The Tipping Point: Strength Of Apple's Services Revenue Comes Into Focus

| About: Apple Inc. (AAPL)

Summary

Apple's ecosystem becomes increasingly material, exceeding the profit margins of all other product categories.

Services revenue is increasingly sustainable and consistent, and estimated to grow 18% in 2017.

Higher profit margin from Services category will increase overall profitability.

We've long held that Apple's (NASDAQ:AAPL) products are gateway devices into the Apple ecosystem, one powered by Apple's operating system in its various iterations. As each device links with the ecosystem, the ecosystem becomes your digital world and the network affects compounds.

This ecosystem provides Apple with certain competitive advantages. First, it provides an inherent "stickiness" to the company's product lines, as users are loathe to switch operating systems when their programs, apps, and media content become voluminous and entrenched in a particular type of software. Second, once in the ecosystem, everything is funneled through Apple. The company's products become the gatekeeper between consumers and vendors. On one side stands you the consumer, one that is demographically wealthier and statistically a higher user of Internet services, and on the other side are vendors (e.g., music, movie and media companies, software companies, goods and service providers such as Uber, Gilt, Airbnb, etc.). For each transaction funneled to you, Apple can potentially take a cut, and the profit margins on it are staggeringly high.

In the first quarter of 2016, Apple made a concerted effort to discuss revenue derived from services, which is really another way of saying the monetization of Apple's ecosystem. Since that discussion, the growth in service-related revenue has really proven out.

Apple's 2016 fiscal year marked what we call the turning point; the point where revenue from monetizing the ecosystem grew faster and generated a higher profit margin than all other revenue categories. To understand this, let's take a deeper dive into Apple's services revenue.

Apple's Services

The company defines services in its 2016 Form 10-K to include revenue from Internet Services, AppleCare®, Apple Pay, licensing and other services. Internet Services is further defined as iTunes Store®, App Store®, Mac App Store, TV App Store, iBooks StoreTM and Apple Music® (collectively "Services"). As Apple's Services has evolved, one-off transactional services are now complemented by sustainable subscription, licensing and insurance revenue.

One-Off à Sustainable

Transactional

Subscription / Licensing

Warranty / Insurance

iBooks Store

TV App Store

AppleCare

iTunes Store

Apple Music

iCloud

Apple Pay

App Store

Mac App Store

Click to enlarge

Source: Open Square Capital Data

By further monetizing the Apple ecosystem, the company is able to generate material and sustainable sales and profits, one that grows as AAPL's hardware sales continue to widen the net.

Services Revenue

We've regrouped Apple's revenue data for the past three years, and separated it into iPhone sales, Services and a third category called "All Others", which includes Macs, iPads, and "Others" (e.g., Apple TV, Apple Watch, etc.).

2014

2015

2016

iPhone Revenue

$101,991

$155,041

$136,700

YOY % Growth

52%

-12%

All Other Revenue

$62,741

$58,765

$54,591

YOY % Growth

-6%

-7%

Services Revenue

$18,063

$19,909

$24,348

YOY % Growth

10%

22%

Click to enlarge

Source: Apple's 2016 Form 10-K, Open Square Capital Data

In contrast to All Other and iPhone sales, it's fairly clear that the growth in Services revenue has accelerated in the past two years despite the volatility in hardware sales. Drilling even further down, by 2016, Services became the second largest revenue segment for Apple.

2014

2015

2016

iPhone

$101,991

$155,041

$136,700

iPad

$30,283

$23,227

$20,628

Mac

$24,079

$25,471

$22,831

iPod

$2,286

$-

$-

Services

$18,063

$19,909

$24,348

Other

$6,093

$10,067

$11,132

Total Sales

$182,795

$233,715

$215,639

Click to enlarge

Source: Apple's 2016 Form 10-K

Sales, however, are only part of the equation, and what's more important is how the change in revenue mix is affecting Apple. The increasing contribution of higher margin services is increasing the company's overall profitability.

Profitability

On a consolidated basis, Apple's overall profit margin ranges between 38% and 40% in the past three years. The iPhone is generally estimated to have a 40% margin (although Apple does not break out margins for specific product segments).

2014

2015

2016

Total Sales

$182,795

$233,715

$215,639

COGS

$112,258

$140,089

$131,376

Gross Profit

$70,537

$93,626

$84,263

Profit Margin

38.6%

40.1%

39.1%

Click to enlarge

Source: Apple's 2016 Form 10-K

This estimate is likely accurate given that iPhones represent close to two-thirds of Apple's sales and is undoubtedly a large driver for the overall gross profit margins.

