Why
Apple Must Move Beyond the ‘Wow’ Moment
Apple’s disappointing second quarter earnings – including the
first-ever drop in sales for the iPhone – sent the company’s stock tumbling for
eight consecutive trading sessions. It was the first such drop since 1998 and,
coupled with comments by activist investor Carl Icahn that he has dumped
his shares in the company, it accelerated worries about how Apple will
deliver the strong future growth that investors have come to expect.
Coming off more than a decade of blockbuster products, Apple –
the most valuable company in the world based on market capitalization — has
become so large that Wharton experts say it is now confronting the law of large
numbers, which suggests that its high earnings and growth in share price will
eventually slow.
At this point, what Apple needs is its next iPhone – but Wharton
experts caution that it will take more than moonshots to cement robust future
growth for the company. Moreover, it’s unlikely that the company can come up
with a new hit product that will rapidly improve sales immediately. In the
meantime, the iPhone is coming off a strong upgrade cycle, the iPad has lost
momentum, and the Apple Watch, while
successful to some degree, hasn’t moved the needle as significantly as
many past new products.
“No … company can grow forever. Apple has had an extraordinary
run, and it’s still a phenomenally successful company,” says Kevin
Werbach, a legal studies and business ethics professor at Wharton. “Few
companies in history have ever had a product as successful as the iPhone, so
it’s a bit much to expect that Apple find a second one.”
An Expectations Problem?
Apple’s sales for the fiscal year ending Sept 30, 2015, were
$233.7 billion, up from $182.8 billion in fiscal 2014. By contrast, in fiscal
2011, Apple sales were $108.2 billion, which was up from $36.54 billion in
fiscal 2009. Wall Street is expecting Apple to grow revenue by under 4% in
fiscal 2016, compared with a 28% revenue expansion in the last fiscal
year, Thomson
Reuters reported in January.
While the smartphone market globally may be hitting the
saturation point, Apple CEO Tim Cook noted that the iPhone, which accounts for
65% of the company’s revenue, can still take share from Android users and grow
globally. Though the earnings announcement was disappointing in the face of
past successes, Apple is hardly hurting: Second quarter net income was $10.5
billion on revenue of $50.6 billion. A year ago, Apple reported second quarter
earnings of $13.6 billion on revenue of $58 billion.
Cook said on the
company’s earnings call that Apple’s iPhone business is still
strong. “From an upgrade perspective, during the first half of this year, the
upgrade rate for the iPhone 6s cycle has been slightly higher than what we
experienced in the iPhone 5s cycle two years ago, but it is lower than the
accelerated upgrade rate we saw with iPhone 6, which as you know, was a big
contributor to our phenomenal revenue growth a year ago,” said Cook on the
April 26 call. “We continued to see a very high level of customers switching to
iPhone from Android and other operating systems. In fact, we added more
switchers from Android and other platforms in the first half of this year than
any other six-month period ever.”
Nevertheless, analysts are anxious about what Apple has in the
iPhone pipeline in the future. “There was massive pent up demand for larger
screens. This led to the mother of all upgrades when the iPhone 6 was
released,” explained Macquarie analyst Ben Schachter in a research note. “We
don’t think this is anything structural and will be solved by time. However, a
second issue is a more significant concern. We believe that the lack of new
‘must have’ innovative features will lengthen the upgrade cycle. If iPhone 7
doesn’t surprise with meaningful new useful features, we worry that consumers
won’t upgrade.”
In other words, the smartphone market is starting to look more
like the PC industry, where there is little to differentiate different
companies’ product lines and customers stretch the lifespans of their systems
for longer than vendors would like. “The market is gradually shifting from
smartphone introduction to smartphones on a replacement cycle,” says Werbach.
“That’s simply not going to be as dynamic a market opportunity, although it
will still be a very good one. Microsoft is still doing fine after personal
computers shifted from a rapid growth market to one based on replacement,
although it’s not the rocket ship it once was.”
