When Apple (NASDAQ:AAPL) reported its earnings last month, the markets weren’t particularly impressed. The stock fell 4% after hours immediately after the release, gaining back some ground in the days that followed. Although the reported revenue and earnings beat expectations, investors were left flummoxed by guidance, which predicted a $8 billion hit from supply constraints.
Shortly after Apple’s results came out, the New York Times ran a piece arguing that Apple had “lost its soul” with the departure of former design chief Jony Ive. The piece described an internal power struggle at Apple in which Ive gradually lost influence as CEO Tim Cook emphasized services over hardware. The article ultimately concluded that Apple’s design team is no longer the driving force of innovation at the company.
In his NYT piece, Tripp Mickle basically took a negative view of the transformation at Apple. Viewing the recent changes as a departure from Apple’s original vision, he argued that the company had lost its way. From a product perspective, he may have been right. Apple product launches used to be world-changing events, changing the trajectory of product development not just at Apple, but in the tech industry as a whole. The iPhone launch, for example, paved the way for the mainstream adoption of smartphones, and the original MacIntosh helped make computers more accessible. More recent Apple launches have been incremental, the last really big one being Ive’s Apple Watch. It was a success, but it didn’t exactly shake up the industry the way the Jobs-era launches did.
For Apple’s creative users, Cook’s de-emphasizing of hardware may have been a real downer. But for investors, it was a blessing. Apple’s new strategy, which focuses on services and chips, plays to Tim Cook’s strengths as a leader. It heavily emphasizes quantifiable business and technical decisions that Apple executives can objectively “get right,” instead of taking the more taste-based approach of the Jobs era. That doesn’t mean that design ought to go by the wayside. To the contrary, it’s still one of Apple’s key differentiators. But by emphasizing chips and software, Apple can now focus more on “concrete,” measurable goals, instead of having to worry about whether its design team still has that Jobs-calibre magic. Over time, this could lead to a company that executes, and delivers ample value to shareholders.
In order to understand Apple’s new strategy, we need to look at how the company defines itself relative to the competition. Design has always been a pretty big differentiator for Apple, but there are others, too, and it is the way they all interact that gives the Apple brand its enormous value.
So, who are Apple’s competitors?
Directly or indirectly, most smartphone and laptop manufacturers, as well as developers of operating systems and creative applications. Some of the most direct competitors include:
Alphabet (GOOG), which is both a competitor and partner to Apple. Google’s Android operating system competes with IOS. The two companies also have a partnership in which Google pays Apple $15 billion a year to be IOS’s native search engine.
Samsung (OTC:SSNLF), the leading manufacturer of Android phones.
Microsoft (MSFT), whose Windows devices compete with Macs.
Adobe (ADBE), whose Premiere Pro app competes with Final Cut Pro.
Spotify (SPOT), Apple’s main competitor in music streaming.
This list could go on much longer. In addition to the companies just named, we could include chip makers like Intel (INTC), whose sales were rocked by Apple’s transition to designing its own chips. But the competition here is indirect, and less significant than the “head to head” competition with the companies listed above.
Apple is generally #1 or #2 in most of its markets.
Its IOS operating system is second in installs worldwide after Android, and first in the United States. It is first by revenue worldwide, by a wide margin. Although Android has more users, Apple dominates the U.S. market, where consumers spend more money on apps.
Apple is in first place globally in smart watch and tablet deliveries. Its lead in tablets has been solid ever since the iPad launched in 2010, while the lead in smart watches has been diminishing due to new entrants at lower price points.
Apple is second behind Adobe and Spotify in creative apps and music streaming, respectively. Apple does not compete head-to-head with Adobe’s entire lineup of services, but Final Cut Pro is a direct competitor to Premiere Pro. Apple Music is the second place streaming app after Spotify.
Apple Music’s position relative to Spotify could be thought of as a challenge for Apple. Music is a huge part of Apple’s strategy, and is a very successful one. AirPods alone did more revenue than Twitter (TWTR), Spotify and Square (SQ) combined in 2021. So Apple’s music ecosystem is on the whole very successful. However, the fact that Apple is a distant second to Spotify in streaming could become a strategic problem down the line. Apple Music is a major platform for selling AirPods, as the pods allow users to listen in spatial audio. If more people are using Spotify than Apple Music, then fewer people are thinking about spatial audio than are thinking about Spotify’s algorithm or Joe Rogan, so it’s strategically better for Apple to be #1 in music streaming than #2.
Apple’s New Strategy
As we’ve seen, Apple enjoys a solid competitive position. It’s in at least second place in every single vertical it operates in, and it operates in a lot of different verticals. However, there are obvious cracks in Apple’s dominance of the tech industry. Its music streaming app, for example, is nowhere near as popular as its headphones, and if users aren’t using the app and the headphones together, they aren’t getting quite the experience they could be having. This isn’t stopping the AirPods from dominating the headphone industry, but it could be holding back sales somewhat.
