Apple iPhone 16 Launch: Don’t Forget Software and Services (NASDAQ:AAPL)

AAPL Stock: Previous Thesis and New Developments

I recently wrote an earnings review on Apple (AAPL). The article was titled “Apple Q3: Disagree with Bears’ Interpretation Of Berkshire Divestiture” and published on August 9, 2024. As you may already I guess from the title, the article was motivated by Berkshire’s ownership changes since the release of its Q3 financial results. More specifically, the article claimed that:

Many analysts issued bearish ratings on AAPL following the Berkshire divestiture and iPhone sales data reported in its Q3 earnings. These concerns exaggerate the risks or are simply misplaced, in my opinion. The prevailing interpretation of the BRK cession has ignored some basic facts. For example, the remaining position is still ~30% of its equity portfolio, and BRK enjoys cash deployment options unavailable to individual investors.

Since then, there have been some new developments around the stock, and the most significant was Apple launch event last week. At the event, AAPL unveiled several new products, and as usual, its new iPhones (iPhone 16) drew the most attention from analysts. On the Seeking Alpha platform alone, several authors reviewed the events, with a focus on the new iPhones. In my view, the release of AI-related features (see next figure below) is likely to catalyze another short-term update cycle and create long-term opportunities.

However, the discussion so far has mostly focused on the hardware aspects of Apple’s new devices. Thus, my goal here is to exchange perspectives and discuss the software ecosystem around businesses, especially subscription-based services. My past investing and consulting experiences have taught me that software often creates a wider and more durable moat than hardware. Judging by the nature of AAPL’s new product features and recent financial data, I believe AAPL is making rapid progress on this front.

AAPL: Focus on subscription and services

Let me start with a bigger picture to set up the discussion before diving into specific examples. The Services category is now the second largest revenue stream for AAPL. The top line rose 14% to $24.2 billion, also an all-time high in the last quarter. The chart below provides a visual representation of Apple’s service revenue growth over the past decade (including iTunes, software and services). Starting from a relatively low point in the first quarter of 2013 ($3.69 billion), Apple’s services revenue has grown steadily over the years. As a highlight of its impressive growth, segment revenue has grown 6.56 times during this period, translating to a compound annual growth rate (CAGR) of around 20%.

Looking ahead, I believe the company is on track to maintain such strong growth rates for years to come. Apple’s installed base of active devices is at record levels across all geographies. And I expect this to continue to grow thanks to the recently announced platform updates. Apple Intelligence – AI – is a notable example. It incorporates OpenAI’s ChatGPT into its operating systems. According to its release, a personal intelligence system is built into the iPhone 16 to help users “write, express and get things done effortlessly.” I expect such features to quickly evolve into a subscription-based revenue model like other Apple services. The growth of the software/service ecosystem does not stop with AI. Elsewhere, Apple continues to add engaging content to Vision Pro, such as concerts, movies and TV shows. Even AirPods have potential for this (eg as part of a health monitoring plan). Shortly after its launch event, news also broke that Apple had obtained FDA approval for its software to use AirPods as hearing aids. more precisely,

Looking for Alpha News: The US awarded Apple (NASDAQ: AAPL) software approval that will allow AirPods Pro to be used as over-the-counter hearing aids. The approval is for the Medical Hearing Aid Feature application, intended for use with certain compatible models of AirPods Pro. It is set up through an iPhone or iPad. A user can adjust the settings without the need for a hearing care professional.

AAPL Stock: EPS Growth Outlook

Of course, sales of its flagship iPhone have slowed recently. For example, in Q3 of the financial year, iPhone sales were down 1% (though growth is still positive at constant currency). However, I expect the increase in software/services to more than make up for this. As a reflection of such potential, the following consensus estimates expect EPS to grow from $6.69 this fiscal year to over $12 in five years, translating to a CAGR of 12.5% ​​this fiscal year. period, a remarkable rate for a multi-trillion dollar rate. company.

More importantly, I will further explain that the EPS growth rate is only a benefit from software expansion. I also anticipate expanding its profitability.

AAPL Stock: Potential for Margin Expansion

In the table, we’ve combined its EPS estimates with consensus revenue estimates to calculate the profit margin. As seen, consensus estimates expect AAPL’s revenue to rise from $390 billion this fiscal year to $562 billion in five years. Such growth implies an annual growth rate of 7.7% in CAGR terms. If you recall, the previous chart shows that the EPS growth rate is estimated to be around 12.5%. Such a difference indicates the expansion of its profit margin. As a simple (and rough) estimate shown in the table, we A) assumed its number of shares outstanding remains constant at around 15.1 billion current shares and B) calculated the net profit margin implied by the above consensus EPS and revenue projections. The bottom line is that AAPL’s net profit margin is expected to expand significantly from 25.96% in fiscal 2024 to an average of ~28.7% over the next few years.

Similar to my thoughts on the EPS growth outlook, I think such an expansion of its net profit margin is very possible. Software and services tend to appear more reliable than hardware sales and enjoy much better margins. We could not find the data needed to calculate its segment’s net profit margins (please leave a comment if you know how/where to find such data). But I think the gross margin can give some insight already at the company level, AAPL’s gross margin is about 46% as shown (and 41.6% on average for the past 5 years). In Q3 FY, gross margin in its services segment was close to 74% in comparison. Based on the catalysts mentioned above, looking forward, I anticipate its services/software contribution to continue to grow in AAPL’s revenue mix and thereby push margins in tandem.

Other risks and final thoughts

In terms of downside risks, its current valuation is high and carries some valuation risk as the stock price hovers around all-time highs. If you recall from an earlier chart, its FY1 FWD P/E price is currently around 33.2x the price as of this writing. Even factoring in the variance of consensus estimates and assuming EPS hits the high end of their estimates, FWD’s P/E is still close to 33x. Such a level is not only well above the sector median (by more than 40%, as seen in the chart below), but also above its own historical average by around 20%.

However, my view is that such a comparison of AAPL’s P/E to the sector median or its historical average should be taken with a grain of salt. As the company derives more and more of its revenue from software and subscription services, a benchmark for just this type of company makes more sense to me. Microsoft (MSFT) and Adobe (ADBE) are the two examples that come to mind given their heavy reliance on such revenue generation. As seen, both companies have traded at P/Es well above 33x for long periods in the past. Specifically, ADBE’s P/E ratio has exceeded 60 and MSFT’s has exceeded 40 multiple times over the past five years. The average P/E ratio for ADBE over this period is 46.8x, and the average MSFT is around 33. I don’t see AAPL’s current valuation as too alarming when viewed this way.

Overall, I see favorable return potential over the next few years, despite potential near-term valuation risks. Next, I urge investors to look beyond its hardware growth (not only with the iPhone, but other things like the iPad, iMac, etc.) and pay more attention to its software ecosystem. I anticipate that the growth potential on this front will more than make up for any slowdown on the hardware front given its installed base. This would not only catalyze earnings growth but further improve the quality of its earnings in terms of strength and margins.