Apple's Fastest Growing Business Is Underestimated

Apple's Fastest Growing Business Is Underestimated

Apple makes most of its money from iPhones and iPads; however, iTunes/Software/Services is the company´s fastest growing business. This segment is not only a key competitive asset for the company but it´s also becoming a massive business with serious long term potential.

Gaining traction

The iTunes/Software/Services business generated $3.99 billion in revenue for Apple in the last quarter. That is a relatively small fraction of total sales for a company with more than $35.3 billion in revenues for the quarter, but it's a huge business on a stand-alone basis. For that matter, iTunes is already bigger than most media and entertainment companies

More importantly, the segment is growing at 25% annually and becoming an increasingly bigger part of the equation. iTunes billings translated to quarterly revenue of $2.4 billion, up 29% from the year ago quarter.

Wall Street analysts usually think of this segment as a competitive advantage that differentiates Apple from its competitors and keeps users engaged to its much beloved ecosystem.

This is certainly an important observation, but maybe it's time to give more consideration to the financial impact this business could have in the middle and long term. Judging by its size and growth rate, it's an opportunity that should not be overlooked.

Moving forward

According to Apple, users have downloaded more than 1 billion TV episodes and 390 million movies from iTunes to date, and they are purchasing over 800,000 TV episodes and 350,000 movies per day.

Movies and TV shows have considerably higher prices than the typical $1 per song the company charges for music, so iTunes could see a big boost in sales and profitability as users continue buying more video in the middle term.

Online radio and music streaming represents a challenge and an opportunity for Apple at the same time. Companies like Spotify and Pandora have achieved remarkable popularity with their free or low cost music streaming services, and that´s a serious competitive threat to watch as it means Apple´s music business could be negatively affected by growing competitive pressure and changing consumer habits.

On the other hand, Apple may be launching its own iTunes Radio as soon as next month, and the Cupertino giant could become a leading player in a growing niche.

eMarketer projects U.S. monthly Internet radio listeners will rise from 132.6 million in 2012 to 176.5 million in 2016, the research firm also estimates that Internet radio ad spending in the US will reach $97 million in 2013 and grow to $1.31 billion by 2016.

According to the Wall Street Journal, Apple plans to pay music publishers more than twice what Pandora pays in royalties. Pandora founder Tim Westergren has said that it isn't fair to compare Apple's royalty rates with Pandora's because the services work differently, but the fact is that Apple has deeper pockets than other players in that business, and that´s a considerable advantage for the company.

Pandora reported more than 71 million active listeners in the last quarter, up a 31% versus the same quarter in the previous year. Monetization has been improving lately as the company delivered a 97% increase in the much important area of mobile revenues for the quarter.

But advertising is not providing enough revenue to cover content costs, so Pandora has been promoting its subscription service. The company added nearly 700,000 subscribers to its 'Pandora One' subscription service in the quarter, bringing the total to 2.5 million and showing that it enjoys strong loyalty from its audience.

Pandora won`t be easy to beat but, just like traditional radio, online radio will most likely have room for several successful players operating at the same time.

In a business in which profitability is scarce and licensing costs are a heavy burden for most companies, Apple´s financial muscle could represent an important advantage for the company. Besides, unlike Pandora and Spotify, Apple will not need to build its user base from zero since it already has a close relationship with millions of users around the world.

iTunes radio may cannibalize music downloads to some degree, but it could also be instrumental when it comes to promoting songs and generating more sales. Listeners may end up buying the tracks they hear on iTunes Radio, and that could mean a double win for Apple.

Bottom line

Digital content, software and services serve an important purpose when it comes to differentiating Apple from the competition. But at the same time it's a big and growing business which has considerable potential in the middle and long term. The iPhone and the iPad are Apple´s present, but the company´s future could be increasingly tied to iTunes/Software/Services.

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Andrés Cardenal owns shares of Apple. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple. 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.

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