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Why This Analyst Is Wrong About Apple

Daniel Sparks, The Motley Fool

Apple (NASDAQ: AAPL) stock received a rare sell rating on Monday when New Street Research's Pierre Ferragu downgraded the tech giant from hold to sell, citing tough iPhone comparisons in the coming years. This year's robust iPhone sales "will drive an 'air pocket,' and the introduction of a lower-price premium OLED phone won't be enough to make up for the shortfall," said the analyst (via Barron's).

While it's certainly possible that Apple's iPhone business could face headwinds as the product segment matures and consumers upgrade their smartphones less frequently, Ferragu's analysis fails to give enough weight to the growing importance of the rest of the company.

A packed Apple store after the iPhone X launch

Image source: Apple.

Apple stock: Headed to $165?

Ferragu's sell rating came with a price target of $165, representing significant downside compared to where shares are trading today. To get to $165, Apple stock would have to fall 31%.

Ferragu justifies his bearishness on Apple by speculating that many consumers have upgraded their iPhones early -- a trend that could negatively impact iPhone upgrade rates next year. "We expect a material disappointment" in iPhone sales "in 2019," Ferragu said in a research note. Specifically, the analyst anticipates iPhone revenue in 2019 to be 10% below consensus analyst estimates, leading to a 9% underperformance in EPS. Additionally, he expects the same trend to pressure 2020 iPhone revenue, leading to 6% lower-than-expected earnings per share during the period.

Today's Apple is not yesterday's Apple

But Ferragu's analysis may be assigning too much importance to the iPhone.

Indeed, the analyst's entire thesis is based on how the Street has reacted to worse-than-expected iPhone sales in the past. "History shows the stock suffers materially when iPhone revenues disappoint," Ferragu said.

But Ferragu may be missing the point. Apple's prior history doesn't include a booming services segment -- a business model investors are far more willing to assign a premium valuation -- that was larger than every product segment except iPhone. Trailing-12-month services revenue now accounts for a meaningful 14% of the tech titan's total revenue -- up from 10% just two years ago. Furthermore, Apple's trailing-12-month services revenue is surging, up 28% year over year. And given that this growth rate has accelerated in three of the past four quarters, there's no reason to expect this important segment to lose its momentum anytime soon.

Apple App Store

The App Store is helping drive services' strong growth. Image source: Apple.

But Apple's increasingly diversified business goes beyond services. The company is seeing undeniable momentum in its Other Products segment, where trailing-12-month revenue soared 37% year over year, driven primarily by Apple Watch and AirPods -- two products that represent a bright future for the tech specialist's foray into wearables. Together, services and Other Products account for 20% of trailing-12-month revenue, up from 15% two years ago.

Thanks to sharp growth from two segments showing no signs of slowing down, Apple is less dependent on the iPhone than it has been in years past. Indeed, the growing importance of the company's services and Other Products is key to the bull case for Apple stock. This contrasts from as recently as four years ago, when the iPhone was the primary reason to be bullish on the stock

Sure, Apple could struggle to grow iPhone revenue in the coming years, but it's successfully building out its services business and Other Products. And its price-to-earnings ratio of 19.5 -- well below the multiples of large tech peers like Alphabet and Microsoft, which have more service-oriented business models -- means it has the strength to weather headwinds in its iPhone segment.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Daniel Sparks owns shares of Apple. The Motley Fool owns shares of and recommends GOOGL, GOOG, and Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.