Shares of Apple (AAPL) are rising $3 today to $116 after Goldman Sachs added the stock to its “conviction buy list” and raised its price target to $163 per share (from $145). Goldman’s thesis is that Apple is transitioning from a hardware company to a recurring revenue services business, which will allow it to garner a higher earnings multiple on Wall Street (which in turn would lead to meaningful price appreciation). While many of my clients are long Apple stock, I don’t buy this “Apple is really a software company” argument.
If we take a look at the numbers it is hard to argue otherwise. In fiscal 2015 Apple derived 9% of its total revenue from services, with 91% coming from hardware (led by the iPhone at 66% of sales). Okay, so Apple is a hardware company today but maybe the services segment is growing so fast that it will ascend quickly to be a huge part of Apple’s business? In fiscal 2014 services represented 10% of sales. In fiscal 2013 it was 9%. The mix isn’t changing at all.
So what services business will really start to grow in the future and allow this software thesis to play out? Goldman Sachs, among many others, point to Apple Pay. Apple’s receives a cut of every credit card transaction processed through its Apple Pay iPhone app (the press has reported the rate to be 0.15% but Apple will not confirm this). So if Apple Pay continues to gain market share in credit card processing, will that make a big difference to the company’s financial results? Not at all.
Total U.S. credit card volumes are staggering; more than $2 trillion per year. Let’s be optimistic and say that Apple Pay can grab 25% of all credit card transactions. The result would be about $900 million of Apple Pay service revenue. That sounds like a lot of money until you realize that Apple is booking more than $230 billion of sales annually. An extra $900 million comes to less than one-half of one percent of incremental sales. Even if we model that as 100% profit, it would add just 16 cents to Apple’s annual earnings per share. It’s a rounding error.
The bottom line is that Apple is a hardware company. Could that change in 5-10 years? Perhaps, but it’s not going to happen anytime soon and as a result, investors should not expect the company’s P/E multiple to expand materially. That is not to say the stock won’t perform well, I just don’t think it’s going to trade at or above the valuation of the S&P 500 index, which would be required if the stock is going to see $163 anytime soon.
Full Disclosure: Long shares of Apple at the time of writing but positions may change at any time.