The iPhone Paradox

For reference, this page lists all prior Apple posts, with a little context. Subscribers to the Jackdaw Research Quarterly Decks Service will be getting a preliminary Apple deck tomorrow, with a final deck to follow once Apple files its 10-Q. 

This is a post I’ve been meaning to write for a while now, but it seems particularly apt given Apple’s results announced today. My key point is this: even as Apple continues to diversify its revenue streams beyond the iPhone, the size of the installed base of iPhones becomes ever more important to its revenue growth.

The context here is that I’ve been talking to lots of reporters over recent weeks in the run-up to Apple’s earnings, and I’ve heard this question (or variations on the theme) a lot: “is Apple’s increasing dependence on the iPhone a problem?” The reason for the question is twofold: on the one hand, Apple’s revenues and margins have been increasingly dominated by the iPhone, and on the other it’s become increasingly clear that iPhone growth would slow following its stellar year off the back of the iPhone 6.

My answer usually goes something like this, and this gets to the heart of the paradox here. On the one hand, yes, Apple has been increasingly dependent on the iPhone for revenue and margin growth, but it’s been working hard to introduce new products and services to the market which can help to contribute meaningfully to growth and profitability. The Apple Watch, Apple TV, Apple Music, and iPad Pro were all introduced in 2015, and could over time provide significant additional revenue and margin. So Apple has the potential to lessen its dependence on the iPhone over time in this way.

However, the other side of the paradox is that almost all of these new products and services are tied to the iPhone in some way, and benefit greatly from the installed base of a half billion iPhone users. The iPad Pro has the weakest tie here, but obviously benefits from its use of iOS and the App Store, and with features like Handoff and iCloud works better with the iPhone than it does independently. The rest have much closer ties to the iPhone: the Apple Watch is (for today at least) strictly an iPhone accessory, the new Apple TV runs apps, most of which were originally developed for the iPhone, Apple Music will be used on iPhones far more than on any other devices, and so on. Even if iPhone growth slows or goes negative (as it will now certainly do in the March quarter), that massive base of iPhone users will keep many other contributors to Apple’s financial success ticking over nicely.

Interestingly, Apple seems to have latched on to this idea as a key talking point for its earnings today, with an emphasis on Services revenue tied to the overall installed base of devices, which it pegs at 1 billion users. (My estimate for the end of December for iOS devices plus Macs was 996 million, so adding in Apple Watch and Apple TV should certainly push it over that billion user threshold). This base of devices, and the rather smaller number of unique users it represents, is Apple’s single greatest asset, and one it will increasingly leverage both as it continues to grow the product and service lines it announced in 2015 and as it adds to them going forward. As such, even as the iPhone itself as a product contributes less to Apple’s overall performance, it’s going to become ever more central to Apple’s future growth.

Quick thoughts on Netflix Everywhere

Note: you can see all my previous posts on Netflix here. The analysis here draws on financial and operating data I collect on Netflix, along with around a dozen other big tech companies. Subscribers to the Jackdaw Research Quarterly Decks Service get quarterly charts based on this data, and data sets are also available to purchase on a one-off or subscription basis. Please contact me if you would like more information about any of this.

Netflix just announced that it’s expanding to around 130 new countries including many of the largest countries it wasn’t in yet. This was a huge and unexpected move, at least so early in 2016, since Netflix had previously indicated that it would make this move more gradually during the year, with just a handful of markets pre-announced for early 2016. I want to focus on the possible financial impact of this expansion, because it seems to me that it could be significant.

First off, Netflix’s International business is significantly less profitable than its US business:Netflix contribution marginsI’ve written in the past (somewhat jokingly) that every time its international business threatens to turn a profit, Netflix expands into a few more countries. As you can see, though, its International segment continues to be unprofitable at this point, and has much lower margins than its increasingly profitable US streaming business. Why is this? There are several reasons, but they’re all applicable to this new expansion and the likely financial impact.

Free trials

Firstly, Netflix offers one-month free trials to customers. Naturally, the impact of these free trials is heaviest in new markets, and you can see this when you look at the percentage of Netflix customers in various markets who are included in its membership count but not in its “paid members” count:
Free trial subscribersIn the past, as Netflix has expanded into new markets, this percentage has been in the 30% range, though it’s recently dropped down to around 10% or just below. However, with 130 new countries going live simultaneously today, it’s likely that this number will skyrocket. With 25 million members in its existing markets, it’s easy to imagine that Netflix might garner comparable numbers of free trial subscribers in the coming months in 130 countries. As such, a huge percentage of its subscribers overseas will be incurring costs but not generating revenue.

Marketing costs and scale

Another major reason why new markets are less profitable is that Netflix has to do far more to promote itself in these markets where customers aren’t yet familiar with its brand. This chart shows marketing spend as a percentage of revenues for the US and International streaming businesses:Marketing costsAs you can see, marketing spend is a much higher percentage of revenue in the overseas business than domestically, where Netflix has actually been reducing its marketing spend other than in its big new content launch quarters.

As Netflix scales in a given market, this impact is reduced, as the base of revenues from existing customers allows the company to spread that high marketing cost over a larger base, and as awareness and therefore word of mouth marketing grows. However, with 130 new countries, Netflix will have to spend heavily on marketing in the coming months to promote its services. Another huge scale effect is the shared costs of doing business in a new country – converting content to new languages, hosting the content locally, and so on all adds up, and in these countries those costs will be shared by a very small number of subscribers in the short term.

Outgrowing the DVD business

One interesting aspect of Netflix’s business which I’ve covered in the past is the fact that the US DVD business continues to throw off very nice profits, which in turn has largely funded Netflix’s overseas expansion:International vs DVD contributionsThe problem is that this new expansion will be so significant that it seems very unlikely Netflix will be able to offset the losses with its cash cow anymore. As such, overall margins will likely suffer significantly.

