This is the seventh segment in an 8-part series on Unlocking the Value in AAPL.
- Introduction
- The Irrational Market Theory
- The Law of Large Numbers
- Market Share
- Apple's History
- Business Model
- A Dollar A Day
- Epilogue
*Disclosure: The author owns AAPL.
Horace Dediu has developed the fundamental insight into Apple's business model which I believe provides a framework for thinking about and valuing Apple's business that is both relevant to reality and accessible to the investment community:
Apple has actually done a very clever thing with the iPhone. It's made it into a service.
In S is for Service Horace elaborates:
in a way, Apple has managed to place itself on many people’s monthly phone bills. It’s a nice place to be. It’s nice for the same reasons operators like post-paid customers: predictability. It’s also nice because recurring services are a better business model than products; they have higher levels of loyalty and are more “sticky”.
As a service, the iPhone’s strengths are easier to understand. Its weaknesses as well. Services simply don’t work in economies which don’t have robust institutions of credit, capital intensive infrastructure and distribution networks.
It’s also the reason why Apple is so slow to penetrate all markets. It’s not in the business of selling phones. It’s in the business of enabling and creating services.
He believes the service model is relevant not just to the iPhone, but to Apple's whole ecosystem:
If you take any Apple product and you measure its life span and then you say the revenue that Apple gets for that product and you divide the revenue by its life span it comes out almost always at a dollar a day.
There are of course variations between products, but a dollar a day appears to be in the right ballpark as an average figure.
Far more important than specific figures is the fact that service models are very familiar to investors in a variety of different guises. They also allow us to quantify future revenue and earnings expectations. If this can be done with confidence investors will no longer view the business as relying on a continuos stream of hit products for future revenue. They will also be able to use these projections as input for discounted cash flow analysis and other valuation models.
Revenue Models
A simplified model of annual revenue expectations for an Apple product might look something like this:1
number of customers * average selling price / product replacement cycle
Of course applying this kind of analysis to individual technology products is dangerous.2 Entire product categories may disappear. These products will be replaced not with a new model but by an entirely new category.3
This is what makes the dollar-a-day idea so fascinating. It values the gestalt of a customer's relationship with the Apple ecosystem, blurring the boundaries of product categories across time. We begin to see the forrest rather than the trees. We begin to see Apple's business holistically and understand how central an incredible user experience is. In the most recent episode of Critical Path, Horace commented:
The thing is to keep loyalty high. To keep satisfaction high. To keep everybody coming back. That's far more important. That's why quality matters. I think this is pivotal. This is the core of the business model here that's working. It's almost invisible unless you really think about it.
And you get confused by competition because you think it's hardware or it's even not just feature set but even platforms as competing it doesn't capture the whole thing. It has to include the whole feeling you get. The reason you're part of this ecosystem. The brand and everything else.
Using this holistic view as a foundation, a simplified model of annual revenue expectations Apple as a whole might look something like this:4
number of customers * average devices per customer * average annual revenue per device
If such a model were to prove reasonably reliable with respect to customer retention and annual revenue per device it would go a long way towards providing the assurance to investors that Apple's revenue will indeed recur. This would likely result in a significant revaluation of the company that would at least be closer to historical market averages. It may even clear the way for investors to begin considering some of the opportunities for new growth available to Apple in the future.
Active Customers
The foundational piece of data for a service business to track is the number of active customers.
The closest proxy of active customers we have for Apple starts with user accounts. This figure has been growing steadily for more than a decade, surpassing half a billion earlier this year. Apple's user account numbers are growing faster than those of any other technology company and are now second only to Facebook. If you only include user accounts with credit card information Apple has far more than any technology company.
