Apple (NASDAQ: AAPL) reported on its fiscal fourth quarter on Wednesday, and while revenue and operating profits were down, it did beat its outlook. Unsurprisingly, CEO Tim Cook pointed to China's economic slowdown and Washington's trade war as the causes of lower iPhone sales, but on the earnings call, he also talked through a bigger-picture evolutionary story that could generate some optimism about the company and the stock. Elsewhere in the investing world, satellite radio monopoly Sirius XM (NASDAQ: SIRI) reported a quarter of record revenue -- but that company, too, is more focused on what's ahead.
In this 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 and the future of the iPhone and what Sirius will look like in its post-Pandora integration, post-Howard Stern form.
A full transcript follows the video.
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This video was recorded on Jan. 30, 2019.
Mac Greer: It's Wednesday, January 30th. Welcome to MarketFoolery! I'm Mac Greer. Joining me in studio, we have Motley Fool analysts Andy Cross and Jason Moser. Gentlemen, welcome!
Jason Moser: Hey!
Andy Cross: Hey, Mac! Hey, J-Mo!
Greer: How are we feeling? A little icy, a little cold?
Cross: That's the whether you're talking about, not the market?
Greer: Yeah, not the market.
Moser: School was cancelled today. We were not. The weather out there is such that I had to drive a little bit more carefully coming in today. We came in, still!
Greer: Yeah, the main streets of North Arlington, two-hour delay. School is not cancelled. That's how we roll.
Moser: At least you only had a two-hour delay.
Greer: We're gritty.
Moser: Wow! Fairfax County, which is big county.
Cross: Fed meets today. We'll get some good news from the Fed this week.
Greer: We're going to be talking about some good news from Sirius XM later. We'll debate that age-old question: is there life after Howard Stern? But first, 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?
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.
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.
Greer: Let's talk some Sirius XM. Shares up on earnings. Jason, record revenues and the integration of Pandora, well, that seems to be going well. A lot of optimism. Sirius XM acquired Pandora last year.
Moser: The conversation for us regarding Sirius XM for a long time has all revolved around Howard Stern, and would there actually be life beyond Howard. He obviously won't last forever. I think we're actually starting to see signs that there may indeed be life after Howard. I think the Pandora acquisition is going to play a pivotal role in that. Initially, when we saw they were doing that deal, there were some questions as to what they could get out of Pandora that they don't already have. What it boils down to is data. When you combine these two entities, they're essentially going to have an audience of over 100 million listeners. There's going to be about 40 million self-paying subscribers, about 75 million who are not paying for subscriptions, but either listening on the ad-based model or whatever. We talk a lot about how Starbucks has a lot of different levers they can pull when they want to try to generate more traffic in the store. Whether it's a treat receipt or a buy-one-get-one-free, whatever it may be. I think that Sirius is going to play that same card here with Pandora. They're going to get a lot of data here to be able to offer up some new products for listeners.
A couple of examples here. One thing they're going to do in early February, they're actually going to give select Pandora listeners an offer to buy a $5 a month mostly news and talk Sirius subscription. That matters because most all of the cars that are coming out now are all satellite-radio-enabled. They just struck a deal with Toyota where Sirius XM is going to be the provider for all Toyota cars going on the road here through 2028. They're projecting 200 million cars on the road over the next decade that will have that satellite radio hardware. Giving a product that scratches whatever itch the listener has is going to be critical. Having Pandora is going to give them the data to be able to do that.
Greer: It also seems like, going forward, the secret sauce for Sirius XM increasingly is going to be news, it's going to be talk, it's going to be live sports. Music feels like it's become so commoditized.
Moser: Yeah, I think you hit the nail on the head there. You can get whatever music you want anywhere. There are a million offerings out there. Spotify, Amazon, Apple, Google, you name it. Where Sirius has really differentiated themselves is the breadth of the content that they offer. Whether it's sports, news, talk, comedy -- look at the relationship with Netflix. They're leveraging some of that Netflix comedy to offer it in audio form on Sirius XM. More and more, it's becoming kind of like a Netflix in that regard. They have a little bit of something for everyone. If they can figure out ways to monetize that as optimally as possible, and whether that's just catered offerings to people who want a certain thing, or people who want the whole package -- remember, we're coming into a very polarizing election year here in 2020.
Greer: I've heard that!
Moser: I'm certain there are going to be a lot of people that would love to have access to a news-and-talk-style offering that's going to be reliable. That's the beauty of Sirius radio, the satellite is so reliable.
