Though Apple Inc. (NASDAQ:AAPL) has historically been, and still is, viewed as a consumer technology name, it’s not a secret that the company has been wading ever-deeper into digital content and even subscription-based waters. To date, that segment of Apple has been deemed a means of selling more hardware like its popular iPhone.
This year, however, its so-called “Services” division has taken on a life of its own. Indeed, though this sliver of Apple still only accounts for 14% of the corporation’s total revenue, the services arm likely contributes a far greater proportion to Apple’s bottom line.
Investors need to rethink how they see and value AAPL stock now that the company itself is rethinking its business model.
Two simple charts tell the tale.
Numbers Don’t Lie
For the longest time it was something of an afterthought … an add-on that made the iPad and the iPhone just a little more marketable. With the number of handheld devices that can be utilized by the world at any given time being finite, however — and with that limit in sight beginning as far back as more than a year ago — CEO Tim Cook has spent the last several months putting a more intense focus on revenue-bearing (and recurring revenue) services like apps, music, and video.
The work is paying off for owners of AAPL stock, even if it’s difficult to see.
The first graph is a look at the raw revenue numbers, going back to the last calendar quarter of 2013. Though each product line’s has ebbed and flowed with the season, there’s no denying the iPhone’s growth of late has been stymied, while services revenue has expanded. As of last quarter, digital content and the like became the second biggest revenue producer for the company.
Here’s a look at the same data from a different perspective — each product’s contribution to the revenue mix. In each of the past two quarters, services has accounted for approximately 14% of the company’s sales.
Yes, during the most recent quarter, the iPhone reclaimed some ground. Bear in mind, though, that the greatly ballyhooed iPhone 7 was released in the latter portion of the quarter. That crimped iPhone sales in the quarter before that, and much of that pent-up demand was unleashed last quarter.
In other words, the bigger trend still suggests hardware is less and less important to Apple (and by extension for the value of AAPL stock), while digital content and subscriptions is increasingly important.
And None Too Soon
The shift is happening at a critical time too.
Apple’s ongoing dominance of the smartphone market isn’t in dispute. Through the third quarter of 2016, the iPhone remains the single-best-selling model of all, accounting for 12.5% of Q3’s total smartphones sold.
Sales aren’t the same thing as earnings, however, and Apple’s per-unit profit on the iPhone — the biggest chunk of its revenue — is under attack.
The company doesn’t disclose the specifics, but a component-cost breakdown of the iPhone 7 performed by IHS Markit suggests the production cost for that version was $36.89 higher than the iPhone 6 cost to make, while the average selling price for the device last quarter slumped 10%. Stiffer competition is at least part of the reason (and arguably the biggest part) Apple has been forced to put more into the smartphone, but ask less for it.
It’s not as if last quarter’s or the iPhone 7’s cost and revenue metrics were a fluke either. The quarter’s operating margin of 27.8% was the lowest margin Apple has produced in any quarter over the course of the past seven years, and was uncomfortably weaker than the margins near 36% seen in 2012 when demand for the iPhone was frenzied.
In other words, Apple needs some high-margin revenue to get per-share profits for AAPL stock growing again. Digital services is its best bet.
Again, Apple doesn’t divulge specifics, but Piper Jaffray analyst Gene Munster has done some number-crunching of his own and concluded the services segment’s gross margins are somewhere around 60%, whereas the company’s overall margins are closer to 40%. A little less hardware and a little more services would drive a big, beneficial impact in the bottom line.
Bottom Line for AAPL Stock
Though the journey is started, it’s still closer to the beginning than its end. The toughest part about owning AAPL stock in the meantime will be the bumps and stumbles along the way as year-over-year hardware sales growth remains unimpressive. The market is simply used to using unit sales rather than profits as the yardstick.
Down the road though — once the majority of investors embrace the transition to a business model that doesn’t lean so heavily on hardware — AAPL stock is going to be well-loved as a reliable cash cow with healthy margins.
The hard part is the waiting.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
