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Apple Inc: (NASDAQ: AAPL)
Investment Research Report

Growth or Value?

Let’s take a look at the values. Cash and Investments equal about $60 per share, about 33% of the current market value of the company. Take out that cash and it leaves a value of only 9 times 2018 earnings. This is quite cheap for a company that employs the smartest people in the world working to find new products for all of us to buy. And note that Apple is in the running for the largest market cap in the world, neck and neck with Amazon and Microsoft.

The stock is now yielding 1.8%. Add to that, Apple is currently paying out $3 billion to shareholders every quarter through dividends, but making closer to $13 billion in profits. Do you think management might be thinking about raising the dividend again? We sure do.

There is plenty of cushion to do so.

Next, we take a hard, objective look at this amazing company.

Apple Basics: For The Record

In simple terms, Apple is a consumer products company focused on aesthetically pleasing, technologically innovative and widely admired devices. Under its founder Steve Jobs, world- changing devices like Mac, iPod, iPhone, iPad, as well as Apple TV, are the hallmarks of the company’s success. These products enjoy a religious following throughout the world by hundreds of millions of satisfied customers. Apple products are manufactured to very high- quality standards and sell for premium prices. These high selling devices help explain why there are billions of consumers in the world hoping someday to have an iPhone or iPad of their own.

Longtime customers know that Apple’s latest “must have” products are available wherever a long line exists in front of an Apple Store, online at the Apple website, through mobile network carriers, and other retailers.

Technology Driven, Driving Technology

Apple has created its own ecosystem tied together by its iOS and MacOS operating systems, iCloud storage, iTunes Store, App Store, iBookstore and the phenomenally successful App Store. Enter an appointment on your iMac and it is immediately synchronized with your iPod Touch, iPad, iPhone, and MacBook.

Apple unquestionably holds the record of being the world’s most successful consumer products company. No matter by what measure of comparison: Sales, market share, profits, cash flow, or consumer satisfaction, Apple is on top. The creative guru behind this empire was the late Steve Jobs. What the king of consumer products created, let no man cast asunder.

Apple is a technology-driven hardware company with great software. It’s just that simple. The Apple ecosystem strategy has achieved the goal of connecting and holding the loyalty of its faithful followers. Its objective is the selling of as many hardware devices as the design geniuses at Apple can create. This has been an enormous success. It has however concentrated the business on hardware and more specifically the iPhone. Should the company be faulted for its world-changing success? Of course not!

The three hardware categories are iPhone, iPad and Mac with total sales of $265 billion in 2018. This is a staggering 84% of total business. Tim Cook, CEO of Apple, announced the billionth iPhone had been sold in 2016. At the current rate the 2 billionth will be sold by 2020.The iPhone has the largest smartphone market share at 43%.

Apple’s product strategy for the iPhone continually evolves. For years, Apple would only release one model. Now the company launches multiple models to appeal to broader markets. But compared to other rivals, Apple is incredibly focused, as other companies in the market release dozens of varying models per year.

It is important to remember that today Apple succeeds through innovation in hardware technology.

The Technology World Is Constantly Changing

Apple’s growth has been nothing short of spectacular with revenues growing annually at an average of 43% and earnings per share by 47%. This would be an enviable achievement for a young startup company. But for the largest technology company in the world, it is totally awesome.

The company’s first dividend was declared in 2011 and since then has risen steadily to $2.92 per share. The ability to pay this generous dividend comes from the enormous cash flow from operations.

Apple is a cash machine. There is no other hardware company anywhere that can compare. There is currently $285 billion in cash in the bank. 74% of Total Assets are in cash and securities! Long-term debt is $115 billion but most of it was added over the past few years at very low interest rates. Value investors looking at just the balance sheet liquidity and the dividend payment find a rare gem in Apple.

Apple: Software Company of the Future:

Steve Jobs succeeded by creating products that served a need that previously did not exist by making devices that were cooler and more compelling. If that era is over for the time being, software is a more likely path for the future.

The four most important trends in technology are in software and services. This includes Cloud Computing, Voice Recognition, Virtual Reality, and Artificial Intelligence. VR and AI are world-changing trends but are some time away from the mass market. The Cloud and Voice recognition are a different story. These are now quite viable opportunities.

