Apple's Ecosystem Growth Is Accelerating
The two most recent Above Avalon articles took a look at how and why Apple’s ecosystem is giving the company a major advantage against the competition.
With Apple reporting 3Q20 earnings two weeks ago, there is value in quantifying how much Apple’s ecosystem is growing. The data should startle the competition. Apple is seeing a clear acceleration in its ecosystem growth as hundreds of millions of iPhone-only users move deeper into the Apple fold by subscribing to various services and buying additional products.
Measuring Ecosystem Growth
There are a number of ways one can attempt to track or measure Apple’s ecosystem growth.
Number of devices per user
Number of paid subscriptions per user
In covering Apple’s business from a financial perspective, my modeling work includes keeping up-to-date estimates for most of the preceding data points. However, there is one metric missing from the list that may come as a surprise: overall revenue. Considering Apple provides this data point every three months, such an exclusion may seem peculiar. Wouldn’t Apple revenue shed light on how the Apple ecosystem is performing?
Relying on overall revenue for analyzing Apple’s ecosystem growth will lead to faulty conclusions. In Exhibit 1, Apple’s revenue is graphed on a trailing twelve months (TTM) basis. This is done to smooth out the seasonality found in Apple’s business (i.e. sales are concentrated around the holidays). The takeaway from the exhibit is that higher revenue demonstrates Apple’s ecosystem continues to grow although the rate of growth has slowed dramatically.
There is one problem with such a takeaway: It’s wrong.
Exhibit 1: Apple Revenue (TTM)
Click / tap exhibit to enlarge.
Overall revenue trends are masking what is actually occurring with Apple’s ecosystem. In FY2019, the iPhone was responsible for 55% of Apple’s overall revenue. On its own, that’s not an issue for Apple. The iPhone is part of Apple’s ecosystem after all. However, Apple has become increasingly dependent on existing users upgrading their devices to generate iPhone revenue. This has resulted in Apple’s overall revenue being heavily influenced by iPhone upgrading trends.
During periods of robust iPhone upgrading, Apple’s overall revenue shows stronger growth. When iPhone upgrading slows, overall revenue growth also slows to the point that Apple’s ecosystem may appear to be plateauing or even contracting (as seen in Exhibit 1). This was a major issue at the end of 2018 and early 2019 as slowing iPhone upgrades led many to conclude that Apple was in big trouble in China and other geographies.
Since iPhone upgrading trends have little to no direct impact on Apple ecosystem viability or strength, a better approach to get insights on Apple’s ecosystem growth is to divide Apple’s revenue into two categories:
iPhone
non-iPhone (Services, Mac, iPad, Wearables, Home, and Accessories)
As seen in Exhibit 2, breaking Apple’s overall revenue into iPhone and non-iPhone revenue leads to a completely different view of Apple’s growth trajectory. Non-iPhone revenue (the red line) continues to demonstrate very strong momentum while iPhone revenue (the blue line) is trending at the same level that it was in 2015.
Exhibit 2: Revenue (iPhone vs. Non-iPhone) - TTM
Click / tap exhibit to enlarge.
A different way of looking at this data is to consider revenue growth rates. Using the revenue figures from Exhibit 2, we are able to create Exhibit 3, which displays year-over-year change in revenue for both iPhone and non-iPhone.
Non-iPhone revenue growth (the red line) has outpaced iPhone revenue growth (the blue line) for the past seven quarters. The higher growth rates for iPhone revenue in 2018 were due to higher iPhone ASPs caused by Apple unveiling the iPhone X. Excluding those quarters, non-iPhone revenue growth has been trending stronger than iPhone growth since 2016. This is a sign that Apple’s underlying ecosystem strength has been gaining momentum for years - it’s just been masked by people holding on to their iPhones for longer before upgrading.
Exhibit 3: Revenue Growth YOY (iPhone vs. Non-iPhone) - TTM
Click / tap exhibit to enlarge.
