Apple (NASDAQ:AAPL) has put all its faith in the Services segment to deliver future growth for the company. But this segment faces several headwinds that should negatively impact Apple stock.

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As the focus of the management and Wall Street moves towards the Services segment, we need to look at some of the key differences between services and products. The biggest question over the next few quarters will be whether Apple can get a price premium for its services. Will customers pay a premium for services that are generally platform and brand agnostic?

Apple’s Pricing Power

The biggest reason behind Apple’s fat profits is the pricing power which the company enjoys over other competitors. This has allowed Apple to not only increase the average selling price (ASP) but has also increased overall profits while the industry becomes more commoditized. Forbes has valued Apple’s brand at $182 billion. AAPL has now been in the first position for eight consecutive years. In all the product lines, especially iPhones, the company has capitalized on its brand image to price the devices at a significant premium. This, in turn, has helped in generating healthy profits and boosting Apple stock.

Customers who have a budget of $300-$400 for a smartphone pay an additional premium to get an iPhone. Even if other options within the market provide a better alternative in terms of overall specs. Besides immediate brand attraction, customers also get a benefit of better resale value for their Apple products. Tim Cook has mentioned this fact several times. While defending the price increase for iPhone X in the last cycle he mentioned, “And the residual value for iPhone tends to be the highest in the industry and many people pick up $300, $350 or so for their iPhone”

Nature of Services Segment

Both of these advantages, the higher brand image of Apple and higher residual value of devices, are not present in many services that Apple is trying to grow. Even if Apple invests billions of dollars in building a compelling alternative platform to Netflix or other streaming services, will it be able to charge customers any premium over the prevailing price of competitors?

The answer to this question might only become evident when Apple starts revealing the margins on individual services. However, we can use current evidence to make a forecast regarding several services. First, in almost all the services, there is never any residual value that can be sold to recoup some of the initial cost of buying.

It is also unlikely that Apple would be able to get a lot of leverage in pricing due to its brand image in various services. We can already see a strong example of this trend in Apple Music vs Spotify (NYSE:SPOT). Apple Music and Spotify have the same pricing. Despite having over 50 million subscribers, Apple has not increased the price of this service compared to its main competitor. It is also unlikely that Apple will be able to get any price premium in this highly competitive industry.

Impact on Margin

In a Wall Street Journal report, Macquarie Capital analyst Ben Schachter estimated that Apple Music had a gross margin of 15%, while Spotify had a gross margin of 24%. There is a high probability that a similar trend would be seen in streaming content. As Disney (NYSE:DIS) and other heavyweights enter the streaming industry, it would be extremely difficult for Apple to eke out any meaningful margins from this business.

At the core of the issue is the problem that Apple cannot leverage its brand image to gain any pricing premium within most of the services business. These challenges can lower the margins and negatively impact Apple stock.

Valuing Low Margin Services

Even low margin, negative free cash flow stocks have been valued at aggressive multiples.

Netflix (NASDAQ:NFLX) has a price-to-sales ratio of 10.5 while Spotify has a P/S ratio of 4.5. Apple could hit the $37 billion mark in a few years by clubbing different streaming services like Music, content, news, etc. At a modest P/S ratio of 3 to 4, this alone would add $111 billion to $148 billion to Apple’s valuation. A recent Morgan Stanley report estimates that Services revenue could increase to $100 billion by 2023.  

Source: Morgan Stanley research

Although Morgan Stanley has forecasted aggressive growth in Services, we should also note that Apple would need to compete with much stronger competitors in this segment. Apple would need to show strong growth in businesses by competing against Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) in the U.S. It will also face the might of Alibaba (NYSE:BABA) and Tencent (OTCMKTS:TCEHY) in China. Besides these giants, Apple also needs to perform well against Spotify, Netflix and future streaming players.

Investors looking to enter Apple at the current valuation should note the future headwinds in the Services segment. It is important to look at the lower margin premium that Apple gets in these businesses.

Investor Takeaway

Apple is betting on growing its Services segment. However, it is unlikely that it will be able to leverage its brand image to gain a decisive pricing premium in its Services segment, similar to what it has done in all product categories.

If it is just one of the service providers with little differentiation, we could see lower profits from this segment. The competitive field within the Services segment is also much stronger than iPhone or iPad segment. Future growth in margins would be very difficult which should put pressure on Apple stock.