Cut Into Apple's Big iPhone Reveal, and You'll Find Its Shift to Services

For years, the health of Apple (AAPL 0.45%) has been most reliant on sales of the iPhone -- that device accounted for the large majority of its revenue. Even as it pushed prices higher, consumers kept right on buying. But the smartphone's sales have slowed, and the company has pivoted its strategy toward a services model. Now, that doesn't mean that people aren't going to focus first on its devices when product announcements are made.

But as Motley Fool Money host Chris Hill and senior analyst Tim Beyers discuss in this segment of the podcast, what it does mean is that investors should look at the individual pieces of news that dropped at the Apple event last week in context, because they combine to show a new strategy for its future -- one that doesn't shy away from moves that might actually cause users to hold onto their old iPhones for longer.

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This video was recorded on Sept. 13, 2019.

Chris Hill: Earlier this week, Apple CEO Tim Cook took the stage at an event in Cupertino, California to unveil the iPhone 11. Here to help us sift through the headlines of Apple's event is Tim Beyers, media and entertainment analyst for The Motley Fool. He joins me now from Colorado. Tim, thanks for being here!

Tim Beyers: Thanks, Chris!

Hill: What is your headline for the Apple event?

Beyers: It's on like Donkey Kong, because we've got games, for real. This is very much a services announcement wrapped around an iPhone upgrade and some new watches.

Hill: Let me put a pin in the games for a second. I want to talk about the iPhone first. Part of what's getting people's attention here is the pricing. Pricing both for the video service, which we'll talk about in a minute, but also for the iPhone 11, which starts at $700. On the surface, this seems like a pretty compelling offer compared to, in years past, certainly the past couple of years, where Apple has unveiled the new phone, whatever it is at the time, and it's usually got a price tag of around $1,000. Did you see enough with the iPhone 11 to make you think this is a compelling argument for someone who's looking to upgrade?

Beyers: It's a compelling argument if you are looking to upgrade but not go all the way up the stack. This is really epic rebranding. Business Insider get some credit for this. They did a review. What they found is that the iPhone XR, last year's big phone, is roughly the same as the low end of the iPhone 11. So now, you're not getting a rebranded low end of the phone. It's just all iPhone 11. It depends on how high you go up the stack, all the way up to the iPhone 11 Pro. That $700 price point looks very attractive, but really, what you're getting is an incrementally upgraded iPhone XR. I think that's interesting. I think it's smart marketing. I don't think that it is a compelling value proposition necessarily.

Now, what's very interesting to me is the iPhone Pro, the recognition that there are some photographers now who are making a living using their phone as their primary camera, or at least the one that they are using to get out and get shots on the scene. It does a really excellent job. I do think there is a professional market for an iPhone camera. I think Apple is pricing in that area. They're certainly delivering in terms of features with the multi lens camera. But I think that is the outlier announcement here.

Really, the big announcement is, can the iPhone 11, at the base level, drive enough demand to stop the bleeding? The iPhone business has been growing a lot more slowly in recent years. We want to see this turn around. I'd be looking to see how many of those $700 iPhones we're lining up for. My expectation is, not that many. But I do expect there to be outsized demand, at least in that niche that needs it, for the iPhone 11 Pro.

Hill: We saw this a few years ago in the enterprise space -- computers, desktop and laptop, were improving over time. So, you had large companies that were essentially not hitting the refresh button. They were extending the lifetime of the equipment that they had in their offices. We're seeing this now a little bit with smartphones. The average consumer keeps their smartphone for about three years. I've had mine even longer than that. If you're an Apple shareholder, or you're thinking about buying shares of Apple, do you need to lower your expectations for what iPhone is going to do to the bottom line?

Beyers: I do think you have to. I'm right there with you, Chris. I've had my tiny little iPhone SE for coming up on three years now. I'm not going to upgrade. I do think we're in this phase now where the smartphone refresh cycle is extending. That's part of the natural evolution of technology. The better the technology gets, the better the underlying gear gets, the sturdier it gets, it has a longer life. There's less temptation to upgrade. On top of that, you have cloud services, services that you can get anywhere, apps that you can get anywhere. It's much easier to upgrade the phone without upgrading the hardware. This is Apple killing itself in a way, because the services business is growing fast. It is the second biggest part of Apple in terms of overall revenue. By making its services business so attractive, it does, in a weird way, make the business of upgrading your iPhone, it's just a little easier to put it off now. So, yes, I do think we're seeing that.

Now, if you're going to become an Apple shareholder -- to answer the second half of your question -- what you really should be focused on is what Apple can do with its balance sheet and in this services business. Certainly, one of the things that people are going to be looking at, is the wearables business. I know we're going to get to that. That is a potential catalyst. But the future of this company is going after Netflix, going after Amazon, going after Nintendo, going after all content and trying to own all of it through every device that they sell. It becomes content at the center, and we happen to sell devices around it. That's an interesting strategy. If you believe that Apple can own that, and disrupt Netflix and Amazon and others, then it's a compelling buy here.

Hill: Apple TV+, their video streaming business, they came out with a price tag. $4.99 a month. Are you surprised they went that low?

