Apple Q1 Earnings Review: A Closer Look At How The Services Business Is Faring

by Trefis Team
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Apple (NASDAQ:AAPL) published its Q1 2019 results on Tuesday, reporting that sales of the iPhone declined by 15% year-over-year amid significant headwinds in China, where overall revenue dropped by close to 27% year-over-year, and a lengthening smartphone upgrade cycle in western markets. Considering the declining sales of its flagship product, which accounts for about 60% of its revenues, the company is looking to change the narrative around its performance, withholding unit sales data for the iPhone and other products while providing more transparency surrounding the fast-growing Services business. Accordingly, in this note we focus on the Services business and where it is headed.

We have created an interactive dashboard analysis on Breaking Down Apple’s Services Revenue. You can modify the various drivers to arrive at your own estimates for Services revenue.

Strong App Store Sales, Subscription Growth

Apple’s Services revenues grew by about 19% year-over-year to $10.87 billion, driven by strong app sales and a growing number of digital subscriptions. While Apple noted that its App Store had its strongest Christmas week ever during 2018, the number of paid subscriptions on its platform grew by roughly 120 million compared to a year ago, to over 360 million. The company has indicated that the metric could rise to over 500 million by 2020, considering the current momentum. While there have been some recent moves by the likes of video streaming giant Netflix to stop in-app subscriptions to avoid Apple’s commissions, it’s unlikely that similar moves from other players will have a material impact on Services revenue. For instance, Apple notes that the mix of subscriptions apps is very diversified, with the largest of them accounting for just 0.3% of its total Services revenue.

Growing Installed Base

Other services such as Apple Pay are also gaining traction. Apple said that the payment service witnessed over 1.8 billion transactions in the holiday quarter, which is over twice the volume it saw a year ago. The company also indicated that revenue from its cloud services expanded by 40% year-over-year in the quarter. The size of the installed base remains a crucial driver of Apple’s Services business, and the company will now disclose the metric regularly going forward. At the end of Q1, Apple’s overall installed base stood at 1.4 billion active devices and the active installed base for the iPhone stood at 900 million, growing by 75 million over the last 12 months.

Services Margins Are Expanding

Apple also provided more color on its Services margins, noting that gross margins for Services stood at 62.8%, marking an increase of about 500 basis points year-over-year and 170 bps sequentially due to favorable sales mix and higher scale effects. This compares to margins of about 34.3% for the company’s hardware business. While Apple didn’t provide a sense of where margins could be heading, it’s worth noting that revenues from the App Store and third-party subscriptions are likely to have higher margins since they are booked on a net basis, while offerings such as Apple Music and iTunes are likely to have lower margins, due to meaningful content costs. We believe it’s possible that Services margins could face pressure in the medium term, largely due to foreign exchange headwinds. Apple noted that about 60% of its Services revenue comes from outside the U.S. As the company typically doesn’t re-price its services for foreign exchange changes internationally, it could face pressure if the dollar strengthens further.

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