The iPhone and Apple’s Services Strategy

Editor’s Note: Stratechery was referenced in yesterday’s keynote. I had no knowledge of or awareness of this reference, and have no relationship with Apple, up-to-and-including not owning their stock individually, as explained in my ethics policy.

It is the normal course for Apple events to come and go and people to complain about how boring it all was, particularly when the company announces said event like this:

Apple Event Invitation: "By Innovation Only"

Apple reporter extraordinaire Mark Gurman was not impressed:

Gurman isn’t necessarily wrong about the highly iterative nature of the hardware announcements (although I think that an always-on Apple Watch is a big deal), but that doesn’t necessarily mean he is right about the innovation question. To figure that out we need to first define what exactly innovation is.

Beyond the iPhone, Revisited

Another Apple keynote that was greeted with a similar collective yawn was in 2016, when the company announced the iPhone 7 and Series 2 Apple Watch. Farhad Manjoo wrote at the time in the New York Times:

Apple has squandered its once-commanding lead in hardware and software design. Though the new iPhones include several new features, including water resistance and upgraded cameras, they look pretty much the same as the old ones. The new Apple Watch does too. And as competitors have borrowed and even begun to surpass Apple’s best designs, what was iconic about the company’s phones, computers, tablets and other products has come to seem generic…

I quoted Manjoo’s piece at the time and went on to explain why I thought that year’s keynote was more meaningful than it seemed, particularly because of the AirPods introduction:

What is most intriguing, though, is that “truly wireless future” Ive talked about. What happens if we presume that the same sort of advancement that led from Touch ID to Apple Pay will apply to the AirPods? Remember, one of the devices that pairs with AirPods is the Apple Watch, which received its own update, including GPS. The GPS addition was part of a heavy focus on health-and-fitness, but it is also another step down the road towards a Watch that has its own cellular connection, and when that future arrives the iPhone will quite suddenly shift from indispensable to optional. Simply strap on your Watch, put in your AirPods, and, thanks to Siri, you have everything you need.

That future is here, although the edges are still rough (particularly Siri, which was a major focus of that article); Apple’s financial results have certainly benefited. Over the last three years the company’s “Wearables, Home and Accessories” category, which is dominated by the Apple Watch and AirPods, has nearly doubled from $11.8 billion on a trailing twelve-month (TTM) basis1 to $22.2 billion over the last twelve months. In other words, according to the metric that all businesses are ultimately measured on, that 2016 keynote and the future it pointed to was very innovative indeed.

Apple’s Services Narrative

Wearables have not been Apple’s only growth area: over the same three-year span Services revenue has increased by almost the exact same rate — 89% versus 88% — from $23.1 billion TTM to $43.8 billion TTM. At the same time, it feels a bit icky to call that innovation, particularly given the anticompetitive nature of the App Store.

That’s not totally fair of course: the App Store was one of the most innovative things that Apple ever created from a product perspective; that the company has positioned itself to profit from that innovation indefinitely is innovative in its own right, at least if you go back to measuring via revenue and profits.

Still, the idea of Apple being a Services company is one that has long been hard to grok. When the company first started pushing the “Services Narrative” I declared that Apple is not a Services Company:

Services (horizontal) and hardware (vertical) companies have very different strategic priorities: the former ought to maximize their addressable market (by, say, making a cheaper iPhone), while the latter ought to maximize their differentiation. And, Cook’s answer made clear what Apple’s focus remains.

That answer was about continuing Apple’s pricing approach, which at that time was $649+ for new iPhones, with old iPhones discounted by $100 for every year they were on the market, and Cook’s specific words were “I don’t see us deviating from that approach.”

In fact, Apple did deviate, but in the opposite direction: in 2017 the company launched the $999+ iPhone X at the high end and bumped the price of the now mid-tier iPhone 8 to $699+. I wrote at the time:

The iPhone X sells to two of the markets I identified above:

  • Customers who want the best possible phone
  • Customers who want the prestige of owning the highest-status phone on the market

Note that both of these markets are relatively price-insensitive; to that end, $999 (or, more realistically, $1149 for the 256 GB model), isn’t really an obstacle. For the latter market, it’s arguably a positive.

What this strategy was absolutely not about was expanding the addressable market for Services. Apple was definitely not a Services company when it came to their strategic direction (even if, as I conceded in 2017, it was increasingly fair to evaluate the financial results in that way).

The iPhone’s Price Cut

This leads to what is in my mind the biggest news from yesterday’s event: Apple cut prices.

It was easy to miss, given that the iPhone 11 Pro, the successor to the iPhone X and then XS, hasn’t changed in price: it still starts at $999 ($1,099 for the larger model), and tops out at $1,449; if you want the best you are going to pay for it.

Perhaps the most interesting aside in the keynote, though, is that for the first time a majority of Apple’s customers weren’t willing to pay for the best. Tim Cook said:

Last year we launched three incredible iPhones. The iPhone XR became the most popular iPhone and the most popular smartphone in the world. We also launched the iPhone XS and iPhone XS Max, the most advanced iPhones we have ever created.

In a vacuum there is nothing surprising about this. The iPhone XR was an extremely capable phone, with the same industrial design, the same Face ID, and the same processor as the iPhone XS; the primary differences were an in-between size, one less camera, and an LCD screen instead of OLED. That doesn’t seem like much of a sacrifice for a savings of $250.

And yet, even while I said Apple’s strategy “bordered on over-confidence”, I still fully expected the iPhone XS to be the best-selling phone like the iPhone X before it; that is how committed Apple’s customers have been to buying the flagship iPhone. Even Apple, though, can’t escape the gravitational pull of “good enough” — which is why the price cuts, which happened further down the line — were so important.