For Services, analysts have differing estimates. For example, Piper Jaffray estimates that Services revenue averages gross margins of +60% and Credit Suisse estimates +70%. Our view is low-70%, yet let's assume a mid-point of 65% for conservatism. If so, this is how overall gross profit breaks out.

2014

2015

2016

Gross Profit

$70,537

$93,626

$84,263

Less iPhone Profit

$(40,796)

$(62,016)

$(54,680)

Remaining Profit

$29,741

$31,610

$29,583

Services Profit

$11,741

$12,941

$15,826

% of Remaining Profit

39%

41%

53%

All Other Profit

$18,000

$18,669

$13,757

% of Remaining Profit

61%

59%

47%

Click to enlarge

Source: Apple's 2016 Form 10-K, Open Square Capital Data

As of 2016, we estimate that Services accounted for more than half of the profits from all non-iPhone-related sales. We can see that Services has overtaken All Other profits, which again we define as everything else excluding the iPhone.

Apple's Gross Profit (Services vs. Other)

(in Millions)

Source: Apple's 2016 Form 10-K, Open Square Capital Data

A Fortune 100 Company

This trend should continue in 2017 as Apple's installed user base continues to grow and more services are rolled out. In the Q3 2016 conference call, Tim Cook, Apple's CEO, stated:

"In the last 12 months, our Services revenue is up almost $4 billion year on year to $23.1 billion, and we expect it to be the size of a Fortune 100 company next year."

In 2016, the Fortune 100 company was Northwestern Mutual with revenues of $28.1B (Time Warner (NYSE:TWX) and DuPont (NYSE:DD) were ranked 99 ($28.1B) and 101 ($27.9B), respectively). Achieving $28B in Services revenue would represent an 18% increase from 2016 (note that 2016 Services revenue included a $598M patent settlement from Samsung (OTC:SSNLF), so we've reduced the reported $24.4B by such amount).

Assuming the same 65% margins, Apple will generate an additional $2.4B in gross profits.

2014A

2015A

2016A

2017E

Services

$18,063

$19,909

$24,348

$28,000

Margin on Services

65%

65%

65%

65%

Gross Profit on Services

$11,741

$12,941

$15,826

$18,200

Click to enlarge

Source: Apple's 2016 Form 10-K, Open Square Capital Data

To put $2.4B in additional Services gross profits into perspective, Apple would have to sell the equivalent of 4% (i.e., 9M) more iPhones (assuming 2016 ASP of $645), or double the amount of revenue AAPL aggregates in "Other Products" ($11B in 2016 with a 25% gross profit margin), which include Apple TVs, Apple Watches, Beats Products and Apple accessories.

Note this last point, and it bears repeating. A "mere" 18% increase in Services revenue is equivalent to Apple creating an entirely new pillar of revenue with the same profit margin as its "Other Products", which includes the closely scrutinized Apple TV and Apple Watch. Thus, every dollar of revenue is not created equal. The shift in revenue mix to include more Services will bolster overall profit margins and mitigate the drag from All Other products that exhibit lower margins.

Case in point, assuming the $28B Tim Cook spoke of is realized, even if all Mac, iPad, Apple TV, Apple Watch, etc. sales are flat, combined profit margins (excluding the iPhone) would still be more than 1%. If we were to assume All Other products increased sales by 5%, profit margins would still rise on a combined basis by 0.8%.

Growth in All Other Product Lines (2017E)

2016

0%

3%

5%

Services + All Others Revenues

$78,939

$82,591

$84,229

$85,321

Services + All Other Profit

$29,583

$31,957

$32,370

$32,645

Services + All Other Profit Margin

37.5%

38.7%

38.4%

38.3%

Click to enlarge

So, although two-thirds of Apple's profit is driven by the iPhone, it's important to take note of what's happening to the remaining one-third. Half of those profits are coming from Services, and that half is growing quickly at a mid-to-high teens rate. Services revenue are also much more sustainable, dependable and replete with annuity-like characteristics.

The increase in Services revenue and the higher margins are a large reason why we believe Apple's profit margin is sustainable over the long term, and this is even before we begin discussing new media initiatives and the advent of augmented reality, which we think will drive additional media consumption (read: driving further growth in Services). So when looking at Apple, while many investors will focus on the iPhone dominated core, don't forget Services because in time it will become the juiciest part of the business.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.