Apple Inc's service department reported a year-on-year growth rate of 12%, the lowest level in the past few years. There is strong resistance to AppStore and licensing, which could drive down service revenue. The performance of AppleMusic and AppleTV+ also fell short of earlier optimistic forecasts. Investors need to be on guard against the poor growth of Apple Inc's services business, which may lead to long-term negative momentum in the stock.

The financial results released by Apple Inc (NASDAQ: AAPL) show that its income, earnings per share and iPhone sales and other key indicators are in line with expectations. However, the company reported that service revenue grew by only 12 per cent year-on-year, and this part of the business is now facing serious challenges. The service sector reported revenue of $19.6 billion, compared with an expected $19.7 billion.

In the past few years, the core investment theory surrounding Apple Inc's stock is that it is transforming from a product company to a service-oriented company. The regular revenue base and the better moat of the service business have given Apple Inc's stock a better valuation multiple and contributed to the bullish momentum. However, the growth rate of the service sector has slowed. The company reported year-on-year growth of 12 per cent, 17 per cent, 24 per cent and 26 per cent, respectively, in the past four quarters.

Most of the service revenue base comes from AppStore and the license agreement with Alphabet Inc-CL C (GOOG). Both sources of income are very profitable and help to provide sizeable profits. However, Apple Inc has begun to feel regulatory resistance in AppStore in several major international regions, including the European Union, South Korea, the UK and so on. The licensing business is also subject to regulatory scanning because it promotes monopolistic behavior between Apple Inc and Alphabet Inc-CL C. At the same time, Apple's new services such as music streaming, TV+ and subscription are not doing well.

We may see low single-digit or even negative year-on-year growth in the service sector in the next few quarters, which may cause serious bearish sentiment on Apple Inc stocks. The disadvantages faced by Apple Inc's service department make it a bad choice for long-term investment.

01 importance of the service sector

The importance of service business to Apple cannot be overemphasized. Once the service business takes off, we can easily see the change in Apple Inc's price-to-earnings ratio.

For most of the past decade, Apple Inc's average valuation multiple was 15. However, the faster growth of AppStore's revenue has brought strong bullish momentum to the stock. Over the past few quarters, its price-to-earnings ratio has averaged more than 25, due to growth in recurrent revenue in the service sector.

We can see a steady decline in year-on-year revenue growth in the service sector over the past few quarters. In the most recent quarter of the third quarter of 2022, service revenue was $19.6 billion, compared with $17.4 billion in the same period last year, equivalent to a 12% year-on-year increase. Revenue from the services sector was $19.8 billion in the second quarter of 2022, compared with $16.9 billion in the same period last year, up 17% from a year earlier. Revenue from the service sector was $19.5 billion in the first quarter of 2022, compared with $15.7 billion in the same period last year, up 24% from a year earlier. Revenue from the services sector was $18.2 billion in the fourth quarter of 2022, compared with $14.5 billion in the same period last year, up 26% from a year earlier.

02 low-digit growth in the service sector

Apple Inc faces huge resistance in the two most profitable revenue streams in the service sector. AppStore is under regulatory pressure because of the huge commissions collected by Apple Inc and the monopoly payment methods used by the company. This challenge is not limited to one region, but can also be seen in different regions. Apple Inc recently allowed third-party payment options in South Korea, but will still charge an extra commission. In its dispute with Dutch regulators, Apple Inc followed a similar model, allowing third-party payments but charging extra commission for those payments.

The core of this problem is the "Apple Inc tax" that developers must pay to use Apple Inc's "walled garden". This is usually seen as a monopoly by most regulators, and we can see a significant change in the AppStore business model. This will obviously hurt the high profit revenue of the business.

Apple Inc is also under pressure from regulators to reach an annual income of more than $10 billion, a net profit for Apple Inc because it is essentially selling real estate on its platform to Alphabet Inc-CL C. Regulators in Europe and the United States will look for ways to limit the scope of the licensing deal, which would prevent new search engine options for customers.

If the current slowdown in growth in the service sector continues, we may see year-on-year growth in service revenue as low as single digits or even negative. This will change the entire investment argument around Apple Inc's stock and could lead to a sharp bearish correction.

03 Apple Music and TV+ are of no use

Apple has launched new services to gain more growth options for this segment. The company did not disclose the exact number of paying users in its music streaming and TV+ businesses. But third-party estimates show that the company faces growth challenges in these businesses. Spotify (SPOT) maintains its market leadership in the field of music streaming. Amazon.Com Inc (AMZN) and Alphabet Inc-CL C are rapidly expanding their music streaming business with their leading position in smart speakers. Amazon.Com Inc also has an advantage because of Prime membership, while Alphabet Inc-CL C is using YouTubePremium membership to attract customers to watch music streaming.

Apple hasn't announced AppleMusic's paid subscribers for more than three years. This alone suggests that the company may face fiercer competition than expected. In announcements before 2019, AppleMusic had more than 50 million paying users. If Apple Inc increases this figure to 80 million, the department will contribute more than $8 billion to the service sector, or nearly 10 per cent of the sector's revenue base. As a result, any slowdown in music streaming alone could adversely affect service growth.

Due to the investment scale of other competitors, the TV+ business also faces great challenges. Amazon.Com Inc, Netflix (NFLX) and Walt Disney Company (DIS) are increasing their streaming budgets. Perhaps not many customers are willing to pay for the fourth or fifth video stream subscription. According to a report from Verge, Apple management has announced that TV+ has a user base of less than 20 million. Unless Apple Inc can increase the number of users of this business on a large scale, it will become a capital pit for the company because of its high investment and low sales.

04's influence on Apple Inc stock

Long-term investors who want good returns should carefully study the growth trajectory of the service sector. If Apple Inc's management is unable to add a very successful business to his service department, we may see a sharp slowdown in service growth, which may even lead to a decline in the revenue base. Products such as iPhone still rely on the upgrade cycle, and sales are volatile.

Apple Inc's price-to-earnings ratio is one of the highest among large technology companies. At the same time, revenue growth is lower than that of these competitors. Only Meta (META) reported a low year-on-year growth rate of minus 1 per cent in the quarter. On the other hand, Meta's price-to-earnings ratio is less than half that of Apple Inc's.

Wall Street is unlikely to be satisfied with the low-single-digit growth or negative growth of Apple Inc's service division. To be sure, if the slowdown in the service industry becomes a reality, Apple Inc's price-to-earnings ratio will not exceed 26 times earnings. Because of Wall Street's pessimism about the broader technology sector, we may see Apple Inc's price-to-earnings ratio fall below 20 or even close to 15 if the challenges of the services business persist.

05 views of investors

Apple Inc reported year-on-year growth of 12%, 17%, 24% and 26% for services in the first four quarters. The sector should be a major contributor to growth and also provide recurrent revenue streams. The service department faces challenges in AppStore and licensing transactions. The growth trajectory of AppleMusic, TV+ and subscriptions was also lower than expected. The decline of service business in the future may cause Wall Street to be bearish on Apple Inc stock.

Apple Inc has one of the highest price-to-earnings ratios among large technology companies, with low year-on-year growth in revenue. Considering the disadvantages faced by the service department, the current price of Apple Inc stock is too expensive.