APPLE & THE NARRATIVE (II)

Here's the second article on Apple and the narrative. Richard Waters: "Apple flitchs the wrong switch", Financial Times, January 29, 2016

Sometimes, giving investors extra insight into a promising new line of business works wonders with Wall Street. But sometimes it does not — as Apple has found to its cost this week. Getting the trick right is of special concern in the technology sector, where established businesses often mature quickly. Having a new story to tell can help investors look beyond a company’s plateauing fortunes. When it comes to using extra financial disclosure to change perceptions, Amazon has become the tech world’s gold standard — somewhat ironically, given its reputation for secrecy. Since it first revealed details last April about Amazon Web Services, its cloud computing sideline, the company’s stock market value has risen by nearly $100bn. Amazon waited until the business was both sizeable and unexpectedly profitable before lifting the lid.

Alphabet, the holding company for Google, has achieved a similar effect with the promise to break out its non-search businesses with its next results on Monday. The purpose here is different: to show off the strength of its core search operation and to demonstrate greater discipline by not shielding the losses of its other activities. But when it comes to Apple, the magic has worn thin. The company’s attempt to draw attention to its services business — which, at $6bn in the latest quarter, produced more in revenue than Amazon Web Services for the first nine months of last year — did nothing to prevent a near-7 per cent slump in the share price on Wednesday. Much comes down to timing. Amazon and Google prepared Wall Street carefully, stoking anticipation for months. Apple, by contrast, dropped its news unexpectedly on a wary investor base. It was hardly surprising that Wall Street chose to see the extra, unexpected disclosure as an attempt to distract attention from what is set to become the first contraction in iPhone sales. 

The data presentation also seemed halfhearted. Apple executives sought to compare their services business with that of a sizeable, freestanding internet company. But they made little attempt to explain a grab bag of businesses that make up what the company calls its “installed base related revenue” (IBRR). These range from the net revenue on App Store sales to supplying replacement iPhone screens and licensing its brand to accessory makers. But Apple declined to lay out a bigger vision for how the services business was likely to evolve. It also did little to counter perceptions that glitches in areas such as its maps app and iCloud back-up and syncing service showed it had yet to match a pure internet company such as Google in terms of quality and reliability.

As iPhone sales go into decline, the group is determined to show it is more than a hardware company.

In the absence of a clear explanation, investors have therefore chosen to view Apple’s service business in the same light as those from hardware makers such as Xerox: a potentially profitable supplement to the core business, but not something likely to grow into a major revenue source that justifies a premium valuation. Despite the shortcomings, services are likely to remain a high-growth bright spot for Apple, not just in the rest of 2016 but for a considerable period of time. That is partly because of slowing hardware growth. Global smartphone shipments will rise at an average annual rate of around 7 per cent in the medium term, according to research firm IDC. Falling prices will put a lid on overall revenue growth, and economic uncertainty threatens the premium end of the market. With little sign that products such as television set-top boxes and smartwatches will become sizeable new hardware categories in their own right, the attractions of services will loom ever larger.

The gatekeeper status conferred by the App Store is already significant. Apple paid more than $14bn last year to app developers and companies selling content through iTunes, an increase of 36 per cent. If it takes around a 30 per cent commission on these sales, then the App Store and iTunes accounted for more than a third of the money it made last year from selling things to its installed base, and virtually all of the growth. This income source will loom larger as it grows, eclipsing other businesses with less potential. It looks like a promising sign of what could grow into a meaningful source of profits. But the reaction to Apple’s disclosures this week suggests that investors do not believe the company is ready to move decisively beyond its hardware business model.
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APPLE & THE NARRATIVE (I)

Let us start with Prof. Damodaran: "Every valuation, even though it's about numbers, has a story, a narrative behind it. A good valuation is more about the story than about the numbers" [VIDEO]. This is precisely the problem faced by Apple. There are two Financial Times stories that deal with this issue. The first is by Tim Bradshaw: "Apple seeks app to change percepction about its core business", Financial Times, January 27, 2016. It is reproduced below. And this was Lex's comment: "Telling a different story with new details on the business -particularly if, as in this case, it happens to be true-, is a legitimate stock boosting tactic. Just as hitting the debt markets hard in order to return additional tens of billions of dollars in cash to sahreholders."

Here's Tim Bradshaw's article:

Apple does not like to be thought of as “the iPhone company”. Back in 2011, co-founder Steve Jobs declared that “technology alone is not enough — it’s technology married with the liberal arts, married with the humanities, that yields us the results that make our heart sing”. Tim Cook, Jobs’ successor as chief executive, is less given to lyricism but has often repeated the mantra that “only Apple” can combine hardware, software and services into a single cohesive whole.“We haven’t been a hardware company since I’ve been with Apple,” he told a Goldman Sachs tech conference last February. “I don’t think Apple was ever a hardware company, even at the beginning.” Yet despite the efforts to persuade them otherwise, Wall Street investors tend to see — and value — Apple as a hardware company. And when growth in its most lucrative piece of hardware is about to go into reverse for the first time, they punish its share price accordingly: Apple has lost about a quarter of its value since it hit an all-time high last February. 

