Here's the Real Apple Story Tim Cook Was Trying to Tell

Apple (AAPL 0.20%) reported on its fiscal fourth quarter on Wednesday. While revenue and operating profits were down, the company did beat its recently lowered outlook. CEO Tim Cook pointed to China's economic slowdown and Washington's trade war as major causes of lower iPhone sales, but also noted that iPhone owners are holding on to their devices longer. (And there are a whole lot of them out there.) For investors, of course, the question is how to parse the multilayered tale of the tape and gauge whether they want to add some Apple to their portfolios.

In this segment of the MarketFoolery podcast, host Mac Greer, Motley Fool Chief Investment Officer Andy Cross, and senior analyst Jason Moser discuss the state of Apple's enormous ecosystem, the iPhone life cycle and its price ceiling, the evolution of the services business, among other company-specific points -- and, more broadly, whether the developed world has reached "peak smartphone."

Check out the latest Apple earnings call transcript.

A full transcript follows the video.

This video was recorded on Jan. 30, 2019.

Mac Greer: Let's kick off with Apple. Andy, earnings beating lowered expectations. Apple had warned earlier this month that sales were slowing. Sure enough, sales are slowing. Shares of Apple up around 5% on earnings.

A few fun facts, Andy. I want you to put these in a blender and then tell me what it all means for investors. First of all, Tim Cook, the CEO, pointed to China and the trade war as two of the culprits for the slowdown. He also said that Apple users are holding onto their iPhones for longer. Fun fact No. 1. This is the first quarter where Apple did not report the number of iPhones sold for the quarter, but Apple did disclose there are now 900 million iPhones in the wild worldwide. What does all that mean for investors?

Andy Cross: Let's just look at the quarter first. This was the first quarter during the holiday period in about a decade that they saw both revenue and operating profits fall. Tim Cook mentioned China. We knew that going in. We knew they also were not going to report the iPhone unit volumes for this quarter, although there were some analysts' expectations, and they announced that unit volume is falling up as much as 20%.

China continues to be the headwind there. But, when you look at the overall picture, Mac, you said 900 million active iPhone installations. Active total devices, 1.4 billion. That's up 8% over the year. Of those total units that are active, 64% are iPhones. That's about what they get in revenue. The total revenue from iPhones is about 62%. Paid subscriptions for their online business now, and their ecosystem, is at 360 million. That's up 120 million over a year.

The real story that Tim Cook was trying to say for this is, iPhone is the past. The future is the ecosystem, it's the Service business, it's the wearables business. He talked a lot about that. That's the future growth for Apple. And they need it. The revenues are stagnant. The forecast for next quarter is a little bit lower than what analysts were expecting. The growth engine for Apple, where is it coming from? It's got to be coming from the Services business. By the way, they also reported that the gross margin for that business is twice as high as it is for the hardware side.

Jason Moser: We're in a different phase of the life cycle for Apple. We've hit, more or less, the maturity of the iPhone. It's unreasonable to expect the same growth rates going forward. Logic tells us that as iPhones evolve, they get better; as they get better, the replacement cycle should get longer. I don't want to replace my iPhone if I don't have to, so I'll hang on to it for as long as I can.

All quarter long, leading into yesterday, it felt to me like all of these analysts out there are talking about the XR being a flop and underperforming, that struck me as odd. I felt like they were totally missing that. And it turns out that they were. The latest data from Consumer Intelligence Research Partners shows that the most popular iPhone during the quarter was actually the XR. It says that the XR accounted for 39% of total iPhone sales, and the XS and XS Max models made up a combined 26% of sales. That tells us a couple of things. No. 1, we're running into a situation here where they're not going to be able to raise prices much anymore at all. Remember, the XR is the one that's significantly cheaper. As an XR user myself, generally speaking, it's a good phone. But, the other point is, we've basically hit peak smartphone. There's not much else you can do with these phones, other than to change, perhaps, the interface or what you're doing. The screens are about as big as they're going to get. Whether it's going to be liquid crystal or OLED, you can't tell me the camera is much better, but I don't think many people care about that. Give me a phone with a battery that lasts a little bit longer, that takes care of a lot of problems.

