At the beginning of last year, Apple (NASDAQ:AAPL) CEO Tim Cook said his goal was to double the company’s services revenue by 2020. For the 2017 fiscal year, services revenue increased 23% year over year, accelerating from the 22% growth it saw in 2016.
Apple just reported its annual App Store sales roundup, and all indications are that momentum continued through the end of the calendar year. Apple paid out over $26.5 billion to developers in 2017, and it recorded $300 million in sales on New Year’s Day alone — a single-day record.
The App Store isn’t the only piece of Apple’s services business, but at about $10 billion in revenue (that’s Apple’s cut), it makes up approximately one-third of the services business. There are major drivers for Apple’s other services as well, which could enable Apple to reach Cook’s goal even earlier than expected.
A closer look at App Store sales
The $26.5 billion paid out to developers in 2017 represents an increase of more than 30% from 2016. The growth in Apple’s revenue may be a bit smaller after it changed its subscription policy last year. It now takes a 15% cut on subscription payments after a user has subscribed for more than a year.
That move may, in fact, have helped propel App Store revenue higher as it incentivized developers to offer app subscriptions. Recurring payments may generate more revenue in the long run. Not to mention the move may help attract more high-profile subscription services to the App Store. Netflix started offering subscriptions through its iOS app in 2015, but fellow Fool Evan Niu suspects it was tempted by a discounted commission structure. Spotify, meanwhile, still doesn’t allow users to subscribe through its iOS app.
App Store growth as an indicator
Engagement in the App Store also directly corresponds to Apple’s app advertising service. The company introduced search ads in the App Store in late 2016, and publishers have really taken advantage. More app downloads means more searches and more opportunities for advertisements.
App Store sales are also an indication of how much Apple’s installed base is growing, a metric Apple introduced in 2016, but quickly moved back from. Naturally, more people using iPhones, iPads, Apple TVs, and Apple Watches means more total app installs.
And the installed base is the key to the services business. With more devices in use, Apple can sell more iCloud and Apple Care subscriptions. It means more people using Apple Pay, which is still expanding to new markets. And it means more people might be inclined to subscribe to Apple Music.
Apple Music is still growing well
Apple Music continues to attract new subscribers every month. From September 2016 to September 2017, Apple added 13 million new subscribers to reach 30 million.
The release of the Apple Watch Series 3 this fall may help spur Apple Music subscriptions (as well as AirPod sales). The new Watch model integrates a cellular connection into the device, but the only music-streaming service currently supported is Apple Music. Apple is also highlighting the new Watch’s music-streaming capabilities in its marketing.
Apple has been lagging Spotify’s user growth over the last 18 months, but the new Apple Watch may help it keep pace.
Apple is also experimenting with exclusive video content for Apple Music subscribers. Whether that will pay off in subscriber growth remains to be seen.
Why services are so important for Apple
Services provide two main benefits for Apple. First, they produce a significantly higher profit margin compared to Apple’s devices (which sport high margins to begin with). The margin on App Store sales may be as high as 90%, according to estimates. That means despite being a relatively small part of Apple’s revenue, services punch above their weight when it comes to the bottom line.
Perhaps more importantly, services keep Apple’s customers loyal. If you’ve already bought $100 worth of apps for your iPhone, you might not want to ever switch to Android. You’d have to pay that $100 again. It also makes the iPad or Apple Watch that much more appealing over an Android tablet. The Apple Watch makes Apple Music more appealing and vice versa, which in turn gives other Apple products an advantage over the competition.
Apple’s services business and the ecosystem built around them is one of Apple’s biggest moats. Seeing the growing revenue coming in is not only a sign of improving profits, but improved profits for years to come.
Adam Levy owns shares of Apple. The Motley Fool owns shares of and recommends Apple and NFLX. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.