Consumer technology giant Apple Inc. (Nasdaq:AAPL), based in Cupertino, Calif., is a pretty unusual case for an investor to consider. Using recent average selling prices (ASP) for iPhones and iPads, for the company to grow annual revenue by just 1% it has to find almost 3 million new customers. Certainly the company's entry into China will help, but it will be an ongoing challenge for the company to identify new products and services that can meaningfully impact revenue and profits.

Phones Lead The Way

Apple's recent fiscal second quarter report was surprisingly good. Revenue rose 5% year-over-year, beating expectations by a similar amount. The company's iPhone business drove all of the momentum, as sales rose 14% and exceeded expectations by a similar amount. As the 13% decline in iPad revenue was also close to the amount by which Apple missed on this line, it sort of makes you wonder how the sell-side was building its models.

In any case, it wasn't just a case of strong iPhone unit sales and weak iPad unit sales. Apple also showed good margin leverage, with gross margin up almost two points on the back of those stronger-than-expected iPhone sales. Apple couldn't keep all of that through the operating lines, but operating income did increase 8% and operating margin did expand almost a point.

Familiar Phone Concerns

Apple is still facing a challenge that has dogged the company for some time: if the high end of the smartphone market is stalling out, where does the company go for revenue growth? Apple hasn't been eager to delve into the midrange and low-end markets, and that probably won't change anytime soon given the company's cost structure.

Instead, Apple should try to continue to add features and functions to maintain its spot on the high end of the spectrum while letting Korea's Samsung Group, and Redmond, Wash.-based Microsoft Corp. (Nasdaq:MSFT) and others battle for those other markets. That may not sound exciting, but if Apple can continue a process of serial innovation that supports even slight pricing increases between generations, it will generate enough free cash flow to support the stock price.

Multiple Dwarfs Versus One Snow White?

Some investors have been waiting for Apple to unveil the “next iPhone” - the next product with tens of billions of dollars of annual revenue prospects. That is probably not the likely trajectory for the company. Investors have been waiting for years for the so-called “iTV” and the reality is that there just aren't that many markets where you can develop a product that 50 million or more people will buy in a given year.

It seems more likely that Apple is going to grow on the hardware side with bits and pieces. Watches and other wearables, TVs, home automation products, and in-car products could all collectively amount to meaningful revenue, but none of these will be the next iPhone all on their own. This looks to be the path that Google Inc. (Nasdaq:GOOG) is following, as individual products like Google Glass and recently-acquired Nest Labs' thermostats and smoke detectors aren't likely to be individually huge.

How Big Can Services Be?

One area where company watchers remain bullish is on the services side. Apple claims 800 million iTunes accounts and even if 20% of those are dead accounts, that's a huge number. Working backwards from the last earnings report, each claimed account is generating about $23 per year in revenue through iTunes, the App Store and so on.

Think about how much you pay for your cable, your cell service, your Netflix account or other such services on a monthly basis. Assuming that Apple can profitably offer additional services, this per-user/per-year revenue figure could head quite a bit higher. The one catch could be in margins, though, as none of the companies behind those aforementioned services can come close to Apple's margin structure.

The Bottom Line

Modeling Apple out for 10 years, expect to see a larger contribution from lower-margin services and modest hardware growth (with some margin erosion). Even just 1% free cash flow growth per year can support a fair value close to $680, and that's including a tax haircut to the company's overseas cash pile. Don't expect that Apple shares are going to be bought or sold on the idea of what 2023 may look like. Instead, expect the stock to continue to react to product announcements, the far more numerous rumored product/service announcements and concerns about how Apple will navigate the shifting currents in smartphones.

At the time of writing, the author did not own shares of Apple.

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