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Is Diversification Really Wrong For Apple?

The tech giant still relies too heavily on its iPhone, could a change in direction be needed?

11May

Apple has become the first US company to reach an $800 billion valuation, having reported revenue growth of 5% up to $52.9 billion in Q1. It has cash reserves of $256.8 billion and a loyal, some would say fanatical, consumer base. Given this, you could be forgiven for thinking that anyone calling for it to change strategy is a lunatic. However, there are valid reasons for concern, particularly surrounding the 1% year-on-year drop in iPhone sales.

The drop is particularly worrying because the technology giant relies so heavily on its iPhone. iPhone accounted for 69% of company revenues in the first three months of 2017, far more than any other areas of the business - the iPad accounted for 7%, Mac 9%, Services 9%, and other Products 5%. This makes any apparent fall in the popularity of the smartphone a huge problem. While the iPhone is arguably still one of the best smartphones on the market - if not the best - Apple’s business would be crushed if a competitor released a superior product and its fans started jumping ship.

It may be that there were mitigating circumstances for the drop off. Tim Cook, Apple’s CEO, holds leaks about future products responsible. And it may be that the next iPhone will be the kind of massive step forward that they haven’t really produced in years, incorporating wireless charging, 3D facial recognition, and a curved display. But leaks are extremely hard to plug, and any new developments to the phone are unlikely to come close to matching the excitement that surrounded the original iPhone.

There is one obvious solution for a company with a massive over reliance on one product and huge cash reserves: Diversification.

Ross Gerber, CEO of investment management firm Gerber Kawasaki, for one, has expressed frustration about Apple's apparent reluctance to make any major acquisitions, telling CNBC that ‘it should be illegal to have $250 billion in cash and not utilize it - that is what you're supposed to do as CEO.’ Analysts at Citigroup, the investment bank, have gone as far as to draw up a list of seven companies Apple could look to buy, including Netflix, Walt Disney, Tesla, streaming service Hulu, and video game makers Activision Blizzard, Electronic Arts and Take Two Interactive.

Making an acquisition in the entertainment space would make the most sense. According to data from Sensor Tower, spending increased 130% year-over-year in 2016 in the ‘entertainment’ category of the App Store, which includes HBO Now, Hulu, and Netflix. Netflix has probably been the most touted as a potential acquisition candidate, with the video steaming service already hitting revenues of around $10 billion a year. Were Apple to acquire Netflix, it could draw down its enormous pile of cash and boost ambitious plans for the App Store. Apple is also making a concerted effort to grow its services business, and Netflix would provide a huge boost here.

However, acquiring Netflix is an extremely expensive proposition. 93% of Apple’s cash is held offshore, meaning it would have to pay repatriation taxes of up to 35% to bring the cash home to buy a domestic company like Netflix, which could see it forced to repatriate $130 billion of foreign cash - roughly half of its total cash stockpile - to make a deal. Even if they were willing to go ahead with this, Netflix’s $10 billion of revenue, while impressive, is unlikely to make any ripples in Apple’s $200 billion. And this isn’t just a problem with a deal for Netflix - even a fairly large acquisition would provide only minimal diversification away from the iPhone.

So is it completely pointless? UBS's Steven Milunovich, a well-respected Apple analyst, notes that, ‘Apple's history has been one of focus — we think management is mature enough to know what it's good at and what it is not. Although many corporations seeing slowing growth would use deals to bolster revenue, Apple appears to have sufficient confidence in its future to be careful, especially in diversification.’ Apple seem to think so too. Eddy Cue, Apple's head of content, said at Recode's Code Media conference earlier this month that, ‘[I]f we wanted to do what everybody else is doing, then you're right, we might be better off buying somebody or doing that. But that's not what we're trying to do. We are trying to do something that's unique.’

Any acquisition should be made with better product and customer experience in mind, not protecting financial results. However, growth as rapid as Apple’s never lasts for ever, and it normally ends with a sharp return to earth, and it’s clear from Apple’s forays into wearables that just developing variations on a theme is not going to cut it. Milunovich is right that they should exercise caution, but it would be foolish not to consider it.

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