brands on their platform:
Incumbents are Using Tech to Increase Engagement With Artists and Fans
Apple is Barely Touching Original Content, Other Tech Companies Are Dominating
Apple is not well positioned to take market share in the digital or cable media industries. Currently, the global subscription video on demand market is estimated at around US$38Bn, and Netflix alone currently controls 50% of that market. At this stage of the game, the market appears to be too small to make a dent in Apple's business, but it definitely has potential. This market is growing at double digit rates due to consumers' cutting the cord of the cable tv providers, given that the cable tv market is around US$100Bn in the USA alone, there are a lot of opportunities here over the long term. Apple is currently barely touching original content while incumbents such as Amazon, Netflix, Alibaba, Disney through Hulu, HBO, and Tencent are spending between US$1Bn to US$8Bn to create proprietary content every year. Additionally, there is a propensity for consumers to consume this content on TVs, laptops, and tablets, devices where Apple has a less commanding presence. Original content will be very important in this business as people want access to diverse programming, and so the company with the bigger catalog will see the most profits.
In considering the structure of the industry, it is our opinion that for Apple to be a major player in the digital streaming industry they would either have to buy out the competition later, or declare war on incumbents now. All the options presented require a massive outlays of capital, which they currently have, but appear reluctant to spend. Netflix's valuation is close to US$148Bn and will only get higher as they build out their platform globally. Amazon is in too many unrelated business for it to be a great fit and is also worth almost trillion, and the others are either too small or part of a larger company with many different business units and complexities. Declaring war on current incumbents is the most viable strategy, but we believe that Apple is not prepared to do any of that, after all their primary expertise is in hardware and to some extent software for their own eco system.
Apple's Best Chance is to Dominate Mobile WAllETs
In our view, Apple is in a position to make an impact on their bottom line through mobile payments, however, it will take a few years for this to play out. Current transaction volumes for mobile wallets globally is around US$718Bn and is expected to grow to around US$2.7Tn by 2023. Apple's install base of around 1.4Bn provides a long run way for growth in this space provided they execute well. First, Apple Pay is a recent addition to the company's platform and so only a small proportion of the install base are capable of using the technology. On the other hand, if they are able to maintain the device count, they will eventually be in an enviable position to leverage the growth in payments. There are many competitors in this space (Google, Samsung, Amazon, Square, Alipay Tencent) but none of the competitors except maybe Samsung is in a stronger position than Apple. It is also difficult to compete against Apple when they control the entire eco system and have a trusted brand. Apple Pay is also gaining momentum with transactions volume going up by 3X in Q4 FY-18 and 60% of the top 100 retails coming onboard.
When all is said and done, Apple will likely face challenges in the near term as the number of profitable growth opportunities for a company its size is small. We think growth rates will decline in the near term owing to saturated iPhone market in developed countries and slower replacement rates. The recently released iPhone X does not have enough new tech to stimulate replacements now, and it also very expensive for consumers in developed and developing countries. We think the Apple brand is still has the most respect on the street and that positions them to take advantage of the long term trends in their industry.