On Tuesday those fears were confirmed: iPhone sales grew by less than 1 per cent last quarter and Apple warned that overall revenues were about to see their first quarterly decline since 2003. Its shares closed 6.6 per cent lower at $93.44 on Wednesday — its lowest point since mid-2014. So the company is taking a new approach to spreading its message that it is not going to go the way of BlackBerry and Nokia. Alongside Tuesday’s earnings, Apple published new data to highlight the scale and pace of its services business, led by the App Store. It also disclosed that more than 1bn Apple devices were in active use over the last 90 days, including iPhones, Apple Watches and Macs. “We have a huge number of devices actively engaged with our services and that number is growing very fast,” Luca Maestri, Apple’s chief financial officer, told the Financial Times. 

He pointed to figures showing that “install base related purchases” — a new metric that includes customers’ spending on apps, music and movies before Apple pays out a roughly 70 per cent share of the revenue to their creators — increased by 23 per cent last year to $31.2bn. This metric rose by 24 per cent in the December quarter, even as iPhone sales plateaued. “A high portion of services business is directly related to our install base and not to our shipments or current quarter sales,” Mr Maestri said. “This part of our business — which is very much recurring in nature because it’s related to the install base — is actually quite large, it’s growing very fast and it’s also quite profitable.” The timing of the disclosure, alongside the warning of the iPhone’s decline, was not lost on observers. “They are trying to change the narrative,” said Ben Bajarin, analyst at Creative Strategies. “They are trying to tell the story that they are not just a hardware company. But Wall Street will only believe that when they show them the money.” 

Changing the perception that Apple is dependent on the iPhone may take some time. Even with services growing much more rapidly than hardware sales, the iPhone still made up 68 per cent of Apple’s total revenues in its latest quarter — less than 1 percentage point below the same period a year earlier. Apple’s $5.5bn in services revenues last quarter made up only 7 per cent of total sales. Revenue from apps, iCloud and other services may be small by the standards of what is still the world’s biggest company by market capitalisation. But that single quarter for Apple services was larger than Yahoo’s sales are expected to be for the whole of last year, and on par with what Facebook is likely to report for its fourth quarter. “If you look at other internet services companies, they enjoy a different multiple” to Apple, Mr Maestri said — a much higher valuation for each dollar of profit. 

As iPhone sales go into decline, the group is determined to show it is more than a hardware company.Investors tend to prefer businesses that sell software or services to hardware vendors because they are less prone to the wild fluctuations in growth that Apple has seen in recent years. “The key thing Apple is trying to get across here is that analysts have it wrong when they say that Apple’s revenue is inherently unpredictable,” said Jan Dawson, analyst at Jackdaw Research. But a direct comparison between the likes of Facebook and Alphabet, Google’s parent, is still not possible based on the figures Apple released on Tuesday. For one thing, the company’s internet business is based mainly on consumer purchases whereas its Silicon Valley neighbours rely on free, advertising-funded services. Unlike Google and Facebook’s standard measure of monthly unique users, Apple’s billion-device figure inflates the number of individuals who buy those apps by counting one person who owns an iPhone, an iPad and an Apple Watch as three constituents of its “active install base”. Mr Bajarin estimated that the actual number of unique Apple customers is closer to 600m. “The number we would need to know is the absolute unique user base — is that growing? What is the annual revenue per user and is that going up?” he said. 

While the App Store is by far the biggest driver of its services revenue line, Apple is also including an indeterminate amount of sales from decidedly offline items such as replacement screens or accessories that bear its Made for iPhone branding, which it licenses to third parties in return for royalties. “The numbers are impressive, but we don’t have enough history,” said Amit Daryanani, analyst at RBC Capital Markets, suggesting that last year might have been unusually strong for services due to the leap in iPhone 6 purchases. “The reality is the services recurring revenue stream only works if your install base is alive and well.” If Apple intended its focus on its huge install base and the rapid growth of its services business to distract from slowing iPhone sales, the gambit may have backfired. The sudden transparency prompted some to wonder about what Apple’s other motives might be. 

“The feedback from clients is, ‘Is the services revenue disclosure being done ahead of iPhone being ex-growth over the next several quarters?’” Mr Daryanani said. Investors were more interested in Mr Cook’s sudden change in tone on the impact of the “turbulent” macroeconomic environment on Apple’s business around the world. “We are seeing extreme conditions, unlike anything we’ve seen before, just about everywhere we look,” Mr Cook warned, despite dismissing looming worries about the global economy just three months ago. “Major markets including Brazil, Russia, Japan, Canada, Southeast Asia, Australia, Turkey and the eurozone have been impacted with slowing economic growth, falling commodity prices and weakening currencies.” So severe was the impact of foreign exchange rates that on a constant currency basis, sales in the quarter would have been $5bn higher — or “about the size of the annual revenue of a Fortune 500 company”, Mr Cook pointed out.
But he could have used a different comparator: fluctuating exchange rates had roughly the same impact on Apple’s business as its entire services unit.
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