Google is said to have contributed 25% of Apple Inc's operating profit growth in the last two years.
Services is one of the fastest growing segments for the Cupertino based tech giant Apple Inc (NASDAQ:AAPL). In the latest quarter, services segment revenues grew by 22%, much higher than the 3% revenue growth in iPhone segment and slightly lower than 23% revenue growth in other product segments. So, what is driving this strong growth inside the services segment? As we have covered earlier, in the third quarter, App Store was the biggest growth contributor. Apple CFO Luca Maestri stated on the Q3 con-call that "The App Store was a major driver of this performance."Another likely growth driver was Apple's partnership with the search giant Alphabet Inc-C (NASDAQ:GOOG).
The iPhone maker and Alphabet compete fiercely with each other on several fronts, including smartphone segment, autonomous cars and now content programming. However, there are areas in which they also have partnerships. Google is currently the default search engine on iPhones and iPads. While this arrangement allows Google to generate billions of dollars in revenue by serving search ads to iOS users, Google, in turn, pays huge licensing fees to Apple. According to analysts, Google pays out approximately 34% of its revenue from iOS search to Apple. In 2014, the search giant had paid over a billion dollars to Apple for the deal, which ensured it remains the default search engine on iOS products. And now analysts estimate that this fees would have grown multifold since then.
Google has contributed a significant chunk of Apple's profit growth.
Based on his analysis, Bernstein analyst Toni Sacconaghi Jr. estimates that Google now pays around three billion dollars in licensing fees annually to Apple, 3x growth in three years. Sacconaghi has based his estimates on multiple factors including 3x growth in Google's mobile revenues and the rise in Googe's" distribution Traffic Aquisition Cost (TAC)". Almost all of the licensing fees paid by Google is a profit for Apple. So, the $3 billion licensing fees is likely to contribute 5% of Apple's operating profit, but an even higher share of operating profit growth. According to Sacconaghi Jr., "Given that Google payments are nearly all profit for Apple, Google alone may account for 5% of Apple's total operating profits this year, and may account for 25% of total company OP growth over the last two years.". So, Google has emerged as a significant contributor to Apple's operating profit growth and in turn Apple stock price.
What does this mean for Apple Inc?
Given the very high margin nature of licensing revenues, growth in licensing fees will not only add to the top line but will help in expanding profit margins. Licensing fees from Google will continue to grow, with growth in Google's traffic from iOS devices. According to estimates, iOS contributes almost 50% of Google's mobile traffic, which gives Apple a significant bargaining power over Alphabet Inc. Apple could also enter into similar licensing deal with other players, making them "default applications within iOS – think Uber (vs. Lyft) or Amazon (vs. Jet) or Facebook (vs. Snapchat/Twitter) or Google Maps (vs. Mapquest) or WeChat (vs. Line) or Netflix (vs. Hulu),". If licensing agreement with Google is anything to go buy, other licensing agreements could mean hundreds of millions of dollars to Apple's bottom line and drive its margins higher.
Apple stock remains a good buy.
Driven by the "iPhone SuperCycle" expectations and strong earnings growth, Apple stock has gained over 35% in the year to date period. While there are some concerns around Apple's valuations, there are multiple factors which could continue to drive Apple stock higher. According to RBC analysts Amit Daryanani and Amitesh Bajad, Apple stock is likely to head higher going into the iPhone launch. "From a near-term perspective, we would note historically AAPL stock has done rather well into product launches with median return 90 days prior to launch @15.6% (median outperformance vs. S&P500 at 10.9%). This, we think, sets up AAPL well heading into the product cycle this time around." they wrote in a note. Apple stock remains a good buy. Apple stock is part of our top stock picks which has outperformed the Nasdaq Composite by over 135%.
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