Service Business Could Be The Next Big Thing For Apple Inc. (NASDAQ:AAPL)

  • Apple Inc. reported the revenue numbers for its service business for the first time in the last quarterly earnings call.
  • The business appears to have much better growth runways than Apple's core iPhone business.
  • Service business could help Apple maintain respectable bottom line growth in the coming years.

Apple Inc. (NASDAQ:AAPL) investors typically focus a lot on how many iPhones, Macs, and iPods the company sells each quarter. But with Apple's core iPhone business now beginning to show early signs of flat-lining, perhaps now is the right time for investors to start searching for the next big thing for the company. With so much focus on Apple's physical gadgets, it's easy for investors to forget that Apple continues to make tons of money from customers once they walk out of the stores with their brand new iGadgets. Welcome to Apple's service business.

For the first time ever, Apple pulled back the curtain on its service business during last quarter's earnings call which revealed that the business brought in $19.9B in gross revenue and $6.1B in net revenue in Q1 2016, up 10% compared to the previous year's comparable quarter. Once Apple customers purchase their gadgets, they are inundated with a cacophony of options to buy Apple Music subscriptions, iTunes Music, iCloud storage plans, paid apps from Apple's App Store, and Apple Care service plans. Further Apple takes a cut out of every Apple Pay transaction. This is basically what Apple's service business is all about.

Apple service business might not have a very big impact on the top line - the business accounted for just 8% of Apple's revenue in Q1 2016. But the bottom line story is something else altogether. The service business brought in a good $14.5B, or 15%, of Apple's gross profit in 2015 compared to just $3.2B in 2010. That represented a robust 35.3% CAGR from 2010-2015.

Wall Street analyst Kulbinder Garcha figures that Apple's service business will reach a gross profit of $33.7B by 2020, or 29% of Apple's gross profit driven by a couple of factors including:

  • The installed base of Apple devices reaching 1B active devices with 600M unique users. The analyst figures that users of Apple devices are highly affluent and spend 7x more on average than Android users.
  • Rapid growth of Apple Pay, iCloud, and Apple Music will drive service spending to nearly double the current levels.
  • New service opportunities in the TV/Video market.

The analyst's projections appear quite reasonable though he failed to mention the importance of Apple's App Store. The biggest growth driver by far for Apple service business is App Store and not the other services that the analyst mentioned here. App Store not only accounted for about 25% of the service business' revenues in 2015 but is growing much faster than the other businesses in this segment. App Store gross revenues exceeded $20B in 2015, which implies that sales were up 40% - 47% or 4-5 times faster growth than the entire service business. In fact, it appears as if almost all the growth in the service business last year came from App Store. That growth was down slightly from 50% in 2014.

Apple's cut on App Store is 30%, which is roughly the same as for the company's other service businesses. The graph below shows that App Store revenue growth has been pretty consistent since 2013.

Source: Computer World
This can be attributed to Apple's huge success in the Chinese market where the company has been enjoying huge growth. App Store revenue in China doubled between 2014 and 2015:

AAPL-2

Source: App Annie

China overtook the U.S. in late 2014 in terms of App Store downloads. The country is poised to overtake the U.S. in App Store revenue in just slightly over a year. The popularity of iPhones and Apple products in China is, of course, the reason why App Store has become such a hit there. Further, there seems to be a radical shift in the mindset of Chinese consumers regarding the need to pay for software. China has in the past been notorious for software piracy but this could be changing. China has consistently been Apple's fastest growing geographical revenue segment and is helping to keep Apple's growth decent even as growth in its domestic market dries up.

Investor Takeaway

Many investors do not usually pay a lot of attention to Apple's service business choosing instead to focus on its hardware business. But the business has been contributing tangibly on the bottom line and is poised to become even bigger in the coming years. Apple's service business is poised to become a very significant contributor to Apple's bottom line growth in the years to come, which is very important for the company and its investors now that its core iPhone business is beginning to slow down.

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