iPhone warning signs: Apple management is losing control

This is commentary by Neil Cybart, an independent analyst covering Apple at Above Avalon. You can read additional analysis here. Sign up to receive his exclusive daily email containing Apple analysis and perspective here.

Apple has spent years proving iPhone doubters wrong. Those who made a habit of calling for the iPhone's demise have watched the product go on to bring Apple over $600 billion of revenue and close to $250 billion of gross profit over the years. Ironically, just when it seemed like iPhone skeptics had thrown in the towel and accepted the iPhone's supremacy, warning signs are beginning to appear in the iPhone business.

Apple's 2Q16 earnings report was not pretty. (I reviewed the full report and management's conference call here and here.) Not only did iPhone sales decline year-over-year for the first time, but management issued alarming guidance for 3Q16, suggesting another very difficult quarter for iPhone sales. In addition, Apple expects iPhone average selling price (ASP) and margin to deteriorate due to the recently introduced $400 iPhone SE. On top of it all, Apple will take a historically large $2 billion inventory adjustment related to the iPhone 6s due to sales coming in below expectations. While some are optimistic that the iPhone 7 and 7 Plus will turn things around in a few months, it's time to become skeptical. The iPhone growth story is breaking apart, and management does not seem to be in control of the situation.

Slowing iPhone Growth

The iPhone business is slowing. When looking at iPhone sales on a quarterly basis (Exhibit 1), it is difficult to see the true extent of the slowdown.

Exhibit 1: Quarterly iPhone Unit Sales

Graphing sales on a trailing twelve months (TTM) removes the cyclical nature associated with annual iPhone launches and enables us to reach a clearer view of the iPhone's growth profile. As seen in Exhibit 2, the recent iPhone sales slowdown becomes quite visible. Apple's 3Q16 guidance implies Apple will report its first quarterly iPhone sales decline when looking at sales on a TTM basis. This is a noteworthy development.

Exhibit 2: Quarterly iPhone Unit Sales Growth (TTM)

Some have argued that recent iPhone sales weakness is due to the iPhone being on a two-year cycle. Accordingly, if the very popular iPhone 6 and 6 Plus are excluded from sales trends, the iPhone's long-term growth trajectory would still be intact. The numbers tell a different story. When looking at iPhone sales on a trailing 24 months, which helps diffuse some of the outsized impact from the iPhone 6 and 6 Plus, the iPhone business is about to experience its slowest growth yet. As seen in Exhibit 3, while sales growth remains positive, recent trends are cause for concern with the iPhone business quickly approaching no growth territory on a trailing 24 months basis.

Exhibit 3: Quarterly iPhone Unit Sales Growth (Trailing 24 Months Basis)

Caught by Surprise

The most alarming aspect of the iPhone's recent growth troubles has been that Apple management appears to have been caught off guard. The company thought the iPhone 6s and 6s Plus would build off of the sales level associated with the very successful iPhone 6 and 6 Plus. Instead, Apple is seeing iPhone sales fall 15% to 20% in 2016.

Rumors from Apple's supply chain had indicated iPhone component orders were cut soon after the iPhone 6s and 6s Plus launch. This was soon followed by additional rumors that Apple had cut iPhone production by 30%. While it is difficult to position these reports as concrete evidence that Apple overestimated iPhone demand, there are clearer signs that suggest management has not been able to completely get ahead of a deteriorating iPhone demand environment.

On October 27th, 2015, Tim Cook mentioned on Apple's 4Q15 earnings conference call that he expected iPhone unit sales to grow year-over-year in 1Q16. Cook based this assessment on the percentage of iPhone sales attributed to Android switchers and the iPhone upgrade rate, or the percentage of the iPhone installed base upgrading to a new iPhone. Three months later, Apple reported total iPhone sales of 74.8 million units, only 311,000 more than the previous year. To make matters worse, the only reason Apple was able to report any growth in iPhone sales was due to 3.3 million iPhones being added to channel inventory. Apple also just barely met its own revenue guidance for the quarter.

