Apple's First Decline in 13 Years, and Its Hunt for the Next iPhone Has Come Up Empty | Top 15 Annual Report

The deeper problem: you can watch the chase for higher margins warp Apple's judgment about its own products.

Apple is in its first decline in 13 years.

From 2003 to 2015, Apple beat the prior year on both revenue and profit every single year, setting one "all-time high" after another. In 2016, the growth stopped.

In fiscal 2016 (October 2015 to September 2016), Apple's revenue fell $18.1 billion from the prior fiscal year — a hole larger than Twitter's entire market value at the time ($13.2 billion).

The iPhone, which brings in 60 percent of total revenue, could not hold the eight straight years of growth it had managed before, and every hardware product sold fewer units than the year before, including the iPad and the Mac.

Apple is still the most valuable company on earth, worth $610.7 billion — more than $50 billion ahead of second-place Alphabet (Google), roughly one whole Baidu.

It is also the most profitable. Even after the decline, its profit for the year came to $45.69 billion — nearly $10 billion more than Microsoft, Google, Amazon, and Facebook combined.

But a public company needs growth. It needs revenue to climb year after year. So Apple needs new businesses to fill this enormous $18.1 billion hole.

The biggest problem: the iPhone has hit a ceiling

The iPhone is at the heart of the overall decline.

Apple shipped the first iPhone in 2007, and sales had never fallen year over year — until this year, when shipments dropped in major markets including China. This is not because Android took the business away.

Apple's quarterly profit margins have stayed more than double Alphabet's, mostly thanks to the iPhone. To this day, more than 100 percent of the profit in the entire smartphone industry comes from Apple — which means most Android makers are losing money.

Apple was not caught flat-footed when this enormous profit machine stalled. Steadily rising R&D spending shows that it wanted to make the iPhone and its other products more innovative.

But the iPhone can no longer pull in more users.

For one thing, there are no large new markets left for it to enter. The expansion is essentially done.

The first iPhone, in 2007, launched in just three countries; eight years later, the iPhone 7 sells in more than 60 countries and regions. The huge markets — the US, China, Japan, Europe — are already covered.

In 2013, Apple began selling contract phones with China Mobile, the last major Chinese carrier to sign on. The next two years were the best the iPhone ever sold. From 2014 to 2015, the hundreds of millions of 4G subscribers China Mobile brought in, together with the large-screen iPhone 6, pushed sales to their peak.

The global handset market is saturated too, growing less than 5 percent a year. Most adults already have a smartphone and internet access; many who do not live in places of extreme poverty or war, where no one would choose a pricey iPhone anyway.

To lift sales, Apple could do what Android makers do and build a cheap phone. The iPhone SE, released early this year, is one attempt — but Apple plainly held back, since a cheaper phone would drag down the average price. The iPhone SE looks like the iPhone 5s from three years earlier and performs like a phone from two years ago, deliberately built not to eat into newer models.

At this point, getting more existing users to upgrade is the best — and maybe the only — option left. But today's iPhone no longer delivers the generation-skipping leaps of its first nine years.

What sold each generation of iPhone:

Year	Model	Selling point
2007	Original iPhone	Multi-touch — the template for every smartphone since
2008	iPhone 3G	Mobile internet, the App Store
2010	iPhone 4	Glass front and back, the world's first Retina display
2012	iPhone 5	New shape, ultra-thin and light
2014	iPhone 6	Big screen
2016	iPhone 7	Same shape; dual cameras, waterproofing, new colors

Think about the rectangular phone in your hand. The screen is sharper than the retina can resolve; processor speed barely changes how most internet services run; "big screen" stopped being a selling point long ago; and the so-called "innovation" has worn thin. There will be no dramatic change to make a phone exciting again.

Unless most existing users start upgrading once a year, and unless Apple gets serious about cheaper products, the iPhone will not return to its old high-speed growth.

The iPhone's decline points to another problem too: Apple's handling of expectations has broken down.