There are two ways to see Apple’s price cuts. First, by iPhone model:

Launch 1 year old 2 years old
iPhone 7 $649 $549 $449
iPhone 8 $699 $599 $449
iPhone XR $749 $599
iPhone 11 $699

Secondly by year:

Flagship Mid-tier 1 year old 2 years old
2016 $649 $549 $449
2017 $999 $699 $549 $449
2018 $999 $749 $599 $449
2019 $999 $699 $599 $449

In the second chart you can see how Apple in 2017 not only raised prices dramatically on its flagship models, but also on the mid-tier model relative to previous flagships. This was important because it was these mid-tier models that replaced previous flagships in Apple’s usual “sell the old flagship for $100 less per year” approach. That meant that 2017’s price hike filtered through to 2018’s 1-year-old model, which increased from $549 to $599.

That means that this year actually saw three price cuts:

  • First, the iPhone 11 — this year’s mid-tier model — costs $50 less than the iPhone XR it is replacing.
  • Second, the iPhone XR’s price is being cut by $150 a year after launch, not $100 as Apple has previously done.
  • Third, the iPhone 8’s price is also being cut by $150 two years after launch, not $100 as Apple has previously done.

To be fair, this doesn’t necessarily mean the line looks much different today than it did yesterday: the only price point that is different is the iPhone 11 relative to the XR. That, though, is because it will take time for those previous price hikes to work their way out of the system, presuming Apple wants to stay on this path in the future.

They should. The success of the iPhone XR strongly suggests that there is more elasticity in the iPhone market than ever before. Apple also cut prices in China earlier this year with great success; I wrote after Apple’s FY2019 Q2 earnings:

The available evidence strongly suggests that iPhone demand in China is very elastic: if the iPhone is cheaper, Apple sells more; if it is more expensive, Apple sells less. This is, of course, unsurprising, at least for a commodity, and right there is Apple’s issue in China: the iPhone is simply less differentiated in China than it is elsewhere, leaving it more sensitive to factors like new designs and price than it is elsewhere.

As I note in that excerpt, China is unique, but the commodity argument is a variant of the “good-enough” argument I made above: while Apple doesn’t necessarily need to worry about iPhone customers outside of China switching to Android, they are very much competing with the iPhones people already have, and, as the XR demonstrated, their own new, cheaper phones.

That’s ok, though, and the final step in Apple truly becoming a Services company, not just in its financial results but also in its strategic thinking. More phones sold, no matter their price point, means more Services revenue in the long run (and Wearables revenue too).

Apple’s Services Announcement

Apple’s two service-related announcements are also good reasons to pursue this strategy. Perhaps the most compelling from a financial perspective is Apple Arcade. For $4.99/month a family gets access to a collection of games featured on their own tab in the App Store:

What makes this compelling from Apple’s perspective is that the company is paying a fixed amount for those games overall, which means that once the company covers the costs of those games, every incremental subscription is pure profit. Contrast this to something like Apple Music, where costs scale inline with revenue; no wonder the service is getting such prime real estate — and no wonder Apple suddenly seems interested in selling more iPhones, even if they earn less revenue up-front.

Similar dynamics apply to Apple TV+: once content costs are covered, incremental customers are pure profit. That noted, I’m not convinced that Apple TV+’s ultimate purpose is to be a profit driver by itself; I explained after Apple’s services event earlier this year:

To be very clear about my analysis of Apple TV+, I don’t think it is a Netflix competitor. I see it as a customer acquisition cost for the Apple TV app; it is Apple TV Channels that will make the real money, and this is not an unreasonable expectation. Roku’s entire business is predicated on the same model; the hardware is basically sold at cost, while the “platform” last year had $417 million in revenue and $296 million in profit, which equates to a tidy 71% gross margin.

Apple TV Channels is a means to buy subscriptions to other streaming services, which makes a lot of money for Roku and Amazon in particular; Apple TV+ content is a reason to make Apple TV the default interface for video leading to more subscriptions via Apple TV Channels.2 This view also explains why Apple is going to bundle a year of Apple TV+ with all new Apple device purchases (which is also very much in line with the idea of Apple giving up short-term revenue on its products — or incurring contra-revenue in this case — for long-term subscription revenue).

iPhone as a Service

It does feel like there is one more shoe yet to drop when it comes to Apple’s strategic shift. The fact that Apple is bundling a for-pay service (Apple TV+) with a product purchase is interesting, but what if Apple started including products with paid subscriptions?

That may be closer than it seems. It seemed strange yesterday’s keynote included an Apple Retail update at the very end of the keynote, but I think this slide explained why:

iPhone monthly pricing

Not only can you get a new iPhone for less if you trade in your old one, you can also pay for it on a monthly basis (this applies to phones without a trade-in as well). So, in the case of this slide, you can get an iPhone 11 and Apple TV+ for $17/month.

Apple also adjusted their AppleCare+ terms yesterday: now you can subscribe monthly and AppleCare+ will carry on until you cancel, just as other Apple services like Apple Music or Apple Arcade do. The company already has the iPhone Upgrade Program, that bundles a yearly iPhone and AppleCare+, but this shift for AppleCare+ purchased on its own is another step towards assuming that Apple’s relationship with its customers will be a subscription-based one.

To that end, how long until there is a variant of the iPhone Upgrade Program that is simply an all-up Apple subscription? Pay one monthly fee, and get everything Apple has to offer. Indeed, nothing would show that Apple is a Services company more than making the iPhone itself a service, at least as far as the customer relationship goes. You might even say it is innovative.

  1. Apple’s product numbers are always best represented on a trailing twelve-month basis given the huge amount of seasonality in their revenue 

  2. I also believe this is now the strategic rationale behind Amazon Prime Video