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Apple’s strongest business faces one major problem

Daniel Howley
Technology Editor

Apple ( AAPL ) on Tuesday reported Q2 2019 earnings, and much of the news focused on its lackluster performance in China. That was hardly surprising, though. Apple issued a rare guidance in early January cutting revenue forecasts because of slowing iPhone sales in China. With continuing fears over a U.S.-China trade war , investors were ready for whatever Apple threw at them.

But one of the main highlights of the earnings report, Apple's services business, is also being called into question. That division is supposed to help pick up the company's revenue as iPhone sales begin to flatten, but it’s also a business that depends on an ecosystem driven by Apple’s hardware.

"Is Apple a services company? No. Apple is an IT Hardware product company with great services which are attached to Apple products," Citi analysts Jim Suva and Asiya Merchant wrote in a research note following Apple's earnings. "Without Apple products its services struggle to exist."

Apple as a service

Apple's services include iTunes, the App Store, iCloud, Apple Music and AppleCare. The company is also expected to launch its own video streaming service, and is rumored to be working on a video game subscription service, though there's no word on what kind of games will be included.

In order for Apple to grow services, it must also increase its hardware sales to lure users into its ecosystem, according to Suva and Merchant. And with so many third-party services alternatives available ranging from Spotify ( SPOT ) to Netflix ( NFLX ), Apple has ample competition as it tries to reach as many consumers as possible.

Apple CEO Tim Cook has a self-imposed goal of doubling the company's fiscal 2016 services revenue by 2020, bringing the segment from $24 billion to $48 billion. That's certainly a large increase, but nowhere near Apple's yearly iPhone sales, which topped out at $167 billion in 2018.

"Yes, the focus by Apple on services may help its valuation over time, but we note even if Apple services were to grow over 50% the next few years it would still represent less than 25% of the company’s total sales," the Citi analysts noted.

Suva and Merchant also point to deceleration in services growth in Q2 2019 versus a year ago, which could be linked to the reduction in iPhone sales and, as a result, AppleCare subscriptions. China's temporary ban on new video game licenses also hurt services.

Still a lot of positives

Other analysts, however, were more upbeat on Apple's services potential. In her note for Morgan Stanley, Katy Huberty explained that the firm remains bullish on services due to increases in Apple's overall user install base, as well as growth in Apple Music.

Apple's active install base of devices topped out at 1.4 billion in Q1 2019. With such a massive number of devices available, Apple can essentially flip a switch and push new apps to its users with ease. If the company ends up launching a Netflix competitor video app, or gaming subscription service, it could quickly suck up millions of users.

Still, Apple will have to contend with a slew of major competitors Apple if it's going to push its services business to the point where it can compensate for the flattening of iPhone sales over time.

There is, however, an opportunity for Apple to grow services outside of its device sales. The company recently announced that it will be bringing its iTunes app to smart TVs including Samsung sets.

iTunes is already available on Windows PCs and Apple Music is on Google's ( GOOG , GOOGL ) Android, but Apple could still spread its services across more types of devices from more manufacturers. And if the company is hoping to reduce its overwhelming reliance on hardware sales, that might be its best bet moving forward.

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Email Daniel Howley at dhowley@oath.com; follow him on Twitter at @DanielHowley . Follow Yahoo Finance on Facebook , Twitter , Instagram , and LinkedIn.finance.yahoo.com/