Apple uses a fairly traditional distribution model. Each year, before a new iPhone launches, Apple sells the phones first to other channels — e-commerce sites, carriers, authorized stores — which then sell them to consumers, alongside its own website and its few hundred Apple stores worldwide.

That means a forecast of buyer enthusiasm sets how many phones to make in the first run.

But the forecast for the iPhone 6s was wrong. Cook himself admitted he had overestimated its popularity, and Apple ended up spending more than $2 billion clearing the iPhones backed up in its sales channels.

This year the iPhone 7 seems to be selling well, helped along by Samsung's Note 7 fiasco. Apple says that, with the iPhone 7's help, holiday-quarter revenue will come in slightly above last year's. If that holds, it amounts only to a brief pause in the decline, not real growth.

Meanwhile, several bets on "the next iPhone" have gone nowhere

The iPhone is unlikely to return to fast growth, so Apple is scrambling to find its successor.

In 2015, every new product Cook launched aimed at that goal:

• Apple Watch, pointed at the fashion industry.
• iPad Pro — not just a bigger screen, but a keyboard and stylus too; the declining iPad recast as the future touch-screen PC.
• Apple TV 4, with its own tvOS, a fresh push into "internet services."
• The car project, code-named Titan, leaked to the press: Apple was going to build a car.

Apple paid dearly for these new products. Its $1.8 billion in advertising in fiscal 2015 was an all-time record.

By now, each of these bets has produced results of one kind or another.

Apple Watch has changed direction — from a fashion piece at launch to a health and fitness tracker. The pricey gold Edition is gone, and the ads are all about exercise.

Paul Deneve, the vice president Apple poached from YSL to make the Apple Watch fashionable, no longer reports directly to Cook.

Apple has never disclosed exact Apple Watch sales. But "Other Products," the revenue line it sits in, had already fallen year over year by its fifth quarter on the market — this April to June.

IDC data show that even with the largest market share, Apple Watch sales fell 70 percent in the third quarter of this year (before the Apple Watch Series 2 shipped).

Looking ahead: if nothing turns around, the watch will be the first hardware product Apple has hit a ceiling on in more than two decades.

iPad Pro, the bid to become a productivity tool, is the one effort showing early signs of working. From April to June, iPad revenue rose 7 percent and the average price climbed. That is a good sign — the more expensive iPad Pro won over some users.

But the small gain did not hold the next quarter, and it was not enough to grow iPad's full-year sales or revenue; the average price has since slipped back. The iPad Pro got no update at all in 2016. None of this looks promising.

"Services" is the only segment still growing in the earnings reports — it includes Apple TV, Apple Music, and the App Store — but it is nowhere near enough to fill the revenue hole left by the iPhone and other hardware.

The car project is the most uncertain of all, and it has even changed its basic direction.

Apple first wanted to build a car outright, and Cook hinted on earnings calls that it was a market with real promise.

This was territory Apple had never touched. The car market is plenty big, and Apple poured in more money than it ever had for any new product.

A Morgan Stanley report found Apple added $4.7 billion in R&D spending between 2013 and 2015. By comparison, building the iPhone from 2004 to 2006 added only about $200 million; preparing the iPad added about $600 million; the watch and the new internet services added $2 billion.

Apple also bought eight parcels totaling 58 hectares — a site larger than its own campus — for vehicle testing.

But in the second half of this year, the car project brought nothing but bad news.

The overall project lead quit, "hundreds" of staff were laid off, and the project stopped aiming to build its own car. The team of more than 1,000 now focuses on in-car systems built with automakers.

You can also read off the growth priorities Cook named on this year's earnings calls and see that Apple has no clear destination for growth after the iPhone:

What Cook stressed on earnings calls in 2016:

Quarter	Emphasis
January	Services revenue still growing fast
April	More Apple Watch apps; App Store revenue up sharply
July	iPad average price rising; "half of iPad Pro users use it for work"
October	Machine learning will drive future products; Apple has more enterprise customers

Under revenue pressure, Apple has lost the nerve to disrupt itself

Right now nothing in sight can challenge the iPhone.

