The Services iPhone

Back when Stratechery first launched there was no bigger day than iPhone announcement day, and there was arguably no bigger year than 2013, when I was just getting started. That was the year Apple was, for the first time, coming out with a non-top-of-the-line iPhone, what ultimately became known as the iPhone 5C. We would find out later that the iPhone 5C was a bit of a one-off: the iPhone 5 with its chamfered edges was simply too expensive to make (and the edges chipped horribly), making it unsuitable for Apple’s “our cheaper phones are our older phones with a lower price” strategy; Apple would one day come out with the iPhone SE to address the lower end, but the real expansion came when the iPhone X was priced at $300 more than the iPhone 8 — up-market, not down.

Still, it’s interesting to look back at how much time I spent on that product launch:

  • Before the event I wrote Thinking about iPhone Pricing, where I guessed that the 5C would cost $450 (but made the case $550 might make more sense).
  • After the event I wrote Two Minutes, Fifty-six Seconds, which referred to how long into the keynote it took me to realize that $550 would be the price; it was clear that Apple was focused on differentiation, justifying its prices, not lowering them.
  • A week later I wrote The $550 iPhone 5C Makes Perfect Sense, which was mostly about subsidies and how they might have impacted Apple’s pricing decisions.
  • A couple of days after that I wrote what I consider one of the seminal Articles of early Stratechery — the ideas in What Clayton Christensen Got Wrong are one of the reasons I wanted to start the site. This was in response to critics who were sure Apple was setting themselves up for disruption with their pricing strategy; my argument was that differentiation in the user experience derived from integration was a sustainable moat that justified higher pricing.
  • Finally, a week after that I wrote Obsoletive, which made the case that thinking about the iPhone as a disruptive product was mistaken; rather, what made it so compelling — including its high price — was the fact it obsoleted so many other products in our lives.

(Oh, and for what it’s worth, I asked a month later: So the 5S is (allegedly) killing the 5C. Why is this bad news?. If customers were actually heavily favoring the more expensive 5S then this actually made all of the points I had written over the previous month.)

I was originally inspired to look up this history as part of an introduction explaining why iPhone events no longer seem Article worthy, but are worth saving an Update slot for; what struck me while reading through these old pieces though, is not only the degree to which they show Apple’s consistency, but also how much the company has changed — and that is Article worthy.

Apple’s Increasing ARPU

CEO Tim Cook is fond of citing Apple’s ability to integrate hardware and software; over the last few years he has taken care to add “and services” as well. What was interesting about his opening in yesterday’s keynote, though, was that he has now moved up to a higher level of abstraction: devices.

Products that are intuitive and easy-to-use, that have a unique integration of hardware and software, and that are incredibly personal. Today we’re here to talk about three products that have become essential in our lives: iPhone, AirPods, and Apple Watch. They’re always with you, whenever and wherever you need them, and are designed to work seamlessly together. On their own, each is industry-leading. Together, they provide a magical experience.

This is an expression of a strategy that became clear several years ago; I wrote in Apple’s Middle Age:

Apple’s growth is almost entirely inwardly-focused when it comes to its user-base: higher prices, more services, and more devices.

Very few people just buy an iPhone: they upgrade to a higher-priced model, they spend money in the App Store and on subscriptions, and they buy an Apple Watch and AirPods that work seamlessly with their phone. The end result is that Apple isn’t making $550 per customer, to go back to the iPhone 5C, or $650 in the case of the 5S: they’re making upwards of $2000 — $1,000+ for a top-of-the-line iPhone, $400+ for a Watch, $200+ for AirPods, and all of that App Store revenue (and this doesn’t even include what is likely a thriving accessories business, AppleCare, or the Google search deal).

It is, to be frank, justified: all of these devices really do work well together, and iPhones remain top-of-class. And, for all of the kvetching about the App Store, and Apple’s arguably anticompetitive actions to maintain its control, it is true that the concept was revolutionary.

The Service Narrative

It was in January 2016 that Apple first articulated the so-called “Services Narrative”; after a quarter in which the company’s new iPhone 6S posted relatively disappointing sales, CFO Luca Maestri made the case on the earnings call that it was a mistake to think of Apple as a hardware company, subject to the vagaries of consumer demand. I wrote at the time (forgive the long excerpt, but it’s directly applicable to the point):

Cook and CFO Luca Maestri went to a lot of effort to sell the narrative that Apple is becoming a services company, and frankly, I think they kind of overdid it.

Specifically, Apple created a new way of evaluating their services called “Installed Base Related Purchases.” This is basically Apple’s services revenue plus the amount they pay to developers from the App Store and to most digital content owners on the iTunes Store. Said payouts don’t appear on Apple’s balance sheet, nor should they: Apple isn’t some sort of middle man for Candy Crush Saga, buying it wholesale and then selling it at a profit. Rather, they are facilitating a transaction between a content creator and a consumer, and taking a 30% tax.

