Apple Services: A Giant Is Growing Within Apple Inc. (AAPL)

Apple Inc. (NASDAQ:AAPL)’s services segment could be worth over $240B, making it a big reason to buy AAPL stock.

– The services segment has grown to become the second largest revenue segment at Apple Inc.

– Services growth will continue as the installed base of iOS users continues to rise.

– The market is valuing Apple as a hardware company, leaving room for multiple expansion driven by Apple services growth.

Shares of Cupertino, California-based Apple Inc. (NASDAQ:AAPL) were recently named by RBC capital markets’ analysts among the top tech stock picks for 2017. This is in stark contrast to 2016, a year in which AAPL stock has barely managed to beat the S&P 500 (INDX:SPAL) (1). Apple stock price is up by 10.7% in the year-to-date, marginally lower than the 10.75% returned by the S&P 500 in the same period. With such a lackluster performance in 2016, is AAPL stock a good buy heading into 2017? Well, Apple’s services business surely deserves more attention, as we believe this could fuel a multiple expansion driven rally in Apple stock price. Here is why Apple’s services business could drive AAPL stock higher in 2017.

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Apple’s Services Business Is Now Its Second Largest Segment

Apple Inc. (NASDAQ:AAPL)’s services business is now the second largest segment at Apple. The services segment closed FY 2016 with revenue of $24.35B, up 22% YoY. To put things into perspective, Apple’s iPad segment closed FY 2016 with revenue of $20.6B, down 11% YoY, while the Mac segment’s revenue was down 10.3% YoY, to $22.8B. Given the recent trends in the different revenue segments (iPhone, iPad and Mac), the services segment looks likely to become the growth engine for Apple over the coming years. (See also: An Unexpected Catalyst For Apple Inc.’s (AAPL) iPhone 8 Super Cycle).

With over a billion ‘active devices’, and growing, the steam in the services segment is far from over. Apple’s SVP of worldwide marketing, Phillip Schiller, recently offered a hint into the continued strength of the services segment. A tweet from Apple’s marketing head acknowledged November as the biggest month in terms of App store revenue. While the growth of its Apple services segment is something Apple’s management has focussed on in the recent earnings calls, there is more good news in store for investors. And, that’s the profit margins of the services segment.

As per Piper Jaffray’s Gene Munster, the services segment netted Apple a near 60% gross margin, far higher than what it makes on its hardware products. As reported by AppleInsider, Gene Munster said “estimates gross margins for Apple’s cut of App Store revenue is between 90 percent and 95 percent, while Apple Care is at 70 percent. As for iTunes, Munster believes margins are between 30 percent to 40 percent, far above the break-even point some have assumed.”

The 60% gross margin compares against Apple’s overall gross margins of around 40%. Based on the margin profile, it would be fair to value the services business at a 40% net margin, compared to Apple’s overall 21% Net profit margin in FY2016.

Valuing Apple’s Services Business

Apple Inc. (NASDAQ:AAPL) stock is currently trading at a PE multiple of 14.09, in line with the valuation multiples of other hardware companies like HP Inc (NYSE:HPQ) (2) and QUALCOMM, Inc. (NASDAQ:QCOM). However, the Apple services segment is significantly different from a ‘hardware’ business, whether in terms of operations or associated cost structure. It would, therefore, be more accurate to evaluate the segment as a services business in order to gauge its ‘value.’ Two popular companies which generate a ton of services revenue are Alphabet Inc (NASDAQ:GOOGL) and Facebook Inc (NASDAQ:FB).

Alphabet stock currently trades at a PE ratio of 29.56X while FB stock trades at an earnings multiple of 45.3X. Valuing Apple’s services business at these multiples puts the worth of the business between $287B – $441.2B ($24.35B*0.4*PE multiple). However, the services segment’s growth profile is closer to that of Google (YoY growth of around 20%) and hence, a 25X earnings multiple (below Google’s nearly 30X multiple for conservatism) would be a more accurate valuation of Apple’s services business, in our opinion, which puts the value of Apple’s services segment at $243.5B. (See also: Apple Stock: Will Apple Inc. (AAPL) Stock Regain Momentum In 2017?).

Conclusion

The $243.5B valuation compares against Apple Inc. (NASDAQ:AAPL)’s market capitalization of $622.5B (based on December 23 closing price). Excluding the service business share from Apple’s FY 2016 profits puts Apple’s ex-services PE multiple at 10.5X, which is significantly lower than the company’s 5-year and 10-year average earnings multiples. This leads us to believe that the market is currently undervaluing the potential of Apple’s services business, which could drive meaningful upside in AAPL stock price through multiple expansion.

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The article Apple Services: A Giant Is Growing Within Apple Inc. (AAPL) originally appeared on amigobulls.com. Watch our analysis video on AAPL

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