It's Time to Acknowledge Apple's Other Business

Apple's (NASDAQ: AAPL  ) iTunes, software, and services revenue is growing rapidly, and investors can't ignore it much longer. In just one sentence, Asymco Apple expert Horace Dediu eloquently illustrated this idea in a new blog post: "On a yearly basis iTunes/Software/Services is nearly half of Google's core business and growing slightly faster."

Apple shareholders, it's time to begin acknowledging the implications of Apple's fast-growing side business.

Is Apple's business sustainable?
That's ultimately one of the most important questions Apple investors can ask right now. Because if Apple's current levels of cash flow are sustainable, Apple is grossly undervalued. Measured by free cash flow yield, or free cash flow per share divided by share price, Apple is basically priced for zero growth; 9% free cash flow yields are hard to come buy in this pricey market.

Keep in mind that free cash flow is the cash left after operating expenses and capital investments used to expand a company's asset base. This cash is the good stuff used to enhance shareholder value by paying dividends, repurchasing shares, making acquisitions, or reducing debt.

To have a free cash flow yield of 9% at today's valuation, Apple recorded a whopping $44.2 billion in free cash flow in the trailing 12 months. This kind of cash, used wisely, can add meaningful value over the long haul. But can Apple maintain the revenue and margins needed to sustain these levels of free cash flow?

More reliable non-product revenue
With a valuation that prices in very little, if any growth, Apple's more reliable and consistent non-product revenue is a valuable asset to investors -- especially as it grows larger. iTunes, software, and services revenue is a much more reliable source of revenue for Apple investors than product segment revenue. It includes revenue from iTunes, which includes the App Store, the Mac App Store, and the iBooks Store, and revenue from AppleCare, licensing and other services. As Dediu explains, not only is the source of revenue large, but it's growing fast too.

Just how voluminous is Apple's iTunes, software, and service revenue? When expressed in total billings (as Google reports its revenues) -- not just the 30% Apple keeps after it pays third parties -- the segment's quarterly revenue now amounts to approximately $7 billion. Measured this way, the segment would be ranked at 130 among the Fortune 500 businesses, Dediu says.

Growth is for the segment is impressive. With $23.5 billion in revenue in the past twelve months, revenue for the segment is up 34% year-over-year. By Dediu's estimates, app revenue was up a whopping 105% in the full year of 2013 and revenue from all third-party content combined was up 46.6%.

Still small, but not small enough to ignore
Apple's iTunes, software, and services revenue may still be a small portion of total revenue, but not small enough to ignore anymore. Reporting by gross revenues, Apple's iTunes, software, and services revenue accounted for about 12% of Apple's total first-quarter revenue, or more than Apple's Mac segment.

Investors should begin to include Apple's iTunes segment in calculations of Apple's enterprise value and their forecasts over the long haul. The segment's growing significance is good news for investors. The larger this segment grows as a percentage of total revenue, the more reliable Apple's overall revenue will likely be -- and Apple isn't priced for reliable revenue at 13 times earnings, less than half the premium to earnings Google trades at.

Of course Apple's core product revenue is still the primary driver for the stock, especially given the iPhone's monstrous profit margins. But investors need to begin to analyze the potential impacts of this growing non-product business on Apple's overall story.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 10, 2014, at 10:16 PM, DanManners wrote:

    Dan,

    I am a little long apple right now, but I firmly believe that Apple's sales will suffer and their buybacks are a sign of desperation. I believe they will borrow money and do what Icahn wants. They told him that and he knows it will be harder for them to do it if it looks like Icahn forced them too.

    They are going to come out with new stuff and a bigger phone but that is where i diverge. The bigger phone will not add customers as many will buy a phablet instead of a tablet and a phone. That will offset new sales. I don't know exactly but it will impact it. Just like China Mobile fizzled out that will too. Their could be a net positive effect but not as huge.

    New products dont mean new successes. There is no guarantee that a new product will succeed like many feel the 5c failed. Yes it is hard to say but it wasn't a runaway success. It may have helped margins but I have read many articles and there is no concrete proof.

    I hope I am wrong and I hope they succeed but that is a big if. Otherwise they will still have cash for awhile and can used their foreign cash in emergencies but the cash growth will slow or disappear.

    One other possibility is that they dont get defeated easily and start pushing out products hoping one is a success. Or their watch (for instance) is not that successful at first but they figure out what was wrong and fix it. They have cash to do all these things. Who really knows. They don't even know what will definitely work.

    I hope this New Years Eve I post that i was so wrong and Tim Cook is fantastic.

  • Report this Comment On February 11, 2014, at 7:36 AM, demodave wrote:

    "I hope this New Years Eve I post that i was so wrong and Tim Cook is fantastic. "

    Dan Manners,

    Why wait? Icahn essentially caved. Cook stayed on focus. I think this little "breather" on Apple is a bit too extended, but I do think it is a lull and that both earnings and P/E will increase over the next 12 months. I'm sure my expectations are just as well backed by "proof" (your word) as yours.

  • Report this Comment On February 11, 2014, at 7:39 AM, jdmeck wrote:

    Dan M - You are very much mistaken about the buyback. It was a great time for them to buy and a fantastic opportunity. Apple has more than enough cash and the purchase has already been rewarded very nicely. They will never give Icahn what he wants, and if I'm wrong, only then will I agree with you, and only then will I sell.

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