This is exactly why Apple’s new service based strategy is so smart. By focusing on the service side of the equation, Apple strengthens the software-hardware integration that has always been its main selling point. Whenever Apple gets another services subscriber, it gains:
The direct service revenue.
A potential platform for selling more products.
To give you an example of how this works, I went into my Apple music app and clicked ‘browse.’ Immediately I saw a featured content box pushing spatial audio. For users who already have AirPods, this could simply be a prompt asking them to listen for the first time. For users who don’t have AirPods, it could be their first time ever hearing about ‘spatial audio.’ Seeing spatial audio advertised in Apple Music could lead to them searching ‘spatial audio’ in Google, which could then lead to them discovering and buying AirPods.
Apple needs services in order for this to work. Arguably, it needs them more than it needs big innovations in industrial design. At this point, Apple’s design philosophy (thin, light, minimalist) is well established, and well liked by the company’s customers. There’ll always be room for incremental improvement, but the pace of innovation will be slower in the future than in the past. With services, it’s a different story. There are obvious ways for Apple to improve its services ecosystem, including:
Getting Apple Music’s recommendation algorithm on par with Spotify’s.
Getting must watch “hit” exclusives on Apple TV Plus.
Expanding iCloud storage options.
The improvements that can be made in these areas are fairly “obvious” ones. They do not depend on having one key individual at a company with Steve Jobs’ or Jony Ives’ attention to detail. So, they are projects that a logistics and results-oriented leader like Tim Cook can take on. As I’ll show in the next section, they are already bearing fruit.
If you want to see how big of a contribution Apple Services are making to Apple these days, you need only look at the company’s recent earnings. In the second quarter, Apple delivered:
$92.27 billion in revenue, up 9% (beating expectations).
$77.47 billion in product revenue, up 6%.
$19.82 billion in service revenue, up 17.2%.
$25 billion in net income, up 5.84%.
$1.52 in diluted EPS, up 8.57%.
As you can see, the growth for the quarter was “so so” overall. But the growth in services was quite strong. At 17.2%, it made a big contribution to overall growth. It also made up a full 21.4% of total revenue. If services growth remains strong, it will make up a larger and larger percentage of total revenue, and could even drive acceleration in sales growth.
Taking a broader view of Apple’s earnings, we see clear signs of financial strength. The earnings reported above yield a net margin of 27%. Seeking Alpha Quant has similarly strong profitability ratios on file for the trailing 12 month period:
Gross margin: 43.3%.
EBIT margin: 30%
Net margin: 26% (slightly different from the one I calculated because this is referring to the 12 months, whereas mine was just the most recent quarter).
Levered free cash flow margin: 26%.
All very solid profitability metrics, on top of satisfactory growth. Despite all of that, Apple stock is not incredibly expensive. Trading at 25 times earnings, 6.7 times sales and 22 times operating cash flow, it is far from the most expensive tech stock out there. It definitely doesn’t sport the rock bottom multiples you’ll see from Alibaba (BABA) or Meta Platforms (FB), but Apple’s earnings haven’t been declining like those companies’ have been. So, the slight premium is arguably justified.
Risks and Challenges
As we’ve seen, Apple is a strong company with solid results in its services business that could keep sales growing long after Apple hardware saturates the market. It certainly looks like a promising buy. However, there are some risks and challenges to keep in mind here, including:
Loss of key design talent. As I showed in this article, services are driving more growth for Apple these days than hardware is. That’s a good thing in principle. However, the loss of top designers like Jony Ive is still a risk for the company. Without them, Apple may lose its edge in sleek, minimalist design. If this happens then “Apple design” will be less of a selling point in the future than it was in the past. Apple once estimated the cost of losing Jony Ive at $50 billion. That figure may have been exaggerated, but the company could definitely lose some of its lustre if Ive stops consulting for it.
Competition in services. Apple’s growth in services is undeniably explosive, but eventually the company will run up against tough competition if it wants to keep growing these apps. Apple’s 15% market share in music streaming is far smaller than Spotify’s, and it’s a similar story with services like books and TV Plus. To keep growing these services indefinitely, Apple will have to convince some customers to switch from the incumbent players, whose services are already popular. That won’t be easy.
Deceleration. Revenue deceleration is a risk to Apple shareholders in that it calls the company’s valuation into question. 25 is not an absurd earnings multiple, but it isn’t a low one either. There are banks out there that are growing sales faster than Apple is this year, and they aren’t trading at 25 times earnings. Eventually, investors might question whether Apple really deserves the premium valuation it currently has, and sell the stock.
The risks above are worth taking seriously. But when we look at Apple as a whole, we see that it is a solid value. The company has a rock-solid brand, a growing services business, and a valuation that is far from excessive. Taken as a whole, Apple looks like a worthy addition to almost any portfolio.