While the topic of services revenue may have gotten a little stale when pertaining to Apple (NASDAQ:AAPL). I think it’s worth re-examining whether there’s any merit in service/app revenue expansion given the availability of more exhaustive data on margins/revenue segmentation from the business segment.
Now, obviously, Tim Cook has moved the investor focus towards software/service revenue given the more attractive margins, and reduced CapEx needs with the exception of Apple iCloud, which is very datacenter/storage intensive.
Furthermore, Apple’s stock price continues to move higher in anticipation of a super-cycle (refresh driven demand given aged iPhone, Mac, and iPad installed based), but whether Apple can sustain enviable margins/revenue over a multi-year trajectory is more contingent on service/software revenue ramp, as it’s a higher margin category.
So, what’s new?
In the past month, the analysts at RBC Capital Markets released a research note that classifies the revenue derived from Apple’s non-hardware business units and the relative profit contribution of the separate business units. I discuss Amit Daryanani’s latest research notes in more detail here.
Source: RBC Capital Markets
Now, keep in mind, Apple Music Revenue is growing at a fairly rapid pace, which is helping to offset the iTunes unit decline. Now, obviously Apple was late to market when releasing Apple Music, as competitors were thoroughly entrenched (Pandora (NYSE:P) and Spotify (Private:MUSIC)).
However, the strength of Apple’s user ecosystem, and its ability to attract exclusive music contracts with various record studios helped to differentiate the app. Notwithstanding, management’s efforts in Apple-branded software should be watched closely, as the release of new applications will sustain the current revenue CAGR. More specifically, the introduction of new hardware categories increases Apple Care revenue, heightened storage attach rates (thus increasing app store volumes), and emerging categories like car infotainment/ADAS (advanced driver assistance systems).
That being the case, Apple needs to devise a strategy for ramping its mobile payment efforts. The adoption of mobile payment terminals, and the buildout of the corresponding payment ecosystem has been slow, as is the case with anything pertaining to banking.
As a general rule of thumb, I believe mobile payments could become Apple’s largest software/business category given enough time, as banking services while slow to reach mass market adoption has the most defensible barrier to entry given network effect, and consumer dependence on banking/payment services.
I explain this in greater detail here, but here’s a brief excerpt on my commentary pertaining to Apple Pay from last year:
To put Apple’s progress in comparison, after roughly a year into its launch, the company generated $10.9 billion in annual transactional volume, according to Timetric. The average transaction amount was $44.54 (what Visa reported in its most recent quarter), which translates to 244.723 million Apply Pay transactions in the prior year. To put this in perspective, it took the financial industry 40 years to reach a comparable transaction volume figure (rough approximation) for debit/credit cards combined.
I believe Apple’s technical adoption curve was relatively quick in comparison to the timescale of original cashless payment services. Hence, the rate of annualized growth, and the relative penetration rate across the bank/merchant processor ecosystem will move at a much quicker pace, substantiating a multi-decade investment thesis pertaining specifically to Apple Pay, and is perhaps the one x factor that gives Apple’s claims of doubling its service segment revenue by FY’20 any legitimacy.
Of course, Apple needs to transition towards being a strategic player in mobile payments, as Visa (NYSE:V)/MasterCard (NYSE:MA) are the primary payment network providers for all transactions done digitally. If Apple were to devise some back-end payment network improvements by also operating as a digital clearing house for transactions, via the open-ledger system used primarily for cryptocurrencies (i.e. Bitcoin), Apple could move further up the value chain, and increase its transaction spread across its installed base of mobile payment users.
Source: RBC Capital Markets
Now, keep in mind, the two most profitable app/service categories is Apple Store and Apple Pay. Hence, Apple’s execution as an ecosystem provider has been great, but their efforts in mobile payments leave much to be desired. While, I can acknowledge that Apple is in the early innings of driving adoption, and payment volumes have been ramping, the need for innovation/platform impact has never been more important. The investor perception must shift from hardware to software if Apple wants to sustain a much higher value premium, which I explain in greater detail.
Source: RBC Capital Markets
With the introduction of EMV cards by the major banks, we’re witnessing a short-term solution for analog card readers, but I think the entire ecosystem will start shifting towards mobile payments.
Generally speaking, the EMV cards while more secure than magnetic strip are also more of a hassle to use at payment/checkout. Hence, the development of more secure transaction settlement tends to result in longer payment/checkout times when purchasing product/services at brick-and-mortar locations.
Furthermore, the implied volume ramp seems fairly conservative, but net revenue contribution is quite difficult to derive from the transaction volume figure, as Apple Pay is monetized on a per-transaction basis.
Even so, we can derive a net revenue figure from the information supplied by RBC Capital Markets, by simply dividing the payment volume by the average transaction amount for debit/credit cards, which is already disclosed by both Visa and MasterCard.
As disclosed in Visa’s Annual 10-K figures, the company reported that payment volumes totaled $6.843 trillion with total transaction figures at 148.5 billion. When dividing the $6.843 trillion in cash volume by the number of transactions reported by Visa, we derive the average cash value of each transaction moving through the Visa Network. Therefore, $6.843T divided by 148.5 billion = $46 in average transaction.
We then take the $46 in average transaction and apply it to Apple Pay’s estimated transaction volume in terms of dollars, which gives us 239.13 million transactions in FY’15, 1.434 billion transactions in FY’16 and so forth. Keep in mind Apple Pay’s transaction volume directly corresponds with the Visa network, as Apple is not the merchant network provider, but is an added service layer for mobile payments.
