Apple shares have fallen 26% from their October 2018 high and they’re poised to fall further.
You can argue that Apple’s decline is due to factors beyond its control. For example, the White House threatened to endanger Apple by putting it in the cross-hairs of its China trade war.
But a Bloomberg report that Apple is offering a 40% discount on the iPhone XR is either a great way to get rid of excess inventory and boost the potential installed based for Apple’s services or the end of Apple as we’ve known it.
How so? Bloomberg reported that on November 2, Apple added
A new banner to the top of its website advertising the iPhone XR for $449, $300 less than its official sticker price. The deal, noted with an asterisk and described at the bottom of the page, requires customers to trade in an iPhone 7 Plus, a high-end handset from two years ago.
Apple has been touting its services as the next big thing. And if Apple can clear its iPhone XR inventory through those price cuts, it might get some new Apple customers who will buy more services.
If you compare iPhone and services revenues assuming that they keep growing at the same rate as they were for all of Apple’s fiscal 2017, it could take a mere eight years for services to surpass iPhone revenues.
How so? In fiscal 2017, Apple generated about $141 billion in iPhone sales and nearly $30 billion in services revenue — up 3% and 23%, respectively from the year before. If those growth rates continue unchanged, by 2026, services will surpass iPhone sales — with $193 billion to $184 billion in 2026 revenues, respectively.
Are these assumptions realistic? It is certainly conceivable that Apple could convince iPhone owners to spend far more money on services than they do now, but that would require Apple to increase its services revenue per iPhone sold — assuming that iPhone unit sales grow at 2% a year as they did in 2017 — over five-fold from $138 to $745.
However, if iPhone sales decline at a 6% annual rate — as the Wall Street Journal suggested they have been — then the services revenue needed to pick up the slack from falling iPhone revenue would be a whopping $1,556 per new iPhone sold.
I don’t buy the bullish case for Apple as a service company. Apple’s past success flowed from a strategy of supplying customers superbly-designed hardware in well-established product categories — charging a price premium of at least 40% over rival products.
Apple had the added strength — thanks to the work of CEO Tim Cook — of operating a very efficient supply chain which allowed Apple to build these products at a very low cost.
Apple also was great at marketing its hardware and making it indispensable to users thanks to iTunes and the App Store.
As a result, Apple earned very high gross margins — over 70% a mere six years ago.
For example, back in September 2012, people paid a 44% premium for the iPhone 4s, yielding a 71% gross margin — much higher than the Nokia Lumina’s 54% gross margin.
Consider the comparison of the prices and bill of materials cost for the iPhone 4S and the Nokia Lumia 900. According to iMore, the iPhone’s price was $649 while the total cost of all its components — an incomplete cost measure — was $190; whereas the Lumia 900 sold for $450 and its parts cost $209.
In short, Apple used to make money on its hardware and gave away its services at cost in order to create “killer applications” that would make consumers willing to pay a premium to own its hardware.
By January 2016, Apple’s chief financial officer, Luca Maestri, was bragging about a strategy that seemed sure to reduce Apple’s margins even more.
How so? According to Bloomberg, he said that investors don’t appreciate that Apple’s “services business — which includes music streaming, the App Store and Apple Pay — is growing rapidly and will help make up for slowdowns in other areas.”
Maestri boasted that Apple generated “$31 billion in services revenue in fiscal 2015, and in the past 90 days about 1 billion Apple devices connected to them.”
Sadly for investors seeking growth, services don’t generate the kind of profit that hardware used to generate for Apple.
As Abhey Lamba, an analyst at Mizuho Securities USA, told Bloomberg, “while Apple makes about $300 for each iPhone sold, it takes about 60,000 transactions via Apple Pay to make $100.”
Apple’s iPhone X bill of materials cost is $390, according to IHS Markit — so reducing the price from $749 to $449 sends its gross margin plummeting from 48% to 13%.
It will be a long wait for Apple’s services business to make up for all the profit lost from Apple’s inability to come up with a new hardware product to pick up the slack from its 11-year-old iPhone.
In the meantime, taking 40% of the iPhone price is strategic suicide for a company that has defined its strategy for its entire history as the high-priced spread.