But it’s clear that Apple’s once-hot product line is
cooling. For the
second quarter, Apple’s iPhone revenue was down 18%, iPad revenue fell 19% and
Mac revenue fell 9%. On the bright side, Apple’s services category (which
includes Apple Music and iCloud subscriptions, software sales and App and
iTunes store revenue) was up 20% to $5.99 billion in the second quarter.
Apple’s “Other Products” category, which includes Apple Watch, Apple TV
and Beats
headphones, increased 30% to $2.19 billion.
“The next two to three quarters will be critical for Apple
because there’s a problem of expectations for both the iPad and iPhone,” says
Saikat Chaudhuri, an adjunct professor of management at Wharton and executive
director of the school’s Mack Institute for
Innovation Management. “There’s a natural maturation process, and Apple is big and
slowing down.”
‘One Great Innovation Can Last for a Decade’
David
Hsu, a management professor at Wharton, says that Apple’s conundrum
isn’t unique. Many companies such as Microsoft and IBM have developed new
technologies to grow quickly, but then are forced to reinvent their businesses.
“One great innovation can last for a decade,” explains Hsu. “But the broader
issue is that the smartphone category has matured and many people have multiple
devices. It’s hard to sustain the iPhone growth and create new products because
Apple is following up the most popular product in history.
“There’s no doomsday
picture here,” adds Hsu. “But the iPhone peak may have already passed.”
Indeed, Apple projected further deceleration in sales as third
quarter revenue is expected to be $41 billion to $43 billion. Average selling
prices will also fall due to the launch of the iPhone SE, a 4-inch phone device
that’s less expensive and aimed at emerging markets. “It is becoming clear that
Apple has a significant iPhone growth problem on its hands,” said Neil Cybart,
a former Wall Street analyst who follows the company via his subscription Above
Avalon site. “The combination of a slowing iPhone upgrade rate and
declining number of growth catalysts for expanding the iPhone’s addressable
market will make it very difficult for management to report unit sales growth
going forward given its current strategy.”
However, Peter
Fader, a marketing professor at Wharton, isn’t worried about Apple.
“Customers are more in love with Apple than ever before. I’d be worried if
Apple customers were switching to Android and Mac users were going to Windows,”
says Fader. “There has been crazy growth, but Apple still has health and stability.
Maybe Apple doesn’t have to swing for the fences.”
After all, Fader adds, Apple’s greatest asset is its loyal
customers. “The customer base is much more important to cash flow in the
future,” says Fader, who notes that Apple will have to monetize its customer
base better through cloud services and subscriptions.
Hits and Misses
One factor behind Wall Street’s concerns about Apple is the
realization that there may not be another iPhone-like hit that can drive the
company’s growth in the future.
For years, rumors have surfaced about Apple getting into
televisions and even automobiles. The Apple Watch is a new product line with
potential, but it hasn’t approached the sales levels of the iPhone or iPad. “If
Apple came up with a new product it may help,” says Chaudhuri. “Apple needs
something new because rolling out next-generation products like the iPhone or
iPad only carries the company so far.”
Reports of an Apple car have been rampant. Apple’s entry into
the auto industry could prove significant, but at the expense of profit
margins. For instance, while Ford had 2015 annual sales of $140.56 billion, the
company’s net profit margin is projected to be 5.6% this year compared to
Apple’s estimated projected 21% for fiscal 2016.
“It is not easy to become an automaker. I don’t know why Apple
would take those profit margins,” says Chaudhuri.
Werbach agrees that Apple shouldn’t fall into the trap of
producing commodity hardware whether it’s a new category or the iPhone.
“Apple’s key challenge is to preserve its premium brand value when it comes to
hardware. People pay more for Apple hardware, even in markets where everyone
else faces commodity margins. It gives them a unique advantage,” Werbach says.
“If that goes away, Apple is unlikely to be able to differentiate enough on
software and services to maintain its margins.”
Fader says Apple needs to be careful about focusing on hit
products as a way to drive sales. “Apple is going to have to be about running
the business better than creating a ‘wow’ moment all the time,” says Fader.
