Apple (NASDAQ:AAPL) received a vote of confidence on Wednesday when Evercore ISI analyst Amit Daryanani reaffirmed his outperform rating for the technology giant's shares. While investors should never rely solely on an analyst recommendation for their investment decisions, Daryanani does have an interesting point about why he thinks sentiment toward the stock is improving this year.
Supporting Daryanani's bullishness on Apple stock is his take on the company's fast-growing services business. The lucrative segment's rapid growth and management's increasing focus on it are causing investors to reevaluate the way they think about Apple, the analyst argues.
It's about services
In a note on Wednesday (via Barron's), Daryanani increased his 12-month price target for Apple stock from $215 to $217. This potential upside in share price appreciation, combined with Apple's 1.5% dividend yield, represents a possible 8% return from where shares are trading today. Notably, the return would come on top of a nearly 30% gain for Apple stock year to date.
While Daryanani lists a number of factors that make the stock a buy, including a likely improvement in Apple's consolidated gross profit margin due to a decline in memory chip prices and increased Mac sales thanks to the launch of new versions of the computers, the analyst is particularly optimistic about Apple's services business.
"We think AAPL remains a 'revaluation' story as the focus shifts from growing the install base to monetizing the install base," said Daryanani. In other words, investors are assigning greater value to the opportunity for Apple to grow its services business.
It makes sense that investors have grown more optimistic about Apple stock as management has shed more light on its services segment, which includes revenue from services like Apple Music and iCloud and digital stores such as the App Store. When Apple reported its results from the first quarter of fiscal 2019 earlier this year, the company began reporting its services gross margin for the first time. The move likely prompted many investors to assign a greater value to the segment. With a gross margin of 63% at the time, investors learned that services boasted far better economics than Apple's hardware business (the company's products segment had a 34% gross margin during the same period). Not only was Apple's 63% gross margin for services higher than some analysts were expecting, but it's widening. Apple's fiscal second-quarter services gross margin was 64%, up from 63% in Q1 and from 62% in the year-ago period.
A key catalyst
Of course, services is more than Apple's most lucrative business segment. It's also the company's second-largest segment -- and it's growing at a torrid pace. In fiscal Q2, services accounted for 20% of revenue, up from 16% of revenue in the year-ago quarter. Revenue in the segment increased 16% year over year, helping offset some of the quarter's 9% decline in hardware revenue.
To help support continued growth in the segment, Apple unveiled four new major services earlier this year, including Apple News+, Apple Card, Apple Arcade, and Apple TV+.
If the segment can keep delivering strong growth and maintain its impressive profit margin, Apple could easily earn a price-to-earnings ratio of 20 or greater -- up from its P/E of 17.1 today -- as investors realize the value of a more sustainable and higher-margin business than the hardware sales that got Apple to where it is today.