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Apple (NASDAQ: AAPL) reported earnings that were able to meet expectations in several key metrics, including revenue, EPS and iPhone sales. However, the company reported only 12% growth in services revenue over the year and this segment now faces serious challenges. The Services segment achieved revenue of $19.60 billion against an estimate of $19.70 billion.

Over the past few years, the basic investment thesis around Apple shares has been that it is transforming from a product company to a service-oriented one. The recurring revenue base and a better fluke in the Services business helped Apple stock gain a better valuation multiple and contributed to the bullish momentum. However, there has been a slowdown in the growth rate of services. The company recorded YoY Services segment growth rates of 12%, 17%, 24% and 26% over the past four quarters.

Much of the services’ revenue base comes from the App Store and the licensing agreement with Google (GOOG). These two sources of income are very lucrative and allow for good margins. However, Apple has started to feel regulatory pushbacks in the App Store in several key international regions, including the European Union, South Korea, the United Kingdom, and others. The licensing sector is also coming under the regulatory scanner as it reinforces monopolistic practices between Apple and Google. At the same time, Apple’s new service businesses such as music streaming, TV+ and subscriptions are not progressing well.

We could see low single-digit or even negative annual growth rates in the services segment in the coming quarters, which could create significant bearish sentiment towards Apple shares. The headwinds facing Apple’s services segment make it a poor bet for a long-term investment.

Importance of the Services segment

The importance of the Services business to Apple cannot be overstated. We can easily see the transformation of Apple’s PE multiple once the Services business took off.

Apple's PE ratio over the past few years.

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Figure 1: Apple’s PE ratio over the past few years.

Apple has had an average valuation multiple of 15 for most of the past decade. However, faster growth in App Store revenue gave strong bullish momentum to the stock. Its PE ratio has averaged above 25 for the past few quarters, which is due to growth in the Services segment’s recurring revenue business.

We can see a steady decline in year-over-year revenue growth numbers from the services segment over the past few quarters. In the recent quarter in the third quarter of 2022, the services segment recorded revenue of $19.6 billion, compared to $17.4 billion in the prior year quarter, equivalent to 12% year-on-year growth annual. In the second quarter of 2022, the services segment recorded revenue of $19.8 billion, compared to $16.9 billion in the year-ago quarter, equivalent to 17% year-on-year growth annual. In the first quarter of 2022, the services segment recorded revenue of $19.5 billion, compared to $15.7 billion in the year-ago quarter, equivalent to 24% year-on-year growth annual. In the fourth quarter of 2022, the services segment recorded revenue of $18.2 billion, compared to $14.5 billion in the year-ago quarter, equivalent to 26% year-on-year growth annual.

Apple's Services segment revenue grew 12% in the last quarter.

Company deposits

Figure 2: Apple’s services segment revenue grew 12% year-over-year in the last quarter.

Low single-digit growth in the Services segment

Apple faces massive headwinds in the services segment’s two most lucrative revenue streams. The App Store is under regulatory pressure due to the massive commissions charged by Apple and the monopolistic payment options used by the company. This challenge is not limited to a single region but can be observed in different geographical areas. Apple recently allowed third-party payment options in South Korea, but will still charge additional commissions. In the dispute with Dutch regulators, Apple is following a similar model to authorize third-party payments but to charge additional fees for these payments.

At the heart of this problem is the “Apple tax” that developers must pay to use Apple’s “walled garden”. This is generally considered a monopolistic practice by most regulators and we could see a substantial shift in the App Store business model. This will obviously hurt the very lucrative income from this business.

Apple is also under pressure from regulators over its licensing deal with Google. who rakes over $10 billion a year. This would be pure profits for Apple as it essentially sells the real estate on its platform to Google. European and US regulators are said to be looking for ways to limit the scope of this licensing agreement that prevents new search engine options for customers.

If the current slowdown in year-over-year growth in the services segment continues, we could see low single-digit year-over-year growth or even a negative growth rate in services revenue. This would change the whole investment thesis around Apple stocks and could lead to a major bearish correction.

Apple Music and TV+ don’t help

Apple has launched new services to gain additional growth options in this segment. The company does not disclose the exact number of paid subscribers in the music streaming and TV+ business. But third party estimates show that the company faces growth challenges within these businesses. Spotify (SPOT) retained its leadership in the music streaming market. Amazon (AMZN) and Google are rapidly accelerating their music streaming business with the help of their leadership in the smart speaker segment. Amazon also has an advantage due to Prime membership while Google uses YouTube Premium membership to attract customers to music streaming.

Apple hasn’t announced paid Apple Music subscribers in over three years. This alone shows that the company may face stiffer competition than expected. In the previous announcement in 2019, Apple Music had finished 50 million paid subscribers. If Apple increased that number to 80 million, that segment would contribute more than $8 billion to the services segment, which is almost 10% of that segment’s revenue base. Therefore, any downturn in music streaming alone can lead to headwinds for the growth of the services.

The TV+ business also faces huge challenges due to the scale of investments from other competitors. Amazon, Netflix (NFLX) and Disney (DIS) are increasing their streaming budgets. Few customers may be willing to pay for a fourth or fifth video streaming subscription. A report in Verge mentioned that Apple management has announced a subscriber base of less than 20 million in TV+. Unless Apple can massively increase the number of subscribers in this sector, it will become a financial pit for the company due to high investments and low sales.

Impact on Apple stock

Long-term investors hoping for good returns should carefully consider the Services segment’s growth trajectory. If Apple management is unable to add a very successful business to its Services segment, we could see a massive slowdown in Services growth and possibly even a declining revenue base. . iPhone and other products always depend on the upgrade cycle and show a lot of fluctuation in their sales.

PE ratio and annual revenue growth of Apple and other Big Tech companies.

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Figure 3: PE ratio and year-over-year revenue growth of Apple and other Big Tech companies.

Apple’s PE ratio is one of the highest among Big Tech companies. At the same time, revenue growth is lower than that of these competitors. Only Meta (META) recorded a lower annual growth rate of 1% during this quarter. On the other hand, Meta is trading at less than half of Apple’s PE multiple.

It’s highly likely that Wall Street won’t be content with low single-digit growth or negative growth from Apple’s services segment. It is certain that Apple will not trade at a PE multiple above 26 if the downturn in services materializes. Due to Wall Street’s bearish sentiment towards the broader tech space, we could see Apple’s PE multiple fall below 20 or even near 15 if the challenges for the services business persist.

Key takeaway for investors

Apple reported YoY service growth rates of 12%, 17%, 24%, and 26% over the previous four quarters. This segment was supposed to be a major contributor to growth and also generate a recurring revenue stream. The services segment is facing challenges within the App Store and licensing agreements. The growth trajectory for Apple Music, TV+ and Subscriptions also fell short of expectations. The future decline in the Services business may cause Wall Street to take a bearish view of Apple stock.

Apple is trading at one of the highest PE multiples among big tech companies while posting lower year-over-year revenue growth rates. Apple stock is too expensive at the current price given the headwinds facing the services segment.