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Waiting for Apple's next breakthrough device? Here's why you shouldn't

Key Points
  • Apple has an installed base of 1.4 billion active devices around the world — roughly equal to one-fifth the size of the world population — yet its recent product pushes have included some big misses.
  • Analysts believe the tech giant needs to broaden its product portfolio into services, such as streaming, payments, credit cards and health.
  • This move is critical to delivering on CEO Tim Cook's vision of the company as being consumer up front and at its core, with technology in a background role.
Apple CEO Tim Cook announces the new Mac Pro, with a cost as high as $6,000, as he delivers the keynote address during the 2019 Apple Worldwide Developer Conference at the San Jose Convention Center on June 3, 2019.
Justin Sullivan | Getty Images

Apple has an installed base of 1.4 billion active devices around the world — roughly equal to one-fifth the size of the world population — yet its recent product pushes have included some very big misses.

To keep its edge, many, including Warren Buffett, believe the tech giant needs to put technology in a background role and broaden its product portfolio into services, such as streaming, payments, credit cards and health — a move critical to delivering on CEO Tim Cook's vision of the company as being consumer up front and at its core.

But this could be one of Apple's biggest challenges yet, says Dan Ives, Wedbush Securities' managing director. "To transition into non-bread-and-butter areas, like autos, streaming, health, it seems a lot easier on paper than in reality, and part of it is cultural."

Putting the consumer at the center

"[Buffett] has been very clear, he didn't invest in technology companies and companies he didn't understand. He's been totally clear with that. And so he obviously views Apple as a consumer company," Cook told CNBC's Becky Quick in a recent interview.

"We believe that technology should be in the background, not the foreground, and that technology should empower people to do things and help them do things they couldn't do otherwise," said Cook at the Berkshire shareholders meeting in May in Buffett's hometown of Omaha, Nebraska.

"We're in the tech industry," Cook acknowledged. "But we work at that intersection of technology and the liberal arts and the humanities. And so we make products for people, and so the consumer's at the center of what we do."

Apple recently reported its biggest quarterly spend ever on research and development, at $4.2 billion

Cook has said Apple has a "long-term strategy of owning and controlling the primary technologies behind the products that we make."

Last month Apple announced a $1 billion deal to buy Intel's modem business.

The R&D spend represented 7.9% of Apple's total revenue, the highest percentage since 2003, when Apple was still focusing on iPods and Macs. The second quarter of 2019 was the first since 2012 in which the iPhone did not account for over half of Apple's revenue.

Wearables are the product category — including Apple Watch, AirPods wireless earbuds and Beats headphones — where Apple sounded most enthusiastic on its recent earnings call. Cook called it a "blowout quarter" for wearables and said there was "phenomenal demand" for the $159 AirPods.

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Services revenue, which includes subscriptions, App Store fees and other online services, grew by 13%, which was slightly under analyst expectations, though Cook told CNBC that payments from a lawsuit and foreign-exchange rates hit a services category that otherwise would have grown by 18%. The total services sales were an all-time record.

"We set new all-time records for AppleCare, music, cloud services and our App Store business, and we achieved a new third-quarter revenue record for the App Store," Cook said in the recent earnings call with analysts.

Apple's next play

Wedbush's Ives said the key number for Apple is not any single-quarter revenue, profit margin or net income. It is the 1.4 billion active devices installed worldwide, a presence on the consumer landscape that is "etched in stone for decades to come if they did nothing more."

The conundrum has been trying to broaden out the product portfolio into other facets of the consumer lifestyle, Ives said: streaming, wearables, payments, credit cards and health.

The lines have blurred. Apple's success as a consumer company is because of the technology it has created and its Silicon Valley DNA. "It wouldn't have 900 million active iPhones today without patents," Ives said.

"Ultimately, the biggest challenge is breaking into the enterprise and non-consumer areas, and that has historically been a bigger challenge, as MSFT owns enterprise," Ives said.

What defines and should continue to drive Apple is consumer needs and how to monetize its user ecosystem.

