Apple Inc. Results Show Importance of Services Revenue to Face Challenges

AAPL's second-largest unit posted impressive 31% gains in Q2, but sustaining the growth won't be easy

Source: Apple

One of the strong points of Apple Inc.’s (NASDAQ:AAPL) second-quarter earnings was its Services division. Once again, Apple Services revenue was up, this time by 31% year-over-year. However, a closer look reveals some challenges on the horizon if services like Apple Music and the App Store are going to help take the pressure off iPhone sales in driving future AAPL stock growth.

CEO Tim Cook had this to say about his company’s stronger-than-expected performance: “We’re thrilled to report our best March quarter ever, with strong revenue growth in iPhone, Services and Wearables.”

That Apple Services revenue is worth spiking out. It increased 31% year-over-year. Services is the second-largest division in AAPL, with nearly $9.2 billion revenue for the quarter –more than double what the company made selling iPads. We’ve been pointing out for more than a year that as the smartphone market matures and iPhone sales level out, Apple Services revenue is increasingly important to the bottom line –and to the performance of AAPL stock.

Infographic: Beyond the iPhone | Statista Source: Statista
Services like the App Store, Apple Music, AppleCare, Apple Pay and iCloud storage provide ongoing revenue based on AAPL’s existing pool of iPhone, iPad and Mac users. The revenue isn’t cyclical and doesn’t require convincing someone to buy a $999 iPhone X. And the sustained growth of that Apple Services revenue shows the potential for it to help keep investors on board as the iPhone mad money begins to dry up.

But as pointed out by Reuters’ Stephen Nellis, there are challenges facing this division.

Services Revenue Does Not Guarantee Profit Margins

One of the reasons the iPhone has pushed AAPL stock so high isn’t just the revenue from iPhone sales, it’s the profit margins the company makes on these smartphones. The iPhone X is estimated to have a profit margin of over 60%. Company wide, Apple reported margins of 38.3%. But within the Services division, the margin levels are mixed and likely lower than that average.

For example, the App Store is considered a higher margin source of Apple Services revenue. AAPL collects 30% of the price of apps and 15% of App Store subscriptions that extend beyond one year. That’s well below the 38.3% average. While iCloud storage likely has margins that are considerably higher than that average, Apple Music likely makes much less. Reuters points out that Apple Music’s primary streaming music competitor Spotify Technology SA (NYSE:SPOT) reported 20% margins for 2017.

Growing Competition, Maturing Business Lines

In addition to lacking the consistently high profit margins of hardware sales, many sources of Apple Services revenue face increased competition and maturing markets.

App Store revenue is projected to continue growing, but at more modest rates compared to the days when iPhone adoption was on fire and new users loaded up on apps. Apple Music has a way to go yet before the streaming music market begins to level off, but it also faces increased competition from the likes of Amazon.com, Inc. (NASDAQ:AMZN), which has been posting impressive growth rates.

Reuters points out that competition not only means the potential for slowing sales, it puts pressure on Apple to spend more to stay competitive — such as the $1 billion it’s projecting to spend this year developing original video content. Higher expenditures can eat into those margins even more.

That’s not to say that Apple Services revenue isn’t going to continue the recent trend of being increasingly important to the company. However, the future impact of the division’s performance on AAPL stock may be tempered by growth that doesn’t keep up with Q2’s 31% rate, and the likelihood of lower profit margins than Apple hardware pulls in.

Meanwhile, Warren Buffett heartily endorsed AAPL stock at this past weekend’s Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) annual meeting, revealing to CNBC that Berkshire bought an whopping 75 million shares of Apple during the first quarter. That adds to the 165.3 million shares Berkshire already owned at the end of 2017, making it one of Apple’s largest shareholders, according to CNBC.

Following on from Apple’s news of a new $100 billion stock buyback program, Buffett told meeting attendees: “From our standpoint we would love to see Apple go down in price.” “We very much approve of them repurchasing shares.”

As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.

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