As Andy was saying, now Apple needs to make that pivot to being a services company. They need to change that narrative. That's why we don't get the same information on the unit sales, but we are getting more information on the profitability of the Services business. But investors need to make sure they have their expectations and check there. It's not like they're going to flip a switch and say, "Hey, now we're a services company. We're going to make $200 billion a year with Services." That's going to take some time to grow. But it's worth noting that the Services business brought in about $40 billion last year. It's not insignificant.

Cross: It's about 13% of their overall total sales. It's growing, as Jason said, 19%. That's actually down a little bit, a fraction, over the past few quarters. The Services business grew 22% in fiscal year 2018, which ended in September. When you look at Apple, I see this amazing business. Jason mentioned the profitability on the Services business. I talked about that a little bit earlier. It's a $700 billion-dollar company. They generate nearly 20% returns on capital. Mac, last year, they generated $60 billion in profit. They bought back $75 billion worth of stock. When you look at this business, they generate so much in profit, and it's hard to reinvest that at a fast-enough rate to continue to juice the top line for a company this big. Now, that's also why you only pay 12X earnings for this business.

The stock was up a little bit today. That's not a surprise to me, considering what Tim Cook had talked about with the weakness in China. By the way, companies in China, Huawei is always doing quite well in China selling phones. A different type of market that Huawei is always going after than what maybe Apple is going after. There's success in China, just not with Apple per se on the iPhone business. This business is very profitable, they buy back a lot of stock. It's just not the fastest-growing business anymore. They have to find those growth rates. And if you're an investor in Apple, you have to either expect that, this is going to be a pretty slow-growing business, very profitable, they're going to invest back into buying back stock, that's going to juice my per-share ownership of it; or, they're going to do something that's going to juice the top line on the Services side.

Greer: Let's go back to that point you made about the money. They've got a sizable piggy bank. Is there an acquisition that you would like to see Apple make?

Cross: I think it has to be somewhere in the Services business. They bought Beats, that really juiced some of their earbuds and music business. That was a very small acquisition. They have so much cash on the balance sheet, almost $75 billion of cash and short-term securities. Long-term securities gets it all the way up to $285 billion. They have so much cash sitting there. They would have to make a sizable acquisition somewhere in the Services or the non-iPhone space to be able to have a meaningful impact to the top line.

Moser: Yeah, I think that's right. My reckless prediction for 2019 was that Apple would acquire Square. That's only half-kidding. I can actually see a world where that would make a lot of sense. They're two companies that are founded on making pretty sleek hardware that people like, then developing an ecosystem around that hardware that's very useful. Apple needs to pursue, like Andy said, the Services side of the business, whether that's music, video, whatever. Music, the economics pretty much suck no matter what business you are. That's going to be a value-add. But when you look at the longer-term opportunities and the big market opportunities, payments, we talk about that all the time, that's a tremendous opportunity because of the global nature. When you look at Apple Pay, Apple Pay yielded 1.8 billion transactions this past quarter, which was more than double from the same quarter a year ago.

Greer: That's a lot!

Moser: People definitely are using it. There's something there, and they do get a little scrape from that transaction every single time. And then, of course, Tim Cook has said more than once that he feels like Apple will be most remembered for their impact on the healthcare world. They're coming up on a little bit of a challenge here, trying to figure out that next piece of hardware. They've done OK with AirPods. The Watch, they're doing OK there. But you look at something like HomePod, you want to talk about fun facts? This is their holiday quarter. HomePod was not mentioned once in the release or on the call. It might as well not even exist. It turns out, remember, they made Apple Music available to the Echo devices a couple of months ago, that was a big tell. It seems like the HomePod really is more or less a flop at this point.

Cross: Yeah. The announcement I found interesting this week was their partnership with Aetna, which is part of CVS family, to create an app called Attain that allows members of Aetna, it's an application that's tied together with your iPhone Watch to be able to collect some of that health data. That's the kind of investment that we will continue to see. But when more than 60% of your revenue is tied to iPhone, the hardware iPhone, you really need to make a big investment to have a meaningful impact on the top line of Apple. They haven't shown that interest in doing it over the past decade. Maybe this next couple of years, we'll see something different.