Apple Services: The Future Growth And Revenue Machine

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About: Apple Inc. (AAPL)
by: D. H. Taylor
Summary

iPhone sales have stagnated to the point where Apple does not even report the numbers anymore.

The growth rate and the margins for Services are outpacing the rest of the company and may very well contribute the same gross margins as the iPhone for Apple.

Long term, the ability of Services to continue to contribute to Apple's top and bottom lines may push P/E ratios to above-average rates.

At the beginning of 2017, Apple (AAPL) set out with the goal of doubling their Services revenue of FY2016 by FY2020. They are on track to achieve that goal. This quarter, the company's Services margins were disclosed for the first time coming in at 62.8%. If the company hits its Services goals and can maintain the same margins, there is a considerable amount of profit potential available. The long-term upside growth of the company would be tremendous considering that Services is primarily digital in nature and is comparatively larger than the company's overall margins of 38%. Because of the outsized margins, in a matter of a few short years, and considering the potential of continued flat sales in iPhones, Services' margins will match the contribution of the iPhone. Long-term investors will be well rewarded from this.

After a heavy sell-off of 35% in December, the stock has been moving back upwards:

Apple Stock: AAPL

The Latest Earnings

Apple's Q1's earnings came in beating EPS and revenue estimates with revenue down 5% Y/Y. What I wanted to focus on was the potential of Services and Payments.

In FY2016, Apple reported a total of $24.348 billion from Services. They are hoping to hit $48 billion in revenue by FY2020. For the past four quarters, the company is at $37.190 billion from these four results:

  1. Q1: $8,471M
  2. Q2: $9,190M
  3. Q3: $9,548M
  4. Q4: $9,981m

The Q/Q growth rate is not linear but it is approximately 7%. Given that, the company would be slightly shy of the $48 billion mark by a rounding percentage. At that number, and if margins maintained the same levels, margins for Services would be $30 billion for the company to work with in 2020.

Given the same trajectory for Services, Apple's Services division could account for $100 billion in revenue by FY 2023. This is echoed by researchers at Morgan Stanley, researchers who have been far more accurate than their counterparts in predicting Services growth rates and the ability of the division to add to Apple's bottom line.

iPhone sales fell 15% Y/Y for the past quarter. And, yet, Apple beat on revenue and earnings despite having the lion's share of the revenue pie. Here is the breakdown of the different divisions in Apple and their revenue breakdown:

  • iPhone, $52B (-15% Y/Y).
  • Mac, $7.4B (+9% Y/Y).
  • Wearables, Home, and Accessories, $7.3B (+33% Y/Y).
  • iPad, $6.7B (+17% Y/Y).
  • Services, $10.9B (+19% Y/Y).

Services is poised to be the growth machine for Apple in the coming quarters. They are the second biggest division; albeit, not by much versus the other divisions and completely overshadowed by iPhone sales. If you added up the other divisions and their revenue, it is ~$30 billion versus iPhone's $52 billion.

If you reverse the math on the numbers above, Apple's overall margins are 35.4% without Services. (Add all of the divisions: $84.3B. 38% of that is $32B. Subtract Services from the total revenue and from margins and you get $73.4B for Revenue and $26B for margins). If devices were all relatively the same margins at 35% and iPhone sales remained flat until 2023, then iPhone's $200B in sales at that time along with Services $100B would add $70B and $62B to Apple's coffers, respectively. That is how important Services could be to Apple. As for how long iPhone sales will remain flat? Hmmm...

iPhone sales have stagnated as the mobile phone market has matured. If Services actually does hit $100 billion by FY 2023 and their margins are still 62%, this would be an outsized profit margin growth opportunity compared to the other devices that Apple sells. This is logical in the sense that devices involve manufacturing, shipping, warehousing, and distribution. On the other hand, Services are digital in nature, such as "Internet Services, AppleCare, Apple Pay, licensing, and other services".

Apple has also addressed the "Planned Obsolescence" issue with Apple devices, namely that every few years the upgrades to the software make older devices obsolete. Now, more older devices than ever are running newer software. This is great news for people who do not want to be forced to upgrade a perfectly working device every few years whether they wanted to, or not. But, this is bad news for the bottom line of Apple and the iPhone growth rate. So, the company was forced to switch gears and now finds its growth in Services.

Active Apple devices are well over 1.3 billion, having cleared that number one year ago. This is more than 1.3 billion potential Services customers that are actively engaged with their devices and could potentially add considerably to revenues. This is where the potential growth machine of Services comes from.

However, I am still wondering about Services overall ability to carry the weight of Apple. iPhone sales are what have propelled Apple to the behemoth that it is. Even if Services grows to $100 billion per year in 2023, that would be ~50% gross revenues of what iPhone sales are doing right now. But, the margins are nearly double and the growth is on track to hit these numbers. And, perhaps Apple figures out a way to grow iPhone sales again. That would mean even more potential for revenue for Apple.

But, then again, maybe iPhone sales do the unthinkable and start a long, slow decline. After all, if your device is running the most current versions of software and the device continues to perform well, what motivating factor does anyone have to upgrade? This may very well be the driving factor of Apple looking to increase its revenue from different areas of their business.

I have pointed out a few times that I felt the Services division would help in propelling Apple's revenue growth. The combination of high growth rates, as well as the nearly double margin percent, makes the division a key factor to focus on. I believe that there is a significant growth opportunity here for Apple and that the potential outsized growth rate of Services will play in nicely for Apple. I am long Apple and am looking forward to the gains that could come from this. The larger margins are going to trickle through to the bottom line in a manner that is likely to push the EPS rate above average. As an investor, I am quite comfortable with this.

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.