Apple’s Risky New Metric

With iPhone sales flattening, Mac revenues eroding and iPad sales falling, Apple broke out a new metric in its Q4 (fiscal Q1) earnings release Tuesday in a bid to direct analysts’ and investors’ attention toward those parts of the business that are still showing robust growth.

According to the “Earnings Supplemental Material” released with the earnings report, the “active installed base” of iOS devices has reached 1 billion, a figure Apple CEO Tim Cook said the subsequent analyst call has actually now been exceeded. That figure, which CFO Luca Maestri said Apple-TV-4reflects 25 percent year-over-year growth, represents the total number of iOS devices out there actively downloading apps, using Apple Music, buying music from iTunes, using iCloud and other Apple services in the last 90 days. And it underpinned, Cook and Maestri repeatedly stressed, $5.5 billion in revenue for Apple in the quarter ($4.7 billion net of the portion of some service revenue shared with rights owners), an increase of 15 percent over the same quarter last year.

“The market has not fully understood that we have a portion of our business directly tied to our incredible installed base that’s not driven by quarterly results,” Maestri said. “Those customers engage with our services and that business, which is a $20 billion business, is growing at more than 25 percent during the last 12 months.”

The executives also stressed strong growth in Apple’s “Other Products” segment, which includes Apple TV, the Apple Watch and iPods, which reached $4.35 billion, up 62 percent YoY. How many Apple TVs and Apple Watches that reflected the company didn’t say, but presumably they are included in the 1 billion active installed base number.

Directing investors’ attention toward the bright spots in your earnings report, of course, is a common and perfectly legitimate tactic for publicly traded companies, of course. Apple may also feel, with some justification, that Wall Street doesn’t value revenue from device sales as much as recurring revenue from services, and is hoping to get a better multiple by pointing out how much of its revenue actually comes form services. As Daisuke Wakabayashi notes in the Wall Street Journal’s Digits blog, Apple shares currently trade at around 11 times 12-month trailing revenue, compared with 33x for Google parent Alphabet and 97x for Facebook.

“We have a huge number of devices actively engaged with our services and that number is growing very fast,” Maestri told the Financial Times. “If you think about it in the context of how [other] internet services businesses are valued, it seems very clear to us that our services business is not valued correctly.”

The strategy is not without risk for Apple, however. While sales of iPhones and iPads may be slowing, or even falling, Apple is indisputably the market leader in the smartphone and tablet categories. Android device makers may sell many more phones than Apple, but the iPhone hogged 94 percent of global smartphone profits last year, according to Canaccord Genuity research. Similarly, sales of Windows laptops may far outstrip those of MacBooks, but Apple devices grabbed nearly 50 percent of laptop revenues in the first half of 2015, according to NPD.

Apple’s device sales may be slowing, Apple clearly knows how to make money at them.

Apple’s record in services, however, is far more mixed. While iTunes and the App Store are successes, Apple has had its share of missteps, too. It’s foray into social networking — the late, unlamented Ping — was a flop while its effort to build an ebooks business landed it in court on the wrong end of antitrust case.

When it comes the two highest profile services aimed at connected devices, moreover — music and video — Apple has been anything but a market leader. It was late to the music streaming game, and, while Apple Music has racked up an impressive 10 million paying subscribers in less than 6 months, it still lags behind market leader Spotify, which claims 25 million.

More to the point, no one so far has figured out how to make music streaming profitable, given the current royalty structure. Even if Apple were to catch Spotify, its far from clear how profitable Apple Music can be.

Apple TV just had its “strongest quarter ever,” according to Tim Cook, but for now, at least, it remains a me-too device. Worse for Apple, the most dynamic changes in the TV ecosystem today are coming not from devices but from standalone services like Netflix, Hulu, Amazon Prime and Sling TV. Yet Apple’s own, eagerly anticipated effort to develop an over-the-top subscription streaming service has repeatedly run into roadblocks and now appears to be on a back burner.

Apple is now betting on an app store strategy to boost Apple TV but it remains very much an open question whether apps really represent the future of TV, as Cook proclaims.

In short, Apple has so far found little room to innovate in music and TV, and has been unable to command premium prices for the services it offers in those spaces.

The risk for Apple is that innovation and premium pricing — it’s ability to extract a disproportionate share of profits from highly competitive markets — is at the core of its investment proposition. By highlighting those parts of its business where that proposition doesn’t hold, even, or perhaps especially, when those parts of the business are growing faster than the parts that still represent innovation and premium pricing, Apple risks diluting its investment “brand.”

The irony in that, of course, is that services play a different role within Apple than for standalone service providers. Apple’s services don’t really need to be highly profitable on their own. It remains fundamentally an ecosystem company, in which services primarily serve to drive continued demand for its devices, not the other way around. By focusing on role of its installed base of devices in creating demand for its services, Apple risks getting the cart before the horse.

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