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Worth Over $200 Billion Alone? Inside Apple's Insanely Profitable Services Segment

By Andrew Tonner - May 5, 2016 at 1:23PM

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A recent analysis of Apple's booming Services segment opens a broader discussion about the tech giant's valuation.

Image source: Apple.

At a valuation roughly half that of the S&P 500, is tech giant Apple (AAPL 0.00%) undervalued? It's a fair question, and one that inspires no shortage of opinions among tech analysts and investors.

As we learned last week, Apple's sales contracted for the first time since 2003, a fact affirming investors like Carl Icahn, who believe Apple's bottom-barrel valuation is indeed justified. However, one recent analysis of Apple's booming services business also speaks to the fact that Apple might indeed be badly undervalued using one run-of-the-mill valuation technique.

Apple's booming services segment
In a note to investors last week, Piper Jaffray analyst and Apple perma-bull Gene Munster examined Apple's booming services segment. Looking at the company's 2015 SEC filings, Munster makes the case that Apple's services segment is indeed a budding jewel within the company's overall reporting structure.

The Services segment, which includes products like Apple Music, App Store sales, Apple Pay, and more, has been an enduring source of growth for the tech giant, even as sales in other segments have slowed in recent quarters. In Apple's latest quarterly report, Services was one of the two reporting segments to see sales increase compared to the same quarter last year. Only Services and Apple's Other Products division, which includes the Apple Watch, have seen revenue rise in all of the company's last four fiscal quarters. 

What's more, Muster estimates that Apple's Services business carries gross margins nearing a whopping 60%, versus the 39% Apple posted in its most recently reported quarter. It's this particularly potent mix of long-term growth potential and outsized profitability that leads Munster to make the case that Apple's Service segment could be worth as much as $260 billion on a stand-alone basis.

With Apple's market capitalization hovering just above $500 billion today and Services revenue representing roughly 12% of the company's total revenue, this claim likely seems absurd at first glance. However, unpacking the assumptions Munster uses to arrive at his conclusion reveals some interesting facts about Apple's services business and the company's valuation as a whole.

Image source: Apple

Rich, but right?
In order to arrive at his $260 billion estimate, Munster turns to rival Alphabet, whose 19 times multiple versus its 2017 estimated revenue the analyst sees as most directly comparable to Apple's services segment. 

To be sure, this involves a fair amount of projection. Since any forward estimate of a company's sales involves having an accurate view of its likely growth (read: predicting the future), forward valuations are inherently less airtight than valuations made using past financial data. Also, Munster's decision to base his valuation off of a revenue multiple, which is more frequently used by unprofitable or early-stage companies, also seems a bit odd, here.

In the note, Munster concedes that this hypothetical valuation is more for illustrative purposes, a kind of "it could be worth this much in theory" kind of argument. He goes on to note that lowering the multiple to 10 times results in an estimated valuation of $139 billion, which still accounts for about one-quarter of Apple's overall market cap. This lower figure strikes me as far more plausible and jives with other EBITDA-based estimates I've seen in the past year or so. 

More broadly, this speaks to how Apple's sheer size likely dampens its valuation. Repeated arguments have been made in recent years that Apple's businesses, if valued as stand-alone companies, would likely prove meaningfully more valuable than its current market capitalization. In finance parlance, this is called a "sum of the parts" or SOTP, valuation.

When applied to Apple in recent years, many SOTP valuations, ones I view as using fairly reasonable assumptions, typically place a substantially higher valuation on Apple than its current $500 billion market cap. Case in point: a 2015 research report from FBR's Daniel Ives, whose work I typically respect, estimated Apple's market capitalization should be slightly over $1 trillion when you appropriately solve for a fair valuation for each of Apple's reporting segments. Valuation is always as much as art as science, so this is by no means bullet-proof, either. However, the repeated chorus from the sell-side community does indeed speak to the fact that Apple might be appreciably undervalued at the moment.

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