Apple Inc. (NASDAQ:AAPL) delivered excellent earnings news Jan. 31 that pushed Apple stock to its highest level since the summer of 2015.
That’s great news for long time owners of Apple stock who’ve had to suffer through a deluge of naysayers proclaiming its lack of innovation. More than a few have even suggested investors dump AAPL stock and buy Microsoft Corporation (NASDAQ:MSFT) stock in its place.
Hey, I like Microsoft and I think what it’s doing in the cloud is going to help it continue to grow over the next decade, but it’s not in the same league when it comes to revenue and profit growth. Microsoft does, however, have a business model that’s transitioning from one-time product sales to ongoing monthly recurring revenue, something many observers have noted is happening at Apple.
Yes, Apple did sell more than 78 million iPhones in the first quarter, roughly five million more than it sold in the same quarter a year earlier, but it was the service revenue that had everyone in a tizzy.
Jim Cramer likened the Apple business model to the Gillette business model, where consumers buy a single razor and keep buying new razor blades; only in Apple’s situation the iPhone is the razor and services such as the App Stores are the razor blades.
You gotta love recurring revenue. Cramer does:
“What has dogged Apple’s stock for ages, what has kept its share price so low, at least in terms of its valuation, is the ‘Blackberry-ization’ issue,” Cramer said on Mad Money Feb. 1. “The notion that in the end, the iPhone is just a device and device companies eventually get wasted as BlackBerry Ltd (NASDAQ:BBRY) did.”
There’s no question recurring revenue is good for a company’s top and bottom line and should be welcome news for owners of Apple stock, but is it enough to drive Apple stock through its all-time high of $134.54 and upward to $200?
While Apple’s services revenue hit $7.2 billion in the first quarter, 18% higher than a year earlier, it’s still only 9% of the company’s overall revenue, or 100 basis points higher than a year earlier.
By comparison, Microsoft’s second quarter saw its service and other revenue increased 29.7% to $7.5 billion. The only problem with that for Microsoft is the gross margins are 40% compared to 67.5% for its product revenue, which accounted for 68.5% of its overall revenue.
You want your recurring revenue gross margins to be higher than your product margins, not lower; because if that’s the way the world is headed, both stocks are looking at lower profits in the future.
Apple doesn’t break down its gross margins between products and segments. Overall, its gross margin in Q1 2017 was 38.5%, 160 basis points less than in Q1 2016. Microsoft’s overall gross margin in its latest quarter was 58.9%, considerably higher than Apple’s.
That would seem to suggest Microsoft’s in a better position when it comes to service revenue. It is both growing this aspect of its business faster than Apple and making more from every dollar of revenue. From this perspective, Apple is doomed.
A quick look farther down the income statement, however, provides some clarity: Apple’s operating margin in Q1 2017 was 29.9%; Microsoft’s Q2 2017 operating margin was 25.7%, or 420 basis points less than Apple.
The biggest reason for this difference: Microsoft spends about three times as much per year on research and development as Apple does; Apple spent 4.7% of its revenue in the trailing 12 months on R&D compared to 14.4% for Microsoft. And when you’re talking about billions of dollars of annual revenue, the difference adds up quickly.
Which brings us back to Apple’s growing service revenue: InvestorPlace contributor Brad Moon highlighted the positives of Apple’s services revenue recently. A couple of his points stick out for me.
First, the App Store had $3 billion in revenue in December — a record. Secondly, Apple paid out more than $20 billion to developers in 2016. Extrapolate December’s App Store sales over 12 months and you get $36 billion in revenue. Subtract $20 billion paid to developers in 2016 and that leaves a gross profit of $16 billion and a gross margin of 44%, which is pretty darn healthy considering very little R&D is required to keep that up and running.
Can recurring revenue take Apple stock to $200? I believe it can. When, however, is another story.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.