Wednesday, Jan 30th 2019

It's the Services, Stupid

Update

Services take center stage in Apple's fiscal Q1 earnings report.

Apple's transition from being a hardware sales-driven business to a more recurring, services-oriented ecosystem marches on. After reporting fiscal Q1 earnings, the stock was up nearly +6% after hours on headline results we felt were fairly average - something we think reflects the stock's valuation and investor sentiment going into the announcement.

The 1-Minute Takeaway:

Headline performance was modest

  • Apple came in modestly ahead of expectations on both revenue and earnings, but guided Q2 revenue slightly below what we think analysts were expecting

China was a major drag

  • While Apple provided a slew of reasons for its revenue shortfall, ranging from iPhone release timing to currency fluctuations, the greatest driver by far was weakness in China
  • Over 100% of Apple's year-over-year revenue decline was driven by China (for more on why, see our last update on Apple)
  • Outside of China, new business records were set in almost every other region

It's all about Services now…

  • The tone of the call seemed to reflect a strong shift to Apple's new area of focus, services. Why?
  • It's recurring: Unlike lumpy hardware sales, services (like iCloud and App Store revenues) tend to be more recurring in nature
  • It's profitable: With a gross margin north of 60%, services revenues are nearly twice as profitable as labor and parts-heavy hardware sales
  • It's growing: Services grew a healthy +19% in the December quarter, with total paid subscription counts up an incredible +50% vs. last year
  • It's diversified: The top category on the services side contributes less than 30% of total services revenue, a number that is expected to decrease as new service launches continue to grow
  • It drives Apple's competitive flywheel: As Apple's services ecosystem grows, we believe the value of its product offering increases, which in turns increases the size of Apple's installed base of devices (currently a massive 1.4 billion devices), which in turn drives further growth in the services ecosystem

…But don't write off the iPhone

  • We think Apple investors are famously myopic when it comes to extrapolating near-term iPhone performance (anyone else remember the death toll ringing pre-iPhone 7?)
  • To that end, we just want to end by saying that while conservatism is warranted given the latest data, we wouldn't write off the iPhone entirely as this new services narrative takes center stage
  • Tim Cook revealed on today's call that customer satisfaction for the latest generation of iPhones sits at 99%. This is not a metric you'll see tracked and scrutinized by Wall Street analysts, but as we think about long-term value, we think it's one of the most salient and revealing metrics out there

A parting quote from Tim Cook from the call:

"We don't measure our success in 90-day increments. We manage Apple for the long term, and when we consider the keys to our success over time, there are 3 that stand out: our highly satisfied and loyal customers, our large and growing active installed base and at the heart of it all, our deeply ingrained culture of innovation."

As of this writing, AAPL was a portfolio holding of Titan. This security may cease to be a portfolio holding at some point in the future.
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