Just How Profitable Are Apple Inc.'s Services?

By Markets Fool.com

Apple executives spent a fair amount of time on the company's most recent earnings call talking up its services business. It's probably high time that Apple start talking this particular line item, particularly as it generated more than $6 billion in revenue in the quarter -- nearly as much as either the iPad or the Mac businesses.

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Although investors have a reasonable view of the kind of revenue this business brings in, it's harder to glean insight into its profitability -- Apple, after all, doesn't break out profit by segment in its earnings reports.

However, during the call, CFO Luca Maestri provided some valuable insight into the profitability of this segment.

First, some basics
Maestri took the time to explain the two different categories that Apple's services can be lumped into. The first category -- and the one that Maestri says makes up the bulk of the services that the company offers -- represents services "tied to [Apple's] installed base of devices."

The examples that Maestri gave of such services include apps, movies, Apple Music, Apple Pay, and more.

An example that Maestri gave of a service that's not related to the installed base and is instead "more related to when [Apple] sell[s] a device" is an Apple Care agreement. Apple Care, for those of you unfamiliar with it, is essentially Apple's version of an extended warranty (with tech support included).

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Digging into the numbers a bit
Per the supplemental information that Apple gave around its services business, the purchase value of installed base-related purchases was $31.2 billion in fiscal year 2015. Of course, Apple doesn't get to keep all of that as revenue (for example, it only gets a 30% cut of an app store purchase), which is why total services revenue came in at "just" $19.9 billion during that year.

What I found particularly interesting, though, is the following comment from Maestri on the call:

Our installed base services are also quite profitable, with gross margins that, on a purchase value basis, are similar to our company average.

Apple's gross profit margin in fiscal 2015 was about 40%. This implies, then, that of the $31.2 billion in installed-base related purchases, about $12.48 billion of that wound up as gross profit. Assuming that the remainder of its services revenue is also gross profit positive, the gross profit contribution from the company's services is likely solidly north of $13 billion.

Putting this into perspective
Maestri was very deliberate in pointing out to analysts and investors on the call that both the "size and growth" of services tied to the company's installed base "compare favorably to other services companies" that they may be "familiar with."

To that end, I decided to compare Apple's installed-base tied services business to Facebook . In its most recent fiscal year, Facebook generated $17.93 billion in revenue. Cost of revenue was $2.867 billion, implying "gross profit" of around $15 billion.

That's actually not too far off from the "gross profit" that Apple's services business on a purchase value basis is.

My suspicion is that Apple emphasized this in a bid to assure investors that a fairly substantial portion of its gross profit comes from "non-hardware" revenue, especially as it had to deliver the "bad news" vis-a-vis iPhone during this same earnings call.

In this market, services companies seem to be getting a lot more love from a price-to-earnings perspective. Perhaps this was Apple's "plea" to the market to assign its stock a richer, services company-like multiple?

The article Just How Profitable Are Apple Inc.'s Services? originally appeared on Fool.com.

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.