Apple’s recent decision to end unit reporting is evidence of Apple’s latest reinvention — into a services business. It will take time, but this change lays the groundwork for future AAPL multiple expansion. Six months ago we introduced our view of an upcoming investor paradigm shift from Apple as a hardware company to Apple as a Service. We are now in the midst of a four step transformation process: from news to knee-jerk to indifference to enlightenment.

Embracing Reinvention

One of the many skills that propelled Apple’s rise to a $1T market cap has been its ability to reinvent itself. From Mac to iPod to iPhone, the company has gone through several significant reinventions. Its next reinvention is beginning, as Apple transforms both its hardware and software businesses into a single unified service.

History of Reinvention

In the fall of 2005, Jobs referred to the launch of the iPod Nano as a “heart transplant,” because it would wipe out the iPod Mini at the peak of its success. The company has done even more aggressive “transplants” throughout its history. One of the clearest examples is Apple’s transition from the iPod growth story to the iPhone growth story. The change seems obvious in hindsight, but to purposely cannibalize one of the greatest innovations of all time (iPod) by entering a complex product category (mobile phones) entirely new to the company, with massive established players (Nokia), was perhaps the biggest gamble the tech industry has ever seen. This kind of reinvention, multiple times over the lifespan of a long-living company, requires lots of foresight and even more humility. Apple has never stopped saying “we can do even better.”

Apple has a great track record when it comes to reinvention. It’s built into the company culture. The annual product refresh cycle that the company has mastered over the last decade exemplifies many smaller-scale annual reinventions. As a result, when it comes time to make these large business transitions, the company is well practiced.

The Next Reinvention

Apple’s next reinvention does not involve product replacement; rather, it will require a shift in mindset to consuming Apple products as a service. This takes multiple forms:

• Hardware visibility: iPhone owners (~805M active iPhones) upgrading their hardware on a more predictable basis
• Services growth: Increasing attach rate of related Services (Apps, Apple Music, Movies, iCloud, Apple Pay)
• New products: Expanding product ecosystem (3 new products in last 3 years – Apple Watch, AirPods, and HomePod), allowing for cross-selling opportunities

The Path to Enlightenment

In the past, when Apple entered a major transition, investor optimism initially declined, then stabilized, then improved. This process takes about a year to unfold and has four distinct phases:

1. News: November 1 – The company announced that starting with the Dec-18 quarter, it will no longer report unit sales figures for the iPhone, iPad and Mac.
2. Knee-jerk: We’re currently in the knee-jerk phase. Shares of AAPL are down ~20% since the news was announced on Nov. 1. The pull back was also driven by the broader market downturn, along with negative data points out of Apple’s supply chain related to iPhone demand. We expect the knee-jerk phase to last until early Feb. 2019 when the company reports Dec-18 quarterly earnings.
3. Indifference: After Dec-18 results, we expect investors’ concerns to ease to indifference. Revenue, earnings, and margins will likely be in-line with expectations, a reassuring sign that the iPhone franchise is intact despite the more limited reporting metrics. The indifference phase should linger until Apple reports its Sep-19 quarter in Oct. 2019. Typically, investors will want to see four quarters of stability in order to rule out all possible effects of seasonality before beginning to embrace a new reality.
4. Enlightenment: Late in 2019 and beyond – Investors will slowly credit the company for results in 2019 that support the Apple as a Service paradigm. Rising investor confidence in a more predictable hardware business, additive Services, and new products should result in a higher multiple for shares of AAPL.

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