After literally years of analysts claiming that we’ve reached ‘peak iPhone’ – that Apple’s year-on-year growth had gone as far as it could go – that day has finally arrived. iPhone sales last quarter were essentially flat (up just 0.4% year-on-year), and the company yesterday forecast that this quarter will see its first ever year-on-year decline in revenue since 2003.
If Apple hits the midpoint of its projected revenue for the current quarter, it will suffer a year-on-year fall in income of 11%. For the first time in 13 years, the ‘Apple is doomed’ merchants can cite real-life numbers as support for their position.
The reality, of course, is far more nuanced. There are some very specific reasons why the current quarter will be such a tough one, and why ‘peak iPhone’ is likely to be temporary, and I’ll get to those in a moment. But there’s also a bigger picture that suggests that Apple may have to be willing to think the unthinkable when it comes to the huge margins it has been able to enjoy to date …
Let’s begin with the reasons Apple expects this quarter to be so tough. To avoid confusion, I’m going to refer to calendar quarters rather than Apple’s fiscal quarters, which begin in October.
First, Apple had supply issues when it launched the iPhone 6/Plus, meaning that it wasn’t able to satisfy all of the demand that existed in the holiday quarter. A chunk of the sales that would normally have accrued in calendar Q4 2014 instead rolled over into calendar Q1 2015. It didn’t have the same issues this time, so there’s an artificially high target to beat this year.
Second, the global economic environment is challenging, notably in China, Apple’s second largest market after the USA. As Cook put it in yesterday’s earnings call:
Targeting the wealthiest tier of the population, Apple is better placed than most companies to prosper even in a stagnating economy, and did continue to grow its business in China by 14% – but that’s a long way short of the 84% growth it achieved the previous quarter.
We’re seeing extreme conditions, unlike anything we’ve experienced before, just about everywhere we look.
Third, Apple generates two-thirds of its income outside the USA, and the strong dollar has hit the export market hard. In some markets, Apple has increased prices to protect its margins, which inevitably hurts demand. In others, it has taken the hit and earned less money from the same number of sales. The total impact of the shift in currency rates was $5B in the previous quarter alone.
To put that figure in perspective, the amount Apple lost in currency exchange was roughly the same as Facebook’s entire quarterly income. Or, as Apple’s CFO Luca Maestri put it yesterday:
If you take $100 of the business that we did outside of the U.S. in September 2014, when we launched the iPhone 6 and 6 Plus, the same level of business today translates to only $85.
Apple is also in it for the long haul. As Cook said yesterday, the company does not live or die on a quarter-by-quarter basis. In particular, it is growing its increasingly important services business – launching Apple Music last year, and likely a streaming TV service this year. With a billion active iOS devices, it has a vast potential market for these.
Apple’s underlying position, then, is not as bad as it appears on the surface. While iPhone sales may have temporarily peaked, it’s likely that growth will resume in one or two quarters’ time as the economy picks up.
Especially during periods of economic uncertainty, it’s important to appreciate that a significant portion of Apple’s revenue occurs over time.
But this does not mean the company can afford to be complacent. While factors like the Chinese economy and strong dollar rate are outside of Apple’s control, they represent the real world, and Apple needs to respond.
To date, Apple has been able to shrug off falling iPhone market share by pointing out that while other companies take home the bulk of smartphone revenue, its high margins mean it grabs almost all of the profit. It has been able to happily watch Android manufacturers compete for the bulk of the market while it skims the cream from the top.
But the market is changing. One big change is the ending of ‘subsidized’ pricing. It used to be that carriers sold you an iPhone for $1-200 upfront in return for a 1-2 year contract, hiding the rest of the purchase price in the monthly plan. You and I weren’t fooled by this, but it’s amazing how many people thought they really were paying only $200 for their brand new iPhone rather than the true all-in price of $650 and up.
The competitive environment is also changing. Once upon a time, if you wanted to opt for Android, you had a choice of only two or three flagship handsets at prices close to those of an iPhone for a device with a horrible manufacturer overlay on top of the stock Android OS. The rest of the Android market was cheap-and-nasty. These days, the Nexus 6P is a very solid piece of aluminum hardware with good specs and pure Android 6.0, free from bloatware. Performance-wise, it’s comparable with an iPhone, and comes in at $499 – not spectacularly cheaper than an iPhone, but enough to catch the attention of some.
