Apple's Services Business Will Power Shares Higher

(Note: The author of this fundamental analysis is a financial writer and portfolio manager. He and his clients own shares of AAPL.)

Apple Inc.'s (AAPL) stock has jumped by 9% in the days following the release of its quarterly results on August 1. The big jump in the stock price made Apple officially the first company in the US to a $1 trillion market capitalization, beating out other technology companies, such as Alphabet Inc.-owned Google (GOOGL) and Amazon.com Inc. (AMZN). As many investors continue to focus on iPhone unit sales, it will be the growth in Service revenue that is likely to propel Apple's stock higher in the coming quarters. 

While iPhone revenue growth follows a predictable cyclical pattern centered around the release of the newest iPhone handsets, service revenue growth has been relatively consistent and linear. Service revenue is the second largest revenue stream for Apple, nearly double that of iPads and the Mac. (For more, see also: Key Levels for Apple Stock in Second Half of 2018.) 

Services Growth

Since the first-quarter of 2016, service revenue has grown by 58% to $9.548 billion as of the third quarter, up from just $6.056 billion. Despite the Service revenue strong growth over the past few years, it is often overlooked because iPhone sales are so dominant, and the cyclical nature of Apple's total revenue can over or understate the importance of Service revenue.

Growing Importance

In the latest fiscal quarter, Service revenue accounted for nearly 18% of Apple's total revenue, up from just 14% in the third quarter of 2016. When looking at the trends in Service revenue as a percentage of the total revenue, it is clear there is a trend of lower highs and higher highs. Meaning that in each iPhone cycle, Service revenue continues to become a more significant piece of the total pie. (For more, see also: Why Apple's Stock May Have Peaked.)

Services Are Number Two

Additionally, Service revenue has secured itself as Apple's second largest revenue source over the iPad and Mac. Since fiscal third quarter 2016, Service revenue has grown by 60%, compared to the iPhone's growth of 24.4%, while the Mac and iPad have been relatively unchanged.

High Valuation

Apple's stock is not only trading at record highs, but shares are also trading at its highest one-year forward earnings multiple since the fall of 2014, at roughly 15.4 times fiscal 2019 earnings estimates of $13.47. At this point, it may be too soon to say that the market is beginning to value the stock differently, assigning a higher multiple to the stock because of the strong revenue growth in Services, while valuing Apple less as a cyclical hardware business. It may also serve notice that shares are overvalued presently. 

Fundamental Chart data by YCharts

It is hard to ignore that Apple is currently maturing into a service business from a hardware business. Meanwhile, at its current growth rate, it may not be long until the services surpass iPhone revenue—and that means more big stock gains may lie ahead. 

Michael Kramer is the Founder of Mott Capital Management LLC, a registered investment adviser, and the manager of the company's actively managed, long-only Thematic Growth Portfolio. Kramer typically buys and holds stocks for a duration of three to five years. Click here for Kramer's bio and his portfolio's holdings. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future performance.