“How much of Apple’s future revenue is going to be product sales vs. services?
The product upgrade approach is working for Apple, but the value is in all the
stuff surrounding the hardware.”
While chasing an automobile could be in Apple’s future, Fader
says the company shouldn’t seriously consider the market for “10 to 15 years” —
but it’s fine to have “a toe in the water.”
Chaudhuri says that Apple can still develop hardware hits, but
it will have to look to new markets. For instance, he argues that Apple’s
partnership with IBM to develop corporate apps highlights how the company is
aiming to target the business-to-business market.
In addition, Apple could be more of a player in the Internet of
Things, networks of sensors that are making
everyday objects smarter. “Apple could play a role in telematics to
even how automation is run,” says Chaudhuri. “There are other areas to
exploit.”
One way that Apple could develop new products and markets is
through acquisition. To date, Apple has bought companies that can be easily
integrated into its products, such as its 2014 purchase of Beats Electronics
for $3 billion, which included the popular line of headphones, an audio
hardware business and a streaming music service.
Fader says Apple could acquire big brands in the future and fold
them into the Apple culture. Maybe Apple even buys Tesla, he adds, which is one
of the few startups in the auto industry to seriously challenge industry
incumbents.
According to Hsu, the larger question is about Apple’s ability
to develop new products through its own research and development. “Apple will
still play a big role, but it’s more about design for the company. Apple is
more of a visionary, but doesn’t have a R&D heritage,” says Hsu. “Apple’s
role has been to redesign existing categories.”
Beyond the Balance Sheet
Given the pressure facing Apple, it’s not surprising that Cook
has emphasized services and subscriptions for the last two quarters. “We feel
really great about the early success of Apple’s first subscription business,
and our music revenue has now hit an inflection point after many quarters of
decline,” said Cook during the earnings call. He noted that App Store revenue
was up 35% in the second quarter. “One billion-plus active devices are a source
of recurring revenue that is growing independent of the unit shipments we
report every three months.”
While Apple searches for its next category to tackle, Fader says
the company needs to focus more on selling services to its installed base of
customers.
To Fader, Apple’s growth conundrum is analogous to software
companies that have to transition from business models that revolve around
licensing to one focused on subscriptions and cloud services. The difference
for Apple is that its growth to date has been mostly about hardware. “Apple
will have to move from selling things to retaining customers and selling
services and subscriptions,” says Fader.
Chaudhuri agrees with Fader, but has doubts about Apple’s
ability to be a leader in services. “I don’t think Apple has it in its DNA to
be a strong services provider,” he says.
Fader says there is historical precedent for a company to
transition to a new model. Adobe Systems was among the first companies to
transition to cloud services, he notes, and Starbucks refocused on customer
experience, easing transactions and then selling its customer base more
products through a loyalty program and apps.
“Starbucks also used to be about selling a product, but realized
that the competition caught up,” says Fader. “Now it’s about a customer base,
experience and related things to monetize.”
Apple still has work to do, according to Fader. “Apple isn’t No.
1 in any cloud category,” he notes. “For instance, Apple Music has a user
experience comparable to Spotify, but it can’t sell services without a shiny
new object to attract customers.”
The challenge for Apple is that it doesn’t have the analytics or
customer knowledge that rivals like Amazon or Netflix have. “Apple has
been bad
with data and predictive analytics behind the scenes,” says Fader.
“The key to victory will be valuing the customer base.”
Apple should study Starbucks, says Fader. “Because of data and
analytics, Starbucks has made it very easy to order more coffee,” he points
out.
Ultimately, Apple has to see its customer base as its primary
asset much like Amazon does. “Apple’s most golden asset is the one that isn’t
on the balance sheet,” says Fader.
http://knowledge.wharton.upenn.edu/article/why-apple-must-move-beyond-the-wow-moment/?utm_source=kw_newsletter&utm_medium=email&utm_campaign=2016-05-11
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