Apple: Why services are in the Q1 earnings spotlight

Apple executives talk a lot about the growth of the company’s services business, which includes Apple Music, Apple TV Plus, and iCloud. Taken alone, the unit’s $46.3 billion in annual revenue would place it in the top 70 of the Fortune 500 list of biggest public companies.

But Apple’s services business is complicated—more so than merely selling subscriptions and collecting easy profits. The division is critical for getting people to buy Apple devices, and some of the unit’s elements, in fact, lose money, according to analysts.

“They all have different earning potentials,” Creative Strategies analyst Tim Bajarin says about Apple’s many services.

Services will undoubtedly be a big focus when Apple reports first fiscal-quarter earnings on Jan. 28. Investors will be looking at whether the unit’s revenue growth is accelerating—last year it increased 16%—and whether new services are catching on with subscribers.

Analysts generally agree that it is. Bajarin, for example, estimates the company will report $14 billion in fiscal first-quarter services revenue compared with $10.9 billion during the same period in 2018.

Last year, as part of a major strategy shift under CEO Tim Cook, Apple doubled down on services. The company premiered its Apple TV Plus video-streaming service to compete against Netflix and debuted the Arcade video-game streaming service to challenge similar ones from Google and Microsoft.

At the same time, some of Apple’s existing services showed huge growth, at least in terms of users. Apple Music, for instance, doubled its paid subscribers to 60 million in 2019 from 30 million in 2017. Meanwhile, the company’s four-year-old News service surpassed 100 million active users at the end up 2019, up from 50 million in March.

That growth, along with strong sales of AirPods and Apple Watch, has helped to propel Apple’s shares to stratospheric levels. Over the past six months, its shares have gained 53%.

A deeper dive

Apple doesn’t disclose profits for its services division, but analysts suspect it’s quite high.

Gross profit margin—the difference between sales and the cost of generating those sales—was about 64% for services last quarter, double the 32% gross profit margin for Apple devices, Apple reported last year.

Loup Ventures analyst Gene Munster says Apple’s App Store, to use just one services business as an example, has a 90% gross profit margin on the revenue it collects from apps and in-app purchases. It keeps costs low by merely taking a cut of the revenue generated from those apps, usually 30%.

But the picture is quite different for services that Apple directly manages. For instance, Munster said that Apple has spent $2 billion on programming for Apple TV Plus, which debuted in November. Over the next several years, the total amount spent could rise to $5 billion, he said.

Because of the high cost, turning a profit on Apple TV Plus will be impossible for at least a few years, said Ed Barton, chief entertainment analyst at Ovum.

It’s unclear how many people are paying $5 monthly for an Apple TV Plus subscription. Complicating the financial calculation is the fact that Apple has given an undisclosed number of free subscriptions to customers who have bought its devices.

Simon Dyson, an analyst who focuses on music at Ovum, thinks Apple Music faces even bigger financial challenges. The streaming music service has a large number of subscribers—60 million—but it also has high costs.

Apple keeps just 40% of the $10 per month it charges subscribers while the remaining 60% goes to music rights holders.

“[Apple Music] is unlikely to have registered much of a profit if at all,” said Dyson.

It’s a similar story with Apple’s Podcasts, Arcade, and other streaming content, which Dyson says haven’t generated much revenue. Ultimately, analysts said Apple’s App Store, its iCloud storage, and its mobile payment service Apple Pay, generate much of the services division’s profit.

Focusing on hardware

But there is more to services than profits. Apple uses its services business to get people to buy its hardware, analysts pointed out. Customers who are loyal to Apple’s iCloud, for instance, often stick with iPhones or Macs so they can easily move their content to new Apple hardware and sync data across devices.

“Everything is designed to drive and retain hardware purchasers, and the ecosystem of Services and content is a critical part of that,” Barton says.

Looking ahead

Services should continue to grow in 2020 and beyond, according to Barton. At the end of 2019, Apple had 450 million subscribers to all of its services, and he believes that will increase to more than 500 million by the end of this year.

Currently, Apple’s services business accounts for nearly 18% of overall revenue, but should jump to 20% or more at the end of 2020, Munster says. More importantly, it will represent 35% of Apple’s profit, up from about 30% last year, according to Apple.

With hardware sales, and especially iPhone sales, slowing, Apple has needed another division to pick up the slack. The rise of Apple’s services business comes just in time.