It's no secret that Apple (NASDAQ:AAPL) stock looks underpriced. But Goldman Sachs believes the company is drastically undervalued, awarding its shares a $163 12-month price target and adding the security to the bank's "conviction buy" list. Trading at close to $117 at the time of this writing, shares are currently at about a 39% discount to this price target. Could Apple stock really be this undervalued? Based on a prediction that the tech innovator will increasingly resemble a service company, Goldman Sachs thinks so.
Apple as a service company
The catalyst for the increased valuation, according to Goldman analyst Simona Jankowski, will be an evolution in the way the market thinks of the tech giant as the company transitions to one that is more service oriented.
"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')," said Jankowski in a recent note to clients (via Bloomberg). "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."
For decades, investors have put Apple stock in the hardware segment. This is sensible, as the company makes the majority of its net income from hardware sales. And given how concentrated Apple's portfolio of products is, which makes predicting the success of its future product launches very difficult, the stock often trades at a significant discount to its earnings compared to other tech peers with more predictable service- and subscription-sourced net income. Alphabet and Microsoft, for instance, have price-to-earnings multiples of 31 and 36, respectively, compared to Apple's P/E of 13.
But Jankowski makes some good points about Apple's transformation into a service company and argues that this shifting model could impact the stock's valuation. Even if investors ignore her speculation about an "upcoming TV service," there are other reasons to believe the tech giant's earnings could more closely resemble growing annuities, going forward:
1. Customer investment translates to greater loyalty. Many Apple customers are so invested in a wide range of Apple products that it's almost inevitable they will make significant product purchases every few years.
2. Installment plans preview Apple's vision. With its introduction of an installment plan for its iPhones, the company's showing how it can convert hardware loyalty into long-term commitments and annuities. These installment plans could spread to other products, as Jankowski notes.
Theoretically, Apple could transition other products to installment plans as well, and charge customers a monthly bill that also includes its other services such as Apple TV and Music.
3. More Apple services reduce hardware risk. Apple is increasingly focused on growing its nonhardware businesses, including the App Store, iTunes, Apple Pay, and Apple Music.
To drive home the potential for Apple's business if the company evolves into a service, Jankowski notes that an estimated average revenue per U.S. Apple iPhone customer could soar from around $42 today to as high as $153. Adding in an estimated $50 in revenue per user in the rest of the world, Jankowski concludes that Apple's revenue could soar from $233 billion in fiscal 2015 to as much as $553 billion for fiscal 2017 -- a mind-boggling jump for a company so big.
Goldman Sachs' move to emphasize Apple's growing services is worth mulling over. Of course, investors would be wise to refrain from giving much weight to Goldman Sachs' 12-month price target (or any 12-month price target, for that matter) since it's difficult to predict where any stock may go in such a short time frame. But Apple's conservative P/E ratio is definitely a bit baffling in light of the company's customer loyalty and annuity potential.
Daniel Sparks owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A and C shares), and Apple. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.