Why Apple became a $2 trillion company in 2020, and what could come next

Some Wall Street analysts are betting that the rollout of 5G iPhones from Apple will consequence in report gross sales in 2021, eclipsing the 200 million-plus unit mark set in 2015-2016 when bigger screens have been launched.

David Paul Morris | Bloomberg | Getty Images

Signs of a dear inventory market will not be onerous to search out for traders fearing a repeat of the dotcom bubble. The speculative edges of the market, just like the booming IPOs and SPACs, or Tesla, get a lot of consideration when traders are searching for indicators that the market is due for a correction. But on the very prime of the market, there’s proof of how far and how briskly shares, and in explicit expertise firms, have run: Apple.

The market’s greatest company simply topped the $2 trillion mark in 2020, and Apple, together with the opposite trillion-dollar-plus tech leaders like Microsoft, Alphabet and Amazon which have dominated S&P 500 good points, collectively grew to characterize between 20-25% of your entire U.S. large-cap inventory index by means of the pandemic yr. For Apple, there’s additionally a primary, stand-alone inventory market metric that reveals a large bullish change in the best way Wall Street and traders seen the expertise company in 2020. Apple’s three-year price-to-earnings ratio is roughly 19 instances. But in 2020, its P/E ratio went as much as over 43 instances earnings.

Wall Street analysts aren’t working scared. Even after the massive yr, many see extra room for the iPhone maker’s shares to run greater, and they level to an evolution in how traders are defining Apple. There’s was a main re-rating of Apple shares by traders in 2020 centered on one rising a part of the enterprise, the analysts say: providers.

For years, Apple was seen as a {hardware} company and its P/E held in verify by that commodity enterprise profile, and for years, Apple CEO Tim Cook has been pushing the narrative that the company’s iOS working system providers ecosystem, constructed round a base of roughly one billion system customers, was a large a part of the long run. In 2020, that evolving mixture of {hardware} and software program in the Apple story acquired its greatest endorsement from Wall Street and traders.

Apple providers is a trillion-dollar enterprise

Some analysts now see Apple’s providers enterprise representing half of the $2 trillion-plus market valuation.

“For a long time, investors bought Apple at 12x P/E and sold it 16x, and that was it,” mentioned Dan Ives, Wedbush Securities analyst. He now values the providers enterprise at roughly $1 trillion of Apple’s market cap and he in contrast what occurred with the re-rating primarily based on providers to a different market high-flyer he covers: Tesla. “Tesla isn’t valued as an auto. Apple is no longer a hardware company.”

“The multiple expansion for the stock was the big theme of 2020,” mentioned Krish Sankar, senior analysis analyst at Cowen, who covers Apple. “It was always viewed as a hardware name and that that sentiment started shifting. … Services drove the multiple higher,” he mentioned.

Pre-Covid, in early 2020, Apple’s ahead P/E ratio was nonetheless in the low 20s, Sankar famous, and that grew over a interval of 4 to 5 months. “If you look at Apple historically, it is an iPhone story that traded as low as 12x, ex-cash.

The services, led by App Store, iCloud storage, Apple Music and Apple Care, are now a $60 billion-plus revenue stream growing in the mid-teens on a percentage basis annually.

“When you look again on the catastrophe tales in cellphone {hardware}, like a Blackberry or Nokia, on the prime of mountain they weren’t in a position to monetize an ecosystem. Apple nonetheless solely has about 15% to 18% penetration of its put in primarily based on the providers aspect. The put in base makes it the most-valued company in world,” Ives said.

All the conversations the Wedbush analyst was having with investors back in March were about stress testing the Apple model and how bad the numbers could get with iPhones to take a hit and stores around the world closed during lockdowns. Wall Street could do no better than play darts, he said, into the April earnings period for Apple, and then services beat by 5%. And then in June, services beat again.

Cowen’s sum of the parts analysis now places the services business as the majority component in Apple’s valuation, at 53%. Sankar stressed that services is not a single line time, and that may make it harder to grasp than a product homerun. As an example, he said many people don’t realize Apple Pay became one of the top fintech players in the world during the pandemic.

“It was a main inflection level,” Ives says. “Bulls like myself and others argued that for years, but it surely felt like we have been yelling into an empty forest.”

The Google, Fortnite risk in the services revenue

The bullish take on the services opportunity worries some tech investors.

Paul Meeks, portfolio manager of the Wireless Fund, says the big move in Apple propelled more by multiple expansion than underlying earnings per share growth should be a concern for shareholders. “Has it achieved a metamorphosis into a providers company? I’m not so certain about that. Yes, it’s rising, however it’s rising primarily no quicker than most software program firms and you should buy these instantly if you need,” he said, adding that many trade at lower multiples when measuring price to sales.

“You have a company that did aggressively go into a quicker development, greater margin enterprise and traders have congratulated them for it, however I believe it’s precarious in the valuation,” he said. “It grows quicker than {hardware}, however it isn’t explosive,10%-15% from the yr earlier than and that is slower than some software program firms.”

Cowen’s Sankar says that investors can find software names growing faster on a sales basis, but Apple looks much better than many of these companies when taking into account its margin profile. “Its compound annual development charge could also be decrease than a traditional software program as a service company, however at excessive gross margins,” he said. And there is also the market’s biggest cash cow of all, the iPhone, which will continue to generate more cash than any other product and serve as an “annuity” as services grows.

A significant supply of Apple providers development, although, faces a new danger into 2021: the billions in licensing charges Alphabet pays to have Google as the search engine default on iPhones.

