Unlike a lot of Wall Street analysts who follow Apple, I’m not too excited about Apple’s growth in services revenue. As I’ve written two years ago, Apple’s future is not in services. In fact, the nature of Apple’s services makes them more dependent on hardware sales than ever. What do I mean by that?
Apple Services Are Not True Diversification
Well, Apple’s primary services of Apple Music, iCloud, and the App Store are all dependent on iOS devices. Services are not a stand-alone business that is diversifying Apple’s portfolio. When the base of installed devices goes up, revenue goes up. And more importantly, when the base of installed devices goes down, so does services revenue.
This is in contrast with a company that is truly diversifying. For example, I used to work for the largest casket maker in the United States, Batesville Casket Company. Since casket sales are declining by about 1.5% every year due to rising cremation rates. The parent company, Hillenbrand, decided to diversify in order to offset that revenue loss. We purchased some industrial companies that manufacture highly-engineered pumps and processing equipment. These new businesses in a different industry were growing and able to offset the loss of revenue in caskets. This is true diversification. A drop in one business segment does not impact the other.
This is in stark contrast with Apple’s services business. If the installed base of iOS devices shrinks, the services revenue will dry up. This is exactly the problem I witnessed while working with the Gateway computer company. Our “Beyond the Box” initiative of increasing services revenue collapsed after we started closing our Country Stores and the installed base of computers began to shrink.
The App Store isn’t Designed to Be Very Profitable
A lot of people confuse rising revenues with rising profits. The two don’t necessarily go hand-in-hand.
I’ve long suspected that Apple’s App Store isn’t very profitable. I made the case in July of 2016 where I said the following:
Well, Apple’s primary services of Apple Music, iCloud, and the App Store are all dependent on iOS devices. Services are not a stand-alone business that is diversifying Apple’s portfolio. When the base of installed devices goes up, revenue goes up. And more importantly, when the base of installed devices goes down, so does services revenue.
This is in contrast with a company that is truly diversifying. For example, I used to work for the largest casket maker in the United States, Batesville Casket Company. Since casket sales are declining by about 1.5% every year due to rising cremation rates. The parent company, Hillenbrand, decided to diversify in order to offset that revenue loss. We purchased some industrial companies that manufacture highly-engineered pumps and processing equipment. These new businesses in a different industry were growing and able to offset the loss of revenue in caskets. This is true diversification. A drop in one business segment does not impact the other.
This is in stark contrast with Apple’s services business. If the installed base of iOS devices shrinks, the services revenue will dry up. This is exactly the problem I witnessed while working with the Gateway computer company. Our “Beyond the Box” initiative of increasing services revenue collapsed after we started closing our Country Stores and the installed base of computers began to shrink.
The App Store isn’t Designed to Be Very Profitable
A lot of people confuse rising revenues with rising profits. The two don’t necessarily go hand-in-hand.
I’ve long suspected that Apple’s App Store isn’t very profitable. I made the case in July of 2016 where I said the following:
With Apple’s recent move to cut off affiliate revenue sharing, I’m more confident than ever that the App Store is a close to break-even proposition if not outright losing money. I don’t think Apple would have made the decision to spike affiliate revenue-sharing if the App Store was running a decent profit. I don’t think Apple was trying to increase an already high profit margin. They were trying to avoid an outright loss. Based on my analysis, the app store has a dangerously thin margin at 15%.
Conclusion
So, no, services is not Apple’s future. It won’t give investors the return that they’re looking for and it doesn’t help Apple diversify. So why bother with services at all? Because Apple’s ability to integrate hardware and service design makes Apple devices better. PayPal could have never brought ApplePay to the iPhone without being involved in the design up front. Spotify can’t sync between my iPhone, Apple Watch, and HomePod the way Apple Music can.
Apple the hardware company is getting deeper and deeper into services because they have no other choice. It's good for Apple's customers, not the other way around.
It’s the flip-side of services companies like Google or Amazon getting involved in hardware. The
integration between hardware and services is becoming so tight that it’s much easier if you can control both sides.
Conclusion
So, no, services is not Apple’s future. It won’t give investors the return that they’re looking for and it doesn’t help Apple diversify. So why bother with services at all? Because Apple’s ability to integrate hardware and service design makes Apple devices better. PayPal could have never brought ApplePay to the iPhone without being involved in the design up front. Spotify can’t sync between my iPhone, Apple Watch, and HomePod the way Apple Music can.
Apple the hardware company is getting deeper and deeper into services because they have no other choice. It's good for Apple's customers, not the other way around.
It’s the flip-side of services companies like Google or Amazon getting involved in hardware. The
integration between hardware and services is becoming so tight that it’s much easier if you can control both sides.
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