Apple Earnings: Look Beyond the Year Over Year Comparison, Judge Opportunity

Apple reported its fiscal third quarter results on Tuesday and Wall Street seemed to like it. But, you know as well as I do, using Wall Street’s reaction to earnings does not make you any wiser to how a company is actually doing.

What I thought was interesting about the call, both on the Apple comment side and the questions coming from the analysts, was the focus on the longer term strategy. Both AR and AI were mentioned several times by Tim Cook, not to mention a hint to a car business when talking about the DIDI investment:

“From a Didi point of view we see that as A) A great financial investment, 2) We think that there’s some strategic things that the company can do together over time and 3) We think that we’ll learn a lot about the business and the Chinese market even beyond what we currently know and Didi has an incredible team there. And, so, that’s sort of the rationale for why we did that.”

The focus on the longer term is unusual for Apple, which tends to never comment on future products. While there was not much substance to the comments, it was clear in my mind Cook was trying to reassure investors that VR and AI are all areas they are investing in (increased R&D figures hint at that) and they will not be blindsided once the market is ready.

In these areas, there were two specific comments I found particularly interesting. On AI, Cook said, “We are going to excel at AI because we excel at customer experiences.” While this sounds a little bit like a salesperson pitch, the point is nonetheless important. It does not matter how intelligent your bot or assistant is going to be, consumers will not adopt or interact with it unless the experience feels natural and if they feel whatever they are interacting with works with them and for them. Apple does user experience and customer experience – in a retail sense – very well and both these will be key in creating stickiness with AI.

The second interesting comment in my view was on VR. Cook said, “I know there’s people that want to call it a new computer platform, and we’ll see. I think there’s a tendency to call everything new the next computer platform, however, that said, I think AR can be huge. So, we’ll see whether it’s the next platform. Regardless, it will be huge.” I might be reading too much into this statement but it seems to me Cook is seeing VR as a feature (and possibly more of an entertainment feature), rather than the answer to everything. If I am correct, this might give us an indication of how Apple will be approaching AR from a hardware perspective: dedicated devices vs an experience for a device that does more than just AR.

This focus on the future left some questions unanswered when it came to the short term. Overall, I felt we got a little less detail on the quarterly performance and on short terms expectations than we normally get. That said, there were some interesting points to focus on when trying to evaluate Apple’s performance going forward.

iPhone

Both Cook and Maestri stated several times the iPhone SE had a successful launch and ASP declines for the iPhone certainly confirms that. ASP reduction was also impacted by a channel reduction of 4m higher-end iPhones. As I expected, the iPhone SE is doing its job in attracting new users to the Apple ecosystem as well as allowing users of older models to upgrade to a fuller experience. Both these factors are good news for the overall ecosystem, not just hardware sales.

Apple was not very clear on what they were expecting when it came to the next upgrade cycle but they did admit they misjudged the opportunity for the 6s and 6s Plus and they remain optimistic for the future:

“On the upgrade rate is that the iPhone upgrade rate for 6s is very similar to the 5s, and I guess in retrospect, maybe that was a predictable thing, although we didn’t predict it at the beginning it took us a little time to realize that. The iPhone 6 was significantly higher than that. And so it likely accelerated upgrades that would have been in the current year ahead of those.”

There are two factors at play here in my view:

• Cook is correct some upgrades that would have normally happened this year happened earlier thanks to the appeal of the larger screen introduced with the 6 family. This meant the usually smaller cycle for the “s” iteration had an even smaller addressable market to cater to
• The installed base the iPhone now has is very large and, while this is great for the ecosystem, it makes it more difficult to predict upgrade cycles. Not all the users are hardcore Apple users who will be looking for the next iPhone no matter what. Price and therefore, the role subsidies play, has more of an impact. This is where both the SE and the upgrade programs will certainly help. For the hardcore iPhone fans, the rumored iPhone 7 Pro might help drive upgrades for customers that have a 6s or 6s Plus. This tactic seems to be working for the iPad so why not the iPhone? Overall, I expect the iPhone 7 upgrade cycle to fall in between the one we had for the 6 and the 6s

iPad

Performance was certainly more encouraging this quarter. While sales were still slightly down year-on-year – 10m vs 10.9 in 2015 – revenue was up 7%. The iPad Pro 9.7″ was certainly the reason for this. It will be interesting to see how much the iPad Pro will be able to contribute to the back to school quarter but there is no question there is a sizable opportunity for Apple in the enterprise segment with these devices, especially the 9.7” version.

Services

Apple generated $6 billion in revenue in services, an increase of 19% over the June quarter of 2015. While as a proportion of the overall business services remain small (14%) compared to the iPhone, I find the year over year growth and the focus Apple is putting on Apple Pay, Apple Music and Apple Watch very promising. While it will take a lot for services to create the revenue the iPhone can generate, Apple’s early move will give them the time to build up. I do not see any other traditional hardware vendor being able to make a similar transition to make up for a hardware sales slowdown. Google, Microsoft, and Amazon are all trying to verticalize their offering in a similar way to Apple while of course coming at it from different point of strength but are all missing key pieces of the puzzle.

If this year’s schedule follows previous ones, we will see the iPhone 7’s initial impact in the last week of September. Then we should prepare for a calendar Q4 with new iPhones, new Macs and new Watch products. With so much hitting in one quarter, Apple might be setting itself up for another tough year over year comparison for 2017 but they’ll cross that bridge when they get there.