- More than just the iPhone, the iMac, and the iPad, Apple is also about a wide array of software tools together with services that are bundled into product sales.
- With an expanding user base and increased monetization of assets, the company is expanding its Appstore as part of the app economy.
- With a high degree of vertical integration, Apple's closed-loop confers protection against competition.
- Its growing tilt towards software and services should be rewarded and the company will be valued accordingly.
- Finally, as a high growth stock, volatility should be there due to inflationary concerns, but the company is cash-rich.
Analysts love to talk about the iPhone, often downplaying it when comparing the number of devices sold with respect to other smartphones, like Samsung's (OTCPK:SSNLF) Galaxy S21. However, it is important to go deeper into the software aspect as the company progresses on quarterly sales.
Now, Apple (NASDAQ:AAPL) does not separately report its software revenues as this is bundled in the sales price of the respective product as well as services. With the company expanding its devices (iPhone, Mac, and iPad) ecosystem, there are opportunities for monetization.
I start by providing insights into the software part.
Software above all
Last year, Apple's annual developer conference was marked by a major shift, with the relinquishment of Intel processors for its Mac computers, in favor of internally designed chips. With this change, Apple has more flexibility for the software developed by its teams and the vast development community. Here, Apple's strategy of owning core technologies, not only enables it to run its own schedule of chip development but more importantly to integrate its devices more deeply with the operating system software.
Hence, the June 2021 WWDC (Worldwide Developers Conference), which sets out Apple's roadmap for the coming months, gave importance to new operating systems.
One of the most notable novelties is a redesign of its audio and video calling tool, FaceTime.
Faced with the growing success of Zoom (NASDAQ: ZM) or Microsoft (NASDAQ: MSFT) Teams video conferencing tools, Apple has chosen openness. Thus, initially reserved for owners of iPhone, iPad, or Mac, FaceTime is now available on Google Android smartphones or Windows PCs. FaceTime now exhibits many of the functionalities of Zoom, with a better user experience.
Furthermore, more proximity within the Apple ecosystem, namely between tablets and computers, reminds me of the secret sauce which made Windows such a valuable platform in Microsoft's vast ecosystem of hardware some ten years back. For this matter, Apple also has the iPhone.
Hence, in addition to some ease-of-use features like switching from a Mac to an iPad without seeing the difference through the "Universal Control" function, there is that inbuilt capability through iOS 12 to allow projection of sound or videos directly from an iPhone to an iMac computer.
Thus, one day, it may be the Appstore that will drive iPhone sales.
Now, according to a report by Business Standard, Apple made a record $64 billion in revenues from its App Store in 2020, a 28% increase from an estimated $50 billion generated in 2019. This was due to sales growth accelerating strongly during the Covid-19 pandemic, as the 2018 to 2019 growth was estimated to be only 3.1 percent.
This growth brings to mind the idea of monetization or the process of earning revenue from an existing asset, in this case, the iPhone. It is important to assess whether Apple is able to generate a higher ARPU (Average Revenue Per User) through monetization of the installed base.
Monetization of the iPhone
One way to gauge how Apple profits from its massive installed base of iPhones is to check revenues from the Services division, which comprises the App Store, cloud services, music, video, advertising, and payment services, as well as Apple Care.
In 2020, total services revenue was $53.8 billion, which is double the amount from 2017. I mention 2017 as, during that year, Apple's finance chief, Luca Maestri, while setting out his sales targets had said that its services division will become "the size of a standalone Fortune 100 company". The $50 billion sales objective he had put forward at that time has now been exceeded.
Still, these figures are dwarfed by iPhone sales amounting to $137.8 billion, but the trend has been erratic for the smartphone, especially with COVID impacts. On the other hand, Services revenue has incremented by a consistent 16% since 2018.
Source: SEC filings through Seeking Alpha
Now, in 2021, Services revenue for Apple's third quarter (or the three-month period ending on June 26), was $17.5 billion or 33% more than the corresponding period last year.
