Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
For Apple (NASDAQ:AAPL) investors, the big day is nearly here. On Monday, March 25, Apple plans to hold a media event at which it will (probably) unveil a new subscription-based TV service -- and potentially other services, such as a news subscription service.
Investors are getting excited, and analysts are rushing to capitalize on that enthusiasm ahead of the main event. TheFly.com reports that already today, two analysts (Wedbush and Citi) have raised their price targets on Apple stock, to $215 and $220, respectively. A third analyst, Needham & Co., went $5 further, and upgraded Apple shares to "strong buy" with a target price of $225.
Here's what you need to know.
Time to tune in
Apple's announcement of a streaming TV service to rival those offered by Netflix, Hulu, and Disney has been "long awaited," says Wedbush, and for good reason. This new service could tie current iPhone users even tighter to the Apple ecosystem at a time when sales of new iPhones are coming under pressure, shoring up the tech titan's revenue streams against future disappointments.
As Wedbush calculates it, Apple's service business accounts for roughly 44% of its $900 billion total market capitalization, even though size-wise it makes up less than 20% of the company's revenue. The reason: As my fellow Fool.com contributor Daniel Sparks recently pointed out, Apple's services business boasts a robust gross profit margin of 63%, versus a companywide gross margin of just 38%.
With services revenue poised to grow to $50 billion annually by 2020, this could be the growth driver for Apple stock going forward.
Check out the latest earnings call transcript for Apple.
The network effect
Needham agrees. Upgrading Apple stock to "strong buy" today, Needham hearkens back to its recent report on network effects and how they power the profits at FAANG stocks, of which Apple is one.
As Needham explains in a note covered by StreetInsider.com, a new streaming TV service would add upside to Apple's market value because it would enhance the company's already strong network effects. (If you don't know what "network effects" are, just visualize an iPhone user chatting on iMessage while listening to Apple Music, or driving a car and navigating with Apple Maps, and you'll get the picture. With each new service the company offers, all the other services in the Apple ecosystem become more valuable, and an iPhone owner is less likely to turn to other providers for their apps -- or switch to Android.)
It's the large number of services accessible through an iPhone that helps to drive iPhone sales, explains Needham, and the utility of the iPhone that makes new Apple services more likely to succeed.
What it means in dollars and cents
So what does all this mean to investors? Citigroup breaks it down by the numbers: Apple generated $62 billion in positive free cash flow last year, according to data from S&P Global Market Intelligence. And despite weakening unit sales of iPhones, Citi expects Apple to be able to maintain annual free cash flow in the $60 billion to $65 billion range going forward, "despite dour sell side sentiment" from other Wall Street analysts.
These estimates, which basically translate into flat free cash flow going forward, may not excite growth investors much -- indeed, Citi believes that "many growth investors" have soured on Apple stock, with short interest in the shares recently hitting its highest level in the last two years. However, for value investors, the chance to buy Apple shares at just 14.3 times trailing free cash flow arguably opens the possibility that Apple has become a "value" stock.
But is it, really?
Currently, Apple is paying a 1.6% dividend yield, and is pegged for 11% long-term profits growth on Wall Street -- a total return of 12.6%, which puts Apple stock close to the magic ratio of its total return matching its expected price-to-free-cash-flow ratio. If Citi, Wedbush, and Needham are right, however, then it's at least possible that the introduction of a paid streaming TV service could soon add enough high-margin revenue growth to grow Apple's profits faster than 11%.
At 14.3 times free cash flow, all it would take to push Apple's total return up to 14.3% (or better) is a couple points of incremental growth. Wall Street seems to think the company can do it.