Different Polish, Same Apple

Despite sputtering sales, the iPhone continues to rule an empire that will be slow to change.

Wall Street and Tim Cook want investors to look at Apple and see an orange. 

There has been a growing focus recently on Apple's "services" business, which generated 9 percent of the company's revenue in the last year, or more than $21 billion. The money represents Apple's share of sales of digital music and TV downloads on iTunes, purchases on the App Store, subscriptions to Apple Music, AppleCare warranties and digital file and photo storage on iCloud. This side business for Apple rings up more sales than Starbucks does in a year. Not too shabby. 

A developing investment theory is that this business is transforming Apple into something resembling Netflix, AT&T or other companies for which people pay regularly for a continuing service. Investors tend to love 1 businesses with a predictable stream of money coming in the door and not, say, consumer hardware companies whose fortunes rise and fall with the release of each shiny new gadget.


While Apple's services business is big and has the potential to be much bigger, it is premature to say Apple is changing into a different variety of fruit.

Many of Apple's services are sporadic purchases that won't sustain company revenue if the iPhone growth machine sputters to a halt. Too many them simply aren't good enough -- cough, iTunes; cough cough, Apple Music -- which should restrain hopes of a coming Apple services juggernaut. And if the company wants investors to start valuing Apple like they do Web services companies such as Netflix, Apple needs to dole out more financial metrics to prove its services are as recurring as online video subscriptions. 

Apple itself is intentionally feeding the attempted shift in investment philosophy. For the first time, the company in January disclosed that more than 1 billion Apple devices were in active use. The implication was that Apple has the power to persuade people who own those billion gadgets to buy more of its digital doodads. "Financially it provides a great potential opportunity," Cook said in a February interview with Fortune

It's hard to quibble with $20 billion in revenue, but there's less than meets the eye. Based on some rough math around Apple's disclosures of App Store billings, the biggest component of Apple's services revenue is from App Store purchases. There are two problems with the app dependence. One, the pace of sales growth on the App Store appears to be slowing, from 50 percent to the 40 percent range in one year. 

Two, it's hard to imagine the App Store becoming a steady stream of sales like a monthly Netflix bill. Apple also hasn't addressed the relationship between sales of devices and services. Do customers buy more app downloads over time, or do they make a flurry of purchases when they buy a new iPhone and then few or even none?

The same device dependency question applies to the company's AppleCare warranty program, which Credit Suisse estimates is the second-biggest component of Apple's services revenue. The company isn't likely to sell a device warranty unless it sells a new device.

App Dependence

Apple generates the vast majority of its services revenue from App Store downloads and AppleCare warranty sales, which are most likely tied closely to sales of iPhones and other Apple gadgets.

Source: Credit Suisse estimates

Note: Revenue estimates are for calendar year 2015

To get credit for the potential of its services business, the notoriously secretive Apple also needs to open up more. Even basic questions about the habits of Apple device owners remain a mystery. One simple one: Does an iPhone owner spend more on iCloud, Apple Music or App Store purchases over time or not?

If Apple wants investors to believe it's more than a hardware company, it needs to give more metrics that are commonplace for Web services or subscription software companies, like average revenue per user or lifetime customer value. Sometimes those numbers are bogus, but they do give outsiders better clues about what revenue is predictable. 

Services Sales Lag

Until a recent flip, Apple's revenue from digital services like apps had been growing more slowly than sales of its iPhone business, which is seven times larger.

Source: Bloomberg

Note: Apple's fiscal year ends in September

The company has mostly treated its services as features to improve the selling point of its devices, but Apple also could do much more if it wanted to maximize average revenue from each user. A customer who buys a Rihanna song on iTunes could receive pitches to buy her biography or a concert video from Apple, too. People are used to this kind of cross-selling from Amazon, but I'm not they would like this kind of pushiness from Apple. 

It can't be a coincidence that Apple found enthusiasm for services just as sales of iPhones, iPads and Macs are all expected to decline this year. Until Apple can prove its services business can stand independently from its devices, Apple remains a hardware company. Full stop. 

-- Chart assistance by Rani Molla

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. The ardor lasts only as long as the businesses have growing sales. Telecom companies don't fit the bill. 

To contact the author of this story:
Shira Ovide in New York at sovide@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net

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