Google pays billions each year. Lots of investors don’t realize a good chunk of the success of services propelling the multiple expansion has come from that Google relationship.

Paul Meeks, Wireless Fund portfolio manager

The Google licensing fees are attractive for Apple because there is no cost associated with the revenue. It is 100% gross margin to the company, whereas the gross margins on phones can range from 20% to 30%.

“Lots of traders do not realize a good chunk of the success of providers propelling the a number of growth has come from that Google relationship,” Meeks said.

Cowen estimates the Google licensing fees in fiscal 2020 at 17% of Apple’s services business. But the services revenue overall has been growing, from $37 billion a few years ago to $56 billion this year. That makes the Google revenue, estimated at as much as $9 billion to $10 billion annually, a much smaller percentage than it was just a few years ago.

“That is coming down and that’s excellent news for Apple,” Sankar said. “But the flip aspect is that it’s excessive margin, 100% margin, so if it goes away or will get minimize in half, you are a hole in gross revenue {dollars} of $9 billion to $10 billion and that hits the general margin profile,” Sankar said.

Every year the court case is extended and services grows, the importance of the Google deal goes down. “But do not get me fallacious, in phrases of revenue {dollars} it is vitally necessary,” Sankar said.

The battle between Apple and Fortnite maker Epic Games which threatens the 30% fee Apple takes for App Store revenue to app developers is another risk, but Ives says what investors most feared, a ripple effect among all developers, hasn’t followed Epic’s bold move. “Epic performed with firecrackers, however the Fort Sumter second between builders and Apple by no means materialized.”

At least, it has not yet. The court battle is not over and if Apple loses any legal challenges related to Fortnite in the future and has to take down the commission rate it charges, every investor will be focused on it, analysts say. But for now, Apple only conceded in the form of a reduction in its fee schedule for smaller developers, and did not extend that olive branch to successes the size of Epic Games. Other tech companies have also attacked the App Store model, including SpotifyMatch Group, and Facebook. Congress probed Apple CEO Tim Cook in a hearing in July about the App Store’s fees and policies. 

If commission rates are forced lower and it hits revenue for the App Store, which it will, that is a negative, but it is hard for analysts to forecast what the revenue reduction might be. Sankar thinks it will be manageable for Apple and among the two legal risks that are the most “imminent” threats to Apple, the Google case is the more significant.

“The App Store and providers ecosystem stays intact and grows,” Ives said. “Services has to proceed to develop or else.”

Apple is still an iPhone story

When Cowen initiated coverage of Apple in 2019, there were one billion iPhones and a five-year replacement cycle, or 200 million per year. Though Sankar’s current estimate is slightly below what would be a new record, at 215 million iPhones, he said the predictions for a record year in 2021 exceeding the fiscal 2015 level of 231 million units aren’t unreasonable, especially after a 2020 in which the final tally, while under 200 million units, will still be tens of millions of phones above what Wall Street feared during the worst of Covid.

“It just isn’t a loopy quantity,” Sankar said, but he and other analysts say the timing of adoption is uncertain and will be key to the iPhone annual sales number. “If you go and have a look at the telecom historical past, all of the 3G, 4G cycles final a very long time and we’re originally of 5G. It’s the next 10 years.”

Meeks said there’s a risk that a faster adoption rate is already baked into the stock price and leaves little margin for error in the hype about the “supercycle.” The iPhone is still the single-largest source of revenue for the company each quarter.

“There is a lot of stress that it needs to be the best product rollout of all time, and what whether it is OK, 5G is cool, however not everyone seems to be compelled to improve,” he said. “The supercycle theme being articulated, that phrase makes me frightened. … Right now, in most components of the U.S., should you purchased a 5G iPhone, you are not really getting any profit for an additional yr or extra.”

Apple’s streaming content challenge

It is not a question of resources for Apple.

“They have billions, they’ll simply pump out content material, however I believe they need to think about a three way partnership as a result of competitors is so fierce,” Meeks said. “They can produce something they need with the most important stars on the planet each time they need, however it should take a very long time to crank out,” he said.

“It’s been on a treadmill method and the window is closing to win in this space,” Ives said. “Unless the plan on shopping for a nation, with all that money after buybacks and dividends, it needs to be a studio and content material.”

The company’s cash balance gives them the ability to do many things across verticals, and for investors right now, the lowest marks Apple receives are on the media side of the services business. As many users come off a one-year free trial, Apple lacks a huge content library and content production remaining limited by the pandemic is a source of weakness.

“That’s the field traders have not checked for Apple but,” Sankar said. “In providers, they’ll do one thing bolder.”

Apple and EV hype versus reality

If the EV market is a trillion-dollar market over the next decade, Apple has to be a player in it, but the recent, renewed rumors about Apple making cars which have circulated for years make less sense to many analysts than a strategic relationship with a major EV market player.

Apple glasses for virtual reality, and new iterations of AirPods and Macs, will continue to grind out incremental hardware success, as will its in-house chip production for multiple products which has been a recent focus and margin booster. There are some huge potential areas for Apple to jump across sectors, such as in health-care technology. But Apple has to be looking at the EV market as a game-changing product category for its own growth potential and EVs could be the product category which has the most potential to increase Apple’s share value.

Manufacturing cars would be a questionable move given the low margins, but the high margin software could be a big business. “If Apple mentioned they have been manufacturing vehicles I believe analysts would promote,” Meeks said. “They must JV with somebody, however most likely not Tesla. That ship has sailed.”

EV software could be key to maintaining and growing the valuation now tied to the services business. “Every a part of that providers group needs to be quicker development and greater margin, and EV software program could be there,” Meeks mentioned.

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