So far iCloud has been a miss. It needs to be fixed as the present version is cumbersome and clunky. Even the company mentions this in the installation video. With tens of millions of loyal users including a growing list of business customers, iCloud income could be meaningful. The company’s old nemesis, Microsoft has over 20% of the Fortune 500 paying for their version of the Cloud. And now Amazon is leading the pack with their AWS – Amazon Web Services. This is billions in revenue that Apple is not getting. This will change.

The Apple Watch was looking for a market to develop but has now found it. Starting slowly, but now forging ahead, Apple Watch sales are moving higher many now cannot live without it. The best days for Apple Watch are ahead.

There is plenty of opportunity for Apple Watch. Remember the futuristic movie, Her, starring the voice of Scarlett Johansson and the talents of Joaquin Phoenix? It tangibly illustrated the future role of miniaturization, voice recognition and artificial intelligence. This is a huge and ongoing phenomenon. There will be more innovation. Remember how Microsoft tried to market a weird device back in 2000 they called the Tablet computer? Today the tablet market is a $50 billion business with Apple dominating. No more need be said.

Apple Pay fits into the same category. We love using it for speed and convenience. Apple entered this business undeterred by the big hurdles. None of the four major credit card companies were open to losing their monopoly. Retail merchants that accept Apple Pay have the added costs of new terminals. IT budgets have already been pressured by the expensive new “chip on a card” readers. There was really no choice about complying with these Federally mandated regulations. The basic argument for Apple Pay was its added security. But the new chip on card technology satisfied that need. That left Apple Pay as a hip, slick convenience for the tech-centric. The real measure of success will come once enough large chain retailers are convinced to add the service. Experts place critical mass at about 30%. But Apple Pay is a great consumer convenience and it is not going away. The next move is up to the company to find those breakthrough retailers that will bring the service to critical mass.

We will touch briefly on Apple’s interest in self-directed automobiles. It would be wrong to overlook this area. It could be a monster. There are just too few facts to make any judgments. Some answers should be coming in the near future. Most car manufacturers have announced plans to have road-ready products on the market before the end of the current decade.


Every year Apple makes small acquisitions by the dozen. Rumors have it there is a super- secret group within Apple that is responsible for these deals. The self-driving car project is part of this group. What future products will come would be pure speculation but we’ll try anyway! Here is a look at several of the most recent acquisitions. Turi is a machine learning and artificial intelligence startup, that will assist developers using Apple’s XCode, and shift focus to more analytics-based services. Flyby Media is an augmented reality start-up that enables mobile devices to create a 360-degree field of view. Metaio develops augmented reality software Apps. Faceshift has software that scans facial features. PrimeSense creates motion-tracking technology.

Overarching Reach

What is clear from these deals is Apple’s commitment to the key technologies for future software technology. Apple has shown time and time again it can and will reach for dominance in new and emerging markets. The number of different areas the company’s software or hardware is integral for, increases each day.

Services: Scaling the Annuity

From the moment Steve Jobs walked on stage at Apple’s Worldwide Developer Conference (WWDC) in 2003 and announced the launch of Apple’s music download store known as “iTunes,” Apple has been synonymous with music, and, more broadly, as a company that marries hardware, software and services experience. Now, in 2019, Apple has built a truly differentiating user experience and ecosystem that many vendors in the smartphone, tablet and PC market are struggling to compete with. Where at one time there was only an iTunes Store and just an iPod/iMac device to access it, the company now boasts a wide range of hardware products that can all simultaneously access the iTunes store with a multitude of additional applications, features, and services, what is often referred to as “iServices.” That includes a highly successful App Store, iBook store, iCloud, and further monetization opportunities ahead with Apple Pay, Home-Kit, and HealthKit. Apple’s Services business is now one of the largest internet services companies on the planet and would be a Fortune 100 company if it were on its own.

Many analysts are now talking about how the future success of the company will hinge on the Services business. We agree. According to analyst estimates, Apple’s Services business will provide a key driver of revenue, reaching as much as $100 billion over the next five years or double 2018 levels of $45 billion. Services — which includes the App Store, ApplePay, iCloud, and Apple Music — now makes up 18% of overall quarterly revenue, up from 16% in Q2 2017.

