Every three months, in the run-up to Apple's (NASDAQ:AAPL) quarterly earnings report, the rumor mill starts to buzz with guesses about how many iPhones and iPads it was able to sell. The laser-focus on iPhone and iPad sales is very understandable. In its 2013 fiscal year, Apple derived 53% of its revenue from the iPhone product line and another 19% from the iPad.
There's another reason why pundits zero in on iPhone and iPad sales -- they're easy to see. Anyone can stand outside the Apple Store and see how busy it is and how many people walk out with new iProducts.
The growing adoption of iPhones and iPads has led to skyrocketing sales of apps -- and, to a lesser extent, media -- through the iTunes Store. While these electronic purchases are harder to observe, they represent a game changer for Apple. Rising app and media sales will make Apple's business less seasonal, and they will mitigate the long-term threat of pricing pressure.
App sales keep flying higher
In the last year and a half, Apple has come under scrutiny from investors due to an abrupt slowdown in growth for the iPhone and iPad product lines. In its most recent fiscal year, iPhone revenue growth plummeted from 71% to 16%, while iPad revenue growth fell from 61% to just 3%.
Last quarter, iPad revenue growth rebounded slightly to 7%, on the back of new products like the iPad Air, as well as price cuts for the first-generation iPad Mini. By contrast, iPhone revenue growth slowed further, to 6%.
However, while sales growth has stalled out for Apple's hardware, iOS users are buying more and more stuff through iTunes -- whether it be apps, music, movies, or books. Last year, Apple reported revenue growth of 25% in the "iTunes, software, and services" product line, making it the fastest-growing piece of Apple's business. Revenue of $16 billion represented nearly 10% of the companywide total.
Last quarter, iTunes, software, and services growth subsided to a still-healthy 19% rate -- slightly down from 22% growth in the prior-year quarter. This was enough to maintain its position as the fastest-growing piece of Apple's business.
Two big changes
Based on its recent growth trajectory, the iTunes, software, and services business will represent more than 10% of Apple's revenue this year for the first time ever. The growth of app-related revenue will gradually transform Apple's business in two key ways.
First, whereas product sales are highly seasonal, peaking in the holiday quarter, app revenue is more constant throughout the year. If anything, the seasonality of app sales runs slightly counter to the seasonality of device sales. Last year, sequential growth for the iTunes, software, and services business peaked in the March quarter -- when revenue was falling for every other product line.
All things considered, this is good for Apple, because it will lead to more stable financial results. Eventually -- although this could take many years to play out -- the increasing importance of app and media revenue compared to device revenue could reduce the volatility of Apple stock, which is very sensitive today to rumors about iPhone and iPad sales.
Second, the growth of app and media revenue will gradually insulate Apple from the risk of pricing pressure in the device business. Many Apple investors fear that as cheaper phones and tablets become "good enough," Apple could be forced to cut prices to ensure that its customers stick around. Additionally, even loyal iPhone users could upgrade less frequently if Apple can't provide significant improvements for each new phone.
Pricing pressure has already had a noticeable impact on the iPad product line. Revenue growth has dropped precipitously to the single digits as lower average selling prices offset continued unit sales increases. The same thing could happen to the iPhone eventually. However, Apple could live with lower margins on product sales if device users are providing a reliable, growing stream of app and media revenue.
Foolish final thoughts
For the last few years, the iPhone and iPad have been front and center in the minds of Apple investors. Other devices like the Mac and iPod have received much less attention, and non-device businesses like iTunes and the App Store have been way on the back burner.
However, the iTunes, software, and services line now represents about 10% of Apple's revenue, and is the fastest growing part of Apple's business. As it continues growing in the next few years, it could transform Apple's overall business in two positive ways -- reducing its seasonality and mitigating the company's reliance on high-priced device sales. Investors should welcome this change.
The biggest thing to come out of Silicon Valley in years
If you thought the iPod, the iPhone, and the iPad were amazing, just wait until you see this. One hundred of Apple's top engineers are busy building one in a secret lab. And an ABI Research report predicts 485 million of them could be sold over the next decade. But you can invest in it right now... for just a fraction of the price of AAPL stock. Click here to get the full story in this eye-opening new report.
Adam Levine-Weinberg owns shares of Apple and is long January 2015 $390 calls on Apple. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.