As iPhone Momentum Slows, This Analyst Says Apple Will Find Revenue Growth In Services

Can Apple Inc. AAPL sustain mid-single digit revenue growth at a time when iPhone sales are showing signs of concern? The answer lies in Cupertino's Services division, according to Morgan Stanley.  

The Analyst

Morgan Stanley's Katy Huberty maintains an Overweight rating on Apple's stock with an unchanged $203 price target.

The Thesis

Apple has shown an 8-percent annual revenue growth rate, 86 percent of which came from iPhone sales, Huberty said in a research report. Investors have valid concerns with Apple's growth prospect for two reasons, she said:

• The iPhone replacement cycle extends further.
• The iPhone installed base growth slowed from 14 percent over the past two years to a single-digit figure. 

Services and the other products and wearables segment will "drive almost all of Apple's growth over the next five years in our updated base case model," Huberty said. 

Encouragingly, the mix shift would add upward pressure on the company's gross margin, which represents an "important driver" of the stock's performance, the analyst said. 

Expectations of Services growth over the coming years is justified by the fact that services revenue is growing on a year-over-year basis for "every customer cohort and in every region," the analyst said. Apple's annual Services revenue per device has risen from $25 per unit two years ago to an estimated $30 per unit today, Huberty said.

At peak maturity, it wouldn't be a "stretch" to model peak revenue per device at $100 or more, according to Morgan Stanley. Amazon.com, Inc. AMZN's Prime boasts more than 100 million users paying $99 per year, and Netflix's 111 million subscribers spend $120 per year, Huberty said. 

How It's Possible

Only 18 percent of Apple's total device installed base are paid subscribers, but the company has multiple levers it can pull to attract new paying users, Huberty said. They are:

• Growth from Apple Music, as just 2.9 percent of total Apple devices are users.
• Investments in iCloud, including new data center launches, should "meaningfully improve" the user experience.
• Apple Pay is now accepted at 50 percent of all retail locations, with plenty of room for continued expansion.
• The introduction of new payment options in the App Store, especially in China with WeChat Pay and AliPay, will support growth. User churn should "meaningfully" decline after the company's hiring of managers with relevant experience in subscription businesses.
• Future offerings in original content and augmented reality-focused apps are "easy wins."

As a whole, Apple's five-year revenue compounded annual growth rate will slow from 8 percent over the last five years to 6 percent, Huberty said. But at the same time, a favorable sales mix coupled with Apple's ongoing share buyback program will result in an acceleration in earnings per share growth from 8 percent over the past five years to 16 percent, according to Morgan Stanley's model. 

Price Action

Apple shares were trading lower by nearly 1 percent early in Thursday's session. 

Related Links:

Apple Services Segment Continues To Exceed Expectations

Apple Is A Buy, Even If You Have Doubts About The iPhone

Photo courtesy of Apple.