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Why Apple May Be Set to Report First Quarterly Decline Since 2003

For the first time since the pre-iPhone era, Apple may be shrinking.

Not since 2003, the year the third generation of the iPod was released along with the iTunes music store, has Apple reported a year-over-year decline in quarterly revenue. That's 51 consecutive quarters of growth.

Yet a sudden slump in iPhone sales, which account for about two-thirds of the business, is expected to push fiscal second-quarter revenue down a whopping 10 percent when the Cupertino, California-based company reports results on Tuesday.

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Analysts on average expect a decline in revenue to $52 billion from $58 billion a year earlier, according to Thomson Reuters. Earnings per share likely slumped to $1.99 from $2.33.

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For the most part, this is Apple playing victim to its own success. The iPhone 6 and the bigger 6 Plus released in September 2014 make up Apple's best-selling smartphone line of all time, and 2015 was the strongest year for the devices. In the second quarter, Apple sold over 61 million iPhones, and revenue in the unit jumped 54 percent from the prior year.

That makes 2016 a relatively slow upgrade year and presents particularly challenging numbers to beat. Gene Munster, an analyst at Piper Jaffray, said the iPhone 6 was expected to produce a 15 percent sales bump over the iPhone 5 line, but it ended up being a 30 percent increase.

"The 6 really threw everything off," said Munster, who recommends buying the shares and has a $172 price target, representing a 63 percent increase over Friday's close. "When you're pulling forward that much demand, you're just naturally going to have a down year."

In other words, don't consider this revenue drop a trend. IPhones run in two-year cycles, and on average device sales should rise in the mid- to high-single digits annually, Munster said.

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The newest iPhone SE went on sale at the end of March, so those figures will start to show up in results this quarter. And the next generation iPhone 7 is expected later this year. Analysts expect iPhone sales to rise 4.3 percent in fiscal 2017 after declining 7.1 percent this year, according to FactSet.

There's no doubt the market is maturing. Concern about whether Apple can find the next killer product has weighed on the company's stock price, pushing the shares down 18 percent over the past year. Meanwhile, Alphabet, Facebook and Amazon.com have each jumped at least 20 percent over that stretch.

According to Pacific Crest Securities, Apple may be facing another headwind: longer upgrade cycles. In an April 19 report, the firm said its latest survey shows that consumers plan to hold onto their devices longer as it becomes challenging to add must-have new features and as carriers change the terms of contracts.

"Although this could change with a compelling new iPhone launch, we view the potential for longer iPhone holding periods as a key risk to Apple's multiyear growth," Pacific Crest analyst Michael Bowen wrote in the report.

While iPhones are by far Apple's dominant product, there's a rising level of enthusiasm about the company's ability to generate growth from its iTunes, iCloud and app store business and the high-margin recurring revenue from subscriptions.

In a report last week, Munster called the services business "underappreciated," and Credit Suisse published a note earlier this month saying that the services unit should double its profit contribution to the overall company by 2020.

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Services revenue rose 10 percent last year to $19.9 billion, accounting for 8.5 percent of total sales. With Apple Music recently added and a TV subscription product potentially on the horizon, investors could start to value the company more like a software business instead of a low-margin hardware provider, Munster says.

Apple shares traded for 11 times earnings, compared with a price-to-earnings multiple of 31 for Google and 86 for Facebook.

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Aaron Rakers, an analyst at Stifel Nicolaus, expects services revenue to increase 24 percent in the quarter to $6.2 billion, with that same level of growth for the full year. Rakers, who recommends buying the stock, says the key is getting Apple's massive customer base to sign on to more subscription offerings.

"In addition to our focus on Apple's iPhone installed base as a latent driver for future iPhone upgrades, we are also focused on Apple's ability to drive increased services revenue through its expanded installed base," Rakers wrote in a report last week.

Investors would surely welcome the diversification.