Apple’s services business has never been bigger

Apple (AAPL 0.47%) recently announced strong second quarter results, but its third quarter may not be as strong. Speaking during the company’s earnings call on April 29, Chief Financial Officer Luca Maestri said supply constraints will have a bigger impact this quarter compared to the previous quarter. Additionally, exchange rate headwinds will test revenue growth and the company will suspend sales to Russia for the entire quarter.

He said services revenue may slow quarter over quarter, but he still expects the segment to grow at a double-digit percentage rate. Facing headwinds for the company’s device sales, the services segment has never been more important for Apple.

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Back to the second trimester

One thing that caught my eye in Apple’s second quarter financial statements was the continued expansion of gross margin in the services business. Gross margin was around 72.5% in the first half. That’s up from about 69.3% during the same period last year.

In fact, Apple’s second-quarter services gross profit grew more than Apple’s total operating profit. That’s not to say that services are the only source of revenue growth at Apple – device sales have also increased and gross margin has increased – but it certainly has an outsized impact on Apple’s bottom line.

Maestri pointed to several records driving these services’ revenue growth and margin expansion. Apple set new records for App Store, Music, Cloud Services and AppleCare sales. It also set records in the second quarter for video, advertising and payment services.

A big factor in this “advertising” element is the traffic acquisition cost that Google pays Apple to make it Safari’s default search engine. Alphabet (GOOG -0.93%) (GOOGL -0.65%) reported a $2.3 billion year-over-year increase in traffic acquisition costs last quarter. This number generally increases sequentially throughout the year, peaking in the fourth quarter, but then decreasing in the first quarter of the following year. Apple should see its payments from Google boost its ad growth again this year, but it’s something investors need to watch out for.

Strong service business can stabilize the whole operation

More and more of Apple’s service business comes from subscriptions. The company had 825 million subscriptions through its own services and through the App Store at the end of the second quarter. This is 165 million more than 12 months ago. These subscriptions create consistent revenue month after month, quarter after quarter, providing a stabilizing force for Apple’s revenue and profit.

And App Store sales growth accelerated in April and may continue throughout the quarter, Morgan Stanley analyst Katy Huberty said Barrons. She thinks the App Store, one of Apple’s most mature services, could grow 15% year-over-year in the third quarter.

Advertising revenue should continue to grow. Google’s core search business is strengthening this quarter with renewed consumer interest in highly profitable verticals like travel and entertainment. These trends should also benefit Apple’s own ad operations and could impact its deal with Google.

So while Maestri expects supply chain issues to drive lost sales of $4 billion to $8 billion this quarter, the services business could help offset that lost revenue. And since Apple is also increasing its already high gross margin on services, it should be able to continue to increase its operating and net income despite the pressure on device sales.

Apple has spent years building its services business into the significant contributory factor it is today. And with the current macro environment impacting overall results, it’s a good thing CEO Tim Cook has decided to make services a top priority for the tech company.

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