Apple is on a roll. The company is seeing record high iPhone ASPs, strong momentum with Services, and a wearables platform connecting with the mass market. Revenue growth has accelerated for the past seven quarters. Apple's growth story has returned with a vengeance. Upon closer examination, it becomes evident that Apple's three primary growth levers are not created equal. While some growth levers are at risk of slowing, others are still just getting started.
Growth Has Returned
In early 2016, Apple hit a rough patch. The company reported its first year-over-year decline in iPhone unit sales as the iPhone 6s and 6s Plus sales cycle proved quite different from that of iPhone 6 and 6 Plus. Overall revenue trends also turned negative with Apple reporting a double-digit revenue decline in 2Q16 and 3Q16.
Just as consensus began to throw in the towel on Apple as a growth story, iPhone unit sales stabilized. As shown in Exhibit 1, revenue bottomed in early 2017 and then once again began to increase. The most recent quarter marked a record high for Apple revenue on a trailing-twelve-month (TTM) basis and the seventh consecutive quarter of sequential growth in revenue.
Exhibit 1: Apple Revenue (TTM)
There are three drivers behind Apple's return to revenue growth:
- iPhone. The average selling price (ASP) of iPhone is up $100 year-over-year.
- Services. Apple is seeing strong revenue growth from the App Store, licensing, and AppleCare.
- Wearables. Apple's wearables platform is gaining sales momentum as Apple Watch and AirPods go mainstream.
The interesting thing about Apple's latest growth story is that few people were forecasting that Apple would grow revenue via hardware sales. Instead, many said that Services would be Apple's growth engine going forward. As it turns out, things are developing differently than consensus assumed.
For the twelve months ending this past June, iPhone was responsible for 57% of Apple's year-over-year revenue growth. Services was the second-largest revenue driver, responsible for 23% of Apple's year-over-year revenue growth. Wearables was responsible for 11% of Apple's growth. As seen in Exhibit 2, iPhone has been responsible for an increasing portion of Apple's revenue growth.
Exhibit 2: Measuring Apple's Revenue Growth Drivers
It is helpful to take a closer look at the factors underpinning Apple's three revenue growth drivers.
iPhone. In 3Q18, iPhone revenue was up 20% year-over-year. The vast majority of this growth was due to Apple selling higher-priced iPhones. The iPhone 8 and 8 Plus are the highest-priced 4.7-inch and 5.5-inch iPhones, respectively, to date. Furthermore, the iPhone X is Apple's highest-priced iPhone yet. As seen in Exhibit 3, iPhone ASP experienced a step increase beginning in 1Q18, which marked the first full quarter of iPhone 8 and 8 Plus sales in addition to the iPhone X launch. Given strong flagship iPhone sales momentum, Apple has continued to report strong ASP trends. Apple reported a record high $119 year-over-year increase in iPhone ASP in 3Q18.
Exhibit 3: iPhone ASP
According to my estimates, Apple has sold approximately 120M higher-priced, flagship iPhones (8, 8 Plus, and X) since September 2017. Some of these devices were bought by former Android users switching to iPhone. However, there are only so many premium Android users out there. The majority of sales have likely gone to existing iPhone users upgrading their devices. With an iPhone installed base of approximately 750M users, less than 15% of the iPhone installed base bought a new flagship iPhone over the last nine months.
A small percentage of the iPhone installed base is responsible for driving much of the year-over-year increase in iPhone ASP. While this doesn't necessarily mean that iPhone ASPs are more fragile than they appear, it does add clarity to the current state of the iPhone business. The iPhone upgrade cycle continues to get longer while growth in customer demand for iPhone remains mediocre. Despite these challenges, the sheer size of the iPhone installed base makes it possible for Apple to sell close to 150M higher-priced, flagship iPhones in any given year.
Services. Apple's second-largest revenue driver, Services, is comprised of five items:
- Digital content (App Store, iTunes, Apple Music, etc.)
- iCloud storage
- Apple Pay
A majority of Apple's Services revenue is associated with Apple distributing digital content to hundreds of millions of people via the App Store and iTunes. Accordingly, the increase in the number of people accessing Apple's content stores, combined with existing users spending more as time goes on, is a leading driver behind Apple's strong Services revenue growth.
Licensing revenue is another major contributor to Services revenue growth as third parties are paying Apple more to get their services in front of Apple's users. It helps that Apple's grip on premium users has gotten stronger over time. AppleCare revenue is also on the rise as the number of Apple devices in the wild increases and Apple expands its AppleCare distribution efforts.