We then use the 0.15% per transaction figure to derive our estimates on net revenue contribution. Hence, each $46 transaction translates into $0.07 for each Apple Pay transaction. We then use the payment volume estimate by RBC, divide by $46 and apply $0.07 as the transaction spread in our net revenue estimate. This gives us a fairly accurate depiction of Payment revenue contribution.
Source: Cho’s Tech Research, Visa Annual Report & RBC Capital Markets
When comparing my modified figures, I derive $1.792 billion in net revenue contribution in FY’20 using the same exact transaction volume figures derived by Amit Daryanani. Furthermore, the figures Daryanani estimates is $1.76 billion, so we’re within the ballpark of each other.
I run figures to include 10% operating expense, and perhaps 25% (in-line with Apple’s reported corporate tax rate). Hence, my net profit margin estimate for Apple Pay alone is 52% currently, which contributes approx. $930 million in net profits by FY’20.
When valuing the business on the basis of peer/comparable multiples, I value Apple Pay at an end of five-year period valuation of $52.8 billion (using peer payment provider multiples). I then discount that forward valuation via Apple’s current WACC (weighted average cost of capital) of 11.53%.
Can Apple double its service/app store revenue by 2020?
Since Apple Pay is the differentiating growth factor in our financial model, we separate the historical revenue growth CAGR from the remaining Apple Services business units, and then integrate the separate Apple Pay contribution separately.
Generally speaking, I don’t necessarily believe in SOTP (sum-of-the-parts) analysis, but it’s a worthwhile exercise to explore, as it helps to illustrate the value investment thesis for AAPL investors.
As such, I believe Apple’s Payment business would need to scale up to $1.8 billion/year, total M&A spending would need to match $24-$25 billion, and services revenue CAGR would need to continue at its five-year average for Apple to grow this business to $50 billion+ by FY’20.
(Click to enlarge)
Source: Cho’s Tech Research
Generally speaking, I believe Apple Pay revenue contribution would give Apple just enough room to double-up on its services business at $47.77 billion, which is just shy of $48.6 billion when added into historical revenue CAGR and extrapolated out into 2020.
However, if the current business segments excl. Apple Pay were to decelerate, then it would diminish the likelihood of Apple actually doubling this business in size. Hence, I also include $24 billion in M&A related activity, assuming the acquired businesses were bought at 6x sales, which would contribute an incremental $4 billion in service revenue. The 6x sales figure is derived from software sector average valuations. Albeit, the scope of the acquisitions would vary in size, I believe my estimates more or less conforms with industry multiples, and likely scope of Apple’s M&A activity upon cash repatriation.
As such, I anticipate the services business to contribute $51.77 billion in sales by FY’20, assuming a reasonable scenario of Apple Pay + M&A ramp.
However, I take on a more neutral stance, and exclude the impact of M&A, while also including Apple Pay contribution to derive my value estimate for the business unit.
I believe the Apple Services business has a net profit margin of 38.9% or so. This is driven by Apple’s average corporate tax rate of approx. 25%, and operating costs that compose 10% of the segment’s total revenue. Hence, I value Apple’s service business after forecasting $18.6 billion in net income contribution by FY’20, and applying 25.29 earnings multiple to that figure. I then discount my estimate by AAPL’s WACC of 11.53% to derive an estimated value of Apple’s service/software business.
Keep in mind, this is more for illustrative purposes than actual value computation. That being the case, I believe Apple Services should be valued at $306 billion. I believe the hardware business contributes $35 billion in net income in FY’17, and when valued using my current estimate of $586 billion, the combined business units on an SOTP basis should be worth $892 billion, or $169.96 per share.
Of course, I’m not suggesting that Apple will reach $169.96 in 2017, but if we lived in a perfectly rational world, AAPL would be trading at a higher value premium.
Keep in mind, the estimate I derived could prove too aggressive if in the event software categories excl. Apply Pay were to decelerate, though I believe Apple can sustain software/service revenue ramp when assuming greater software attach to hardware sales.
Furthermore, there’s no indication that Apple will acquire businesses as aggressively as my estimates suggest. If anything, valuation is a bit subjective, as Apple tends to buy smaller tech franchises that have yet to report meaningful revenue/earnings contribution. Apple may supplement service revenue growth with some M&A activity, but the degree to which it may impact revenue/earnings is subjective at best.
In the most optimistic scenario, Apple acquires a cumulative $4 billion in attached revenue from M&A at a $24 billion market capitalization (assuming 6x sales). However, if Apple acquires private tech unicorns, the value premium could easily balloon past 15x sales, hence, Apple’s cash repatriation may trigger an M&A race that pushes tech valuations even higher thus diminishing the actual revenue/earnings accretion.
I’m fairly optimistic on Apple’s service segment, and will likely revise my financial model to reflect greater service revenue contribution in FY’17 and FY’18.
We continue to reiterate our high conviction buy recommendation, and $156 price target.
About Cho’s Technology Research
Cho’s Technology Research is SA’s premier technology research package that gives investors and traders an additional edge when investing into tech companies. It’s a trade publication, research service and an idea generator. It includes short-term trade ideas that yield 5%+, long-term small cap investment ideas that yield 25% This service comes at a low annual subscription cost of $20/month. The promotional price period will end soon! Subscribers get a free two-week trial upon checkout and can cancel at any point in time. For more information click here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.