Apple launched the smartphone era and remains its number one beneficiary. It was the first company to reach $1 trillion in market value, largely thanks to the iPhone. And despite much opinion to the contrary, the company is well positioned even if smartphone sales stagnate.
In aggregate, devices represented 79 percent of Apple’s business in 2018. The balance is comprised of faster-growing and closely related services like the App Store, Apple Music, and iCloud. Although iPhone revenue rose 18 percent to $167 billion during the year, the number of devices sold did not rise in tandem. Higher prices explain the difference. It’s really no surprise that phone sales would slow given that, as I wrote here recently, we appear to be entering the end of the smartphone era. Worldwide smartphone sales fell in both 2017 and 2018, according to research firm IDC. Red flags are waving.
Despite posting an impressive 16 percent growth on last year’s massive base of $230 billion in revenue and a 29 percent gain on earnings, Apple’s stock is off nearly 25 percent from its high earlier this year. This is driven largely by three things: iPhone unit sales are stagnating, recent progress has been more a function of rising average selling prices (ASPs) and is likely to slow, and Apple announced it will no longer disclose unit sales data for the iPhone, iPad, and Mac. Many on Wall Street felt that Apple wouldn’t have stopped releasing the numbers unless they were unimpressive.
But Apple doesn’t need to sell more iPhones for its stock to rise.
Services, services, services
The fastest growing parts of the business include services and “other products.” Apple’s services segment revenue consists of the powerful App Store, digital content like movies and Apple Music, iCloud, AppleCare, and Apple Pay, which is probably still in its infancy. Meanwhile, the “other products” category is comprised of more nascent efforts such as Apple TV and the Apple Watch, for which Apple does not break out numbers.
Let’s do a simple exercise. If one assumes zero growth for all primary hardware products (iPhone, iPad, and Mac) going forward, the outsized growth fueled by the services and other products businesses — which are growing near 30 percent annually — should still enable Apple to deliver at least 6 percent revenue growth and closer to 7 percent growth in profit. Further, Apple is committed to stock repurchases totaling about 5 percent of the share base annually. Adding all that together supports sustainable earnings power of 12 percent per year, a figure on par with Apple’s current forward earnings multiple of 12 times; in other words, a PEG ratio of 1. (PEG ratio is calculated by dividing the earnings multiple (P/E) by the earnings growth rate. A ratio of 1 implies a fairly valued stock.)
Based on this analysis, Apple’s current valuation prices in neither growth in device units nor growth in average selling prices. Any upside on either front would imply upside to the bottom line, and in turn, upside to the stock.
Market share opportunity
Despite lofty gains in iPhone penetration, Apple’s iOS market share still hovers around 15 percent of the total global smartphone market, compared to Google’s Android, which commands about 80 percent. These numbers haven’t changed for some time and most observers do not expect them to change significantly.
What will be most critical for defining success in the next era of the smartphone is providing consumers with quality experiences on their devices that lead them to use them even more, as well as a commitment by vendors to privacy and personal data integrity.
It will be paramount to ensure that data provided voluntarily by consumers is housed safely and not shared with third parties without permission. Apple has made a public show of contrasting its commitment to privacy with that of the big social platforms, especially Facebook.
What’s interesting is that all the tech companies that rode the smartphone wave were built on the voluntary collection and monetization of consumer personal information. But the protection of that information will likely serve as the primary differentiator for the next era of the smartphone. The fact that Android is segmented across a plethora of derivative versions available on hundreds of devices from different manufacturers in some ways confers a privacy advantage to the vertically integrated Apple.
That said, the education of the consumer in privacy is progressing rapidly and Apple is in a prime position to capitalize. Apple can in fact experience share gains versus Android as consumers worldwide increasingly prioritize privacy. The smartphone market is saturated in the high-demographic, developed-world geographies that matter most financially. But those are exactly the consumers most likely to grow concerned about privacy. If Apple can successfully position itself as the privacy-conscious brand, it could help that 15 percent smartphone market share to climb.
Apple is not a retailer
In a world where product cycles are lengthening, Apple’s lock on consumers in their ecosystem is generally rising in tandem. And their growing dependence on Apple services — whether it’s the cloud, media, or the App Store — is only increasing.
Apple trades like a retailer, as its relatively low 12 times forward earnings multiple underscores. Although management will cease unit sales disclosure next quarter, Apple will start to provide greater transparency on gross margins, including the services segment. That could illustrate some impressive realities about this business.
What we saw in recent years from both Amazon and Google was a positive re-rating of the stock when added financial transparency was provided to investors. In fact, the multiple of both companies’ stock price to its sales is up nearly 50 percent since that time.
There are question marks around Apple’s services margin, since it is comprised of multiple components such as the cloud and music. But any indication that it is additive to the margin — which should be the case — may help investors value Apple for what it is becoming rather than what it is today — a services company, not a retailer. That changes the entire valuation framework for Apple and may spur a re-rating of the stock.
Apple is in a good spot right now and the stock essentially reflects no growth in the iPhone. As long as iPhone unit sales stay at least flat (quite a conservative assumption), the stock should rise.
James Cakmak was until recently, a Wall Street security analyst covering the internet sector. He is also co-founder of Snailz, a nail salon booking app now operating in New York. Follow him on Twitter: @JamesCakmak
Ryan Guttridge, Adjunct Professor at Smith School of Business, University of Maryland, contributed to this article.