More important the gross margins obtained from Services have constantly been increasing, from 60.8% in 2018 to 66% in 2020, while for products, there has been a decline from 34.4% to 31.5% in the same period. Pursuing further, the third quarter saw Services gross margins move up to 69.8%, with Products gross margins also managing to reverse the trend, by being up to 36.0%. These were mostly due to higher volumes and a product/services mix.
Now, with more services bundled into sales, there is a high probability that sales from the Services gross margins will cross the 70% mark, in the same way as software companies.
Source: Charts built from SEC filings
In this respect, the record June quarter revenues of $81.4 billion, which represented an increase of 36% from a year ago, saw double-digit growth in each of the product categories (including iPhone, Mac, and Wearables, Home, and Accessories). These helped to drive an all-time record for services revenues.
Also, by encouraging developers from all walks of life and around the world to join its community through financial incentives and empowering them with technologies, like augmented reality and software programming like Swift, Apple has significantly raised monetization prospects of the Appstore.
Coming to competitive positioning, many analysts were disappointed with the September 14th product announcement day and the market reacted accordingly, punishing the iPhone maker's stock as well as its component suppliers.
Apple is often compared with rival Samsung. The latter appears more innovative with the features offered on models such as the Galaxy S9. The Korean smartphone maker also has the upper hand through its AMOLED curved display which renders the image more immersive than that of the iPhone. Many gamers also see Samsung as more value for money.
However, iPhone revenues were at a record $39.6 billion in the June quarter, growing 50% year-over-year with performance being consistently strong across the world and double-digits in each geographic segment. This shows exceptional customer loyalty and the strength of the Apple brand.
Another positive for the company is the Gartner Smartphone sales report stating that, while worldwide sales declined 5% in the fourth quarter of 2020, Apple became the top smartphone vendor, with Samsung experiencing a year-on-year decline of 14.6%, but, it still retained the No. 1 global smartphone vendor position in full-year results.
Admittedly, this has been a weird 12 months, and purchasing decisions may have been impacted by the pandemic, like working from home. In this case, according to PCMag, "for years, iPhones have had the upper hand when it comes to processing power, and it doesn't look like the tide has turned just yet". This may be due to users like myself who use the productivity tools in the iPhone.
Moreover, I am no professional photographer or amateur gamer, but I have used high-performance software development tools on my iPhone, which, just five years ago would have required a high-end computer. On the other hand, I am highly concerned about IOS's security aspects and the protection of my personal data. Hence, I don't mind Apple simply pushing minor upgrades on its base and raking in tens of billions of dollars from product upgrades.
Finally, for those who are still not convinced, revenue was up in China of all places, despite Huawei recording the highest decline among the top five smartphone vendors in 2020.
Valuations and key takeaways
Thinking aloud, in contrast to Samsung, Apple is more vertically integrated and has full control of its ecosystem, which is a closed one, with compatibility with Android systems only existing at the application tier. For example, mail sent through an iPhone can be opened on a Galaxy J7. Therefore, there are high barriers to entry in the Apple bastion.
Furthermore, with an active installed base of iPhones reaching new all-time highs and the latest survey of consumers from 451 research indicating 97% of customer satisfaction, together with that software tilt, I see monetization building up stronger.
Coming back to my earlier comparison with Microsoft, which also exhibits a gross margin of 69.7%, Apple with its Services division showing 68.9%, deserves higher valuations from the current 27.76x Price to earnings multiples. Adjusting for a moderate increment of 10% from a possible estimate of 26.6% (35.14/27.76) as Apple expands Services, I have a target price of $155-157. By the way, this is the peak reached in the second week of September.
I am not bullish because of some IOS goodies like iMessage photo sharing. Also, the growth in iPhones sales numbers was high due to 2020 being a low year and going forward, there are questions about whether these figures can be sustained. I am bullish because of the way Apple is sustainably developing services based on software.
Ending on a cautionary note, amid all these inflation talks with high-growth stocks being unnecessarily punished, volatility should remain a valid concern in the last two remaining months of this year, but with $194 billion of cash, there is the financial capability to buy back shares and pay dividends.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of XLK either through stock ownership, options, or other derivatives. 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.
This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing. The research work for this article was done with Bhoshan Woodun, who also helped in the editing.
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