Merrill Lynch: The Street is betting too heavily on Apple Services

At the same time, it’s overly pessimistic about Apple’s hardware. So says analyst Wamsi Mohan, who has run the scenarios.

From a note to clients that landed on my desktop Wednesday morning:

In our opinion, consensus is incorrectly baking in a relatively higher contribution from Services (to total company GP dollars) and is arguing for a higher multiple on the stock. While margins are indeed high in Services, the materiality of Services to total company profit dollars is still a work in progress, in our opinion, and for the next several years, Hardware remains the dominant driver of earnings. We maintain Neutral on lack of near- term catalysts, continued weak iPhone sales, balanced by large net cash/share and relatively attractive valuation.

We analyze three scenarios for Apple’s revenue growth and margin improvement. In scenario 1, we keep Hardware revenue and margins flat, while considering various scenarios of Services revenue growth and GM improvement to calculate the percent of total company gross profit dollars in F21 that come from Services. Scenario 2 has Hardware revenues and margins declining, considering various scenarios of Services revenue and margin growth. Scenario 3 assumes some Hardware revenue growth, in addition to Services revenue and margin expansion. We see that in every case, Services contributes less than 50% of total company gross profit dollars three years out in F21 (contribution mostly ranges from 30-40%).

In our opinion, Street estimates for F21 are too pessimistic and are reflecting scenario 2, which assumes Hardware revenue and margins continue to decline. While we see no significant near-term catalysts and remain Neutral on the stock, over the longer-term we believe Apple should benefit from the launch of a 5G iPhone (expected in C2020) and this should drive significant y/y iPhone unit and Hardware revenue growth in C2021.

Maintains Neutral rating and $180 price target. 

My take: For fiscal 2019, Mohan is anticipating a 2.2% drop in revenue year over year. I’ve seen worse.

3 Comments

  1. David Drinkwater said:
    “We see that in every case, Services contributes less than 50% of total company gross profit dollars three years out in F21 (contribution mostly ranges from 30-40%).”

    While “less than 50” may seem damning, 30-40% is quite significant, and, at a high margin, Services should (IMHO) look like a good growth replacement for iPhone sales growth.

    Note that my emphasis here is on growth. I assume iPhone sales/replacements will be fairly stable. If they fall by as much as 10%, Services should more than cover the shortfall as a total of recurring revenue.

    It’s also hard to know today how big supporting devices like AirPods and Apple Watches will be.

    Or how bigly (sic) cash return will pay/play out for investors.

    1
    February 13, 2019
  2. David Emery said:
    I’m not convinced “The Street” has a conscious deliberate bet 🙁 It still feels like a lot of “iPhones can’t last forever” and “Apple is doomed”.

    We’ve seen a couple interesting thoughts from the analysts that PED summarizes for us, but there’s certainly no consistent pattern of credible thought across the population.

    2
    February 13, 2019
  3. Gregg Thurman said:
    Merrill Lynch: The Street is betting too heavily on Apple Services
    At the same time, it’s overly pessimistic about Apple’s hardware. So says analyst Wamsi Mohan, who has run the scenarios.

    That’s just one opinion from among many, nearly all of which are historically wrong to the low side.

    1
    February 13, 2019

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