I’m a skeptic toward Apple Inc. (NASDAQ:AAPL) stock. So far in 2017, that skepticism has looked downright foolish, as AAPL stock’s price today is up 33% this year alone, even after a recent pullback.
The bear case for AAPL stock is tough to make on the surface. Apple is the world’s most valuable company, ever. The company has more cash than it knows what to do with, and it’s the premier brand in the world. And yet Apple stock trades for 14x 2018 analyst EPS estimates — around 13x when backing out the company’s net cash.
Even right now, the market is pricing AAPL stock as if its growth will come to an end relatively soon. That seems almost ridiculous as consumers wait in anticipation for the $999 iPhone X. But if an investor understands the role of hardware in the future tech ecosystem, that possibility starts to make more sense, as does the low valuation of Apple stock.
AAPL Stock Relies Heavily on the iPhone
One of my long-held concerns about Apple stock is its reliance on the iPhone. Ancillary products have come and gone. The iPod once was a profit center, iPad revenue soared and fell, and now Services sales are rising (+19% through the first three quarters of FY17). But no matter what the product, non-iPhone revenue simply hasn’t moved ($77.8 billion in 2012 and $78.9 billion in 2016).
Non-iPhone sales have risen 6.5% so far this year, which is a step in the right direction. But in a relatively down year, the iPhone still has generated 64% of total revenue. For all the coverage of Apple Watch, Beats, or Apple Music, when it comes to AAPL stock, nothing else really matters.
From a short-term standpoint, this could be a problem for the Apple share price. I still think there could be a “buy the rumor, sell the news” type response to the iPhone X. But the long-term impact is more interesting and potentially more troublesome.
Are iPhone Sales Peaking?
With the iPhone likely driving two-thirds of FY18 revenue, the most important issue for Apple stock is the long-term trajectory of iPhone sales. And I still believe there’s real reason for concern on that front.
There’s two factors there. The first factor is that product cycles lengthen. The better products Apple makes, the longer consumers are happy using them. So far this doesn’t appear to be a major issue for Apple because iPhone unit sales remain in an uptrend. But as Apple saturates key markets, notably the U.S. and Europe, that will become a problem at some point.
The second related factor is that incremental improvements become less and less attractive. The original iPhone was truly a revolutionary product. Few would say the same of the iPhone X. At a certain point, a camera is good enough for 90%+ of users; the same is true for speakers and image quality. That too decreases the need for upgrades and helps lengthen product cycles.
At some point, iPhone sales are going to peak. I’m not necessarily sure it will happen with the iPhone X; higher prices alone could offset unit erosion, at least for a while.
But it will happen, and Apple’s weakness in China, as Tom Taulli pointed out, adds to the concern here. In tech, hardware always becomes commoditized. It happened in PCs and the iPad, and it will happen in smartphones too. At some point, smartphones will just be phones. At that point, will Apple be able to differentiate itself?
What Else Drives AAPL Stock Higher?
The problem is that Apple remains a hardware company. 64% of revenue comes from the iPhone, and another 18% comes from iPad and Mac products.
Apple is a great company, but hardware isn’t a great business. Apple itself knows that, which is one reason why CEO Tim Cook has set a goal of doubling services revenue to $50 billion. But Apple isn’t a great company in services. Apple Music is behind Spotify and Pandora Media Inc (NYSE:P) in subscribers. Apple TV is just another entry in the streaming device space, along with efforts from Alphabet Inc (NASDAQ:GOOGL) unit Google, Amazon.com, Inc. (NASDAQ:AMZN), and recent IPO Roku Inc (NASDAQ:ROKU).
More broadly, even $50 billion in revenue isn’t a huge number against an $800 billion market cap. And it may not even be enough to offset hardware declines, once they come.
Apple stock looks ridiculously cheap based on earnings metrics. But those multiples aren’t ridiculous; they’re logical. The bear case for AAPL stock may not be right, and indeed it hasn’t been right so far in 2017, but that doesn’t mean the bears won’t be correct eventually.
As of this writing, Vince Martin has no positions in any securities mentioned.