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Apple’s biggest business — accounting for some 60% of its revenues — is the 11 year old iPhone. But that mature business is barely growing. Fortunately for investors, Apple has a smaller business that’s growing faster — its so-called Services unit which includes revenues from App Store downloads, iCloud storage and Apple Music subscriptions.
If Services — which enjoyed a 31% pop to over $9 billion in the first quarter of 2018 — was a separately-traded company, it would command a much higher valuation than Apple — which has been growing at a five year average rate of 7.9%.
Should Apple spin off Services? By keeping Services inside the company, Apple is holding back $231 billion in value from shareholders. (I have no financial interest in Apple securities).
Before getting into that, a well-known strategic error is for a company to depend too heavily on a single product. After all, if that product is popular and represents a big opportunity, it will attract competitors who may take market share from the incumbent by offering a lower-priced version that many consumers find irresistible.
The remedy for this error is innovation — but not all CEOs can do it well. Some, like Steve Jobs, are able to build on a company’s strengths to create much better products aimed at large markets. Jobs was able to accomplish this with amazing success in the MP3 Player, cell phone, and tablet markets.
His successor, Tim Cook, has tried — for example, he oversaw the launch of the Apple Watch. But that product does not generate enough revenue to make much of a difference.
How so? Bundled in Other for financial reporting purposes with AirPods, Apple TV, Beats products, iPod Touch and the HomePod, the Apple Watch was an unspecified part of Other’s $5.5 billion, or 6.2% of Apple’s first quarter 2018 revenue of $88.3 billion.
Along with the iPhone, Jobs oversaw the introduction of the App Store and iTunes which made the profitable devices Apple sold much more compelling to consumers.
Under Jobs, Apple did not make much profit on these services but they fueled demand for its highly profitable hardware — for example, in September 2012 due to its 44% higher price and lower unit cost, Apple earned a whopping 71% gross margin on its iPhone 4S — much higher than the Nokia Lumina’s 54% gross margin.
But in recent years, iPhone revenues have not been growing rapidly and predictably. To wit, they increased 3% in 2017, fell 12% in 2016, and soared 52% in 2015.
To his credit, Cook presided over the decision to report to investors the financial results of its Services unit. And according to Gene Munster of Loup Ventures, Services has grown at an average annual rate of 22% since 2006.
According to the Financial Times, Munster used a price/sales ratio of 10 — by looking at software as a service companies like Adobe, Dropbox or Intuit — to estimate that Services would enjoy a market capitalization of $381 billion — assuming it will generate $38.1 billion in 2018 revenue (Cook’s 2020 target is $50 billion) — if it was a standalone company.
Applying Apple’s price/sales ratio of 3.93 to that 2018 estimate — which would value the services revenue at $150 billion — suggests that Cook is holding back a whopping $231 billion in shareholder value from Apple investors.
The potential of Services is based on a growing number of Apple devices owners and a rise in the service revenue per device. In January 2016, Apple disclosed that it had more than 1 billion active iOS devices — smartphones, tablets, watches and its TV set-top boxes — to which it could sell services, according to the Financial Times.
Over the last four years, that number has grown about 30% to 1.3 billion during which time services revenues doubled.
Morgan Stanley’s Katy Huberty noted that Apple’s paid subscriptions — from its own services, including Music, as well as third-party apps like Netflix or Spotify — grew from 100 million in 2017 to 270 million this year.