The Street’s obsession over iPhone units has distracted investors from the fundamentals and weighed heavily on AAPL’s multiple.

• The company’s recent decision to end the reporting of hardware unit numbers should help focus investors on what matters most: revenue and earnings growth.
• Second to revenue and earnings growth, trends in hardware and Services margins will impact AAPL’s multiple.
• While it will take a year or more, we believe this reporting change should raise Apple’s multiple, potentially 2x higher, to be more in line with other predictable and growing businesses.

20 & 40: Key Metrics Nobody’s Talking About

I’ve covered Apple for a long time and have always tried to center my investment opinion on a 2-5 year view while being vigilant that quarterly unit sales are the building blocks for the long term. Over the years, the Street’s focus on units (Mac, iPod, iPhone, and iPad) has intensified. Over the past 3 years, this focus has largely blinded investors to the most critical investing metrics: revenue and earnings growth.

I’m guilty of falling into the unit trap. It took me 5 days to realize the company grew revenue 20% y/y and earnings 40% y/y in the Sept. 2018 quarter, despite Apple highlighting those data points 3 times on the earnings call.

Evidently, the Street also missed the impressive revenue and earnings growth, as the stock fell almost 10% following the Sept. quarter earnings call, and the narrative has been dominated by a 1% miss on iPhone units and guidance 2% below consensus (due to timing of new phones, production, and emerging markets). A negative view of the company’s new unit reporting methodology is also depressing shares. Investors that rely on unit visibility argue that this change only masks declining units sales.

Moving Away from Units Is a Good Thing

Valuing Apple based on the number of units it sells provides a very narrow lens with which to look at a complex business. The value of the ecosystem is greater than the sum of its parts. Instead of looking at each product or service as an individual line item (or item in your “cart,” per Tim Cook), Apple’s entire ecosystem creates real value for Apple’s customers and, therefore, its investors.

As Horace Dediu points out on a recent podcast, AirPods, Apple Watch, or HomePod may not be large drivers of the bottom line on their own, but that is the incorrect way to think about it. The value is in the integrated system, and this new reporting methodology will force investors and analysts to think about Apple as a Service over individual unit sales. 

Analyzing the September Quarter Through the New Reporting Lens

We believe this is how Apple would have reported the Sep-18 quarter under the new reporting approach:

• Grew revenue by 20% (highest rate in 3 years) and earnings by 41%. (We expect 11% revenue growth and 26% earnings growth in FY19).
• Grew installed base at “double digits,” which now likely exceeds 1.4B devices.
• Services grew at 17% despite a difficult y/y comp.
• Returned $23.2B to investors.
• Retail now has 506 locations, with 70k employees, up from 65k earlier in the year.
• Saw Wearables growth of over 50%, compared to 60% in Jun-18, and 50% in Mar-18.

The 6 Key Metrics Under the New Reporting Methodology

In this reporting methodology, Apple will be valued based on 6 metrics:

1. Earnings growth – earnings pays the bills, funds innovation, and returns capital to investors.
2. Revenue growth – revenue precedes earnings.
3. Hardware gross margin –  hardware gross margins are an indication of Apple’s pricing power, competitive position, and manufacturing efficiency. While investors will be okay with fractional declines in hardware profitability if it comes with offsetting increases in Services profitability, they will be alarmed if hardware gross margins dip unexpectedly. This is critical because the health of hardware underpins the strength of all of Apple’s businesses. Lastly, declines in hardware margin would be reminiscent of the start of Blackberry’s and Nokia’s challenges.
4. Services gross margin – Services are Apple’s most profitable segment. Therefore, it will be an obvious area of focus.
5. Install Base – We expect updates on an annual basis.
6. Revenue per user –  This will also need to be estimated but will be used as a measure of the value of each member of the ecosystem.

Comparative Valuations – Staples and SaaS

Apple is increasingly performing like a services business, so we thought it appropriate to compare Apple’s current multiple to a few SaaS multiples including Salesforce and Adobe. Adobe currently trades at 30x 2019 earnings, and Salesforce trades at 49x. Apple trades at 13.5x 2019 earnings.

We also looked at consumer staples companies, given they, like Apple, tend to be longer-term, lower growth, and higher visibility. Clorox, for example, currently trades at 23.5x forward earnings and Coca-Cola trades at 19x. While we do not believe that consumer staples are the appropriate comp group for Apple, the valuation differences illustrate how little respect Apple’s multiple receives.

SaaS companies earn higher multiples because dependable, long-term customers are worth more. Apple has dependable, long-term customers. Stable businesses like Clorox and Coca-Cola earn their multiple because the underlying investment is less risky. This quarter marks the eighth consecutive for a stable iPhone business (avg 1% growth). These examples are extreme but serve to demonstrate why Apple as a Service is not being properly valued.

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