Here’s a Risk to Apple’s Highest-Growth Business

Apple's highest-growth segment faces a host of risks going forward.

Aug 22, 2014 at 6:45PM

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Well, that was quick. Merely a year after the Wall Street Journal reported that apps were a "quickly growing business," a recent Deloitte study article now casts doubt on the future of app sales. While the study focuses on users in the U.K., the results aren't pretty: 31% of all smartphone users do not download any apps in a typical month as compared to 20% in 2013.

In addition, those who do download apps have slowed their pace. The average number of apps downloaded decreased by nearly 22%, and 90% of all people never pay for an app. All in all this is a somber report for a recent high-growth area. Following King Digital's recent disappointing results, for which the company blamed a huge decline in paying customers in its franchise game -- Candy Crush Saga -- it now appears the app-based economy is having a rough time. What does this mean for tech giant Apple (NASDAQ:AAPL)?

Apple's highest-growth business
For those who have been following Apple with a keen eye, you know that during the last four quarters on a year-over-year basis, Apple's highest-growth business has been its iTunes/Software/Services product line. Growing revenue by a 15.9% clip, it exceeded the growth of Apple's highest-grossing product line -- the iPhone -- by nearly 50%, and Apple's total revenue growth by nearly 200%. The chart below gives some context:

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Source: Apple's 10Qs. Revenue figures are in millions. Left Y-axis is revenue and right Y-axis is in percent.

While this segment is working from a smaller base than the iPhone, you can see how it contributed to overall growth. By increasing more than $2.4 billion, this provided nearly 30% of Apple's total revenue growth -- $8.7 billion -- during that period.

Will growth slow?
Compounding the importance of apps to Apple is a precipitous slowing of digital downloads. It appears that, much like Apple's iTunes disrupted brick-and-mortar record shops like Tower Records, the rise of streaming-based music services like Pandora, Spotify, and Rdio are doing the same to digital downloads. As a matter of fact, Billboard reports that in 2013 digital downloads experienced the first year of decreased sales.

While Apple doesn't release inter-product results, a shocking report from Jackdaw Research pointed out Apple's increasing reliance on apps for growth in this category by noting that users were spending more money on apps than on actual content (read: music and movie downloads). In addition, Apple analyst Katy Huberty also noted that iTunes' share of online services revenue would eventually be edged by apps by the fourth quarter of 2013.

Would more real estate help?
While the results are shocking, the cause is never really ascertained. One rather small change Apple could make is to create an iPhone with larger memory. The size of apps and games are growing daily, but Apple's largest iPhone is still 64Gb. The end result is akin to grocery shopping for a home without kitchen cabinets -- perhaps you'd like to buy something new, but don't have any space to store it.

Another potential reason is something called "app overload." Basically, there are so many apps that it is hard for developers to effectively target an audience. According to Ouriel Ohayon, CEO of Appsfire, "If you are not in the chosen 200 to 300, it's very hard to make money in a substantial way on the app store." If Apple could better curate and personify the app experience, this could possibly lead to more app sales.

Final thoughts
On the surface, it looks like there are headwinds for Apple's highest-growth business. Pushed on the content side from both streaming movie services, like Netflix, and from streaming music-centric services, Apple adapted by growing its app store.

However, if Deloitte's report points toward a larger trend, it will be hard for Apple to continue to grow this product line at such a high clip. The end result will be a company with increasing reliance on its iPhone for growth. Apple investors would be wise to watch this segment for signs of slowing growth going forward.

Leaked: Apple's next smart device (warning, it may shock you)
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Jamal Carnette has no position in any stocks mentioned. The Motley Fool recommends Apple, Netflix, and Pandora Media. The Motley Fool owns shares of Apple, Netflix, and Pandora Media. 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.

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