Apple Earnings: Services Continues to Crush it

Apple's (AAPL 0.24%) services business continues to soar and boost the company's overall profitability. In this segment from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu, CFA, discuss all the ways that Apple's services business is executing.

Dylan Lewis: Services revenue jumped 18% to $7 billion, and it has been Apple's second-largest revenue stream just behind the iPhone. That's pretty awesome, and I think it's been underappreciated for quite some time. I think the market is starting to wise up to this pretty significant and very high-margin part of Apple's business.

Evan Niu: Right, I definitely think that's what's happening, in particularly if you think about the historical context of the services business. If you go back maybe five years, Apple's whole approach to content, services, and things like that was to basically break even, and offer these things as a way to build its ecosystem and solidify retention period -- it was more of a strategic piece than a profit piece. They used to operate all their storefronts -- they don't really break it out as far as exposures, but they used to very publicly say, "We're really just trying to break even on this stuff. It helps people use the phones and buy the phones, but we're not trying to make a whole bunch of money on it." I think now, that's very much swapped around, because now they are very much making quite a bit of money on these services, and it is becoming a big profit driver. I remember last quarter when we talked about earnings, we mentioned how their guidance had called for a small uptick sequentially in gross margin.

We talked about [how] that's really hard when you're coming off of a holiday quarter, when your revenue comes down from a seasonal factors, you lose a lot of operating leverage, all these things, and it's like, how are they going to actually put up an increasing gross margin? Now we know why, the answer is services, because services are so profitable. CFO Luca Maestri very much said, the mix shifting toward services is really helping profitability. They did put up a sequential increase in gross margin, some 40-odd basis points. I think that's really impressive. That's really the services profitability shining right there. So, four out of the past six quarters, it's been the second-largest business. But, greater than the Mac or the iPad, the iPhone is the only thing that's bigger. So, this is really becoming a very big, large, meaningful business, both in terms of revenue as well as profitability. This is now a $26 billion business on a trailing-12-month basis, and it's also much more profitable than the hardware operations. I think investors aren't fully appreciating it, and I don't think you'll be able to ignore it for very much longer, because like they said last quarter, they're going to try to double this business over the next four years. It's only going to keep growing from here.

Lewis: And it's something that really only continues to grow and get stronger the larger their installed base gets. As they continue to penetrate new markets, services is going to be another tailwind that follows all those iPhone unit sales. It's kind of an add-on in some ways, but also, because it's so profitable for them, certainly something to continue to watch. I think a lot of people are curious as to what's going on with wearables in Apple. We hear so much about the Apple Watch and you see tons of people wearing them. Any updates on that product segment?

Niu: They dropped a few clues. Of course, they obfuscate Apple Watch sales within the "other products" segment. They did say that Apple sales were up roughly double, but without having any context, who knows what that means.

Lewis: It's a meaningless number.

Niu: Yeah, two times? OK, thanks, Tim [Cook]? But, what they did say is, wearables -- it's kind of weird, I'm not sure why they do this, but Apple considers AirPods and wireless Beats headphones as wearable products. I know that technically, wireless headphones are wearables, because you wear them. I'm wearing wireless headphones right now. But, I don't think headphones are what people think of, when you hear the term "wearable technology," you don't jump to headphones. You think about smartwatches and fitness trackers and things like that. He did say that the wearables business is now the size of a Fortune 500 company, which means it's at least $5.1 billion over the past year. With AirPods only recently launching, and it's not clear how much they're bringing in from Beats wireless headphones, but I think it's safe to say that the majority of that revenue is from Apple Watch. So, that's kind of a hint. But, again, they're not really giving away too much, as usual, which is really frustrating. But, maybe eventually, one day, they'll start breaking that out. It's weird, because they've always said, "We don't want to give it away for competitive reasons," but competition in smartwatches is actually declining. People are getting out of the smartwatch market. And there haven't been a whole lot of really strong product introductions. So, competition is actually getting easier. So they should just share the numbers. [laughs]

Lewis: Yeah, it's still tough to parse out what's going on there.