Apple's growing services business depends on lower-cost iPhones

Apple has saturated the "rich people" market, and China won't help it out any longer. The company needs to introduce cheaper ways to hook customers on its services.

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Apple CEO Tim Cook

Image: James Martin/CNET

With Apple's huge slowdown in China (Asymco analyst Horace Dediu puts it at a Q4 decline of 40% year-over-year vs. Q3 growth of 16%), the company is under pressure to figure out how to prop up growth. With under 1% market share in the only other fast-growing mega-market (India), Apple's high-price, high-margin business plan finally seems to have run out of runway, something promised for close to a decade, and only now coming into focus.

The problem, it seems, is not that Apple charges too much for its phones—the problem seems to be that it's getting harder to justify paying any premium for devices that largely seem unchanged from year to year. As Indie.vc founder Bryce Roberts has called out, "Anyone who has 'upgraded' from the [iPhone] X to the Xs knows Apple's trouble has very little to do with China."

This, in turn, makes Apple's services business increasingly critical, but that success depends on lots of people using Apple hardware, not a few rich people doing so.

SEE: Hardware purchasing task list (Tech Pro Research)

Blocking out the green

Apple's most promising business is its services business, which includes fees derived from Apple Pay sales, App Store fees, Apple Music, etc. That services revenue is growing at 25% year-over-year and is expected to top $44 billion in 2019. By the first quarter of 2020, Apple's services business should top $15 billion, setting up a $60 billion business in 2020, as projected by Mott Capital Management. While not enough to cover the iPhone shortfall Apple CEO Tim Cook has warned about, it's a gift that should keep on giving as iPhone users remain loyal to the Apple brand.

Historically, that loyalty may have been bought with a superior product; however, it's increasingly harder to argue that iPhones offer the best functionality at any price point. China is awash in phones from Huawei and others that meet or beat Apple's iPhone specs, and usually at dramatically lower price points.

SEE: iPhone deals ahead? Bad news for Apple is good news for Apple buyers (ZDNet)

Some of us (mea culpa) have continued to purchase new iPhones each year, despite there not being any obvious reason why we should do so. While Apple's bi-annual upgrade cycle used to be driven by carrier subsidies, and not really from significant functional enhancements, the move from the X to Xs was a new low for some of us. For me, the only noticeable improvement from my X to my Xs was that Face ID became less of a torment to use (but I still pine for Touch ID).

In this world of non-obvious reasons to upgrade, Apple's iMessage remains the one big reason to stick with iOS. It's an annoying ploy to lock in iPhone buyers, but it works. Once you get used to large group texts and other benefits of iMessage (including being able to text from my Mac during work hours), it's hard to get excited about going Android, despite the fact that I absolutely loved the Pixel 2 I once bought as an experiment. Android and the Pixel were awesome...until iMessage and Apple Pay demanded attention.

Even so, it's getting harder to justify paying so much for miniscule incremental innovation. And even if I or others who can get their employers to pay for their iOS habits, that's not a winning strategy for Apple long-term—which would be too bad, as Apple's services business is a winner.

Sell less for more...or more for less?

One observer tried to encapsulate the services strategy this way: "Sell fewer iPhones and assorted devices such as Macs and iWatches at a higher price than mass-market rivals, and then flood those millions of users—who have more than average disposable income because they were able to afford those devices in the first place—with apps and content that they will pay for." Sounds great, with some positive signs supporting this thesis. For example, just over the US holidays, Apple registered $1.22 billion in App Store sales.

Still, there's a problem with this formulation: Price those phones too high and you get too few people using the services.

SEE: iPhone XR: Why the cheapest 2018 iPhone might be the one you want (CNET)

I'm not sure Apple needs a "Diet iPhone," as Jason Perlow has posited on sister site ZDNet, an "entry-level iPhone anyone can own." But Apple does need to lower prices commensurate with the lack of a compelling, highly differentiated value at the high end. This could bring many new iOS users into the Apple fold, each buying apps, purchasing using Apple Pay, subscribing to Apple Music, and so on.

Yes, there will always be people who will buy whatever Apple offers—sadly, I may be one of those (though I have yet to see any need for an Apple Watch, which seems completely superfluous)—but that's not a booming market. Apple has saturated the high-end market, and China's faltering economy won't prop it up. To further cement its growing services business, Apple needs to bring more people into its ecosystem with a more approachable price point.

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By Matt Asay

Matt Asay is a veteran technology columnist who has written for CNET, ReadWrite, and other tech media. Asay has also held a variety of executive roles with leading mobile and big data software companies.