Something Is Rotten in the State of Apple

By Leonid Bershidsky, The Washington Post | Updated: 28 April 2016 11:14 IST

Apple executives have been explaining the company's first year-on-year revenue drop since 2003 as down to macroeconomic headwinds and a less impressive upgrade cycle than in 2015. Those excuses miss the point. The colossus doesn't exactly have feet of clay yet, but Apple's business model is challenged.

That business model is largely dependent on selling one hugely successful product - the iPhone - in a growing but still small number of models. The iPhone accounted for 65 percent of Apple's revenue in the quarter to March. That share has been fairly constant over the last two years. The flagship product accounted for much of the year-on-year drop in the three months through March.

The iPhone is so expensive that the company captures more than 90 percent of all global smartphone profits while holding down less than a 20 percent market share of unit shipments. This incredible market position has lately rested on three pillars: the enormous brand equity built by Apple's smartphone revolution of 2007-2011; the US (and, less importantly, European) sales model in which mobile operators subsidized phone sales, absorbing most of Apple's exorbitant markup; and the rapid consumption growth in China.

The first pillar is still there: Apple is the world's most valuable brand. The other two are eroding, though. The phone subsidization model is all but dead in the US. The mobile operators have always hated the up-front cost of the subsidies, but they put up with them throughout their extensive growth phase. They were fighting for market share at the time while smartphone penetration was growing fast, doing all they could to get customers on their networks. Now, penetration is on course to reach 90 percent, and there is no point for operators to pay every time a customer wants to upgrade her smartphone.

What this means for handset manufacturers is that they have to sell more phones at the contract-free price or through operators' installment plans, which are not as useful as direct subsidies because it's a struggle for operators to securitise the installment sales and thus spread out the customer's cost over a longer period. Selling without subsidies is a difficult proposition for Apple because of its mark-up. Essentially, it sells the same phone as other manufacturers - and in some cases an inferior one - at a much higher price, lulling buyers with tales of a comfortable ecosystem that includes all kinds of apps, media and life hacks, such as an easy payment solution or unlocking hotel rooms doors with one's phone.

(Also see: As iPhone Sales Slump, Apple Bets on Services From Apps to Music)

That works with the Apple fan club and its new converts (see the first pillar). It doesn't work with most people though, judging by unit shipment data; and it's not just a matter of not being able to afford a $700 (roughly Rs. 48,000) smartphone. Today's flagship devices, some of them with better specs than Apple's offerings, sell for $400 (roughly Rs. 27,000) or thereabouts. I haven't bought an iPhone since 2013; the phone I currently use is a $450 (roughly Rs. 30,000) Huawei-made Google Nexus 6P, which has a bigger, sharper display, a faster processor and a longer-lasting battery than the $750 iPhone 6s Plus - all in a lighter package. I can afford the latest iPhone, but I don't want it: There are better options available.

This brings us directly to the third pillar - China. During the most recent earnings call, Apple Chief Executive Officer Tim Cook and Chief Financial Officer Luca Maestri talked about the company's problems in Hong Kong, where the currency is pegged to the US dollar, making it less attractive to tourists. To an extent, that explains a 26 percent year-on-year revenue drop in Greater China, but there is also an 11 percent decline in Mainland China (7 percent in constant currency terms). This may be due in part to the fizzling of the country's exuberant growth, but I rather suspect that there's a limit to how many Chinese consumers may be seduced by a strong Western brand over price and tech considerations. Xiaomi and Huawei are the market leaders in China in terms of unit shipments. They make great phones, and they sell them for less than 60 percent of Apple's prices.

I said last year that Apple's Chinese miracle, which explained the phenomenal sales of the iPhone 6, was over. Now the numbers prove it.

On the earnings call, Cook kept saying that a lot of people switch from Android devices to Apple. "We added more switchers from Android and other platforms in the first half of this year than any other six month period ever," he boasted, meaning Apple's 2016 financial year, which started in October, 2015. There is, however, no way to tell how many people are switching from Apple to Android because many producers use the Google-developed operating system; I am probably not the only such switcher.

Apple cannot fix its outdated price-to-tech ratio by introducing the iPhone SE. Cook says he is happy with the smaller phone's performance so far, but it costs $399 - as much as some Android flagships. Again, consumers are expected to buy a stronger brand rather than a better device. That's why Apple can hardly expect a Chinese-style demand explosion in India, which Cook targets as a big future market: Unlike in China, the company will have to sell retail there, rather than make deals with big operators, and the overpricing problem will loom large.

Time is not on Apple's side where the iPhone is concerned. It has been overtaken and undercut by the competition, and it's hard to imagine how Apple will keep up, since it outsources production and buys components from the same vendors as the competition.

Apple's app and media universe isn't the major attraction it once was, either. Google offers the same apps, movies and music to Android phone owners.

Though Apple's "services" and "other products" segments (the latter of which includes the Apple Watch, the only major product launched during Cook's tenure as chief executive) show impressive growth, they combine for just 16 percent of the company's revenue, and their combined year-on-year growth doesn't even make up for the drop in the sales of iPads and Mac computers, which occurred despite recent product launches in these categories .

Apple, of course, would be a huge business even without the iPhone; with 2015 revenue of $78.6 billion (roughly Rs. 5,22,350 crores), it would be about the size of Toyota and bigger than Procter & Gamble or Sony. That non-iPhone business is doing OK - some parts of it are shrinking, others are growing - but there's nothing spectacular or magical about it.

In its heyday, Nokia too was a company with two parallel lives: A quiet network equipment business and the world-beating handset one. Now, only the first one bears the Nokia name. It's a strong company in its market, a world leader, but not the kind of powerhouse that pushed the Finnish economy forward.

It was hard to imagine that Nokia's leadership in the mobile handset market would erode as quickly as it did, but Apple killed Nokia with the iPhone. Now, the iPhone is beginning to face problems of its own, and that doesn't bode well for Apple's future. Resting on one's laurels and focusing on brilliant execution - squeezing suppliers, scouting out new markets, making sure channel inventory doesn't grow faster than sales - can be a good strategy for some time, but it's not an industry leadership strategy.

Comments

For the latest tech news and reviews, follow Gadgets 360 on X, Facebook, WhatsApp, Threads and Google News. For the latest videos on gadgets and tech, subscribe to our YouTube channel. If you want to know everything about top influencers, follow our in-house Who'sThat360 on Instagram and YouTube.