What We Got Wrong About Apple

| About: Apple Inc. (AAPL)

Summary

Apple's rise today is driven by service revenue.

CEO Tim Cook put billions of dollars to work and is now a player in cloud.

This is a game-changer for Apple's shareholders.

Apple (NASDAQ:AAPL) has been outspending Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT), IBM (NYSE:IBM) and even Amazon.com (NASDAQ:AMZN) on cloud over the last year. This had many Apple bears, and even bulls like myself, ringing alarm bells over the short-term earnings outlook.

We were wrong.

The lesson of Apple's third-quarter report, which sent shares soaring today, is that CEO Tim Cook knows what he is doing. Services really can drive earnings forward.

What's needed to be a player in cloud is cash flow that can sustain an immense capital investment, where $1 billion/quarter is an ante to the game. Amazon got it from the store, Google from search, Microsoft from software, and Apple from its devices.

But the question for me always was whether this investment could be sustained by organic revenues coming from things that clouds do, the creation and delivery of purely digital goods. It was to sustain its capital investment that Amazon began selling cloud as a service in the first place.

A second thing a player in cloud needs is a CEO willing to pull the trigger and make the investment ahead of those revenues. Facebook (NASDAQ:FB) CEO Mark Zuckerberg did that, deciding it would be better for his fast-growing company not to be dependent on Amazon for a service he considered vital. Facebook's shareholders have benefited enormously from that. It's now clear that Cook made the same call. His goal, and it's now within reach, is to become independent of all competitors in cloud - Amazon, Google, the lot.

Cook said yesterday that he believes Apple's service revenue can make it into the Fortune 100, on its own, within a year. Last year, that meant $28 billion in revenue, $7 billion per quarter. It is a measure of Apple's past success that this would represent only 12% of its own 2015 revenue, which came in at $233 billion. But if it's growing faster than the rest of the company, and if the profitability is through the roof (once the capital costs are taken out), it's a game-changer for shareholders.

With its cloud investment, Apple has put itself in position to host the next Pokemon Go, the next augmented reality hit, wherever it might come from. It has put itself in position to go after the computing contracts of other Fortune 500 enterprises and to make itself independent of IBM except as a sales force.

All this puts a completely different gloss on a report that, based on Apple's devices, really wasn't that great. Macintosh sales are continuing to decline, the iPad has peaked, and iPhone growth is slowing. It was in expectation of all this that Apple's stock had been sinking since its last report in April, from $112/share to below $92. The question now is how much higher it can go, whether it can threaten or even surpass the all-time high of $132.54 achieved last year, when Apple seemed poised to become the world's first trillion-dollar company.

What we know now is that it can. Whether it will make it depends on what it can do on the product side. Its next product roll-out just became a hot ticket again.

Disclosure: I am/we are long AAPL, AMZN, GOOGL, MSFT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.