Services Might Not Be Large Enough to Boost Apple Stock

The company's Services business may not be sufficiently lucrative to prevent AAPL stock from declining

It’s common knowledge at this point that Apple (NASDAQ:AAPL) has an iPhone problem. And that problem continues to pressure Apple stock.

Services Might Not Be Large Enough to Boost Apple Stock
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Indeed, it was barely six months ago that Apple stock reached a $1 trillion valuation. AAPL stock would peak in October – and then fall some 39%. Even with a rally in 2019, AAPL still is down 1% over the last year and still off some 27% from its highs.

Weak iPhone demand appears to be the primary driver of the company’s difficulties. Revenue from the product declined 15% year-over-year in Q1, per the company’s 10-Q filing. The reduction of the company’s guidance ahead of its December quarter results sent AAPL stock plunging. Longer replacement cycles, weakness in China, and a potentially imminent ceiling on price increases all suggest iPhone revenues may well have peaked.

Apple needs a new growth driver. And it’s common knowledge that the company’s Services business is supposed to be that driver. CEO Tim Cook has frequently discussed the company’s long-term goals for the Services business. It’s the only way for Apple to offset the “commoditization” problem facing the iPhone and a number of its other hardware problems.

And as the Wall Street Journal reported this week, Apple is repositioning itself for a more services-based future. The key question for Apple stock is whether AAPL will be rejuvenated by its Services business .

The Pivot to Services

The Journal highlights myriad changes that Apple is implementing. At the management level, the company’s head of artificial intelligence was promoted to the executive team, and the executive in charge of Siri departed. Additionally, 200 staffers were removed from the company’s long-discussed but still-secretive autonomous driving efforts. Meanwhile, services division chief Eddy Cue “is focusing much of his engineering team on developing the company’s media offerings, including Apple’s coming Hollywood programming.”

The changes remove any doubt that Apple itself believes that demand for the iPhone is declining. Any growth that Apple can drive going forward  will come from its smaller products and services. But that might be a problem for Apple stock.

The Fundamental Problem Facing Apple Stock

The fundamental problem facing Apple stock is the same one it’s had for years. The iPhone is such an important product that it’s literally irreplaceable. In calendar 2018, iPhone sales totaled $157.6 billion. All of that revenue came from just one product (albeit with different versions).

To put that figure into perspective, Amazon.com (NASDAQ:AMZN) generated $232.9 billion of revenue in calendar 2018, and it has tens of thousands of products. Apple’s iPhone revenue equaled more than two-thirds of Amazon’s total sales.

And the iPhone is hugely profitable. Apple doesn’t break out product margins, but its consolidated, trailing, twelve-month operating margins are about 27%. Apple generated $59 billion of net income in calendar 2018. At least half of that (and likely more than half) came from the iPhone.

In other words, the iPhone generates at least $30 billion of after-tax profit for Apple. Declines in that figure – of even a few percentage points a year, let alone the 15% sales decline seen in Q1 – create an enormous headwind for the company’s earnings. Relying on Services to offset that pressure might be asking too much.

Is Services Enough?

Admittedly, the Services business is performing exceedingly well. Its revenue jumped 23% to $37 billion in fiscal 2018, and its sales grew another 19% in Q1.

Again, Apple doesn’t break out segment or product margins. But the profit margin of its Services business is probably higher than that of its hardware. The 30% “Apple tax” paid by app developers, for instance, costs Apple very little, so most of it drops directly to the company’s bottom line.

AAPL also has opportunities in Services. It has ambitions in content, with the Journal citing an estimated $1 billion of spending on content this year alone by AAPL. And a new “killer app” could be on the way. Specifically, the company is looking to roll out an integrated news subscription, per the WSJ, which could be bundled with other offerings (such as cloud storage). Apple could offer something like Amazon Prime, but without the shipping and shopping benefits.

Still, expecting Services to keep Apple’s profits stable – which is what the current valuation of Apple stock requires – is quite ambitious. Again, the iPhone generates at least $30 billion of after-tax profit. Services, over the last four quarters, has created $39 billion of revenue.

The move into content may be late: Apple faces competition from Netflix (NASDAQ:NFLX), Amazon, Alphabet (NASDAQ:GOOGL,GOOG), and many others in that market. A $10 per month news subscription won’t move the needle when Apple stock is still valued at some $800 billion. And companies including Netflix have looked to work around the App Store, creating a potential threat to the walled (and profitable) “ecosystem” that AAPL is trying to build.

Services can help. But it’s tough to believe that it alone can offset the iPhone’s decline.

Services Probably Can’t Rescue Apple Stock

All told, from here, Apple looks like it could decline. Apple can’t replace the iPhone with Services because nothing can replace the iPhone. It’s the most profitable product in the history of mankind, and there truly isn’t a close second.

Apple’s shift does make some sense: Services is the best business Apple has left. That’s precisely the problem, however: it might be the best business left, but it’s not as good as the one that AAPL is being forced to pivot away from.

As of this writing, Vince Martin has no positions in any of the securities mentioned.

 


Article printed from InvestorPlace Media, https://investorplace.com/2019/02/big-shake-up-enough-aapl-stock-apple-stock/.

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