Tim Cook set out to double Apple's (AAPL 0.17%) services business revenue from 2016 to 2020 -- and the iPhone maker's CEO succeeded. Last year, Apple's services brought in nearly $54 billion in revenue, more than double the amount they generated in 2016.
Importantly, most of Apple's services have much higher gross margins than its hardware sales. Last year, services accounted for less than one-fifth of revenue, but more than one-third of gross profits. And if services revenue growth continues to outpace hardware sales, the segment could easily account for half of gross profit by the middle of the decade.
Services could double again by 2024
Apple increased services revenue about 24% last quarter on the back of strong hardware sales. Evercore ISI analyst Amit Daryanani thinks Apple can continue its strong services revenue growth in Q2 and beyond.
While the consensus among Wall Street analysts is for services revenue growth to slow to about 16% this quarter, Daryanani expects Apple to exceed that number. In fact, he reiterated expectations that Apple's services revenue will exceed $100 billion by 2024, expanding at an average rate of 19% for the next four years.
Hardware sales are fueling App Store sales
Continued strength in iPhone sales has led to strong sales in the App Store. Daryanani says App Store revenue grew 40% in January and 30% in February. The App Store accounts for around 28% of services revenue, and it has a higher-than-average gross margin among Apple's services.
Growth in app downloads and subscriptions could slow as we enter March and lap the start of lockdowns from 2020. Early iPhone 12 sales have exceeded expectations so far, though. With lots of new iPhone activations comes a lot of new app downloads, which ought to support continued strength in App Store revenue even as we lap the tough comparable period.
The long-term potential of Apple TV+ and Apple Arcade
Two Apple services that haven't gained much attention for their revenue potential are Apple TV+ and Apple Arcade.
The former has seemingly struggled to attract an audience, as the company has pushed out free trials for new hardware purchasers twice. Presently, the net revenue generated by the streaming video service is probably close to $0, as it's unlikely attracting very many subscribers outside of free trial members.
The early struggles may be related to television and film studio production shutdowns, leading to more limited content and marketing, and therefore, lower adoption rates among those eligible for the trial offer. But Daryanani estimates Apple TV+ will have 90 million subscribers by 2025.
The tech titan has also remained quiet on Apple Arcade, its subscription mobile gaming offering. But the service ultimately has potential to grow Apple's services business, although it will cannibalize App Store sales to do so. Daryanani sees 80 million subscriptions for Apple Arcade over the next five years.
Both services are part of Apple's new services bundle, Apple One. That will be a key driver of subscriber growth for both.
Most important for Apple investors is its ability to leverage the fixed costs of content for both services. Apple pays for films and TV series up front for Apple TV+. Likewise, Apple pays developers an up-front fee for Arcade titles, and it may pay out additional flat fees to keep the title on the service. To be sure, the margin potential for both services is much better than its other subscription services like Music, which pays a fixed percentage of revenue to labels and songwriters.
Combined with the continued success of the App Store, these high-leverage services should allow Apple to maintain its high gross margin on services over the next five years. Daryanani expects services will account for 45% of the FAANG stock's gross profits by 2024. As the segment's revenue continues to outpace hardware sales growth, it should reach more than 50% of company gross profits by mid-decade.