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If there was a bright spot in the disappointing (relatively speaking) quarterly results that Apple Inc. delivered last week, it was the company’s services division, which turned out to be its second largest revenue-generating category from Jan. 1 to March 26, in addition to delivering its highest-ever numbers.

“The services business is powered by our huge installed base of active devices, which crossed 1 billion units earlier this year… [and] are a source of recurring revenue that is growing independent of the unit shipments we report every three months,” Apple CEO Tim Cook said during a conference with investors and the media. “In fact, the purchase value of services tied to our installed base was a record $9.9 billion in the March quarter, up 27 per cent over last year.”

Despite what he acknowledged as “ongoing macroeconomic headwinds,” Cook said he believed that Apple’s future was bright, thanks in part to services such as Apple Pay, which is currently available in more than 10 million locations around the world and adding 1 million new users per week; the App Store, which he said had delivered a revenue increase of 35 per cent over last year; and a series of acquisitions that he said were accelerating the company’s product and services roadmaps.

During the conference call’s question-and-answer portion, however, when a listener asked if services could be viewed as a primary source of income for Apple moving forward, Cook gave an evasive answer.

“We want to have a great customer experience,” he said. “Overwhelmingly, the thing that drives us [is] to embark on services that help that and become a part of the ecosystem. The reality is that in doing so, we have developed a very large and profitable business in the services area. And so we felt last quarter and working up to that that we should pull back the curtain so that… our investors could see the services business both in terms of the scale of it and the growth of it… It’s huge, and we felt it was important to spell that out.”

Brian Blau, technology research firm Gartner, Inc.’s lead Apple analyst, says that in his opinion, it’s quite clear that Apple will be relying more on services in the future, though he notes that services have always played an integral role in Apple’s business model.

Brian Blau
Brian Blau, Gartner’s lead Apple analyst

“Apple’s placed a lot of priority on providing quality devices… but they also create an ecosystem for others to flourish using those devices,” he says. “You could say the apps have been the real lifeblood of the iPhone ecosystem this whole time. And because brands and apps have responded that way, Apple can think about services as a potential major revenue source.”

That said, he believes that Cook’s remarks could also be seen as an indication that Apple is taking a different view of its business model, one that will position the growth of its services division separately from the revenue generated by its devices.

“Essentially, [Cook] said that services can do really well on their own, despite the fact that they’re not selling more iPhones, because the people who have iPhones already… are going to be the audience, and that audience is quite big at this point for Apple,” Blau says. “It’s simplistic in a way, but Apple has always done a pretty good job of taking on an initiative, building a lot of infrastructure around it, and making it stand as a proper part of Apple’s business, and if that’s the intent for their services, as they seem to be indicating, then I think that’s exactly what we’ll see over the coming years.”

Blau says the most direct answer to whether Apple could begin focusing on services would have been another question: Can the company’s services generate enough revenue to make up for the shortfall in iPhone sales?

The answer is yes, he says: software can have much higher profit margins than hardware, because hardware has fixed costs, whereas software costs are much lower beyond initial research and development.

“If your service does well enough, the revenue will greatly outweigh the initial R&D because you can sell your service over and over and over again and there are very few recurring costs, especially around distribution,” he says. “Yes you have to pay for infrastructure and bandwidth, but the costs are quite a bit different from the shipping of physical products to somebody.”

At which point the question becomes: could Apple’s services generate high enough profit margins?

“I have to say, it’s hard to see how that’s going to happen in the short term, but over the longer term… I think that there could be a really nice mix between iPhone hardware sales and software services,” Blau says. “I don’t think that Apple has any intention of making services the main revenue stream of the company – they certainly have lots of other efforts… but I think they would strive to have a good mix between the two, and that would actually lessen their risk across the board on everything.”

Our thanks to investment research platform Seeking Alpha for the transcriptions from Apple’s April 26 quarterly results meeting.



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