Sorry Goldman Sachs, Apple Is A Hardware Company Plain and Simple

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.

2 thoughts on “Sorry Goldman Sachs, Apple Is A Hardware Company Plain and Simple”

  1. “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).”

    I believe that’s the wrong way to look at it. Apple monetizes mostly through selling hardware, but a lot of the value and differentiation of its products comes from the software, and thus a lot of what people are truly paying for is the software. Put Android on the iPhone and Windows on a Mac and see how much people are willing to pay for it compared to other Android and Windows devices (it might still be a premium because of the nicely designed hardware, but it won’t be nearly as much because you’ve just lost a lot of the value).

    1. I don’t disagree that the software is what makes the products immensely popular. But that is not enough for multiple expansion. Cash flow is still driven almost entirely by consumers upgrading their hardware (the software updates are free) and paying lots of money to do so. This is why the stock trades at a very large discount to the market.

      It’s sort of like a home builder: the better designed and appointed the home, the faster it will sell and the more money it will sell for. But the home builder will still be valued as a home builder (not as a design services firm) even though what’s inside is what will differentiate it from the competition and get people to buy it.

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