Cook has also given recent comments regarding iPhone sales that proved to be too optimistic. On Apple's 1Q16 earnings conference call, Cook said that he did not think iPhone unit sales would decline more than 15% in 2Q16 (in reality sales fell 16%). Cook then said that iPhone declines would trough in 2Q16 with better results during the back half of FY2016 given an easier sales comparison to prior year results. Apple's weak 3Q16 guidance proved that comment to be grossly optimistic. These types of miscalculations are not common for Apple and demonstrate that management has been unable to completely grasp the full extent of slowing iPhone demand.

Warning Signs

On Apple's 2Q16 earnings call, management positioned pent-up demand for the iPhone 6 and 6 Plus and the weak global economy as the two primary reasons for slowing iPhone sales. While there is tangible evidence to support a portion of that claim, I'm skeptical that the iPhone's slowing growth is strictly related to two iPhone models, currency fluctuations and weaker economic conditions.

Instead, there are a number of warning signs beginning to appear in the iPhone business indicating underlying deterioration:

Longer iPhone Upgrade Cycle. Much of the iPhone's current success has been a result of iPhone users regularly upgrading their devices every two years. However, there are signs that this upgrade rate is actually much longer than two years. Over the course of the past year, Cook has provided updates as to the percent of the iPhone installed base as of September 2014 that had upgraded to a larger iPhone (6, 6 Plus, 6s, or 6s Plus). At the end of 2015, 60% of the iPhone installed based as of September 2014 had not upgraded to a larger iPhone. That data point is not representative of an iPhone business on a two-year upgrade cycle. Instead, the iPhone installed base is, at a minimum, on a three-year cycle.

Much more concerning for Apple is that the longer the remaining 60% of the installed base delays an iPhone upgrade, the longer the upgrade cycle is extending. It is not unreasonable for the iPhone installed base to extend out to four or even five years. Not surprisingly, these trends were never accurately captured in consumer survey research reports. This is unchartered territory for Apple.

iPhone Growth Catalysts Are Disappearing. While there are legitimate reasons for explaining some of the iPhone's recent sales declines, much more concerning is how the largest multi-year growth catalysts for the iPhone business are either disappearing or turning out to be much less attractive than first thought.

1. Mobile carrier expansion is slowing. A significant contributor to iPhone sales growth over the years has been mobile carrier expansion. As Apple brought the iPhone to new mobile carriers, the device's addressable market continued to expand. In early 2014, China Mobile began selling the iPhone for the first time, opening up the iPhone to hundreds of millions of new consumers of which tens of millions were in a position to buy an iPhone right out of the gate. There are no additional carriers like China Mobile waiting in the wings where Apple can expand the iPhone's addressable market. Most of the world's population is now on a mobile carrier that sells iPhone.

2. India is not the next China. India has recently been positioned as the next big growth engine for iPhone. However, it is becoming clear that this optimism has been grossly misplaced. Cook even admitted on Apple's 2Q16 earnings call that India's smartphone market is where China was seven to ten years ago. That comment is not too reassuring for anyone thinking India would pick up the sales slack from a slowing China market. The country is just not in a position to represent a significant driver for iPhone unit sales given Apple's current pricing strategy.

3. High smartphone saturation rates. High smartphone saturation rates in the U.S. and other developed countries have removed feature phone users as an iPhone growth catalyst.

4. Declining number of premium Android switchers. Apple has been very successful over the past year and a half appealing to high-end Android switchers craving larger iPhones. However, there are signs that the easy growth in terms of Android switchers is ending. There are only so many premium Android users in the marketplace, and Apple will need to begin appealing to Android users in lower price brackets to achieve the same kind of user growth. During 2015, there were approximately 1.2 billion people that bought a non-iPhone smartphone, up from a little more than 1 billion in 2014. Of that total, approximately 100 million were likely in a position to even buy a flagship iPhone. This does not exactly leave much room for Apple to grow the number of Android switchers year after year.

ASP and Margin Pressure. During Apple's 2Q16 conference call, management attributed a portion of its weak guidance to the iPhone SE impacting iPhone ASP and margins. Over the past two years, both of those metrics had held up remarkably well despite Apple peers facing increasingly deteriorating conditions. The combination of a higher priced "Plus" iPhone model and iPhone storage configurations provided a significant tailwind for maintaining attractive iPhone ASP and margin trends. The iPhone SE introduces a new headwind into the mix as the more successful the iPhone SE sells, the more pressure overall iPhone ASP and margin will face.

