Apple's Q1 Earnings Is A Celebration Of Incrementalism

| About: Apple Inc. (AAPL)
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Summary

Apple's Q1 earnings demonstrates the power of "good enough".

The company's plans to double Services revenue should increase EPS by over $4 per share by 2020.

Under a base case scenario, we believe shares should trade above $210 by late-2019.

Did you hear it? That raucous roar from Apple (NASDAQ:AAPL) bulls for Apple's Q1 earnings beat. No doubt the market did, as the stock promptly lifted off by 7% the next day. Based on Apple's Q1 statements, we think Apple will cross $210/share by 2019.

Apple's Q1

Apple's Q1 earnings release was a celebration of incrementalism because everyone was worried about iPhone 7 sales. Let's be honest, the iPhone 7 upgrades are fairly mundane, pretty unspectacular, and nothing extraordinary. Yet, at the same time, it didn't have to be anything but. It just had to be "good enough"; incrementalism right now is its own reward. After using your phone for two years, wear and tear and the normal desire for something new for such a personal device compels you to upgrade, and upgrade they did as iPhone sales showed "growth" for the quarter and exceeding analysts' "expectations". Thus, Wall Street and Main Street rejoiced.

While we join in the celebration as Apple shareholders, what we're focused on isn't the hardware, but its Services segment. Is the performance of hardware sales important? Sure, but is a "beat" in the number of units that important, no. We're more concerned with the trend line, which is still intact. Customer captivity is still present, and customer retention rates are still high. iPhone 7 customer satisfaction was 99%, and iPhones overall garnered a 97% satisfaction rate. When you sell almost 100M devices in a quarter, it matters very little whether you sold 78M iPhones or 78.5M iPhones, what's important is that you're actually selling a staggering 78M iPhones.

Services Takes the Stage

What's even more important, and what shareholders should focus on is not what the phones can do today, but what the ecosystem can do tomorrow. We'll let Tim Cook's words speak for itself:

"Our Services offerings are now driving over 150 million paid customer subscriptions. This includes our own services and third-party content that we offer on our stores. We feel great about this momentum, and our goal is to double the size of our Services business in the next four years."

Apple previously said in its 2016 Q3 earnings call that it wanted to increase Services revenue to that of a Fortune 100 company. We analyzed this comment in a previous article.

2016

Revenue

Fortune 500 Rank

2020

Revenue

Fortune 500 Rank

Time Warner

$28.10

99

Disney

$52.46

53

Northwestern Mutual

$28.10

100

Cisco

$49.16

54

DuPont

$27.90

101

Pfizer

$48.85

55

Now, Apple says it wants to double Services revenue in three years. Ponder this for a second. Apple has publicly laid out a goal to double the revenue of its second largest business segment; a segment for which we estimate margins to be in excess of 70%. This would put that business segment on par with Disney (NYSE:DIS), Cisco (NASDAQ:CSCO), or Pfizer (NYSE:PFE). Prior to this earnings release, we had some idea that the Services segment would grow, but having Apple confirm this means that our thesis is on the right track.

Let's perform some basic calculations. If we double Services revenue, assume a 70% profit margin (similar to what we assume is the current profit margin), and Apple buys back 3% of its shares each year, here is Service's potential contribution to overall EPS:

Revenue Profit Shares O/S EPS
2016 $24,348 $17,044 5,332,313,000 $3.20
2017 $29,218 $20,452 5,247,540,000 $3.90
2018 $35,061 $24,543 5,090,113,800 $4.82
2019 $42,073 $29,451 4,937,410,386 $5.96
2020 $50,488 $35,342 4,789,288,074 $7.38
Incremental EPS from Services 2017 to 2020 $3.48
Multiple 12
Stock Price Accretion $41.78

Doubling the revenue for Services would essentially add close to $4/share to Apple's EPS, which translates to $40/share increase at a 12x multiple.

Here's the surprising thing. If Apple repatriates its cash and makes a tender offer for 20% of its shares, and then doubles Services revenue, just the increase in Services profits alone will translate to approximately $65/share.

Revenue Profit Shares O/S EPS
2016 $24,348 $17,044 5,332,313,000 $3.20
2017 $29,218 $20,452 5,247,540,000 $3.90
2018 $35,061 $24,543 4,040,605,800 $6.07
2019 $42,073 $29,451 3,919,387,626 $7.51
2020 $50,488 $35,342 3,801,805,997 $9.30
Incremental EPS from Services 2017 to 2020 $5.40
Multiple 12
Stock Price Accretion $64.78

Now, many will contend that the additional EPS will surely be less given the cost to produce/procure the content. We believe, however, the increase in Services will likely be incremental. First, some of the increase in Services revenue will come from organic growth from Apple's current product offerings and potential new ones. Second, if the growth in Services stems from a streaming service offer, then some of the content costs will be captured within the 70% margins we're assuming. Third, we believe Apple will actually use some of its repatriated cash (assuming corporate tax reform is passed) to acquire a media company to consolidate its supply chain and give it access to media content. If so, then the content development costs will be accounted for in the target's P&L.

We've examined one such scenario (involving Disney), but many other potential smaller targets exist that could serve a similar purpose, and a cash acquisition of any of these targets would almost certainly generate a higher return on investment than the current interest income Apple receives on its idle cash. A smaller acquisition could also mean that Apple could both buyback shares and acquire a target.

Bear in mind that we're running a base-case scenario, one that still easily translates to the stock increasing first by 20% from today's $130 (due to the buyback) and then potentially another $65/share by 2020 if Apple doubles its Services revenue. At today's forward 12x multiple, the accretive earnings means, as a base case, we believe Apple's shares should trade above $210/share by late-2019 (i.e., a +60% increase from today's $130/share). Note that this conservative scenario assumes that Apple's cash balance is used simply to buy back stock, acquire/license media content, and that Apple's other business segments stagnate and/or fail to grow. We haven't even mentioned the iPhone 8 supercycle, accretive earnings from a well-thought out M&A strategy, or potential new products (e.g., AR, car, etc.). While we believe our base case is too conservative, it's beneficial to understand how Apple's plans, viewed in isolation, will affect the stock price.

Apple's stock price has been trapped by its own success. In many ways this explains why Apple's stock continues to trade at such a large discount to the market. Sure size is another factor, but when the stock trades at a free cash flow yield of 10%, and the company is telling you that they aim to double Services revenue in a few years, you're getting all of the catalysts for free.

Will Apple's iPhone be supplanted one day? Will a "disrupter" appear? Possibly. More likely not though or at least not yet. Arguably, it took a once-in-a-generation iconoclast to usher in the smartphone age, and yet everyone searches around for the replacement as though such new products and insights are right around the corner. Steve Jobs brought us the smartphone age almost a decade ago, and we believe in this next decade we'll see the ecosystem evolve. So while analysts focus on the minutiae, step back and focus on the larger picture, give a cheer for incrementalism today, because tomorrow you'll see how far small steps can take you.

Disclosure: I am/we are long AAPL.

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.