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Stocks  | January 21, 2019

Investment Thesis

All the bad news has fallen on Apple (NASDAQ:AAPL) recently. First, they stopped reporting iPhone unit sales. Also, the company published soft future guidance due to longer upgrade cycles and macro backdrop, particularly in China. Coupled with the recent market correction, investors no longer see the positives but only the negatives. As a result, we think 40% share sell-off which drove the price all the way down to $145/share was excessive.

While we understand Apple may not return to the same growth in the iPhone segment, they have evolved into a highly diversified technology company, which revenue and profit derive increasingly from recurring and sustainable sources. In the most recent earnings report, the company posted revenue growth of more than 20%, which was partially driven by a 30% increase in iPhone revenue and a 20% increase in services revenue. Additionally, they retain a strong balance sheet that supports share buyback and dividend payout. More importantly, price matters. The current share price, standing at $150, is equivalent to 13 times 2019 earnings expectations (EPS $12). Therefore, it is an excellent investment for the long run.

When to Invest

Peter Lynch was a master at picking stocks at the time of maximum distress. Throughout his 13-year tenure at Magellan fund, his average returns were 29%. There is no secret to his success, except that he studied good companies religiously and bought them around the point of maximum pessimism.

The market sentiment can change very quickly. The mood around Apple SA's articles shifted drastically in the last few weeks after the pre-earnings announcement was made. It is in our contention that:

"If the business does well, the stock eventually follows." - Warren Buffett

The Network Effect of Multiple Ecosystems

Apple's strategy to capture value from an ecosystem of hardware and software is not new. However, the market has yet to appreciate the importance of earnings quality of Services. The most recent 10-K extract below also shows Services is becoming more significant to the company's total revenue. As iPhones sales hit a plateau, Services is bound to become more important.

Source: Apple 10-K, 2018

The recent drop by 40% in share price implies two things: either that Apple has some serious fundamental issues, or the growth of Apple has stagnated to the point that it will fall below its current PE multiple.

We think investors have interpreted the situation incorrectly. Despite the fear of a plateau in iPhone unit sales, iPhone's revenue will rise around 20% in the near term.

Moreover, Services and other products segments grew by 21%. These two segments are forming a network of micro-ecosystems such as Apple Music and Apple TV in entertainment, and Apple Pay in commerce. Interestingly, even the Smartwatches segment is creating a micro-ecosystem for itself in the Healthcare sector.

Best of all, these individual micro-ecosystems reinforce each other and increase the stickiness of Apple's products as the number of iOS devices grows (currently at 1.4B iOS devices).


Paid subscription numbers is an important operating metric to gauge the potential of Apple's ecosystem. In Q4, the number reached 330M, which is a 50% growth Y-o-Y. Apple's goal of doubling its 2016 Services revenues from $25 billion to $50 billion by 2020 looks more achievable quarter by quarter. If this revenue number sounds impressive, the margins potential is even more fascinating.

Services Margins

Apple's Services gross margin is estimated to be higher than that of iPhone and the company as a whole, which is 65% and 38%, respectively. We cannot know for sure, but it will be at least 70%. This figure will be confirmed in the following quarter as Apple will begin disclosing the cost of goods.

If Services is indeed more profitable than iPhone, then the market will have to rethink how it values Apple. We think the significance of this information is akin to the time when Amazon (NASDAQ:AMZN) revealed its AWS's number in 2015. It pleased the Amazon crowd. Since then, Amazon started to enjoy much higher multiples.

Interestingly, Netflix (NFLX) is a company that commands a really high multiple for generating subscription revenue like those in Apple's Services segment, at 100 times PE. Yet, Apple is valued at only 13 times.

Granted, the subscription revenue from Apple is only 20% of the total revenue. The absolute amount is 4 times that of Netflix total revenue, $54.5B vs. $14.8B. Moreover, Apple's Services revenue growth is also just as fast as Netflix's.

Thus, if we apply Netflix multiple to Apple, Apple would be at a much higher valuation than 13x. The differential in the ability to generate free cash flow between the two companies also makes valuation numbers puzzling. While one collects $64B in free cash flow each year, one burns $3B. You know which belongs to which.

Netflix's Next Move

Netflix recently announced it will increase the subscription price by 18%. A move to fund its effort to create original contents and also to reduce its $3B cash burn. It is after all, unsustainable.

The news is a great opportunity for Apple. The last time Apple raised prices for its iCloud, iPhone, and other services, its revenue also increased. With Netflix's aggressive move, Apple now has a license to increase the price of its services. But even if it decides not to, Apple TV service will look a lot more competitive when it comes online.


After the 40% decline in market value, Apple gave away its crown as the largest company in the world. The decline also makes it one of the cheapest bluechip out there. Meanwhile, it remains as one of the most successful companies.

We urge investors to rethink Apple as not just an iPhone company, but also a software-as-a-service company. While the portion of the subscription revenue is still a small part of the company. Eventually, it will grow and Apple will be revalued to a much higher valuation than it currently trades.

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