Cross: Also, the defensive mechanism that this, against the likes of Spotify, the other competition that Jason mentioned. The top line growth rates for Sirius have slowed a little bit. Taking on something like Pandora to help bring some excitement back to both the product, as well as for shareholders -- the stock has reacted nicely on the news over the past couple of years. Thinking through how this changes the landscape of providers when it comes to music and talk radio is really interesting. If you were in the Sirius boardroom, you're saying, "Hey, we have to make some kind of move here, and here's a Pandora price that's pretty reasonable to get the assets that they own."
Moser: Yeah, they'll have a Pandora channel on Sirius XM here in the coming months. They're starting to place some big bets on podcasts. They felt like they missed that boat more or less. I think it's all based on growing out that offering, using the data to slice and dice different product offerings to give at least an option for everybody out there, considering how many people are going to actually have access to that satellite radio via the car.
Greer: It's really amazing, we were talking before the show, when you look at the 10-year stock chart of Sirius XM. It wasn't that long ago that this stock was trading for under $1. There was a very, very fair, reasonable question: are they going bankrupt? I didn't invest in them, and I love Sirius XM as a consumer. I think a lot of people probably underestimated the power of Howard Stern.
Moser: I think you're right. They obviously made a very smart bet in using him to really launch that offering. Such a loyal listener base on the Stern side of things, when he moved over to Sirius. That enabled him to do a lot more, as well. He didn't have to worry so much about the FCC anymore. I think it's made the show a lot funnier. Granted, it's probably not for everyone, but hey, I'm one of those loyal listeners. I think what Howard Stern ultimately bought them, other than really awesome content, he bought Sirius a lot of time to actually build up a subscriber base. And now that they have that base -- they also have some data on that user base, because they have a pretty slick app there -- they're more and more able to slice and dice and come up with product offerings that give you what you want to listen to when you want to listen to it. If you can offer it at multiple price points, or even possibly a free ad-supported model, which it sounds like they're coming out with, hey, they're making it available to the biggest space possible. That's important.
Cross: We talked about the advantage of subscription businesses, when you think about the Apples and the different profit margin between their Services business and Hardware business. Sirius actually has higher profit margins than Apple does as a subscription business. Just a little, 28% vs. 26%. But it's telling. This is why Tim Cook, looking at the Services business and reporting the gross margin that they reported this quarter, and saying, "Hey, this is the future of what Apple may look like," it's just a matter of getting the revenue growth high enough for that to make a meaningful difference for Apple's shareholders.
Greer: Any chance that Apple would buy Sirius XM? Doesn't make sense?
Cross: I don't think so!
Moser: Yeah, I don't think that's right up their alley. Content is such a tricky business. When you have a company like Sirius that's already bringing Pandora into the mix, I don't know that they would be interested in an acquisition like that, anyway. I'm sticking with Square. Apple needs to buy Square. That makes sense.
Greer: OK. Andy, you just set up beautifully my desert island question. This is going to be an easy one because we only have two stocks: Sirius XM or Apple.
Cross: [laughs] For him not picking --
Moser: It's actually a fair question right now!
Greer: That's right. As a reminder, do not invest this way at home. If you're on a desert island and you have to buy one of these two stocks for the next five years, what are you going with? Sirius XM or Apple?
Moser: Alright, if I'm on a desert island, I feel like I'm pretty bored. I want to add some excitement to my life. Roll the dice, so to speak. Sirius is the bet there. Sirius is the investment. Certainly a higher risk, but perhaps a higher reward, too. Apple is going to be pretty steady-eddy. Let's add a little excitement to our lives.
Cross: You're on a deserted island, and you want more excitement in your life?
Cross: That's great! I think, just from the size perspective, Sirius is a $25 billion business vs. the $700 billion-plus business of Apple. The optionality, even though Apple has tons, the excitement with the Pandora acquisition -- at this point, I would lean toward Sirius. But the conviction in that call is a little bit low.
Moser: Hey, now!
Greer: Andy Cross, Jason Moser, thanks for joining me!
Cross: Thanks, Mac!
Greer: As always, you can weigh in with your feedback, with your thoughts on our desert island question, Sirius XM or Apple over the next five years. Our email is email@example.com. As always, people on the show may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's it for this edition of MarketFoolery. The show is mixed by Austin Morgan. I'm Mac Greer. Thanks for listening! We'll see you tomorrow!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Andy Cross owns shares of Netflix and Starbucks. Jason Moser owns shares of Alphabet (C shares), Amazon, Apple, Square, and Starbucks. Mac Greer owns shares of Alphabet (C shares), Amazon, Apple, Netflix, and Square. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Netflix, Square, and Starbucks. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.