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Apple Stock Is Supported by Robust Services Growth

Luke Lango

One of the world’s largest technology companies, iPhone maker Apple (NASDAQ:AAPL), just had its biggest day of the year. Recently, the company unveiled a suite of new products and services for the rest of this year and the next. In response to this product launch event, Apple stock has soared to fresh 2019 highs.

Apple stock has always been an iPhone investment but Services might change that

Source: Shutterstock

That must mean the new iPhone is going to sell well, right? After all, for the past decade, as go Apple’s iPhone sales, so goes Apple stock.

Despite the iPhone 11 Flopping, AAPL Is Moving Higher

But that’s no longer the case today. Instead, most analysts, insiders, and investors think that the iPhone 11 will be a flop. That’s mostly because the smartphone critically lacks 5G capability whereas many other new smartphones do have this new tech.

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Indeed, early responses to the iPhone 11 have been tepid. The only iPhone news I saw trending on Twitter (NYSE:TWTR) the night of the reveal is how the new phone is triggering people with trypophobia. According to Wikipedia, is an “aversion to the sight of irregular patterns or clusters of small holes, or bumps.” That’s not exactly a bullish read on forthcoming iPhone 11 sales.

In other words, AAPL stock is soaring to 2019 highs in spite of the fact that most people think the iPhone 11 will be a bust. How is that possible?

One word: services.

Apple’s Services business has been the talk of the town for several years now. Broadly, Apple is no longer hyper-focused on growing its ecosystem of hardware users. Instead, the company is focused on deeply engaging and monetizing that ecosystem through subscription-style software services. The launch event showed that these services are on the up and up, with Apple TV+ and Apple Arcade set to launch soon at compelling price points.

And that was enough to get investors to buy AAPL stock. But will this rally continue? I think so. Here’s why:

Services Are on the Up and Up

Apple’s Services business is on the up and up. That’s hugely important for AAPL stock, because it is the key to big profit growth in the long run.

Here are the numbers: Apple’s Product business has grown revenues at a choppy 2% rate over the past three years, is down about 6% so far in 2019. It currently runs at 33% and produces shrinking gross margins.

Apple’s Services business, meanwhile, has grown revenues at a steady 20%-plus pace over the past three years. It’s up about 15% so far in 2019, and runs at 63% and is expanding gross margins.

To be sure, the Products business is far bigger today. It accounts for about 80% of overall revenues. But the Services business is clearly the big growth driver here.

Fortunately, that Services business is on the up and up. By the end of 2020, Apple will have a streaming TV service (Apple TV+), a video game streaming service (Apple Arcade), a music streaming service (Apple Music), and a news subscription service (Apple News+). It will also still own the App Store and iCloud.

Here’s the big picture: Apple’s Services business will continue to grow at a double-digit pace for a lot longer. That will push Apple’s overall margin profile higher in the long run, because the Services business runs at nearly double the margins as the Products business.

Thus, so long as the Services growth trajectory remains on track, Apple will reasonably project as a steady revenue and profit grower in the long run.

Apple Stock Has Runway

The big bear argument against Apple stock is that it trades at 19-times forward earnings. That is both significantly above the historically average multiple for AAPL stock, and a decade high valuation for the stock.

The response to the bearish argument? This isn’t the Apple stock of 2015. It’s the Apple stock of 2019, with the big difference being the Services business.

Come 2025, there’s a reasonable chance for Apple’s Services business to account for about a third of overall revenues. Thus, by that time, Apple will be two parts stable growth, low margin hardware business, and one part hyper-growth, high margin software business.

That former characteristic wasn’t there back in 2015. Back then, this was 100% a stable growth, low margin hardware business. As such, it makes sense that during this big Services push, Apple stock is being re-rated higher, to account for bigger growth and a more attractive and sustainable margin profile.

Indeed, relative to other large capitalization software growth stocks of this ilk, Apple stock is still pretty cheap. Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) all trade well north of 20-times forward earnings. I’m not saying Apple stock should be as richly valued as those stocks. It shouldn’t. Facebook, Microsoft, and Alphabet are all growing more quickly.

But I am saying that at 19-times forward earnings, AAPL stock isn’t overvalued. Instead, the valuation seems fair. A fair valuation coupled with healthy fundamentals is a combination which should keep the stock on a winning path.

Bottom Line on AAPL Stock

I don’t love Apple stock here. But I do think it can head higher. So long as the outlook in the Services business remains robust — which it does today — then AAPL stock should benefit from a dual tailwind of upward estimates revisions and multiple expansion.

As of this writing, Luke Lango was long FB and GOOG.

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