The financial impact could be considerable in the short term

For all these reasons, I believe the financial impact of Netflix Everywhere could be very significant in the short term. I’ve been pretty bullish on Netflix overall, and I’ve felt that its slow and steady international expansion coupled with its gradual improvement in US streaming margins was a fantastic combination. This big-bang approach threatens to derail that strategy, albeit only temporarily, bringing what might have been a longer-term dampener on margins forward into a much more compressed space of time, but opening up a far bigger opportunity longer term. I’m very curious to see how Netflix talks about the financial impact here – its press release on the news was conspicuously devoid of any talk of the financial side. But the market certainly seems to like the news so far.

Digesting Apple’s new App Store numbers

Note: Following something of a hiatus in late 2015 after the birth of our fourth child, I’m hoping to get back to a more regular publishing schedule here as we kick off 2016. Here’s my first post for the new year, which will hopefully be the first of many. You can see all previous posts on Apple from this site listed here.

Apple today released its customary end of year / holiday period App Store numbers in a press release. By themselves, these numbers are impressive, but it’s important to put them in context to really understand their significance. Today, I’ll share a few charts and other related numbers to evaluate the new numbers and their real meaning.

A quick word on sources

It’s important to note briefly before we start that App Store numbers are one of many data points Apple reports selectively and indirectly. We get these occasional milestone announcements at year end and in keynotes, but between those we’re left to extrapolate and interpolate based on other sources, including Apple’s financial reporting, which has historically provided some direct and indirect guidance on App Store sales. So please bear in mind that while some of the numbers below are based on announcements like today’s, many of them are based on these estimates, extrapolations, and interpolations. I believe they’re accurate, but I want readers to understand they’re not direct from the source.

Today’s numbers

Today’s numbers, in brief, were as follows:

  • “In the two weeks ending January 3, customers spent over $1.1 billion on apps and in-app purchases”
  • “January 1, 2016 marked the biggest day in App Store history with customers spending over $144 million. It broke the previous single-day record set just a week earlier on Christmas Day.”
  • Customers spent “over $20 billion” on the App Store in 2015
  • The App Store has now paid out “nearly $40 billion” to developers since it launched in 2008, and over a third of that was paid out in the past year.

There were also some numbers about jobs and job creation, but those won’t be the focus of this post.

Putting the numbers in context

So let’s put those in context. Focusing just on the numbers Apple has reported directly, here’s the picture on the cumulative payments to developers, ending with today’s “nearly $40 billion” (which I’ve pegged at $39 billion):Cumulative payments to devs as reportedUsing my estimates for the periods not directly reported, we get this smoother and less patchy version, which also goes back to the inception of the App Store in 2008:Cumulative dev payments estimatedAs you can see, it’s a lovely curve, with what appears to be accelerating growth. In fact, we can look at that growth more easily by charting trailing four-quarter payments instead, as follows:Four quarter dev payments estimatedWhat you see here is that the growth has been fairly steady for the last few years, since about 2013, with the occasional bump here and there. Apple’s annual run-rate for payments to developers is now around $14 billion, which translates into the “over $20 billion” customer spend number in today’s press release. That’s an enormous revenue number for something which is effectively a feature in Apple’s platform.

Longer-term patterns

If you look again at that last chart, though, you’ll see that the early history is less consistent. There are some ups and downs in the early years, though they’re a little hard to make out in that chart because of the sheer scale of payments in the later years. One way to dive deeper into this and to look at the longer-term trends is to use another set of numbers – the base of iOS devices in use – to put these figures in context. Here, again, we have to make certain assumptions about the size of that base, but we have enough data points to be reasonably confident there too.

The chart below shows the average annual revenue per iOS device in use since the inception of the App Store:Four quarter revenue per iOS device estimatedWhat you see in the chart is a series of different eras in the history of the App Store in which the trends were quite distinctive. In the early going, spend quickly leveled off at around $15 per year per iOS device, and it then began to falter a little. Apple introduced in-app purchases as a new feature in late 2009, and that seems to have sparked a slight renaissance in 2010, along with the launch of the iPad and some higher-priced apps which launched for that platform. However, by 2012, this number was back in decline, likely as the base of iOS devices diversified beyond early adopters and into new markets with lower spending power. In fact, that is the trend you’d expect to see over time, as existing users make do largely with apps they already own, and as new users in new geographies join the base.

However, what you actually see is that, starting around late 2012, the number starts rising significantly, eventually leveling off again at around $25, significantly higher than in the early years of the App Store. What drove this growth? I mentioned already that in-app purchases launched in late 2009, but it wasn’t until late 2012 that Candy Crush Saga launched. Of course, one app didn’t change the trajectory of the whole App Store, but this app exemplifies a new business model that’s become increasing prevalent – even dominant – in the App Store, and in App Store revenues. Many others have followed a similar path to monetization since then, and I suspect it’s the rise of in-app purchases in games that’s driven that growth since late 2012. I’ve written about the rise of these games, and some of the unpleasant economics associated with them, elsewhere, but there’s no doubt they’ve had a significant impact on the App Store and its revenue composition.

There’s no doubt that games in general, and those featuring in-app purchases in particular, are a major driver for the App Store growth Apple trumpets on a regular basis. The two big questions that arise out of all of this are whether Apple wants to continue to rely so heavily on a model that has unsavory characteristics, and whether in focusing on this dominant category it’s neglecting other business models in the App Store. That latter topic is something we’ve discussed a couple of times recently on the Beyond Devices podcast, most notably in Episode 24.