Wearables. Apple is seeing strong unit sales growth for both Apple Watch and AirPods. In just three years, Apple Watch sales have exceeded 20M units per year with a user base nearing 40M. Despite extended supply issues, Apple likely sold more than 10M AirPods during the first year on the market, and coming close to 20M unit sales is a distinct possibility in CY2018. Apple Watch and AirPods sales are benefiting from aggressive pricing, strong mindshare, growing word of mouth, and increased distribution, especially with the cellular Apple Watch Series 3. As shown in Exhibit 4, wearables unit sales (the orange portion of bar) are no longer a footnote on a Apple gadget sales chart.
Exhibit 4: Apple Gadget Unit Sales
When it comes to thinking about how Apple's revenue growth drivers will perform in the coming quarters, it is important to assess the broader environment facing each driver. At the same time, a look at Apple's product strategy is required to the weigh the impact from new products and pricing decisions.
iPhone. Among Apple's three revenue growth drivers, the iPhone faces the most headwinds. While Apple can still grow iPhone revenue with modest unit sales growth, the company will likely see less of a revenue boost from huge iPhone ASP gains. It will be difficult for Apple to increase iPhone ASP by another $100 in 2019. Instead, iPhone ASP increases will likely decline.
Apple is expected to unveil three new flagship iPhones (6.5-inch OLED, 5.8-inch OLED, and 6.1-inch LCD) next month. Even if we assume the 6.5-inch OLED is priced higher than iPhone X, the model likely won't have as large of an impact on iPhone ASP as iPhone X, given a smaller share of overall iPhone sales. Instead, the majority of iPhone sales will be found with the 6.1-inch LCD and 5.8-inch OLED iPhones. These models will likely be priced similar to this year's flagship iPhones, making it that much harder for Apple to see another step increase in iPhone ASP.
Services. There are a number of factors supporting continued robust Apple Services revenue trends into 2019. Apple Services will benefit from continued growth in the iPhone installed base. At the same time, larger industry themes such as video subscription services gaining popularity stand to benefit Apple Services revenue in a few ways. In addition to earning a share of revenue via third-party video subscriptions, Apple is widely expected to launch its own paid video streaming service in 2019. Additional Services growth levers are found with higher licensing fees from third parties, more AppleCare revenue, and a larger number of iCloud storage subscriptions. In a scenario in which iPhone revenue growth slows, it is reasonable to expect Services will represent a larger portion of Apple's revenue growth in 2019.
Wearables. Apple's wearables segment will likely serve as an Apple revenue growth engine for years. The days of Apple wearables being considered a revenue footnote are over. Over the past 12 months, Apple sold over $10 billion of wearables (Apple Watch, AirPods, and Beats headphones). Assuming Apple is able to maintain at least 30% to 40% unit sales growth over the next few years, Apple's wearables platform will reach $20 billon of annual revenue within three years. Given the still relatively low adoption rates for Apple Watch and AirPods within the Apple user base, there are plenty of potential users left to fuel unit sales growth. Over the long run, Apple will likely expand the wearables platform to include new form factors and product categories. These developments will add even more growth potential to the segment.
On the last two quarterly earnings conference calls, Tim Cook has talked about the smartphone market being one of the best for a company like Apple in the history of the world. There aren't too many markets capable of supporting 215M+ annual unit sales at an average selling price exceeding $750. Read between the lines, and Cook's confidence signaled Apple's belief that nothing will displace smartphones as the most valuable computer in our lives in the near term. For example, Cook's answer to an analyst's question about tech in the home didn't make it seem like Apple management was worried about stationary smart speakers.
Much of Cook's optimism around smartphones is supported by recent Apple financial trends as revenue growth has been driven primarily by iPhone, with Services and wearables serving in more supporting roles.
However, this doesn't mean that Apple is betting on iPhone over the long run. In fact, over the next few quarters, it is reasonable to expect that iPhone will become less of a growth driver for Apple, with the growth spotlight turning to digital content distribution and wearables as Apple's primary growth engines.
Apple continues to place bets on new products that have the potential to gradually serve as iPhone alternatives (not replacements). In essence, Apple wants to be the one to disrupt the iPhone. These iPhone alternatives, having to be powered or supported by iPhone out of the gate, will initially be viewed as rudimentary or even as toys. However, these products will be placed on the path to independency from iPhone. The Apple Watch is a great example of such a product. Apple Glasses have the potential to be an even bigger catalyst for growth.
At the same time, we are seeing Apple gain confidence in delivering services focused on distributing digital content and adding value to hardware used by a billion users. As the average number of Apple products per user increases, thanks to wearables, these services will prove essential in delivering personalized and proactive solutions to the Apple community. This strategy will provide Apple years of revenue growth opportunity and pave the way for Apple's eventual entrance into the transportation industry.
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