Moreover, one of the benefits of being recognized as a services company is that your revenue is valued more highly with the presumption that it is higher margin; by adding in the 70% Apple pays out they are certainly able to crow about a higher revenue number, but they are dramatically reducing their associated margin by doing so. It’s silly.

To be sure, Apple’s services revenue numbers are impressive (although it should be noted that services revenue on a per-active-user basis actually decreased year-over-year). But it is very clear that the company remains a differentiated hardware company, as evidenced by everyone’s favorite question:

In the past, Apple’s been very known in always having a premium product. With the slowdown in the macro FX and also GDP revision, is Apple’s strategy go-to-market still always at premium product, or is there a need to go to more also a middle market or lower price point to attract more customers?

Ah, it’s the ol’ “Will Apple make a cheaper iPhone?” query. This one, though, was smarter than it appears, thanks to the next sentence:

Just because it seems like growing that installed base and services, as you pointed out, really economically could really help out Apple in the long-term.

As I’ve written innumerable times, 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:

Our strategy is always to make the best products…We have the premium part of our line is the 6s and the 6s Plus. We also have a mid-price point, with the iPhone 6 and the iPhone 6 Plus. And we continue to offer the iPhone 5s in the market and it continues to do quite well. And so we offer all of those and I don’t see us deviating from that approach.

To be clear, I think this is the exact right approach for Apple, and as I noted above, I think these results show that the strategy continues to work. But let’s be honest: that means Apple is not a services company; they have a nice services revenue stream, but the company is rightly judged now and for the foreseeable future on the performance of its hardware.

I revisited this take a few years later, in an Update entitled Apple the Services Company (for Real!), where I noted that Apple’s estimated $44/user per year in services revenue still paled in comparison to Google or Facebook, but was meaningful all the same, particularly once you realized that Apple’s users had to spend a whole lot of money to even enter their ecosystem. I concluded:

Of course only looking at services revenue is not quite right either: that number does not include the cost of the iPhone itself, the price of entry to Apple’s ecosystem (although that payment may not necessarily flow to Apple, as is the case with phones handed down or resold). Apple, though, by de-emphasizing unit sales and focusing on the installed base, is making clear that the number that matters is average revenue per installed device; in other words, to the extent a company is what it measures — or at least reports — Apple is now a services company for real.

This was perhaps a bit generous, given the strategic tension I noted in the earlier excerpt: Apple may have been shifting its metrics to ones that reflected a focus on services, but at the end of the day, the company was still charging a pretty high price for entry.

The Services Company

I thought the products Apple introduced yesterday were pretty impressive:

  • The Apple Watch Ultra looks like the SUV of watches: it will be sold as a tool for extreme athletes, and mostly bought because it is so clearly new and different, clearly distinguishable from all of the other Apple Watches on the market.
  • AirPods Pro was a killer product in its first iteration; the 2nd generation looks set to address the 1st generation’s few flaws while delivering the sort of improvements we might expect from every tech product.
  • The iPhone Pro is increasingly differentiated from the iPhone, not just in terms of having a faster processor — a first — but also with software-driven differentiation like the new Dynamic Island functionality.

The most surprising announcement of all, though, were the prices. Everything stayed the same! This was not what I, or close followers of Apple like John Gruber, expected at all. After all, Apple’s strategy the past several years seemed to be focused on wringing more revenue out of existing customers. More importantly, the last year has seen a big increase in inflation:

U.S. inflation over the last five years

What this means is that in real terms Apple’s products actually got cheaper. Apple did, to be sure, raise prices around the world, but this is better explained by the fact the company runs on the dollar, which is the strongest in years; to put it another way, those foreign prices are derived from the U.S. price, and that price stayed the same, which means the price is lower.

This doesn’t make much sense for the product company Apple has always been thought to be, and doesn’t fully align with the approach I laid out in Apple’s Middle Age. It does, though, make all kinds of sense for a services company, which is focused first-and-foremost on increasing its install base. Indeed, this is the missing piece from that Update I wrote about Apple’s changing metrics. To measure its business based on users, not products, was to measure like a services company; to lower the prices of the products that lead to services revenue is to price like one.

This is, in a weird way, a relief: it has been disconcerting for people who think of Apple as a product company to see the company fight so fiercely for its App Store model, and to see the way it is willing to approach if not cross the line of anticompetitive behavior when it comes to App Tracking Transparency and its clear ambitions in the advertising space. To declare that the company is now clearly driven by Services doesn’t refute these narratives; rather, it at least justifies them, because they are exactly what a Services company ought to do. Here’s hoping that the products that made the company great don’t suffer from what is, at this point, a clear shift in strategy.

I wrote a follow-up to this Article in this Daily Update.