- Apple Services has become Apple's second largest category after the iPhone.
- Apple Services will continue to be one of Apple's growth catalysts.
- There is untapped value in Apple's 1 billion active devices. Apple Service is unleashing that value.
You define a company by the product category that constitutes the majority of its revenues. This is the biggest challenge with Apple Inc. (NASDAQ:AAPL). As of Q2 2016, the iPhone category accounted for ~65% of Apple's total revenues. This is why the ~16.3% y/y decline in iPhone units sold was concerning.
Nonetheless, we also need to define Apple's growth by its fastest growing category. For Apple, that category is not the iPhone or iPad or Mac but Apple Services. Apple Services constitutes revenues from Internet Services, AppleCare, Apple Pay, licensing and other services.
The $5.991 billion sales from Apple Services' accounted for ~12% of Apple's total revenues in Q2 2016.
- iPad accounted for ~9% ($4.413 billion)
- Mac accounted for ~10% ($5.107 billion)
- Other Products accounted for ~4% ($2.189 billion)
Making Services Apple's second largest product category by revenues.
In addition, Apple's Services revenue grew by 20% y/y. Ony second to Other Products, which grew by 30% y/y. In comparison, the iPhone, iPad and Mac categories declined by 18%, 19% and 9% y/y, respectively.
Therefore, to evaluate Apple moving forward, we need to evaluate the growth potential of Apple Services.
Why Apple Services will continue to be one of Apple's growth catalysts
"Now that we have reached this milestone of 1 billion active devices, we felt this would be a great opportunity to share more information on what has become one of the largest service businesses in the world." - Tim Cook, Apple's Q1 2016 earnings call transcript.
First, Apple is and has always been in the "user experience" business. From combining a typewriter with a TV monitor to putting a 1,000 songs in people's pockets, Apple has always attempted to perfect user experience.
Therefore, whether Apple Services is categorized as an add-on or as a standalone, all that matters is user experience.
But to maximize user experience, the hardware, software and services ought to be perfectly synced.
This is why Apple's 1 billion active devices are critical. Apple has developed a complex and large ecosystem, but the company has not optimized its revenues from this ecosystem. Apple can maximize revenues by selling more hardware and services to its ecosystem.The more people Apple can keep engaged and glued to its products, the more revenues it can realize from them. Apart from hardware, Apple can also focus on developing and selling services that resonate with its customers. For instance, how its hardware and software allow people to take amazing photos, surf the internet, do their work, connect with family and friends etc.
Second, Apple Services will continue to be successful because it is built on a formidable hardware foundation. Apple is the most valuable brand in the world. By 2015, its brand was worth $145.3 billion, up 17% from 2014. For this reason, it is easier for Apple to successfully integrate hardware, software and services because people all over the world are familiar with the brand. Enabling it to make user experience better and further grow its service business.
Third, without owning the hardware and the software, competitors might not always build their hardware and software to be perfectly compatible with your services. This is why owning hardware, software and services is a competitive advantage for Apple. It enables the company to develop the compatible hardware to its software and also enables Apple to sell more services that help improve user experience.
Fourth, integrating hardware, software and services is critical as the smartphone technology plateaus. Reasons for people to upgrade to a new iPhone will start to shift. Among them, things like better services might start to influence people's decisions to upgrade.
Conclusion - the untapped value
We have always attributed great value to Apple's ecosystem. This is because a large ecosystem allows Apple to sell more of its products to its loyal customer base. But what exactly does this mean? How do you make money from people who are not upgrading? How do you make money from people who do not want to own more Apple hardware?
All the aforementioned questions point to the untapped value in Apple's ecosystem. This is why Apple Services is critical moving forward. They allow Apple to unleash this untapped value in its ecosystem. Whether its through iTunes, Game Center, iCloud, AppleCare or Apple Pay, the great value proposition of Apple Services is to develop more services and consumer products that they can add to their ecosystem to optimize margins. This will be done by creating a seamless experience and the best user experience possible.
In addition to the margin expansion story, the other advantage that Apple's Service has is that it is a source of stable and growing recurring revenues.
"As we discussed on this call in January, those 1 billion-plus active devices are a source of recurring revenue that is growing independent of the unit shipments we report every three months. In fact, the purchase value of services tied to our installed base was a record $9.9 billion in the March quarter, up 27% over last year, accelerating from the 24% growth rate we reported in the December quarter." - Timothy Donald Cook - Chief Executive Officer & Director. Apple Q2 2016 earnings call.
They have built up a huge installed base around their main platforms: iOS, Mac OS, watchOS and tvOS. The relationship with most customers does not stop when they buy their first iPhone. Customer loyalty is high. In addition, Apple has had a record number of switchers from androids to iPhones. This is important because as long as switchers and upgrades are high, Apple can grow even if the smartphone landscape is not growing as fast. Apple Services will be a great asset for Apple to unleash the untapped value in its ecosystem.