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Apple Will Outperform on Growing Services Sales, Says Analyst

By Rich Smith - Jun 6, 2019 at 3:00PM

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Evercore ISI thinks it's time to take a bite of Apple.

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...

The stock market is a fickle beast.

Once upon a time (actually, just last year), Apple (AAPL -5.64%) won the race to become America's first trillion-dollar company. It's lost that honor since, and currently has at a market capitalization of less than $850 billion. However, investors may still entertain hopes of seeing Apple hit 13 figures again.

This morning, Evercore ISI explained how that might happen.

Exterior of an Apple Store in Milan, Italy

Image source: Getty Images.

How Apple shares can move higher

Getting back to a trillion won't be easy. It won't happen in a day. Both revenue and units sold of Apple's marquee product -- the iPhone -- remain "muted," says Evercore. But as the analyst explains, "[W]e see several catalysts that should enable the stock to grind higher from current levels." (How much higher? To be precise, Evercore is looking for a rise to $205 per share within a year, which would add 12% to Apple's market cap, putting it at about $950 billion -- which isn't technically a trillion, but close enough for government work, as the saying goes.)

One of the catalysts that Evercore is counting on will be the iPhone itself. Evercore believes that Apple will "launch" a 5G-capable iPhone toward the end of its fiscal 2020, which should lift both unit sales and revenue. In the meantime, Evercore also sees "easing commodity costs and better leverage" helping to grow the gross margin on the iPhones the company does manage to sell this year.

iPhones aside, though, Evercore also believes that the Apple "narrative" needs to shift "toward services and a higher mix of recurring revenue for AAPL."

How services can help Apple

Now, at first glance this might seem a tough row to hoe. As my fellow contributor Ashraf Eassa pointed out last year, 87% of all profits earned by all smartphone makers around the world go to Apple, which is why the iPhone is so key to the business. Tech analysts estimate that the iPhone 8 earns the company a gross margin of 59%, while the iPhone X and iPhone XS Max have a gross margin of 64%. Other, non-iPhone "hardware sales," says the analyst, have even better margins.

And yet, Apple's services margin isn't too shabby, either. In Apple's 2018 financial report, for example, the company let on that it generated $37 billion from services, and earned 60% gross margin on those sales -- very close to flagship-phone levels of profit.

Evercore notes that Apple is currently growing its services revenue at a double-digit clip "with potential acceleration given new revenue streams" (such as Apple News+, which racked up 200,000 subscribers in its first week).

Rounding out Evercore's list of potential catalysts to drive the stock higher is the analyst's belief that Apple's ongoing share buyback program "enables 2-4% share reduction." Because fewer shares means more profit per share, buybacks should improve the rate at which the company's profits would otherwise grow, and presumably translate into a higher stock price.

What it means to investors

I'm inclined to agree. Like Evercore, I see a path forward for Apple climbing to a higher stock price than it fetches now. Maybe not $205, precisely, but almost certainly more than the current $183 and change. Here's why.

With $57.2 billion in trailing earnings, $59.8 billion in trailing free cash flow, a $842 billion market cap, and $80 billion in short-term cash helping to offset $90 billion in long-term debt, Apple's enterprise value today is about $852 billion. Valued on GAAP earnings, the shares trade for a 14.9 multiple. Valued on free cash flow (which I prefer), the stock's even cheaper at a 14.2 multiple.

Now, most analysts who follow Apple stock agree the company could grow its profits at about 13% annually over the next five years. Add in a modest 1.7% dividend yield, and you're looking at a 14.7% annual return on the stock -- very close to the "right" price when you value Apple on earnings, and even a bit of a discount relative to its enterprise value.

Seems to me a company raking 87% of the smartphone industry's profits should probably fetch a bit of a premium to fair value, though -- and certainly not a discount. Simple math, therefore, tells me that Evercore is right, and Apple stock should "grind higher" from here.

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