The historic run in Apple (NASDAQ:AAPL) continues with shares again making new all-time highs on Monday. The question now is: How much further can Apple stock really run?
Since then, Apple stock has risen another 6.1%. It’s now added roughly $510 billion in market capitalization in six and a half months, a figure greater than the total value of all but six other companies listed on U.S. stock exchanges.
Despite the unprecedented rally, Apple stock remains reasonably cheap from a fundamental perspective. It’s certainly cheap enough that the rally can continue — depending on how investors view the stock going forward.
The Commoditization Risk to AAPL Stock
The skeptical/bear case for AAPL stock long has centered on the iPhone. That seems somewhat counterintuitive: the iPhone, after all, is without question the most successful product in the history of mankind.
But it’s also a piece of hardware. And the history of technology shows that hardware eventually becomes commoditized. As I detailed last year, that trend has played out for the likes of IBM (NYSE:IBM) in mainframes and HP (NYSE:HPQ) in personal computers, among many others. Costs come down for key components, the quality of low-end products improve and eventually there’s a “race to the bottom.”
Apple itself saw such a trend with the iPad. That product was a huge initial hit that essentially created the tablet category. It then fell victim to cheaper, similar, “good enough” products that ran Alphabet’s (NASDAQ:GOOG,NASDAQ:GOOGL) Android operating system. Sales peaked in fiscal 2013, only a few years after the product was launched.
Bears have been waiting for a similar trend to play out with the iPhone, and to some extent, it has. According to the company’s Form 10-K filed with the U.S. Securities and Exchange Commission, iPhone sales declined 14% year-over-year in fiscal 2019. Launch timing played a role, but product revenue still has risen just 2.1% total over the past two years.
It certainly looks like iPhone revenue is near or even at a peak. And given that the product still accounted for 54.7% of total sales in fiscal 2019, that would present a significant problem for growth going forward.
It’s why investors reacted so strongly when Apple cut its guidance in January: the fear was that lower-than-expected iPhone revenue was the beginning of the proverbial end for that product. And commoditization fears are a big reason why AAPL stock, backing out its net cash, often has traded at a low double-digit price-to-earnings multiple over the last few years.
But over the past few months, there seems to be a steady increase in optimism toward the iPhone’s future. Wedbush last month called the iPhone 11 a “massive success.” KeyBanc called out strong holiday demand. Commentary from Apple itself shows the company still has been able to take pricing, which can offset lower unit sales as replacement cycles lengthen.
This is a big shift for Apple and a big deal for Apple stock. Higher pricing and modestly lower unit sales still keep revenue flat — and profits increasing. Suddenly, half of Apple’s revenue still is driving some earnings growth, instead of posting declines as skeptics (admittedly, myself included) long worried. And as bulls have continued to argue, the rest of the business seems to be in excellent shape.
Services, AirPods, and the Rest
The bull case for Apple for some time has rested on the company’s ability to drive increasing services revenue. Those revenues offer higher margins and more stability. They also have minimal exposure to the replacement cycle: App Store revenues, for instance, are relatively unaffected by whether an iPhone is one year or four years old.
On this front, Apple has delivered, with 16% growth in fiscal 2019 on top of a 22% increase the year before. And while services accounted for under 20% of sales in FY19, its margins are stronger. Per the 10-K, services accounted for 30% of the company’s total gross profit in fiscal 2019, up from barely 20% two years earlier. Gross margins in services are 63.7%, almost double the 32.2% figure for products.
Elsewhere, the news is mostly impressive. Mac sales continue to be stagnant, but at just shy of 10% of total revenue that headwind is manageable. Wearables, Home, and Accessories sales have almost doubled in two years, and generated over 9% of the FY19 total. Even the iPad has shown some life, with sales up 16% in FY19.
Outside of the iPhone, Apple looks like a legitimate growth company. Total non-iPhone sales grew an impressive 17% year-over-year in fiscal 2019, off a roughly $100 billion base. The list of companies with that combination is basically Alphabet and Amazon.com (NASDAQ:AMZN). That’s it.
Valuing Apple Stock
And so there is an increasingly intriguing case that Apple stock actually merits an even higher price-to-earnings multiple. Apple doesn’t specifically break out the figure, but we can estimate that roughly half of gross profit dollars come from the iPhone. (It appears the iPhone has better profit margins than the rest of the hardware portfolio, but it also has much lower margins than services revenue, which as noted now drives 30% of gross profit dollars.)
A mid-teen price-to-earnings multiple for iPhone profits doesn’t seem unreasonable if the profit trajectory can stay modestly positive. The commoditization risk isn’t gone, to be sure. Apple struggled in China in fiscal 2019, a potential headwind, though performance did improve toward the back half of the year. Something like 15x earnings for iPhone profits seems reasonable.
What about the rest of the business? Again, it just grew sales 17% off a $100 billion base. Microsoft stock, backing out its net cash, is trading at over 27x earnings estimates for its fiscal 2020. Amazon stock obviously trades at an even higher multiple, though near-term investments are a factor. GOOG stock is a bit cheaper, at roughly 25x this year’s profits backing out its own cash hoard.
Is it unreasonable to value the non-iPhone businesses at 25x earnings? Even 30x earnings, given the predictable nature of Services cash flows?
If half the business is worth 15x, and the other half 25-30x, then Apple as a whole should receive a low 20s P/E multiple, again excluding net cash. With about $21 per share in cash, and FY20 consensus earnings per share estimates just above $13, a 20x multiple would get AAPL stock to $281. Bump that figure to 22x and AAPL clears $300.
The Risks for Apple Stock
To be sure, that discussion is more of a back-of-the-envelope calculation rather than a full deep dive. But it’s a useful exercise because it highlights the risks and rewards of AAPL stock at this level.
From one perspective, it does suggest that maybe the run is set to fade. After all, it certainly seems like AAPL stock is pricing in good news for both the iPhone and the rest of the business.
It probably takes an implied ~30x P/E multiple for non-iPhone earnings to justify a run past $300, and 40% of non-iPhone sales come from the iPad and Mac categories. Growth prospects for both product lines probably are relatively modest, if stable.
It also requires that optimism toward the iPhone hold, and investor sentiment toward that product has been notoriously fickle. iPhone sales aren’t going to fall off an immediate cliff, but longer replacement cycles and lower-end competition both represent threats in the U.S. and overseas.
All that said, bulls could see this framework as suggesting the run should continue well past $300. The iPhone simply may be a product whose lifespan is far longer, and whose growth is far stronger, than even some bulls believed. Services growth merits a premium multiple. There’s perhaps a case at this point that AAPL as a whole should receive a similar multiple to MSFT or GOOG, given its prospects. Value Apple stock at 25x earnings plus cash and $350 is easily in play.
It does seem like the edge is thinner here. AAPL, in fact, has run well past Wall Street analysts, whose average price target sits at just $263. The path to $400 requires simply a blowout fiscal 2020 performance across the board.
But bulls certainly won’t dismiss the possibility of such a performance, and bears can’t either. Apple stock has had a historic run, and there’s a reasonable chance it will continue, even if at a slower pace.
As of this writing, Vince Martin has no positions in any securities mentioned.