Image source: Apple.
Apple (NASDAQ: AAPL) depends heavily on the iPhone when it comes to sales and earnings, but the services division is becoming an increasingly important growth engine for the company. Both from a quantitative and qualitative point of view, services could be a powerful return driver for investors in Apple going forward.
A huge and growing business
When looking at Apple's financial statements, the iPhone generates the lion's share of revenue. The company made over $24 billion in sales from the iPhone during the third quarter of fiscal 2016 (the quarter ended in June of this year), accounting for a massive 57% of total revenue.
However, services are rapidly gaining ground. The services division includes revenue from the iTunes Store, the App Store, Apple Pay, Apple Music, and other services. This business generated almost $6 billion in sales last quarter, and it's now the company's second-biggest division behind the iPhone, accounting for nearly 14% of total revenue.
To put these numbers in perspective, Facebook (NASDAQ: FB) generated $6.2 billion in sales during the second quarter of 2016, and Netflix (NASDAQ: NFLX) has recently reported $2.1 billion in total revenue for the third quarter of the year. This means that Apple's services division is nearly as big as Facebook, and almost three times bigger than Netflix.
Even more importantly, the services division is firing on all cylinders, with revenue growing 19% versus the third quarter in fiscal 2015. The App Store was a particularly strong driver last quarter, with revenue growing 37% year over year. Apple produced $23.1 billion from the services business in the 12-month period ended in June, up by $4 billion during the past year. According to management, the services segment is on track to becoming the size of a Fortune 100 company next year.
In stark contrast, revenue from the iPhone and the Mac contracted by 23% and 13% respectively, and iPad sales grew by a modest 7% year over year last quarter. This means that services are outgrowing the rest of the business and gaining participation in the overall revenue mix.
Hardware sales are typically quite volatile, as they depend on new product launches and other product-cycle considerations. Performance in the iPhone business could easily improve going forward, especially since Apple launched its new iPhone 7 and iPhone 7 Plus models in September, and the company could materially benefit from Samsung (NASDAQOTH: SSNLF) discontinuing the Galaxy Note 7.
Nevertheless, even if other segments will probably improve in the coming quarters, everything indicates that the services segment will continue outgrowing other businesses over the midterm, and this should have a positive impact on overall revenue growth.
Apple does not disclose profit margins for specific business segments, but services are typically more profitable than product sales. Based on data for 2015, investment bank Piper Jaffray estimates that Apple's gross margin in services could be above 60%, substantially higher than the gross profit margin that Apple typically makes on a whole-company level (it's in the neighborhood of 40%).
Beyond the numbers
One of the main uncertainty factors affecting Apple is lack of growth visibility. Hardware companies are typically valued at considerable discounts versus the overall market because demand in the industry is quite unstable and cyclical. Besides, the iPhone market is maturing and market penetration levels are much higher than in the past, so Apple can't be expected to generate from the iPhone the same kind of performance it produced when the device was still an emerging technology.
Services are a whole different story, though. Revenue in this segment depends on the size of the installed base, not so much on product sales over a particular quarter. For this reason, it makes sense to expect a smoother growth trajectory from Apple in services than in other business segments related to product sales.
In addition, services play a key role from a competitive perspective. As customers become entrenched in Apple's ecosystem of services and applications, they are more likely to remain loyal to the company's products. If you are actively engaged with Apple Pay and Apple Music, chances are you will go for another iPhone when it's time to replace your smartphone.
The iPhone will most probably remain Apple's biggest segment over the coming quarters, but the services division is growing at full speed and gaining participation in the overall revenue mix. This is not only important from a quantitative perspective, but a larger share of revenue and profits coming from services would make overall financial performance more stable and easier to predict going forward. Investors in Apple have a lot to gain if the company can sustain rapid growth in the services business over the years ahead.
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