Apple – Hardware heroin

Apple needs 2.1bn paying subscribers to make it a services company.

• Apple will launch its new video service today, but it is very unlikely to ever be big enough to wean Apple off of its long addiction to selling hardware.
• This new service is also unlikely to be a place where unique content is to be found and will be more about enabling users to get access to all of the content they like in a single, integrated digital location.
• There is some logic behind this move as the content industry is rapidly fragmenting with producers of premium content increasingly choosing to also distribute their productions over the internet.
• This is leading to fragmentation where a user has to flip from one app to another to find what he wants and any hope of having everything easily accessible and indexed in one place is slipping away.
• This creates the opportunity for something to come in over to the top and tie them all together but it is difficult to see how Apple can make a lot of money this way.
• This is because users will still be free to purchase these services directly from the providers rather than Apple which will almost always be cheaper meaning that Apple will have to add a lot of value to keep users paying up.
• Apple will be making some content itself but the family-friendly image that it aims to cultivate will obviate it from making the more adult-oriented, edgy shows which have enjoyed the most success.
• Hence, it will be in the user experience and intelligence that Apple puts behind the service that determines its success.
• This is much more like a version of Apple Music doing video than it is a rival to Netflix.
• In this regard, I think that Apple can be reasonably successful as the AI that sits behind cataloguing video metadata is simple compared to music and the user experience is Apple’s speciality.
• However, I seriously doubt that this will make a noticeable contribution to Apple’s financial performance as content more important than ever.
• Consider the numbers:
  • First, Apple: in calendar Q4 18 generated $74.4bn in hardware revenues upon which it generated 35.7% in gross margins.
  • Second, Netflix: in calendar Q4 18 reported 139m paid memberships from which it generated $4.19bn in revenues from which it made 29.6% gross margins.
  • This amounts to quarterly revenue per subscriber of $30.1 or around $10 per month.
  • Third, outlook: Netflix customers are not about to dump Netflix and move to Apple because its content will not be available there and much of Netflix’s catalogue is its own content.
  • Nor are they about to dump Amazon Prime or Disney+ both of whom have a big head-start when it comes to content.
  • This means that Apple will have to convince consumers to spend more on a new service or switch from getting their existing subscriptions directly to a merged model.
  • As I have said before, I find it hard to see a strong case for switching to add a middle-man who has to be paid, rather than staying direct as it inevitably will become more expensive.
  • To make this work, the service will have to have a fantastic user experience, and I am not convinced that even Apple will come up with something of this calibre.
• To put this into perspective, in order to bring services to 50% of total turnover, Apple will need to add $62.6bn in quarterly revenues.
• Using Netflix as a benchmark, Apple would need to add 2.09bn subscribers at $10 per month to make that happen which is roughly double the total number of iOS unique users after 12 years.
• This is obviously never going to happen meaning that Apple will remain a hardware company until it takes a huge hit on revenues like Blackberry did when it gave up hardware and went moved to software and services.
• Given that hardware is still hugely cash-generative for Apple and that there is nothing on the horizon that is likely to make that change, there is no reason why Apple should give it up.
• Consequently, this notion that Apple will soon become a services company does not bear up to financial scrutiny meaning that any return to growth will have to come from hardware, not services.
• This is the problem that all hardware companies have when they run out of growth and Apple is far from alone.
• Apple is hooked on hardware heroin and there is very little bar a complete catastrophe that destroys its hardware business that is likely to change that.
• It is on this basis that the company should be valued and there its valuation looks fair.
• The value argument has now departed following its rally in Q1 2019, but as a hiding place from other concerns swirling around Facebook or Tencent, it still holds water.