In Greenlight Capital's first quarter 2012 letter to investors a significant section is devoted to a discussion of Apple (NASDAQ:AAPL), one of their largest holdings. In their articulation of how they view Apple they say that "rather than view AAPL as a hardware company, we see it as a software company that monetizes its value through the repeated sales of high margin hardware."
On April 24th, Apple reported its earnings for the quarter ended March 2012. Its EPS of $12.30 per share beat expectations by over 22% as iPhone 4S sales soared in China. In the quarter Apple sold 35.1mm iPhones, above most analyst projections leading to the earnings beat. Gross margins were also stronger than expected, largely due to the massive iPhone sales. That's the hardware side. But how do investors assess the power of the software?
On the earnings conference call Apple CFO Peter Oppenheimer referenced the iCloud when he said: "And iCloud is off to an incredible start, currently with more than 125 million customers signed up since its launch in October."
There is no doubt that the unit sales of the iPhone and iPad will drive quarterly earnings. As Greenlight Capital suggests it is through the sales of hardware that Apple monetizes its software. This can potentially lead to lumpiness in the quarterly results as we saw in the earnings announcement for the quarter ended September 2011 when iPhone sales fell below Wall Street estimates because consumers were waiting for the release of the new iPhone 4S. Apple's stock declined 6% post-earnings as a result.
When Apple next releases earnings in July the focus will again be in iPhone and iPad sales. Given the increasing rumors around an iPhone 5 there again may be a slowdown in sales as consumers delay purchases. I agree with Greenlight's view that Apple is a software company and, as a result, the number I will be focused on, is not iPhone or iPad unit sales. I will be looking for an update on the number of iCloud users. This is the best indicator of the power of Apple's software platform. An iCloud user is an Apple customer who likely has more than one Apple product, and is likely to be loyal and continually upgrade as new hardware is released. iCloud will only improve over time as more services are offered and its resulting ability to provide stickiness to the Apple ecosystem will grow in lockstep. Given that Apple sold 35mm iPhones and 12mm iPads in the last quarter, I want to see the consumers who were making their first Apple purchase migrate into the Apple ecosystem and become part of Apple's recurring revenue stream. I hope to see this in the iCloud user number.
Let's try to quantify this concept.
Let's make the following assumptions, which I believe to be conservative:
- All iCloud users have more than one Apple device
- 100% of users have an iPhone
- 60% have an iPad as their second device
- 40% have a Mac as their second device
- Unit pricing per Apple's March 2012 quarter (~$650/iPhone, $560/iPad, and $1260/Mac)
- iPhone users upgrade/replace their phone every 2 years, iPad users every 2.5 years, and Mac users every 5 years
These assumptions lead to $70 billion of annualized recurring revenue. The consensus estimate for Apple's fiscal 2012 sales is $162 billion. This then suggests that 43% of Apple's 2012 revenue is recurring. If iCloud users doubled to 250mm under these assumptions recurring revenue increases to $140 billion or 86% of Apple's projected 2012 revenue.
We have left out Apple users who have more than 2 devices. Let's assume that 25% of iCloud users have a third device. If we assume that 75% of iCloud users have an iPad and 50% have a Mac recurring revenue increases to $77 billion or roughly half of Apple's projected annual 2012 revenue. If we decrease our assumption on the replacement cycle on all three devices by 6 months (to 1.5 years for iPhone, 2 years for iPad, and 4.5 years for Mac) recurring annualized revenue increases to $98 billion or 60% of annualized revenue. Finally, under this scenario, if iCloud users doubled to 250mm, the recurring revenue stream increases to almost $200 billion, which is greater than Apple's projected 2012 revenue. That is the power of the iCloud ecosystem.
You can tweak these assumptions but the point is clear, a significant amount of Apple's revenue from the sale of hardware is recurring revenue that exists because of a closed software ecosystem that is only accessible from Apple hardware. If Apple brings a TV product to market, while it will likely have a much longer replacement cycle, it is additive to the recurring revenue steam. It makes the system even more powerful and will lead consumers to purchase additional Apple hardware. Said another way, the percentage of iCloud users that have 2, 3, 4 or even 5 devices will increase.
From a valuation perspective Apple remains inexpensive. At $576 per share, Apple still only trades at 10x consensus fiscal 2013 earnings (8.5x if you remove the cash). Further, with the $10.60/share annual dividend on the way Apple offers a decent 1.8% dividend yield. And despite these low multiples, Apple is a growth company and has averaged 91.5% EPS growth over the last six quarters.
Don't get lost in quarterly results based on backward looking hardware sales. You need to consider the recurring nature of Apple's revenue streams and think bigger. The growth of the iCloud user-base is the best measure of Apple's true power.
Disclosure: I am long AAPL.