Perhaps more worryingly for Apple is the fact that we’ve seen the emergence of really strong mid-market smartphones. For example, the Moto X Pure/Style, which allows you to choose your materials (including metal, wood and leather) and delivers a solid spec for $400. Add a few bucks to throw in a 128GB MicroSD card and you can match the storage capacity of an iPhone 6s costing twice as much.
You can even pick up an attractive and solid Android smartphone for just $250 in the form of the OnePlus X. You’re making one or two sacrifices for the price, but surprisingly few. Many mass-market consumers will be perfectly happy with this.
I’m not, of course, suggesting for a moment that Apple would ever need to compete with a $250 price point. I’ve also made the point before that the ‘Apple tax’ is lower than it appears due to high resale values, something echoed only yesterday in a WSJ piece suggesting this was a significant factor in Apple’s success in China.
Apple’s innovations like 3D Touch and Live Photos give it an edge, but never for long.
There is also the famed Apple ecosystem. To be honest, when friends ask me what to buy, this is probably my primary reason for pointing them toward Apple rather than Android: you’re buying into a tightly-integrated system in which you can work pretty seamlessly between devices. That ecosystem is a large part of Apple’s success; if you have an iPhone and are in the market for a tablet, laptop or smartwatch, it makes a lot more sense to buy another Apple product than to mix-and-match systems.
But Android and Chrome are catching up fast. A Chromebook, pure Android smartphone, Android Gear smartwatch and Google Apps get you about 75% of the way toward Apple-style integration. Apple definitely still leads the way, but Google has significantly closed the gap.
So what do I think Apple needs to do to protect its position, and ensure that ‘peak iPhone’ is a temporary state of affairs rather than a permanent one?
The first and most important thing, it’s already doing: continuing to invest in growth markets. It hasn’t let the difficult Chinese economy slow its rapid rollout of retail stores in the country, and it is investing in future growth markets like India. China will soon be a bigger market than the U.S., and while India represents a tiny percentage of sales today, it will one day be huge, and Apple will by that time be extremely well-established in the country. The four-inch iPhone will also likely help, especially if it sticks around long enough to get $100 sliced off the initial price next year.
But Apple cannot afford to have anything resembling a sense of entitlement when it comes to customers at the premium end of the market. Leaving aside those geeks who have their own technical or philosophical reasons for favoring Android, it’s largely been the case to date that anyone who can afford to buy an iPhone does so almost automatically. That fact is testament to Apple’s extraordinary marketing prowess.
But players like Google, Huawei, Xiaomi, Lenovo and OnePlus are learning fast. (Xiaomi has learned rather too literally, with blatant ripoffs of both Apple products and Apple marketing, but it will mature beyond that stage at some point.) So while Apple’s current dominance of the premium end of the market gives it a massive head-start, it can’t count on forever remaining the automatic choice. It will need to learn to compete on a slightly more level playing field as its competitors continue to up their game.
I’ve argued before that when Apple is selling premium products, it needs to deliver on that promise. It needs to be less stingy when it comes to things like RAM and flash storage.
But I think it will also need to learn to be a little more flexible when it comes to its profit margins, especially in growth markets. That ~40% markup has served it well for a great many years, but I don’t think it can necessarily expect to maintain it indefinitely. When a non-techy customer (which is most of them) is exposed to decent marketing for attractive and well-specced smartphones in the $250-400 range, each of them backed by a competitive ecosystem, Apple may need to be a little less ambitious in its margins.
Again, I stress that I’m in no way arguing that Apple needs to compete at the $250 level, or even the $400 one, but I am suggesting that there will come a time when it will no longer be able to reach quite as high as $950 at the upper end. That even a company pitched firmly at the premium end of the market will have to be willing to accept a slight redefinition of what that term translates to in dollar and margin terms once the U.S. becomes a minority market and growth economies come even further to the fore.
Do you agree? Or do you see Apple maintaining its 40% margins forever, even at the cost of seeing its market shrink? Please take our poll, and share your thoughts in the comments.
Cam Bunton kindly assisted with Android smartphone recommendations.
