Apple's (AAPL 5.98%) services segment -- home to the App Store, Apple Pay, music and video streaming, iCloud, and anything else that's not hardware -- generated $85.2 billion of revenue in fiscal 2023, which ended on Sept. 30. Apple now generates more revenue from services than other product category except the iPhone.
This services revenue appears lucrative for Apple. While sales of products produced a gross margin of 36.5% in fiscal 2023, sales of services generated a gross margin of 70.8%. A dollar of additional services revenue is worth more to Apple's bottom line than a dollar of additional revenue from anything else the company sells.
A gigantic caveat
There's one important thing to know about Apple's services segment: It includes payments received from Alphabet for making Google the default search engine on Apple's devices. Google paid $26.3 billion in 2021 to various companies in deals to make its search engine the default in mobile and web browsers. Apple almost certainly receives the lion's share of these payments given the company's massive device install base.
One analyst pegs Google's payments to Apple at $19 billion for 2023. Assuming that figure is accurate, around 22% of Apple's services revenue is derived from its deal with Google. The impact on gross profit is more striking. Because these payments likely carry a gross margin near 100%, they have the effect of greatly increasing the gross margin of the services segment as a whole.
If we treat the $19 billion payment from Google as pure profit, the gross margin of Apple's services segment excluding the Google payments would have been a bit less impressive at 62% in fiscal 2023. That's about 8 percentage points lower than the reported value.
Here's why it matters
Alphabet's Google is currently facing multiple legal challenges. The company recently lost an antitrust lawsuit filed by Epic Games aimed at the company's Play Store for Android devices. There are two other antitrust cases in progress, including one initiated by the U.S. Justice Department.
The DOJ sued Google in early 2023 alleging the company engaged in anticompetitive behavior. The $26.3 billion figure for Google's payments for search engine placement came from this trial. Closing arguments in this trial are set for May, with a verdict expected sometime this year.
If the verdict goes against Google, the worst-case scenario for Apple would be a cessation of the lucrative payments for search engine placement. Overnight, something like one-third of the gross profit from Apple's services segment could vanish.
That would be a big hit for a company that's been struggling to grow revenue and profit. Apple's revenue sank 3% in fiscal 2023, and net income edged lower. The only category to book an increase in sales for the year was services, and growth was sluggish at just 9%.
With Apple stock trading for close to 30 times forward earnings estimates despite the company's growth challenges, any negative change in the payments from Google could send shares tumbling.
Editor's note: This article has been corrected. If we treat the $19 billion payment from Google as pure profit, the gross margin of Apple's services segment excluding the Google payments would have been 62% in fiscal 2023.
