Image source: Apple.
Goldman Sachs is out with a bullish note on Apple (AAPL 1.27%). The investment bank has added the company to its "conviction buy list" with a price target of $163 per share, implying a big upside potential of nearly 40% from current prices.
Wall Street analysts can make mistakes just like everyone else, and these kinds of forecasts depend on multiple assumptions that may turn out to be right (or not). For this reason, investors need to always do their own homework as opposed to blindly following recommendations from Wall Street. However, in this particular case, the analysts at Goldman Sachs seem to have a strong case.
The main idea
In a nutshell, Goldman Sachs believes that Apple is undervalued because investors are pricing the company as a typical hardware manufacturer. Hardware companies tend to have unstable and cyclical revenues -- the winner of today can easily be the loser of tomorrow -- so companies in the industry typically trade at low valuation levels.
Analyst Simona Jankowski highlights in the report that Apple trades at a price-to-earnings ratio that's 30% below the average valuation for companies in the S&P 500 index. Apple carries a P/E around 13 versus approximately 19 for the average company in the index.
However, Goldman Sachs believes that Apple is transitioning into a services business, this could provide additional growth venues for the company, and it would also make revenue more stable and predictable. In their own words:
We expect that over the next year, the focus will shift from unit growth (which is slowing given a maturing smartphone market) to installed base monetization and recurring revenues ("Apple-as-a-Service"). Apple's model has already tilted that way with its new iPhone 6s installment plans, and we see the upcoming TV service as a powerful next step.
Under that scenario, the analysts at Goldman Sachs believe that Apple's valuation should be more in line with that of other companies focused on services and producing recurrent revenue, and that's the main idea behind the bullish thesis for Apple stock.
Can Apple stock rise 40%?
Apple is in fact going through an important transition that could make revenue more stable and predictable in the future. The company is increasingly venturing into services and subscriptions via iCloud, iTunes Match, Apple Pay, and Apple Music. Customers can buy all kinds of services, subscriptions, and digital content via Apple devices, and the company makes a commission on these purchases. Apple is also reportedly working on a TV/video subscription service as well, and this could mean a big boost to the company's revenue in this area.
And the latest iPhone upgrade program could be a major game changer. iPhone users can now pay between $32 and $45 monthly to lease an iPhone directly from the company, and it wouldn't be too hard for Apple to extend this program to products such as a Mac, iPad, and Apple Watch.
Hardware leasing programs in combination with services and subscriptions could make Apple's revenue smoother by reducing dependency on annual product launches, and they could also make it more affordable for consumers to enter the Apple ecosystem. This would have huge implications in emerging markets, where the carrier-subsidy model is not as common as in the U.S. and many customers find Apple products too expensive. This new dynamic could be beneficial to both customers and investors, since it would dissipate concerns about slowing sales in the coming quarters.
It's hard to tell if Apple will reach $163 per share in the medium term, as this will depend on multiple factors related not only to the company's fundamentals but also to investor sentiment and overall market conditions. On the other hand, Apple is clearly cheap due to fears about slowing growth in the future. If the company can prove to investors that it can sustain better-than-expected performance in the years ahead, then Apple stock offers material upside potential from current levels.
