The iPhone is Taking Over Apple
One theme has become clear in 2015: the iPhone's gravitational pull is simply too strong for any new Apple product or service to reach escape velocity and become the next big thing for Apple in the near-term. From a financial and business perspective, the iPhone is the only product that matters. The iPhone is amassing so much power at Apple, it is difficult to imagine any product being able to dramatically surpass the iPhone in terms of importance over the next five years. Apple will be the iPhone company for the foreseeable future, and that classification introduces opportunities and risks that Apple will need to navigate over the coming years.
Perspective
This past month, the iPhone celebrated its 8th anniversary. It is easy to forget how significant of a factor the iPhone has been to Apple's business since launching in 2007. Taking a look at cumulative data over that time span helps to put the iPhone's one-of-a-kind product status into perspective.
- 726 million iPhones sold
- $443 billion of revenue (50% of total)
- $200 billion of gross profit (60% of total)
- $120 billion of net income (60% of total)
As a sign of continued iPhone momentum, Apple is now selling up to 250 million iPhones a year, or close to a third of total iPhones sold to date.
iPhone's Importance to Apple's Financials
Everyone knows the iPhone is a crucial part of Apple's business, but few realize the extent to which the iPhone is literally taking over Apple's financials. In the first half of FY2015, the iPhone accounted for 69% of Apple's total revenue, up from 57% of revenue during the same time period last year. In terms of gross profit, the trend is even more pronounced, with iPhone accounting for 81% of Apple's gross profit over the past two quarters, up from 68%. Much of this change is related to strong iPhone sales in China following the iPhone 6 and 6 Plus launch in addition to China Mobile beginning to sell the iPhone last year. It has gotten to the point that Apple's quarterly earnings reports should be renamed "iPhone sales updates" because no other part of Apple's business is able to impact the financial statements quite like iPhone.
Exhibits 1 and 2 highlight the iPhone's overall contribution to Apple's revenue and gross profit.
Exhibit 1: iPhone Revenue as Percent of Total Apple Revenue (Fiscal Year)
Exhibit 2: iPhone Gross Profit as Percent of Total Apple Gross Profit (Fiscal Year)
The iPhone's strong margins and short upgrade cycle contribute to the device's significant share of Apple's revenue and earnings as iPhone users are likely to upgrade their high-margin phones every two or three years.
One example of how important the iPhone is to Apple's earnings is a hypothetical scenario in which Apple missed iPhone unit sales quarterly expectations by 10%. Such a scenario wouldn't necessarily be too much of a stretch considering Samsung misjudged demand for the Samsung Galaxy S5 by 40% last year. If Apple missed iPhone sales expectations by 10%, or five million units, EPS would have fallen by 10%. If we then assumed iPad or Mac sales missed expectations by 10%, the resulting EPS impact would be a rounding error.
It is getting to the point that the iPad or Mac are nothing more than asterisks on Apple's quarterly earnings reports which is saying a lot given their influence and sales numbers. Even the pace of Apple's capital return program is starting to be controlled by the iPhone given the product's significant contribution to U.S. cash flow and consequentially available funds to spend on buyback and dividends. Over the course of eight years, the iPhone has earned more than $100 billion of cash for Apple, which has gone a long way in buying back shares and paying dividends.
iPhone's Importance to Apple's Business
From management's point of view, the iPhone's significant power presents both business opportunities and risks. The iPhone's success has given Apple a formidable presence in mobile in terms of market power and positioning. Across the world, the iPhone 6 and 6 Plus have helped Apple grow market share, with a total iPhone user base close to 500 million. This environment remains quite appealing to developers and third-party companies willing to invest in the iOS ecosystem.
Besides funding the capital return program, the cash flow produced from iPhone sales has also been used to help develop new products and initiatives. While iPod sales helped fund iPhone development, iPhone sales will help fund Apple Car development.
Nevertheless, very strong iPhone growth trends do present some risks. From Apple's point of view, it is in their best interest to keep the iPhone user base vibrant and engaged. Such efforts go a long way in preventing fragmentation or stagnation. Accordingly, a situation may arise in which Apple finds itself with such a large iPhone user base that a growing number of users do not upgrade to the latest OS version, weakening the iPhone ecosystem.
In iOS 9, Apple included a series of features to address and turn around slowing iOS adoption rates likely due to users not having enough iPhone storage. As one example, users will receive a pop-up when trying to install iOS 9 on a device with insufficient space and offer to temporarily delete apps in order to make room for the update. The deleted apps would be reinstalled once iOS 9 has been installed. In addition, app thinning, app slicing, on-demand resources, and bitcode are all designed to maintain the vibrant nature of the iPhone user base, especially those who may be using older models.
Another risk created with strong iPhone sales is the difficult part of needing to push the iPhone forward in terms of hardware or software design while facing a growing amount of pushback from users opposed to change. The theory here is that the larger the user base, the more heterogeneous the composition including variation in taste and desires. The end result may be that changes alienate a group of iPhone users. One example of this is Apple changing the iPhone dock connector. A software example is how iOS 7 brought a new look to everyone's iPhone. The fear of embracing change due to potential user pushback or revolt has led to disaster at other technology companies since the lack of change gave competitors room to offer a better product. Evidence would suggest Apple has no intention of following a similar path. Take a look at the newest Macbook for evidence of Apple not being afraid to push design forward even if it meant alienating some users.
One of the biggest risks that Apple faces from a strong iPhone is that the product's importance leads management to ignore other opportunities that may seem too small to matter and are unlikely to reach the iPhone's stature in terms of revenue and profit. In reality, it is those kinds of risks that need to be taken in order to be in a position to eventually ship a product that will one day surpass the iPhone in terms of importance. Once again, Apple seems to be aware of this risk as the Apple Watch certainly contains attributes that may one day lead to people being able to accomplish a good portion of their computing needs with just a device worn on their wrist.
Strengthening iPhone's Value Proposition
The next five years for Apple will likely focus on new products and services positioned to increase the iPhone's value proposition instead of become the next big thing that will eventually surpass the iPhone. On some level, that may sound like Apple is operating in a lower gear than it did in the 2005-2010 period, and in some ways that is true for the simple fact that it is incredibly difficult to ship a product that is more important than the iPhone within a few years of its birth. This dynamic raises some interesting questions including whether this is one reason for Jony Ive's promotion to Chief Design Officer, which frees him from day-to-day managerial duties and instead allows him to look at more strategic tasks in terms of Apple design. These tasks include adapting the company's retail infrastructure to embrace luxury wearables.
It is impossible to say Apple will never ship a product as important and profitable as the iPhone because "never" is quite a long time. Most consumers spend $600-$700 on an iPhone every two or three years which means there is plenty of opportunity to have people spend more money on new Apple products and services. However, over the next five years, the iPhone will remain the most important product that Apple sells, and it would seem that Apple wouldn't have it any other way.
One of Steve Jobs' quotes that has been displayed at Apple HQ sums up Apple's long-term plan with the iPhone really well: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next."
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