Raw user account numbers are good, but they don't tell us anything about whether those accounts are dormant or not. As far as I know Apple doesn't publish any numbers that would indicate active user accounts. The good news is that Apple does break out revenue numbers for the iTunes Store (which includes App Store and services revenue). This number can serve as a reasonable proxy for user activity. iTunes revenue continues to grow steadily.5
KPIs
At this point we have a developed deep enough insight to see through the noise and arrive at four key performance indicators that will allow us track the health of Apple's business:
- Active users (via total user accounts and iTunes revenue)
- Customer retention (via product usage, customer satisfaction and loyalty numbers)
- ARPU (total revenue / active users)
- Gross margins
As noted in the previous section, particular emphasis should be given to the first two indicators. We should expect the active user base to continue rising, at least modestly. We should also expect Apple to retain those users as keeping a customer is much cheeper and easier than acquiring a new one. The customer retention should be stable (within a range) and should be very high.
ARPU and gross margins are secondary indicators6 which track the degree to which the business is able to profit from the customer base. These measures will fluctuate through product cycles and over time as product categories evolve and the customer base expands. The focus for these measures is not continuous growth, but rather maintenance at reasonably high levels. Any declines should clearly relate to strategic objectives and be understandable with reference to product cycle, category shifts and expansion of the user base.
Revaluation
Of course the simple models I show here are just examples serving to illustrate the narrative. The main point I want you to take away from this segment and from the whole series is that Apple's revenue does not come from static one-time purchases. It comes from a dynamic long-term relationship with their customers. It may not be secured via corporate multi-year contracts7 but it does recur with meaningful reliability. Apple's revenues are not about to head over the proverbial cliff any time soon. In fact, I would go so far as to suggest that they are at least as reliable as any product or service that relies upon habitual consumer behavior for repeat business.
In order for Apple to realize a valuation in line with historical averages or better, fear and uncertainty will need to be laid to rest. This will only happen when investors develop a deeper understanding of the driving force behind Apple's recent success and how their current market position facilitates ongoing revenue. If enough market participants develop this understanding, Apple's valuation will rise. Significant rewards await those who reach this understanding while the stock still trades at a discount (as it appears Carl Icahn has in recent months).
In the final segment, I will close out the series with some thoughts for the future.
A more realistic analysis would include accommodations for churn rate, new customer acquisition and a variety of other factors. If the analysis were targeting profit rather than revenue it would also need to include margin assumptions. The challenge with any model is to include the relevant variables while leaving out irrelevant, noisy, or misleading details.
Dangerous and misleading as it may be for investors to track the performance of individual products in this way, it is far more dangerous when this is done internally within the company. It creates internal conflict which inhibits a clear focus on how to best use emerging technology to solve real problems for the customer, thereby maximizing the value delivered to them. Existing products are defended where they should be disrupted. This is why Steve Jobs insisted that there only be one profit and loss statement for the whole company.
Apple is famous for bringing these new product categories to the mass market.
Again, a more realistic analysis would include accommodations for changes in number of customers and devices per customer over time.
In his post that introduced the idea of the active customer proxy, Horace Dediu also showed how iTunes revenue and total Apple revenue per user are declining slightly over time. His explanation of this is Apple's expanding global reach into less affluent markets. This is probably the most significant factor in these declines, although dormant and duplicate user accounts may also account for some of the per-user decline. In any case, the good news for Apple investors is that the number of total accounts is growing much more quickly than the decline in per-user revenue. The rate of decline for expected per-user revenue as the user base grows can easily be included in revenue models.
I consider these secondary indicators because without users there will be no revenue and no profit. Gross margins are obviously critical in maintaining profitability, and thus value in the business.
Observers have questioned Apple's ability to maintain gross margins for many years. I believe this results from a crucial misunderstanding of how Apple functions. Gross margins of at least 30% are designed into each product Apple brings to market. If they do not believe they can earn this they will forgo the product or the market share rather than forgo the margins. This is why believe it is best to focus first on active users and customer retention.
Interestingly, a material portion of Apple's revenue actually is secured in advance through multi-year carrier contracts. This may be overlooked by investors as they only last 2 years and are easily viewed as less likely to renew than corporate contracts.