What is driving the non-iPhone revenue strength shown in Exhibits 2 and 3? The answer is found in the strong iPhone revenue trends from a few years ago. Years of strong new user growth driven by the iPhone is now contributing to hundreds of millions of iPhone-only users moving deeper into the Apple ecosystem. This trend began in earnest around the beginning of 2017.
The Services Myth
Some may look at the preceding exhibits and say that the data is still incomplete. Apple Services include a number of recurring revenue streams such as iCloud, Apple Music, and various paid subscriptions. Given the recurring nature of something like paid iCloud storage, it ends up being easier for Apple to report year-over-year Services growth. Apple’s Services business accounts for 40% of non-iPhone revenue. There is a different dynamic found with hardware revenue. Since hardware isn’t a recurring revenue stream, year-over-year growth ends up being that much harder to achieve as Apple is in effect needing to replace every dollar of revenue with new sales.
(One can argue something like the iPhone Upgrade Program is a recurring revenue stream for hardware. However, that ends up being a stretch. The Upgrade Program is a loan with a built-in upgrade optionality after the 12th payment. That is very different than something like an iCloud or Apple Music subscription.)
To address this issue, non-iPhone revenue can be broken out into Services and Products (excluding iPhone). In what will come as a shock to many people, Exhibits 4 and 5 show how Products revenue excluding iPhone (i.e. iPad, Mac, Wearables, Home, and Accessories) is now growing at nearly the same pace as Services. This represents a major narrative violation as consensus spent years positioning Services as Apple’s growth engine.
Exhibit 4: Revenue (Apple Services vs. Apple Products Excluding iPhone) - TTM
Click / tap exhibit to enlarge.
Exhibit 5: Revenue Growth YOY (Apple Services vs. Apple Products Excluding iPhone) - TTM
Click / tap exhibit to enlarge.
Based on Apple management commentary, we know that upgrading is not impacting the iPad, Mac, and wearables as much as the iPhone. Approximately half of people buying iPads and Macs are new to the product categories. For Apple Watch, the percentage is more than 75%. The new user percentage for iPhone sales is a fraction of those percentages. This tells us that iPad, Mac, and wearables sales are a very good indicator of Apple ecosystem strength.
Tying It All Together
One way of thinking about the Apple ecosystem is to view it as a pie. There are two ways for Apple to expand the pie: Bring in more customers and have existing customers spend more on services and products in the ecosystem (higher ARPU).
New users entering the ecosystem - The iPhone SE should not be underestimated as a successful tool for bringing Android users into the Apple fold.
Existing users moving deeper into the ecosystem - iPhone users are buying iPads, Macs, and wearables as well as subscribing to various Apple services.
Apple currently finds itself in an ecosystem expansion phase. Hundreds of millions of people with only one Apple device - an iPhone - are embarking on a search for more Apple experiences. We see this with non-iPhone revenue growing by 14% in 3Q20 on a TTM basis, which is higher than growth rates seen in the mid-2010s, as seen in Exhibit 6.
Exhibit 6: Apple Non-iPhone Revenue Growth Projection
Click / tap exhibit to enlarge.
Looking ahead, my estimates have non-iPhone revenue accelerating from 14% growth to 20% growth in the coming quarters. iPad, Mac, and wearables are a major source of that growth acceleration. Considering how Apple is working off of a much larger revenue base, for revenue growth percentages to actually increase this far along in the process is intriguing. The takeaway is that Apple’s ecosystem is gaining momentum at a pace that should frighten the competition.
Hundreds of millions of people will be buying their first Apple wearable device in the coming years. Given the inherent nature of wearable devices - new form factors designed to make technology more personal - it is very likely that one Apple wearable purchase will eventually lead to additional Apple wearable purchases. Apple can then leverage high-margin Services to run with more aggressive pricing on wearables (and other Apple devices) which only ends up boosting demand.
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For additional discussion on this topic, check out the Above Avalon daily update from August 13th.