Its recent product pushes have included hits and misses. While the AirPods have been a hit, Apple's entry into the smart home device market, Apple HomePod, was "late to the game and mispriced," Ives said. He said Apple's success and huge installed base of users can be a double-edged sword, as it allows the company to ignore the first-to-market mantra in developing new products, which may become a riskier strategy in today's world.

Apple's HomePod (left) displayed next to the Google Home and Amazon Echo devices. Apple's entry into the smart home device market was "late to the game and mispriced," says Wedbush Securities managing director Dan Ives.
The Washington Post | Getty Images

Amazon has been moving in the opposite direction — branching out from its enterprise market success with cloud services giant Amazon Web Services to the consumer market with Alexa.

"Homepod was a failure; AI was a failure," Ives said. "AirPods are nice, but it doesn't move the needle."

Nevertheless, Apple is in an enviable position. "It's the golden brand, and with that comes pressure as it goes into the next phase of growth around services," Ives said.

Wedbush estimates that the services market is only 15% penetrated, and with a total addressable market of $500 billion, it provides a floor in Apple shares even with all the noise, from iPhone sales slowing down to the trade war with China. "It is a key part of the Apple valuation story going forward, monetizing the platform."

But the company's focus on services in recent years has been like the "drum roll" to the services initiative, which will really define the company's future: streaming TV.

Will Apple get the formula right?

"Their advantage is the installed devices, and as it becomes more of a distribution platform, as the consumer company and tech company definitions blur, what they need more is a distribution platform that capitalizes on the success as a consumer stalwart," Ives said.

Can Apple get the formula right? Ives is looking for 100 million consumers on the streaming platform within the next three years. "That is the goal, the main thing missing, and the biggest question mark."

How Apple gets there also remains to be seen, specifically, as it is forced into a much more significant content acquisition because it is playing from behind the eight ball and versus competition like Netflix and Disney spending a combined $20 billion. "They are spending a billion," Ives said. Original content spending was a failure, or at least a disappointment in terms of total spend versus Netflix or Disney

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"R&D is the lifeblood of the future. What's come out of Cupertino has always driven success, but what has been disappointing is that relative to what they are spending on R&D, they have not had the silver bullet growth initiatives," Ives said. "The last one was AirPods, Apple Watch. Outside of that, few and far between for a company spending billions on R&D, and that's why investors start to grow anxious."

There are next-generation services, such as 5G, and products such as foldable phones, that could help an industry that has hit maturity find another consumer sales cycle.

"When you go into an Apple store, whether in India or Indiana, there is a vibe and a cache, and you feel it because of the innovation and technology and what's next on the product line. It is important to keep that luster, continue the initiatives," Ives said. "Sometimes you try to be all things to all people, but it also is important to continue to keep your roots as an innovative tech company, which was the vision Jobs created back in the garage."

He added that it is not just about attracting consumers to an Apple store but Wall Street that needs the Apple brand to thrive: "If the bloom ever comes off that rose and it's just known as a consumer company that's going into a different phase of maturity ... investors don't want to see that."

Finding that next big growth platform

The whole idea of Apple being a technology company "badly misses the point of who they are," said David Robertson, an innovation expert who has written several books on major brand evolution and is director of MIT's executive program in general management.

Robertson said you can go back to the first iPod in 2001 to see how wrong many Apple watchers have been all along.

"People thought of it as this disruptive technology that would change the music industry. That was a real misinterpretation of what they were trying to do. They saw consumers were trying to manage their digital lives, and what they built around that was the understanding of the customer. It was technology and platforms to help people manage their digital lives more effectively and completely. Technology was just in the service of that idea," Robertson said.

"There was the idea that the iPod was intended to disrupt the music industry as opposed to a peripheral that helped make the Mac more valuable. ... It was clearly the second thing. ... The iPod was an MP3 player," he said, adding that Apple resisted putting iTunes on PCs for years.

"They really do need to find that next big growth platform, and they have not found it in Watch — maybe in TV, but it looks like they are late to the party," Robertson said. "Definitely not way better than others, like the iPhone was."

Robertson stressed that to understand Apple means knowing it is not on a technology search. It is "the great, unmet customer need" they have a history of finding. "They tried to put it on the wrist, and it has not worked as well."