Apple Has an iPhone Growth Problem

When looking at all of these iPhone warning signs, it is becoming clear that Apple has a significant iPhone growth problem on its hands. The combination of a slowing iPhone upgrade rate and declining number of growth catalysts for expanding the iPhone's addressable market will make it very difficult for management to report unit sales growth going forward given its current strategy. In addition, the iPhone SE highlights how any strategy to fix some of these issues will likely end up jeopardizing iPhone ASP and margin trends.

It is important to note that the iPhone business is not imploding. Satisfaction rates and loyalty trends remain industry-leading. Apple has a very attractive iPhone installed base numbering close to 550 million users with additional users purchasing an iPhone in the grey market. Each quarter, Apple is still bringing new people to the iOS ecosystem. Instead, it is becoming much more difficult for Apple to grow iPhone unit sales each year.

How Did This Happen?

All of this seems a bit surreal. Apple just recorded its best quarter for iPhone sales in 1Q16. How can there now be so many iPhone warning signs only a few months after this milestone to the point that even Apple management was caught off guard?

The iPhone 6 and 6 Plus masked deteriorating iPhone trends. While those two iPhone models ushered in a wave of sales from both existing iPhone users and consumers new to iOS, upon closer examination the iPhone installed base had become much more diverse than first thought when it comes to thoughts on upgrading. In addition, the sheer success associated with launching iPhone on China Mobile made it that much more difficult to see an even greater amount of success in subsequent years. When dealing with unit sales growth, Apple needs to bring in many new consumers just to break even each year. At a certain point, it is just not sustainable.

Finding the Path Forward

Apple needs to get ahead of this deteriorating iPhone demand environment. There are a few key elements to such a strategy:

1) Throw out all existing conventions about upgrade cycles. Management cannot assume that iPhone users will upgrade to new iPhones like they have in the past. This will have an impact on how Apple approaches iPhone development schedules. It was clear that the iPhone "S" cycle ended last year, and current iPhone trends all but confirm that to be the case. It is now time to get rid of the "S" iPhone nomenclature as well. A case can even be made that it is time for Apple to change its entire iPhone numbering nomenclature given changing device upgrade behavior.

2) Keep a pulse on the iPhone user base. It is becoming more critical than ever for Apple to understand the average iPhone customer. There is much change going on within the iPhone user base with a more diverse collection of thoughts towards technology and smartphone features. With Apple rumored to push ahead at the premium end with a differentiated iPhone Plus model later this year, Apple can no longer assume that iPhone users will follow the company in a similar direction. Greater focus needs to be placed on the risk that Apple ends up over serving the market by introducing certain features. It may sound odd, but Apple may end up slowing the introduction of certain new iPhone features and instead focus on other items that consumers are truly craving.

3) Recognize the iPhone SE's power. The iPhone SE has the power to impact Apple ASP and margins much more than Apple management initially thought. There is an increasing level of risk that there may be unintended consequences associated with the iPhone SE including greater cannibalization of higher-end iPhone models.

At a certain level, none of this should surprise Apple. The company's long-standing iPhone strategy involved it beginning at the high end of the market and slowly making its way down market, capturing as much profit share as possible at each subsequently lower price tier. At a certain point, this strategy enters a phase where growth slows and the business enters a much more mature product trajectory. The various warnings signs flashing in the iPhone business indicate that point has arrived.

The good news for Apple is that the company is organized in such a way as to handle these iPhone warning signs better than most other companies. There are signs that Apple has been working to move beyond the iPhone for well over a year with Project Titan and other wearable devices representing the company's future. The one thing management needs to work on is moving the Apple narrative away from iPhone unit sales growth.

One Steve Jobs quote displayed at Apple HQ will end up doing a great job of describing Apple's path forward for iPhone: "If you do something and it turns out pretty good, then you should go do something else wonderful, not dwell on it for too long. Just figure out what's next."

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