Apple’s Message: Think ‘Apple as a Service”

By Gene Munster and Will Thompson of Loup Ventures

Apple reported its results for the Sept. 2018 quarter essentially in line with expectations and gave guidance for Dec. quarter revenue 2% below Street expectations. Shares were down 5% after hours but fell further to ~7% on news that the company is adopting a new reporting methodology and will no longer break out hardware unit sales for iPhone, iPad, and Mac. Here are our thoughts:

• The new reporting methodology is Apple’s attempt to get investors to think of their entire business as a service (including hardware).
• This move should not be a surprise, given Apple’s efforts over the past four years to encourage investors to look more at its Services segment and, separately, to measure the iPhone on an annual basis rather than quarterly.
• It will likely take a year for investors to embrace the new reporting methodology.
• Ultimately, this is a good thing for Apple investors. The new reporting method will force the Street to think about Apple’s business as a stable and growing service, which should yield a higher earnings multiple in the long run.

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New Reporting Is Frustrating, but a Good Thing Long-Term

While the move should not come as a surprise, the elimination of reporting unit metrics for iPhone, iPad, and Mac is significant—the Street obsesses over them. Unit metrics have made it easier to model Apple’s traditional hardware business, but Apple is no longer a traditional hardware business.

For the past eight quarters, the iPhone, which accounts for about 2/3 of revenue, has been growing units in a range of -1% and +5%, with an average of 1%. We attribute 90% of iPhone stability to existing iPhone owners upgrading and 10% to market share gains. This 1% average unit growth rate is, by definition, stability. Conversely, if iPhone units were less predictable, investors should demand the company continues to report units.

Apple has earned the right to ask investors to determine its value based on the two most important metrics – earnings and revenue growth. Understandably, investors and analysts will be frustrated over the next year, but will eventually gain confidence that Apple’s mix of loyal customers and product innovation will drive sustained revenue and earnings growth.

Apple as a Service

The change in reporting metrics lays the groundwork for an accelerated (2+ years) investor view that Apple is a services business. This is not to be confused with Apple’s Services segment. We’ve written about Apple as a Service in the past. The Apple investment paradigm is moving away from a focus on device sales toward a more predictable Services-driven business that should command a higher multiple. This new paradigm has four core tenants: a stable iPhone business, Services growth, faster-than-expected capital return, and new product categories.

The Most Expensive iPhones Are The Best Selling iPhones

iPhone units missed Street estimates by 1.3% but iPhone ASP was 5.7% ahead of the Street. Net-net, iPhone revenue was 5% ahead of the Street, coming in at $37.2B compared to Street consensus of $35.5B. iPhone ASPs reached $793 compared to the Street at $751. The strength in ASPs was driven by iPhone XS and XS Max, which were available for about 10 days in the quarter. Apple’s most expensive phones are also their best selling phones, which provides optimism that iPhone ASPs in FY19 will exceed the current Street expectations.

Services Still a High Growth, High Visibility Business

Services growth decelerated to 17% y/y, below analyst expectations of 18%. Despite the miss, the segment is still predictable and growing at a rate that should satisfy investors.

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