The Uphill Battle for Apple's Services Strategy

Apple Inc.’s (AAPL) rally this year has been fueled in large part by investor optimism that the company's fast-growing Services business will offset slowing growth of the company's flagship iPhone, which is one of history's most successful consumer products and accounts for more than 60% of Apple's sales. Yet that stock growth, up more than 30% this year, could falter. Sharply slowing App Store sales lead some analysts including Goldman Sachs' Rod Hall to warn that the company's Services segment will begin to fall short of its growth targets in the current quarter ending in September, as outlined by Barron’s. 

What It Means For Investors

The Apple App Store provides a large share of the Service segment's sales, analysts say, which also includes subscriptions like Apple News, Apple TV and a new streaming video game service. Investors are likely to focus on the unit's health when Apple reports earnings for the period ending June on July 30. In the latest quarter, Services accounted for 14% of sales while Apple’s iPhone business made up 63% of revenues.

Downside Risk

Sensor Tower, a research firm, says App Store sales may indicate weakness in the company’s Services segment later this year. The firm estimates that Apple’s App Store sales in June grew 14% year-over-year, a sharp slowdown from 18% in May, 21% in April, and 22% in March, per Barron’s. Sensor Tower co-founder Alex Malafeev points out that the deceleration in App Store sales came after the launch of Tencent’s wildly popular mobile game called Perfect World in China, which helped boost sales earlier in the year. 

Goldman's Hall also sees a downtrend. “App Store growth slowed markedly in May and June,” he wrote per a recent story in Barron's. “Deceleration implies downside risk for FQ4 [September quarter] Services growth.” 

Other bears, including Rosenblatt Securities analyst Jun Zhang, have lowered their forecast for Apple. Zhang cut his rating on Apple stock from neutral to sell, citing expectations for deteriorating revenue growth for Apple Services. 

Looking Ahead

This darkening outlook suggests that recent estimates that Apple Services could be worth $500 billion, more than half of Apple's more than $950 billion market value, may be way too optimistic. If so, collapsing valuation estimates could hammer Apple's shares in the coming months if investors conclude that there's no quick rescue for Apple given its faltering iPhone business.