There are still many places Apple can succeed, especially in the house, Robertson said, going up against Nest and other smart house sound and temperature and security devices. But he said Apple is "taking a long time to get there."

Analysts say one of the many places Apple can still succeed is in smart home technology, like the Nest, a brand of Google that consists of smart home products, such as thermostats, smoke detectors and security systems including smart doorbells and smart locks. Ironically, the Nest brand name was originally owned by Nest Labs, co-founded in 2010 by former Apple engineers.
David Paul Morris | Bloomberg | Getty Images

The device path has been the path for Apple to 2019, but it is not necessarily the future. "I've been studying innovation history for a while, and if you are lucky, you get a good run out of some advantage. The iPod lasted for a while and the iPhone is now losing its luster, but it had a 12-year run, pretty good," Robertson said. The innovation expert, who wrote a book on Lego, said it had a nine-year run of sales that's ending — Lego has had flat sales for three years now. Now Lego is seeing growth from non-product areas like movies and theme parks, its Discovery Centers."

For all big brands the biggest challenge is recreating the growth it had in the past. "Lego grew at a fairly steady clip, half a billion dollars per year for eight years, and at first that was a huge growth rate when it was only a $2 billion company, but just kept adding a half-billion to sales. That is what Apple is facing," Robertson said. But the solution does not mean perfecting a single technology product in the R&D lab that breaks out.

"It's a customer challenge, not a technology challenge," he said. "Stay focused on uncovering unmet needs in the customer base and finding cool ways to meet those needs."

Robertson said Apple has a chance in TV for a reason that relates to unmet need: "Who is satisfied with their TV offering now? It is such a mess."

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Apple's R&D spending: 'Not enough bang for the buck'

"It'll never launch a hardware product that will come even close to the success that it has had with the iPhone," said Paul Meeks, CFA and portfolio manager of the Wireless Fund (WIREX) & Independent Solutions Wealth Management.

Meeks said there hasn't been a big enough "bang for the buck" with Apple's R&D spending. While Cook boasted about the wearables growth, Meeks thinks Apple spending on consumer electronics is spending in the wrong area. "I think that they should use their mega-balance sheet to make a relatively large software or services acquisition to get to where they need to be in the technology sector."

Apple is a consumer electronics company until further notice. It needs to become a technology company and, specifically, a software and services firm, whether that be serving the consumer or enterprise markets or both, here and abroad.
Paul Meeks
CFA and portfolio manager of the Wireless Fund and Independent Solutions Wealth Management

Meeks said the success of the AirPods does not change his view of Apple's future. "It is critical for Apple to migrate away from consumer electronics to become a consumer and/or enterprise software and services company."

"I'm not confident enough that Apple will be successful with the next big thing, particularly since it'll likely be in software and services and they don't have that DNA. They must do a large acquisition in that space ASAP," Meeks said.

He said recent software and services products are me-too: "How can they possibly compete with Netflix in original streamed content with Apple TV+?"

"Apple is a consumer electronics company until further notice. It needs to become a technology company and, specifically, a software and services firm, whether that be serving the consumer or enterprise markets or both, here and abroad."

"If the company can successfully cross-sell software and services to its 1.4B iOS devices, then that would be great. ... I'll believe it when I see it," Meeks said.

David B. Yoffie, professor of international business administration at Harvard Business School, said the Apple pundits trying to decide the company's fate by steering it in the direction of being a consumer company or a tech company are both wrong.

"The distinction between a consumer company and tech company is not really meaningful for a company like Apple," Yoffie said.

Apple's $16 billion run-rate in R&D makes it hard not to define Apple as a tech company. Even before the big quarter for R&D just reported, Apple was the fifth largest investor in R&D in the U.S. last year.

"What's a tech company? A company that spends above-average dollars on R&D," he said.

At the same time, Apple's strength has always been selling directly to consumers, and that has been true since the unveiling of the Macintosh in 1984.

"I believe that Tim is trying to communicate that Apple will be less dependent on technology product sales in the future, despite its heavy R&D spending," Yoffie said. "Going forward, Apple's emphasis will be on [tech as well as non-technology-based] services, such as streaming video, payments and health."