Apple’s Service Business Is Shining, But There Are Risks

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Apple (NASDAQ:AAPL) has been highlighting the robust performance of its service business on its recent earnings calls, as its core hardware sales shrink. Services revenues have expanded by 22% year-over-year over the nine months of fiscal 2016, emerging Apple’s second largest business segment, overtaking the iPad and Mac. The cash cow of the services segment – the App Store – saw its highest ever monthly billings during July, with over $50 billion in cumulative developer payments, while newer business such as Apple Music (15 million+ paying users) and Apple Pay have also been performing reasonably well. The reasons for Apple’s strong showing on the services front are straightforward. Firstly, device engagement is often higher for Apple products compared to Android. Secondly, iOS users typically have higher disposable incomes and are willing to spend more on paid services. That said, Apple does face some significant risks ahead.

We have a $120 price estimate for Apple, which is about 10% ahead of the current market price.

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Services Revenues Are Tied To Device Sales, Which Are Slowing 

Apple’s services business is largely tied to its active device user base (1 billion as of Q1’16) and service revenues are likely to be correlated to hardware sales in recent quarters. For instance, customers often buy the AppleCare plan at the time of their device purchase while potentially loading up more paid Apps earlier in the life cycle of their product. While Apple also garners recurring revenues from services such as Apple Pay, iCloud and Music, in-app and content purchases, this could be lower compared to upfront purchases. This is likely to be problematic for Apple, as shipments for all its major products (iPhone, Mac, iPad) are slowing down, amid competition from lower-priced vendors, a strong dollar and longer upgrade cycles.

Compelling Third-Party Services 

The increasing proliferation of cloud-based services is also likely to be undermining Apple’s historical service ecosystem advantage. There are compelling cross-platform alternatives to most of Apple’s service applications ranging from streaming music (Spotify), messaging (Whatsapp, Wechat) to cloud storage (Dropbox, Google Photos). Moreover, these services offer better network effects, given their larger user bases, which in turn improve data collection, allowing companies to further enhance services. Besides posing a threat to just Apple’s services business, the platform-agnostic nature of these apps could also be reducing the switching costs for consumers on Apple devices, allowing them to look for lower-priced devices which still run the same services.

Monetizing Customers In Emerging Markets Could Prove Difficult 

Apple has been increasingly counting on emerging markets to drive growth by launching lower-priced devices such as the iPhone SE, as smartphone sales stagnate in developed markets. However, we believe that service revenues per device are likely to be significantly lower in these markets for multiple reasons. Firstly, users in developing markets are less likely to spend on paid Apps, which are a big money spinner for Apple (about $6 billion revenue in CY’16, per our estimates). Secondly, pricing for Apple’s internet services in these markets is also significantly lower. For instance, Apple Music costs $10 for a single user in the U.S., while it is priced at just about $1.80 in India. Moreover, there may be little room for Apple to grow in other areas such as mapping, payments, cloud storage and messaging. The Chinese internet services market is dominated local giants such as Tencent, while Facebook and Google hold sway in the Indian market.

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