Beyers: I am very surprised they went that low. That's a gut punch, man! I think Netflix and Disney took a hit after that announcement, the stocks of both those companies, because that's a gut punch. Basically, Apple is saying, "We're going to run our content business at a loss in the short term because we are intent on grabbing market share." This is not new. Apple has been in content business for a little while. Their content hasn't caught hold. Now, by lowering prices so dramatically, Apple is saying, "Give us a try. You're going to like what you see." The content is not selling itself right now. They're looking for the price to sell the content until the content can sell itself. I'm very surprised. It's a bold move. It may pay off, but not in the immediate term. This is much more of a long-term play, where Apple is using its balance sheet, that $100 billion in cash that they have available, to make a power play in both the gaming business and the TV business.

Hill: They also got a tiny bit of a leg up on Disney with the timing of when Apple TV+ comes out. It's coming out November 1st, nearly two weeks ahead of Disney+.

Beyers: Right. That's important, too. There's definitely going to be a rush to figure out, especially going into the holiday season, do I want the Apple TV? Am I going to buy a new Amazon device? Am I going to order Disney+? It's going to be a really interesting holiday season. And in the middle of all this is Netflix. So, now we get to see just how sturdy the Netflix model is. Up to this point, Netflix has had two principal advantages. The first is that they had scale. They have a lot of scale, a lot of shows, a lot of inventory. The second advantage they had is, they're beloved by artists and creators because they give you a budget upfront, and you create, and you dictate terms. Artists have been willing to give up things like royalties and residuals in order to work with Netflix. Will that continue to be the case when Apple is throwing money at the business? If Disney is throwing money at this business? We'll see. I think it's going to be a very interesting time for all three of these companies. But the one that's most at risk is Netflix.

Hill: Let's talk about wearables for a second. One of the things I was thinking as I was looking at coverage of this event, and also some of the highlights, is that it seems like Apple is positioning the Watch as a health device. They had this video of people who were warned of heart attacks by the Watch. I'm not someone who wears a Watch. But they made a pretty compelling, almost emotional, case for buying this device.

Beyers: That is Apple at its best. Apple at its best makes emotional appeals and connects emotions to technology so that you feel invested. It's interesting. It's certainly a good short-term strategy to connect the dots and say, "Look, this is what you need." In the environment we're in now, people are working longer hours, we're working out, we're trying to measure our fitness, measure our lifespans, and everything else. The Watch is the hub for health tracking. It's an interesting play. But it's also bigger than that. If that is the loan pitch that Apple makes for the Apple Watch, I think that dies in six months. We've heard this before. Before, our health tracking device has been our smartphone. Are we really going to take the leap from where we are using our smartphone to track our health with apps like Strava, or even the built-in app inside the iPhone or any other smartphone you pick, and moving it to the Watch? I don't necessarily think, despite the emotional appeals, that translates over the long term. But in the short term, yeah, it's an interesting pitch.

Hill: Tim, this event reminded me, without Apple ever talking about it on stage, and there's no reason that they would, of how much of an asset their cash balance is. If you think back to the initial launch of the Watch, it was a ho-hum response from Wall Street. The talk of video programming for a long time has been just that, talk; or, to the extent that they've executed against that, it hasn't been that inspiring. This has been a nice reminder that, one of the things that cash enables you to do is, it buys you time. We have now new iterations of the Watch. And now, they're in a position where they can throw enough money at video programming. As you said, we're going to operate this at a loss, we're going to give stars in the industry the bandwidth to create great programming. And we can do that because we got the cash.

Beyers: Absolutely right! Let me give you a stat here, Chris. Apple has about $100 billion on its balance sheet in cash. Right around $95 billion. They also have a little under $110 billion in debt. What you don't see unless you look at the balance sheet is, there's another $100 billion in long-term investments. Apple has a lot more cash that they could either repatriate from other countries or from other businesses and put to work. They have a huge runway. Apple has gone from being a company that's keeping cash as a cushion to now being a company that's using cash as a weapon. That's different. This is a very different look for Apple. It could bring in a new era for this company and drive returns for a while. But it does remain to be seen. It's a fundamentally different pitch. Apple has always pitched itself as, "we build something that is high quality, that has emotional resonance, that you're going to want to associate with." They've never been able to get over that hump in entertainment. Now, the sales pitch is different saying, "Look, this is cheap. If you give it a try, I know we can convince you that the stuff we've got is high quality and has emotional resonance." But they haven't been able to make their core sales pitch in this entertainment business. They're trying something different. And they're using cash to do it. It's a very interesting time to be an Apple shareholder if you have shares now. If you don't, it's an interesting time to look at the business. They're going to be very aggressive. That's one of the main takeaways I got from this event, Chris. This is a sharper-elbowed Apple that is taking fewer prisoners than it used to.

Hill: Last thing, then I'll let you get back to work. Shares of Apple are up around 40% year to date. What is something you're going to be watching in Apple's business going forward?

Beyers: I'm going to be watching the services line item. It's growing quickly. It's not growing as fast as wearables. But I want to see what the uptake is. I want to see not only the growth on the top line, but, what does the operating margin look like? If I'm right, and this is running at a loss, we're going to start to see some thinning margins inside that services business. That's OK as long as the top line is growing very quickly. I'm looking for maybe some acceleration in terms of revenue from the services business, while the operating income, where a lot of the expenses, some of the fallout from running this at a loss, is going to show up. If those two things start to normalize and get bigger, boy, I'll be very interested to see that. If it moves faster than I expect, then two things I expect will happen. First, the stock will respond accordingly. It might be a dark day for Netflix.