Growth in the Services unit is being driven in part by Apple's subscriptions business. Nearly 30,000 third-party apps sell subscriptions through the App Store. And in the past year, Apple has sold more than 300 million subscriptions through both its own apps (like Apple Music) and third-party apps (like publishers' apps), up more than 60% YoY.

Apple takes a percentage share of monthly fees for any subscriptions sold through the App Store — it takes a 30% cut in the first year, and 15% every year thereafter. For example, the $9.99-a-month music-streaming service Apple Music now has well over 60 million subs — up from the roughly 40 million it had in early 2018 — with revenues up 50% YoY.

There are some very important implications from this trend. First, the trend offers significant support to gross margins as the services business is more profitable than the hardware business. Running all the numbers, analysts are now saying that as much as 55% of gross profit will come from recurring business within five years versus 15% today.

Second, the trend toward an increasingly annuity type business model will ultimately warrant a higher valuation – as Wall Street pays more for recurring software/services revenue streams versus one-time hardware sales. Accordingly, the business mix shift should cause the stock to move higher from what is already a pretty low P/E multiple. To be clear, a shift in Apple’s valuation is not likely to happen overnight, but will more likely occur over the next few years as the business shows gradual revenue growth, sustained margin, and more predicable free cash flow.

Before we keep going deeper, let’s step back and make sure we all understand the 10 most important points about Apple’s Services business.

1 – Services growth has been spectacular. Analysts call for a 2-fold increase by 2021 in gross profit dollars.

2 – Gross margin estimates need re-calibration. Corporate gross margin is sustainable at 40%, contrary to some of the naysayers’ views.

3 – The Services business is primarily driven by the App Store, which is doing well.

4 – The installed base of 1.5+ billion devices is comprised of 600 million highly affluent and highly transacting users, which amounts to a wonderful recurring business model as these users are unlikely to leave the company.

5 – Average spend per user could keep growing and accelerate from $60 in 2015 to $110 by 2020 analysts say. Why? We all already have the hardware. We will be spending more and more on software and services to get more out of it.

6 – The breadth of product and services offering conveys an advantage and bolsters retention rates. The market is having a very hard time competing with Apple.

7 – 55% of gross profit could be annuitized by 2020 versus 15% today driven by services growth, analysts say.

8 – Video is an essential market where there are multiple options for Apple to get involved.

9 – Is acquiring for TV and Video an option? Could we see a mega-deal with Netflix or content originators? Stay tuned. It seems to make a lot of sense to drive the Services business.

Apple has built an entire portfolio of services, which is set to expand. Let’s look more into the portfolio to see how exciting it is.

— Whereas downloads (music and movie) from iTunes are in secular decline, the Apple App Store, originally launched in 2008, is now a $45+ billion business and enjoying healthy growth of over 50% per annum.

— Services such as iMessage are more of an offering to make Apple’s portfolio more attractive rather than driving commercial revenues in its own right.

— HomeKit, while nascent, could be viewed in a similar light, paving a path for Apple devices to become a point of control for the home.

— Meanwhile, HealthKit could provide real benefits to consumers.

— Apple Pay is an interesting commercial opportunity which hasn’t yet enjoyed a global rollout, and could potentially add $600+ million of revenues long term.

— Additionally, beyond what is public information today, it would be prudent to assume that Apple will enter the TV streaming business at some point and capitalize on more opportunities in the gaming segment as well.

In summary, there is a vibrant, growing services stream at Apple that ultimately has an unrivaled opportunity to monetize an installed base of over 1.5 billion active devices and 600 million unique users.

Additionally, beyond the commercial opportunity of Services, there are some other favorable characteristics of the business to note. Many analysts point out that Apple’s vertically integrated structure across hardware, software and services, and across multiple products results in several strategic advantages versus its peers. For example, it leads to a high- quality level of integration that rival platforms such as Android and Windows lack. With this high level of integration comes high loyalty (Apple enjoys a retention rate of close to 90%) for key products such as the iPhone.

Another example – seamless availability of services and software competency results in high levels of usage. Whether looking at mobile browsing, mobile commerce, or data usage, iOS devices materially outperform their installed base of competitor devices, which makes the company an attractive partner for new ecosystems.

As for one final example, given that many Apple devices cover all aspects of its consumers’ lives, from TV consumption to mobile telephony to PC’s, the company owns a Big Data advantage that few of its competitors have, which is useful for new businesses and product improvement.

