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Apple Inc.'s Services Segment Is Bigger Than You Thought

By Motley Fool Staff - May 5, 2016 at 10:00AM

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Apple’s second biggest revenue stream won’t ever become No. 1, but it should help the company’s margins as it grows.

In this clip from the Industry Focus: Tech podcast, Dylan Lewis and Nathan Hamilton talk about a few of the biggest ways Apple (AAPL 0.96%) has changed in the last year, from its stock price to its business segments. Listen in to hear how focusing more on their services segment has set Apple up for fantastic growth potential, how different the company's services segment is from the rest of their segments, and how Apple's emphasis on their ecosystem could mean huge opportunities for them in the coming years.

A transcript follows the video.

This podcast was recorded on April 29, 2016. 

Dylan Lewis: I thought it would be fun to look at some of the big differences between the Apple of today and the Apple of a year plus ago -- how the business has changed a little bit, some segments that are now a little bit more relevant than they had been in the past. Just taking stock of where things are.

Over the last 12 months, Apple's actually down 20%, which is crazy.

Nathan Hamilton: Yeah, we're not loving that, huh?

Lewis: No, especially as someone who had added to my position during that period. (laughs) 

Hamilton: Did you catch the high? Or the low?

Lewis: I caught bits of both. Dollar-cost average, right? Always continue to buy, and make sure you're working down that dollar-cost average.

Hamilton: Very Foolish.

Lewis: Of course. Compared to the previous 12 months, they were up over 60%. So, there was a period where it was very hard to be down on an Apple position. Obviously, the story has changed a little bit there. I think, looking at things to be very optimistic about as an investor, from this most recent report, the services segment has to be one of them. This is, of course, the segment of their business that houses App Store, Apple Music, Apple Pay, just to name a few. They revealed that this is their second-largest revenue driver, which blows my mind. I didn't realize it was getting that big, and I think a lot of people were surprised by that number. But it provided $6 billion last quarter, which is up 20%. 

One of the things that showed, I think, that there would be an increased emphasis moving forward on this is, in the conference call, they described this new non-GAAP metric. They're calling it "the purchase value of services tied to our installed base." Last quarter, that was $9.9 billion. If that's not a sexy accounting name, I don't know what is.

Hamilton: (laughs) Is that official GAAP legal language?

Lewis: No, they had to somehow curb that in.

Hamilton: It is a good metric, though. I really like that they're breaking it out.

Lewis: Yeah, so this is essentially the value of stuff their service segment is facilitating. The reason they have to create this metric is because there are a couple different accounting approaches for the different segments. Some of them run on gross accounting, and some of them run on net accounting, in terms of what actually shows up in the financial statements. So, this is done to clean up all of that.

You hinted at this earlier. A couple things for investors here. One of them is, this segment operates in kind of a different margin profile than what you'd expect with the hardware business, right?

Hamilton: Absolutely. It's essentially an asset-light business, where there are high margins that are accompanying it, but you also have to put it in the context, you said it exactly there, about $6 billion worth of revenue...

Lewis: And I think it was $9.9 billion of facilitated transactions. That new non-GAAP number is $9.9, actual revenue is $6 billion.

Hamilton: Then, put that in the context of the iPhone, and you start to see how it'll actually affect the margins. It's not a huge driver, but could Apple add five to 10 of these businesses over time? Sure. Add some margins, get a couple billion out of them. That sounds hilarious, when you think about it. But it definitely is something to consider. Apple Pay, the actual gross purchase volume is up. But, put in context of the payments market as a whole, I believe Apple is around $9 billion in payment volume. PayPal, over the December quarter, not matching up exactly, was above $80 billion. There's definitely room to grow there.

And the important thing, which I think is definitely necessary to focus on is the Apple ecosystem. Tim Cook hit upon it in the call. Essentially, you hold your iPhone, it can really do everything. And what it's doing at this point is nothing, compared to what it eventually can do. It doesn't control your home, doesn't control your car, doesn't control your desktop computer, doesn't control your life and everything around you, when it comes down to it. And those are businesses that Apple very well could get into and essentially generate more revenue from the ecosystem. It's just like telecom. Once you're locked in, it's a pain in the butt to change.

Lewis: Yeah. I am an entrenched Mac user, iOS user. I love having it all in one place. I love being fully integrated. I'm going to change out of that dragging, kicking, and screaming, and I'll hate it, if I ever do.

Hamilton: You are what the financial world would call a "sticky customer."

Lewis: Yes.

Hamilton: That's exactly what Apple has within their ecosystem. There is value to it, and it seems like they're recognizing that with the new metric, just seeing what value this creates, subsequent knock-on events, and so forth. So, I like that they're breaking it out. But also put it in context. If you're looking for significant growth to hit Apple, the company as a whole, from these businesses, let's wait a little bit and see.

Lewis: Yeah. It is another way to enhance the value of that 1 billion installed base that they have. It's a tack on there. Hopefully, they can monetize that group a little bit more.

Hamilton: Healthcare stuff, that's something that hasn't even been tapped into at all. I don't think Apple even knows exactly what they want to do with it at this point, but there's definitely a lot of potential there.

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