The 3 Biggest Challenges Facing Apple

By Timothy Green Markets Fool.com

Shares of Apple (NASDAQ: AAPL) have gone essentially nowhere over the past two years or so, despite incredible profits, a fast-growing dividend, and over $130 billion worth of share repurchases to date. The iPhone, which accounts for the bulk of Apple's revenue and profits, has suffered from slumping sales for multiple quarters, with the launch of the iPhone 7 unable to reverse that trend. Sales of iPads and Macs also tumbled during Apple's third quarter, leading to a 9% year-over-year decline in total revenue.

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Apple will attempt to return to growth in 2017 and beyond, but the company faces some major challenges on that front.

Image source: Apple.

The smartphone market has become the PC market

Consumers stopped getting excited about new laptops years ago, and that same phenomenon is now happening in the smartphone market. Smartphones are still improving each year, but the relative change is getting smaller. Just like how each new generation of PC is only modestly better than the last, smartphones launched today are no longer dramatically better than those launched a year ago.

The iPhone 7, while one of the best smartphones available, offered little in the way of compelling new features. A faster processor, better graphics, and an improved camera have become table stakes in the smartphone business, and features like water resistance are far from revolutionary. The iPhone 7 was another refinement to Apple's successful iPhone formula, but refinements aren't moving units like they used to.

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There's hope that the next iPhone will bring with it substantial improvements, including an OLED screen and a dramatic new design. Analysts are talking about an iPhone "super cycle," which could spur a massive number of upgrades and return Apple to growth. But that requires Apple to come up with something genuinely new and exciting, something that it's had trouble with as the iPhone has matured. Is there any innovation left in smartphones? I guess we'll find out later this year.

Coming up with the next big thing is hard

Apple changed the world, first with the iPod and then in a bigger way with the iPhone. Other products have been successful in an absolute sense; Apple sold more than 9 million iPads during the fourth quarter alone. But relative to the iPhone, the iPad isn't very meaningful for the company, producing just 9% of total revenue.

The Apple Watch, while still in its early days, also hasn't set the world on fire. Apple still lumps its wearable device in the "Other Products" category, which saw revenue slump 22% year over year during the fourth quarter to just $2.4 billion. While the iPhone became a must-have device that essentially created the smartphone market, the Apple Watch doesn't have the same shine.

Image source: Apple.

The odds of Apple coming up with another device on par with the iPhone are vanishingly small, for the simple reason that the iPhone has been such a massive outlier in the consumer electronics industry. Apple is reportedly still interested in self-driving cars, and rumors have been swirling about the company working on a virtual reality or augmented reality device. But Apple is playing catch-up in all of these areas. If iPhone sales continue to slump, it will be very difficult to offset that decline with sales of new devices.

Services are no panacea

Apple has made a big deal about its growing services businesses, but it's nowhere near big enough to counteract iPhone weakness. Services generated $6.3 billion of revenue during the fourth quarter, up 24% year over year. Again, in an absolute sense, the services business is impressive. But relative to the iPhone, it's peanuts.

There are a lot of questions surrounding Apple's services business. With iPhone, iPad, and Mac sales all declining, can the company keep up its services growth rate if it's selling fewer devices? Will Apple's push into content, first with Apple Music and now, reportedly, with original TV shows and movies, be anywhere near as profitable as selling hardware? Getting into original content is going to be expensive, and while Apple certainly has deep pockets, I don't see a clear competitive advantage for the company.

The major challenge for Apple will be replacing high-margin hardware revenue with enough services revenue to prevent further declines in profitability. That's not impossible, but it's a tall order.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.