The key point to understand is that there is tremendous value in the Apple installed base and more of that value is going to be realized through growing Services. Here are three reasons why. First, the installed base is highly affluent. In fact, within emerging markets the per capita income of Apple users is some 50% higher than non-Apple users. There is an even more pronounced gap within the US, with Apple users earning approximately 55% more than their non-Apple counterparts. Second, there is material evidence that Apple’s users are highly digitized and are “transacting users” as Apple’s users have the highest usage and adoption of Internet services. For example, Apple users made up 63% of total traffic recently compared to 29% at Android. Third, the installed base has a very high level of customer retention with predictable rates of replacement cycles and it is likely to continue upgrading devices over time. In others words, while Apple’s hardware sales are 91% of sales and 85% of gross profit, such sales are a function of the installed base of devices, which is a highly recurring business. All in all, Services could rise to become a $100+ billion business versus $45 billion reported in 2018.

Growth in Services is a big deal for gross margins. In fact, based on analysis of Apple Services, its gross profit contribution is 15% at a gross margin of 68%. This gross margin level could be sustained near 70% over time. How? The major contributors over the next 5 years will include: Apple Music, Apple’s TV offerings, and growth in Apple’s other services such as iCloud, Apple Pay, etc. However, the biggest potential contributor of the incremental gross profit will come from the App Store. Apple enjoys a gross margin of 68% on Services. The shift in Services revenues has already driven material gross margin expansion, which is likely to continue.

Ultimately, the trend toward sustained gross margin (or in other words improved profitability) should benefit the stock’s valuation. More predicable revenue and higher profit margins equals higher valuation. Very simple.

Analysts are already having to recalibrate estimates for each business. The gross margin on the key hardware products are running lower than previously assumed. Specifically, the iPhone business is generating a 42.5% gross margin, lower than the 45% previously assumed by the market. This margin is now likely to decline to 38% long term. But not to worry – this is normal.

Additionally, the iPad business could have significantly lower margins and we now see iPad gross margin at 31%, down from closer to 37%. Those only doing light homework on the topic start clamoring here that Apple’s gross margin is eroding and investors should run from the stock. However, those who keep digging, find that the Services trend is going to offset all the bad mentioned above. Outside of quarter-to-quarter volatility, the improvement in the Services mix will drive higher gross margins for the company overall. As a result, total corporate gross margin should be retained in a range of 40% or slightly higher. Concerns over gross margin pressure are overstated!

In summary, an annuity-based hardware business model is unheard of. Perhaps the most important aspect of Apple’s services innovation over the past decade is that the results have come at record levels of customer satisfaction with retention rates close to 90%. Additionally, while monetizing many of these services is not Apple’s primary objective, it does allow the company to price at premium levels. Whether it is the customer lock-in and essential headache of leaving the iOS ecosystem or the loyalty to the brand, the output is the same – once an individual or family is part of the Apple ecosystem, they very rarely leave it.

The end conclusion is that while Apple books its revenues and earnings based largely upon a point of sale, the actual installed base of over 1.5 billion active devices presents a largely reoccurring cash flow stream as users replace and upgrade their devices due to the innovation and introduction of new products over time. Conservatively, 55% of gross profit could be annuity-based within five years. It could be argued, given Apple’s record level of loyalty and retention, that large parts of its customer base are now recurring, which in part explains why the company has not succumbed to the same pressures seen by other handset vendors in the past. The company is much more than a point of sales product company, with the offerings spanning hardware, software, retail, and services across multiple products.

BMR TAKE: An Amazing Company; Outstanding Value

But is Apple a growth or value stock? Let’s see: Revenues for the past four years were $234 billion for the year ended in 2015, $216 billion in 2016, $230 billion in 2017 and $265 billion in 2018. And estimates call for double digit revenue growth per year looking out for the next several years. Growth is still very much alive and well at the company.

Apple is the champion of technology-based consumer products. They are the most admired company in the world. While investors wait for the next major wave of growth, they are comforted by the $60 per share in cash and a generous dividend that will grow further. We would buy this company and put it away for the kids. It will be a cash generating machine for decades to come. They’ve astounded us before and they will astound us again. This time next year will see new products and more importantly, a higher stock price. Of that there is no doubt



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