2 Choices For Apple

| About: Apple Inc. (AAPL)

Summary

A base case of $130.29 assumes Apple changes nothing. If history tells us anything Apple will definitely not take this route.

If the firm conducts a major overhaul of the iPhone line the stock should be valued at $147.16.

If the firm opts to increase the encapsulating Services revenue segment the stock should be valued at $149.21.

Apple (NASDAQ:AAPL) is at a crossroads where they have to make a decision to rely on the slowing growth of the iPhone or shift their focus to their services segment. Below are two models comparing the effects of both options. For comparison, the base case DCF model, with no shift in revenue distributions or expenditure growth, values AAPL shares at $130.29.

Though the first route seems grim, because of slowing smartphone growth as shown in the chart from Statista below, let's take a look at the numbers.

In the past two years, Apple has increased its R&D by an average 19.07%. By projecting this rate forward and normalizing with a percent of sales figure the model expects R&D to be 6.53% of sales in 2019. To benefit the iPhone and maintain current rates of growth for other lines R&D will have to increase at a higher rate, and the extra spending must be devoted solely to the new iPhone's development.

To model this the rate of increase is bumped up to 25%. The extra 5.93% puts R&D spending at 7.43% of sales. This will also be boosted by a larger expected sales number overall. With Apple's record of reliable innovation that customers believe in an increase in R&D would likely result in positive growth. Prior to the drop this year the iPhone sales were increasing at 35.6% year over year. To restore the sales growth rate quarter over quarter sales must increase by a net 2.8% quarter over quarter in 2017 and then increase at a 1% rate moving forward. Also, since the iPad can benefit from new technologies implemented in the iPhone the model also adds .7% quarter over quarter net increase in 2017 sales for the iPad. The increase is severely dampened due to the iPhone 6, and 7 Plus offering iPad-like screens, and these large-format phones are cannibalizing iPad sales. Case in point, the revenue for the Microsoft Surface line doubled in 2016 to its highest level to date, while revenues for the iPad have been slowing down since Q1 2014 as shown below.

But in ideal conditions some new customers, from other smartphone lines, will likely adopt the Apple ecosystem through an iPad. With these changes the new model values the firm at $147.16.

The second scenario comes from wording in the last quarterly report. Apple says "as part of its strategy, (Apple) continues to expand its platform for the discovery, and delivery of digital content, and applications through its Digital Content, and Services, which allows customers to discover, and download digital content." As premium hardware lines from several tech companies have saturated the market, Apple is leveraging a customer that is encapsulated in Apple gear by offering them services to complement their hardware. To do so they will have to increase R&D again, but this time devote it primarily to developing the Services unit. It is also important to note that in this scenario they cannot shy away from continuing innovation in the hardware lines. Failing to sustain the current hardware ecosystem will cause customers to move over to more lucrative, and innovative lines. For this reason, R&D will have to be significantly increased.

Again, time for the numbers. As mentioned R&D will have to be significantly increased. For this scenario, the increase is 30% over the three-year average putting the 2019 figure at 8.36% of sales. The stark bump in expense here is due to new development. Building new services from the ground up takes more capital especially when the customer base expects the utmost quality. As with all stocks, this is a gamble. A product failure would put Apple several years back in cash flow, thus forcing them into a corner for future options. As with high risk, however, there is a possibility of high reward. Assuming an industry average scenario this tremendous increase in expected expenses is also offset by a large growth rate.

Subscription-based service companies such as Netflix and Spotify have experienced 20.71% and 81.76% annual revenue growth in the past five years, respectively. Taking an average of both firms we arrive to a value of 51.23%. Though these firms had the first mover advantage, Apple has the ability to push convenience and integration through current Apple product users. Moreover, Apple represents a strong but growable position as shown below in MIDI's research.

Clearly users appreciate the product as it has a sizable market share. A net increase of 5.5% in 2017 and 5% growth from then on puts the revenue stream just shy of 50%. The model also accounts for an increase in iPhone and iPad sales by 5% from 2018 on. Assuming the services are successful and able to reach the expected growth rate, more users will move into the Apple ecosystem than expected, thus driving up hardware sales. Using these inputs the firm is valued at $149.21.

These valuations are very close showing the increase in reinvestment creates a similar trajectory whatever choice Apple takes. It is safe to assume with the current effectiveness of the firm's capital the stock should appreciate regardless of the option or even with a blend of both.

The coming quarter and shift toward or away from hardware will show which option they are taking. This said, the second growth factor is much more likely. With heavy smartphone saturation, it would be a feat for the iPhone to regain lost ground in growth rates. As shown above smartphones sales are expected to consistently fall from 2018 on.

The only viable option to break this trend is to increase the rate at which current Apple customers switch to the next iPhone. Currently iPhone users are 20% more likely to switch to the new model when released, according to Forbes. With such a large lead, it is unlikely the firm will push this gain further.

Unless Apple is able to convey to customers to buy several phones, switch to the new model more often, or increase the access of their hardware to new markets it is terribly unlikely they will break the trend. For this reason, it is much more likely the firm will opt for the second choice. Going the services route should improve margins, diversify revenue streams, and result in higher free cash flow. But this model is highly dependent on Apple's ability to deliver. A large investiture in R&D is at the end of the day a gamble. As an investor, you have to decide whether Apple is a pair of aces or a two and a three.

To better understand the models, feel free to email me at pranav@monthlycashthruoptions.com and I'll send you the complete excel sheet with formulas.

Supporting Documents

  1. AAPL_comparison_DCF.xlsx

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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

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