But to make up for falling profit, Apple has already started making troubling changes — changes that may threaten its future. One of them: Apple has lost the nerve to disrupt itself.

A clear case is the iPod versus the Apple Watch.

The iPod was the first new kind of product Apple launched after Steve Jobs returned. A big reason it caught fire in 2003 was that, that year, the iPod no longer needed a Mac to work — it could sync with a Windows PC.

The Mac was Apple's most important product line then. Letting the iPod work with Windows meant this beloved new device would no longer be the thing that set the Mac apart and gave people a reason to buy a Mac over a PC. But the Mac was far less common than the PC, and that limited the iPod's reach.

In the end, Jobs chose to make the iPod cross-platform and support Windows PCs. The iPod took off. It helped Apple become a consumer brand rather than a niche-tools brand, build a global supply chain, and bank the cash to operate at scale.

The iPod laid the groundwork for the iPhone. And the iPod became the iPod because it betrayed Apple's most profitable business at the time: the Mac.

Now the Apple Watch is in its second generation and has been through a major strategic pivot. Yet it still works only with the iPhone.

When Apple was selling the Apple Watch as a fashion accessory, that made sense. The iPhone had already captured most people with the money to spend.

Tying the Apple Watch to the iPhone strengthens the iPhone's pull and protects Apple's most profitable business.

But once the Apple Watch becomes a health product — one whose powers keep growing and that has begun to probe what computing might look like next — supporting Android, which holds 80 percent of the market (by users, not quarterly sales), is what Apple should be doing.

Wearables may not be the future. But if they are, keeping the Apple Watch an iPhone accessory keeps it from becoming the next iPhone.

This habit of protecting the iPhone runs through everything Apple does.

Take the iPad Pro: a product that wants to be the next generation of personal computing, yet it has no system-level cooperation with the most widely used mobile operating system on earth.

That doesn't stop it from being a fine iPhone companion or a family entertainment device on the couch. But that path cannot sustain growth. For the iPad Pro to have a future, it must replace the personal computer through a genuinely new way of interacting.

iMessage, born in 2010, has been upgraded many times and gained all kinds of features — but those features still work only between iPhone users. There is no reason to assume iPhone users socialize only with other iPhone users. When WeChat, born in 2011, became Tencent's main engine of profit growth, the older iMessage stayed a moat — for Apple alone.

The same goes for Apple Music. It does support Android. But its feature updates follow the iPhone version, and the iPhone version follows iOS's schedule. Apple has built an Apple Music team of hundreds, yet it still competes with internet companies while carrying that dead weight.

None of these businesses is guaranteed to become the next iPhone, of course. But if everything keeps yielding to the iPhone, Apple may never get the chance to find what comes next.

In his five years in charge, Cook has led Apple to sell more iPhones and made it the most valuable company in the world.

Its long-term future now turns on whether Apple can sacrifice iPhone profit for something new. With the iPhone at its ceiling and Apple's overall revenue and margins starting to fall, that choice has only gotten harder.

In Apple's attempts this year to find the next iPhone, there is no sign the company has the courage to challenge the iPhone.

About the Top 15 Annual Report

2016 was a turbulent year worldwide, and by business performance, the market leaders were hurting more than their challengers.

The Top 15 companies QDaily follows — the ones shaping how people live — had a hard year. And they all shared a single problem: the ceiling.

Whether by building new products (like Apple's watch and car) or chasing new users and channels (like IKEA moving into e-commerce), these industry leaders have been searching urgently — and perhaps blindly — for the "next" growth engine.

Breaking through that ceiling has proved harder than anyone imagined. QDaily's Top 15 year-end report for 2016 is not all good news.

Cover image from Pixabay