Apple Services slowdown in Q3 could worry investors

Apple CEO Tim Cook speaks during the Apple Worldwide Developers Conference (WWDC) at the San Jose Convention Center in San Jose, Calif., on Monday, June 4, 2018.

Josh Edelson | AFP | Getty Images

For more than half a decade, Apple has touted its services business as a growth engine that will offset smartphone saturation and deliver healthier earnings to investors.

This story may be losing some of its power.

In its quarterly earnings report on Thursday, Apple beat on the top and bottom lines. But the services sector was a weak spot in an otherwise better than expected report. The unit rose 12% from a year earlier to $19.6 billion, behind analysts’ average estimate of $19.7 billion, according to Refinitiv.

It was also the slowest growth rate since the fourth quarter of 2015 for the services unit, which includes Apple Music, iCloud storage, App Store revenue, Apple Pay and warranties. The current quarter does not look any better. Apple Chief Financial Officer Luca Maestri said that in the September period, services business would grow less than 12% due to macroeconomic conditions and a strong US dollar.

Apple shares rose in extended trading on Thursday on strong iPhone and iPad sales, which beat estimates. But Wall Street has reason to worry given the slowdown in services, which grew 27% in fiscal 2021 and 16% in 2020, the first year of the pandemic.

Investors generally like Apple’s shift to services because products are more profitable than hardware and often generate recurring revenue. The unit had a gross margin, or profit remaining after accounting for cost of goods sold, of 71.5% last quarter, compared to Apple’s overall gross margin of 43.3%.

Morgan Stanley analysts wrote earlier this month that Apple’s long-term valuation could increase by 30% if the company focuses on making its current customers profitable through expanded services.

“We believe Apple shares undervalue the lifetime value of an Apple user,” Morgan Stanley analyst Erik Woodring wrote, citing growth in services as a key investment driver.

Maestri said the services business performed in line with its expectations. And even with growth slowing to 12%, it still experienced more robust expansion than the overall company, which grew 2%.

Apple CEO Tim Cook said the services division was affected by the economic situation. In particular, he cited the company’s advertising business, which is one of the smaller services.

“Digital advertising has clearly been impacted by the macro environment,” Cook said. “It’s a mixed bag in terms of what we believe we saw.”

The Covid-19 shutdowns may also have made service growth “lumpy,” making year-over-year comparisons difficult, Maestri said.

“There have been closures and reopenings etc.,” Maestri said. “It is therefore very difficult to speak of a stable growth rate for our services business.”

Maestri said the number of iPhone users continues to grow, suggesting the service business can continue to grow by attracting new customers. He added that music, cloud services, AppleCare warranties and payments all hit record revenue levels in the quarter.

The company said nothing about licensing fees, such as payments Google makes to Apple to be the iPhone’s default search engine, or revenue from the App Store. Analysts say these are some of the most important service components.

LOOK: Tim Cook is the best operator in the tech sector

Leave a Comment