Apple (AAPL +0.17%) is no stranger to taking chances en route to capturing -- or even creating -- a market. It's exactly what the company did with its desktop competitor to the PC, with the creation of the iPod to dominate the MP3 player market, and with the iPhone, which revolutionized smartphones.
Now, though, with iPhone sales declining, Apple is making another bold shift in strategy away from devices and into services. It's a move that may take years to truly pan out and could scare some investors away from a tech stock that is typically considered a strong buy.
Image source: Apple.
While Apple certainly doesn't shy away from competition, it will be entering a highly competitive services market that, in some ways, is tied directly to sales of its hardware products.
What exactly are Apple's services?
It's no secret that services are an attractive sector for many companies. After all, what's not to like about recurring monthly revenue from subscription-based services, or taking a hefty percentage of another company's sales simply for listing it on an online store?
There are reasons why Apple is so gung ho on services, and why it believes there is a strong future in the sector for the company. Apple doesn't break down its services category by source, which makes it difficult to project the future.
One of Apple's main source of services has been its revenue share for purchases made in the App Store by customers who own iPhones and iPads. Apple takes a 30% cut of all purchases made on the App Store for the first year and 15% every year after, with the remainder going to the developer.
Another main source of services revenue is Apple Music, a subscription-based music service that launched in 2015. The company reported 56 million customers at the end of 2018, but there's no clear delineation of how many of those are paying the $10 monthly subscription fee and how many are utilizing a free trial.
Apple's newest foray into services is a streaming video service called Apple TV+, which is set to launch on Nov. 1. At $4.99 per month, the subscription service will offer original programming including movies, shows, and documentaries.
How are Apple's services doing?
On its third-quarter earnings call, CEO Tim Cook emphasized services, saying, "This was our biggest June quarter ever -- driven by an all-time record revenue from Services."
For the third quarter, which ended June 29, services accounted for $11.46 billion of the company's $53.8 billion in total revenue, or roughly 21%. That revenue category ranked only behind the iPhone -- at $25.99 billion. All Apple hardware products combined -- including iPhone, Mac, wearables, home, accessories, and iPad -- accounted for $42.36 billion of revenue in the third quarter, about 79% of the total.
Still, the focus on services seems to make sense on the surface, especially as iPhone sales continue to dip. Apple doesn't officially report data on iPhone sales anymore, but a study from Gartner shows a continued decline.
According to the study, iPhone sales suffered the worst quarterly decline in the fourth quarter of 2018 since the first quarter of 2016. iPhone sales totaled $408.4 million in the fourth quarter of 2018, representing a 0.1% growth year-over-year. It captured only a 15.8% share of the market that quarter, compared to a 17.9% market share in the fourth quarter of 2017.
The challenge with Apple's services going forward
There are three main challenges Apple may be facing with its focus on services: The fight against App Store revenue share, heavy competition in the streaming market, and the link between services and devices.
Not surprisingly, developers aren't happy about paying Apple a 30% share of sales completed on the App Store, and some of the company's biggest customers are fighting back. Both Netflix and Spotify eliminated the ability for users to sign up for subscription services through the App Store so they wouldn't have to shell out that huge percentage of revenue, and Amazon's Kindle limits in-app purchases of ebooks as well.
In the streaming market, Apple TV+ will be competing with streaming giants Netflix, Hulu, Amazon Prime TV, and even Disney with its new Disney+ service.
Perhaps the biggest concern for investors, though, is the direct tie of Apple's services to the sales of its devices. Sales in the App Store can only be completed using an Apple device such as an iPhone or iPad, and the biggest customers of Apple TV+ are likely to be owners of Apple devices. If the sales of these devices continue to shrink, then, will the market for services customers also shrink?
It's a very real challenge Apple must face as it heads into a new era.
Should investors be concerned with Apple?
In 2019, Apple is crushing it, to say the least. The stock has risen more than 42% year to date, from $157.92 on Jan. 2 to $224.59 at close on Oct. 1. Compare that to the 19% gain of the S&P 500, and it would seem there are bright things ahead for the company.
But as some pundits have said, Apple's public foray into the services sector means it should be valued based on how it would perform against other services businesses, and not as a hardware company. That means that despite Apple's solid performance this year, its stock could be overvalued now based on how the company is shifting.
Apple has long been a solid buy, but investors may want to pause on hefty future investments, even if the company reports strong earnings again in the next quarter.
