Apple's App Store is Peaking, Warns Pacific Crest

Pacific Crest's Andy Hargreaves today reiterates a Sector Weight rating on shares of Apple (AAPL), warning that the company's software and services businesses are "not the panacea for slower iPhone growth" that some might have believed.

As a result, Apple is unlikely to meet CEO Tim Cook's stated goal of doubling its revenue from services by 2020, he concludes.

In particular, Apple's App Store, where users of the iPhone download apps for their devices, is the crown jewel of Apple's services, he observes, but it is "likely at peak growth," he estimates.

"We expect App Store to grow 32% in FY17 and generate over half of Services profits," writes Hargreaves. "While App Store appears well positioned to continue growing for several years, App Store sales per iPhone user appear likely to decelerate, which, along with slowing iPhone user growth, is likely to drive a significant decline in the pace of growth going forward."

A big problem is that the iPhone is such an outsized contributor to Apple's profit that it takes a lot of services revenue to offset declines in iPhone profit. Hargreaves is expecting sales of iPhone to decline in 2019, leaving a gap that's hard to fill:

In FY19, we estimate services gross profit would have to grow by 4% for every 1% decline in iPhone profit. We estimate iPhone gross profit will decline by 8.5% in FY19, which suggest Services gross profit would have to grow by 33% to fully offset the decline. We do not believe Services gross profit has grown that fast since FY12, and we estimate it will grow 6% in FY19. Consequently, it seems unlikely that Services growth can offset a meaningful decline in iPhone units.

Hargreaves notes there's not much outside of the App Store, and Apple Music, to get excited about.

Excluding App Store and Apple Music, which likely generates no operating profit, we estimate Apple's Software and Services revenue per iPhone user has declined to approximately $6.40 in the most recent March quarter from $10.50 in the March quarter three years ago. In absolute terms, we estimate Software and Services, excluding Apple Music and App Store, will grow at an annualized rate of 3% in the three years through FY17. During this period, we estimate iPhone users grew at an annualized rate of 17%, TAC fees from Google grew at an annualized rate of 27%, and the Company launched Apple Pay, an entirely new source of revenue.

Moreover, Apple has a "relatively poor track record of launching successful new services," writes Hargreaves.

While the decline in à la carte music has been a significant drag, the lack of profitable growth in services outside of App Store suggests that the broader services initiative has vastly underperformed the underlying market driver (iPhone user growth). This suggests a broad stagnation in Services is likely to accompany slower iPhone user growth, and reduces our confidence in the potential for Apple to generate profitable future services organically.

Apple shares are up $1.36, or 1%, at $1456.09.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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