Why the Bears Are Wrong on Apple Stock
Apple Inc. (NASDAQ:AAPL) is a stock that the bears love to hate.
And this shouldn’t come as a surprise. Apple is one of the biggest companies in the world, but for the most part, it relies on one device: the “iPhone.”
The revolutionary smartphone, the first version of which was introduced over a decade ago, is still the biggest top-line contributor for the Cupertino, California-based tech giant.
Therefore, when iPhone sales started showing signs of slowing down, concerns started to rise.
According to Apple Inc.’s latest earnings report, the company generated $52.0 billion in iPhone sales in the quarter ended December 29, 2018. That represented a 14.9% decline year-over-year. And since Apple earned total sales of $84.3 billion for the quarter, iPhone sales accounted for more than 60% of the company’s total revenue. (Source: “Condensed Consolidated Statements of Operations (Unaudited),” Apple Inc., last accessed March 8, 2019.)
It doesn’t look good when a company’s biggest revenue contributor is posting a double-digit sales decline.
But if you decide to ditch AAPL stock based on this one metric, you could be missing a big opportunity.
Let me explain.
This $3.30 Fee Could Make Billions for Apple Inc.
To see why Apple stock is special, here’s a figure: $3.30.
That’s the amount that Apple made whenever someone spent $11.00 on Netflix, Inc.’s (NASDAQ:NFLX) streaming service using the “Netflix” iPhone app last year. (Source: “Apple makes over $3 every time someone subscribes to Netflix from an iPhone app,” MarketWatch, March 7, 2019.)
Compared to how much money Apple makes from the devices it sells (the flagship “iPhone XS” starts at $999.00) a $3.30 fee doesn’t seem like much.
However, Apple didn’t really have to do anything to earn that $3.30 fee. It just pocketed the money whenever a user paid for Netflix through an iPhone app.
Obviously, Netflix wasn’t happy about it. The last I checked, Netflix no longer allowed new users to sign up just through the iPhone app.
But here’s the thing: Apple is not just making money from Netflix. It takes somewhere between 15% and 30% of almost everything sold through its “App Store.” And even if the app is free, whenever the user makes a purchase within the app, Apple takes a cut.
That is a huge business. And because of Apple’s giant user base (the iPhone has an active installed base of over 900 million devices), companies and developers that want to reach these users have little choice but to pay a fee to Apple. (Source: “Apple Inc. (AAPL) CEO Tim Cook on Q1 2019 Results – Earnings Call Transcript,” Seeking Alpha, January 29, 2019.)
According to Statista, there were nearly two million apps already available in Apple’s App Store by the third quarter of 2018. Combining 900 million active iPhones with two million apps, it’s safe to say that Apple is making money hand over fist through the fees. (Source: “Number of apps available in leading app stores as of 3rd quarter 2018,” Statista, last accessed March 7, 2019.)
The neat thing is, this business, which is part of Apple’s “Services” segment, is recurring in nature. In other words, unlike the hardware business, where you have to sell new devices to earn a buck, Apple can make money just by letting developers and consumers use its platform.
So, just how much money can Apple actually make from services?
On that front, keep in mind that the company’s Services segment includes not just the App Store, but also “Apple Pay,” “Apple Music,” “Apple Care,” and “iCloud”—among others. Added up, the segment delivered $10.9 billion of revenue in the company’s most recent quarter. (Source: “Apple Reports First Quarter Results,” Apple Inc., January 29, 2019.)
What’s more impressive than the sheer size of the business is its growth.
Unlike iPhone sales, which have gone up and down, revenue from Apple’s Services segment has been growing at a double-digit pace year-over-year for quite some time. The $10.9 billion that the segment earned in the December quarter not only represented a 19% increase from a year earlier, but also marked an all-time high for the company.
As you’d expect, selling services (like charging a fee through every in-app transaction) is much more profitable than selling hardware devices. In Apple’s latest reporting quarter, its Services segment had a gross margin of 62.8%, which was substantially higher than its “Products” segment’s gross margin of 34.3%. (Source: Ibid.)
This means, if the growth momentum continues in Apple’s Services segment, the company will generate not just more revenue, but also more profits for shareholders.
Apple Stock Chart
Chart courtesy of StockCharts.com
At the end of the day, you might be wondering whether other companies will follow Netflix and stop allowing users to make purchases within their Apple “iOS” apps.
Well, the blunt reality is, most apps don’t have as big of a customer base or brand name as Netflix. So, while Netflix can ask its users to make payments on a separate browser and then come back to the app, most apps don’t really have that option. Therefore, if they want to make money from their users, they have to allow in-app purchases.
As I mentioned earlier, it’s hard for any developer to ignore the 900 million active iPhones. If you count other products made by Apple Inc., such as “iPad” tablets and “Mac” computers, you’ll see that the company’s total active installed base contains a whopping 1.4 billion devices.
Apple stock took a serious beating during the market sell-off in the fourth quarter of 2018. Most recently, though, it has started to make a comeback. With the company’s booming Services segment, AAPL shares could see more upside ahead.