Quarz Capital Management (QCM), an investment manager, recently issued a letter urging Apple Inc. to positively reshape the investment community’s perception of the company by clearly segregating the operating results of their rapidly growing and high margin Software & Services segment from the rest of their hardware business.
Through this increased transparency, QCM believes that investors will better appreciate and value the tremendous growth dynamics and rich margins of this segment, driven by Apple’s growing, huge and captive installed base, addition of new product platforms and expansion into powerful new service categories. The potential increase in value of the share price resulting from such a financial segregation and reorganization has already been evident in other tech companies’ moves such as Google (Alphabet), Amazon (AWS) and Microsoft (New reporting segments).
QCM views that the financial reorganization will allow this segment to be valued in line with peers, unlocking the persistent undervaluation that Apple currently trades at. QCM believes that Apple can achieve a share price in excess of $200 per share by pursuing this move in combination with the capital return program and various growth catalysts.
QCM has delivered the following letter to Apple’s management team, board of directors and other stakeholders.
We applaud you and the entire Apple Inc. (the “Company”, “Apple” or “AAPL”) team for another year of record profitability. It is truly remarkable that the installed base of Apple products currently exceeds 800 million and continues to expand as Apple increases its market share in all of its key geographic markets. With the launch of new products and entry into powerful new service categories, we look forward to Apple’s strong sales momentum to sustain into 2016/2017.
As a long term shareholder of Apple, we could not be more supportive of your leadership and the team at Apple. We welcome the capital return program and also share your excitement that ‘Apple’s best years lie ahead’. However, we doubt that growth opportunities and capital return policy will be sufficient in fully unlocking the substantial discount that Apple’s stock currently trades at.
We view that the key reasons for the persistent undervaluation of Apple’s stock are that the investment community has a fundamentally misguided perception of Apple as purely a hardware business, and Apple management’s failure in effectively addressing this issue. Most investors do not give enough credit and neglect the rapidly emerging Software & Services (“S&S”) business and the compelling ecosystem that Apple has been successfully building.
The main purpose of our letter is to urge and convince you and the board that now is the time that Apple takes the decisive step to positively reshape the investment community’s perception of the company by more clearly and in detail segregating the operating results of the Software & Services segment, from the rest of the business.
We view the current consolidated reporting approach of the financial results as the main cause of why Apple S&S is continually valued as a hardware instead of a software business. As the majority of the cost base in the consolidated financials is from the hardware segment, it is nearly impossible to understand the financial details, such as margin development, costs and return on capital of the S&S segment. Discerning the ‘health’ of this segment has also been a tedious and roundabout process with analysts scouring Apple’s press releases, conference calls and events to put together different and often incomplete pieces of information on the segment. Put together, it is challenging, if not impossible to accurately value this segment as a standalone entity in the current reporting structure.
The appropriate valuation of S&S will be critical to valuing Apple in its entirety. While a significant proportion of Apple’s profit is still contributed by the hardware segment, we believe that Apple’s next leg of growth will be increasingly led and dominated by S&S. This is driven by 1.) The massive and growing installed base of Apple device users, 2.) New product platforms and services, and most importantly, 3.) Hundreds of thousands of Apple App and Software developers globally who are pushing the boundaries of development and bringing their latest and greatest works to the Apple Ecosystem. The impressive ramp up of Apple Music, Pay, and enterprise software further affirms our bullish view that AAPL S&S is at the dawn of a multiyear growth cycle and that Apple has ‘no shortage of growth opportunities’ to pursue in this segment.
With the split out of the operating results of S&S from the hardware segment, we view that investors will better appreciate and value the tremendous growth dynamics and rich margins of the different S&S product lines such as iTunes, App Store, Apple Music, Apple Pay, enterprise offerings and future new service offerings. The potential increase in value of the share price resulting from a more transparent financial reporting and reorganization has already been evident in tech companies such as Google (Alphabet), Amazon (AWS) and Microsoft (New reporting segments) when they undertook similar steps to provide clearer financial information on key revenue segments to their investors.
Our evaluation of the different product lines within the S&S segment indicates a conservative valuation of $260 billion or $47 per share at a trading multiple of 35x P/E 16E. This is in line with trading valuations of similar size software and internet peers. We would argue that AAPL’s S&S business deserves a much higher valuation multiple due to numerous growth catalysts and resilient revenue attributed to the captive and growing user installed base. Together with the cash value of $28 per share, and $158 per share for the hardware business at a valuation of 16.3x P/E 16E, in line with the S&P 500, we believe that Apple’s share is easily worth in excess of $200, providing investors with an excellent upside potential in excess of 60% after this move.
We view that the argument for not providing greater granularity of financial information to prevent competitive harm is without merit. Firstly, there are no comparable competitors as Apple designs and produces the product platforms which these S&S are delivered over. Secondly, Apple’s strategy has always been to offer unparalleled and differentiated products and services that redefine the industry instead of through price competition.
We have shared with you our strong conviction of Apple’s future growth trajectory. Most importantly, we hope that we have impressed on you and the board the compelling need for Apple to clearly segregate the operating results of the Software and Services segment from the rest of its business. We believe that Apple S&S is at the onset of a multiyear structural growth cycle. By reporting S&S as ‘just another segment’ within the broader scope of an investor perceived ‘Hardware Company’ only serves to undermine the value of this business.
Splitting out the operating results of the Software & Services segment, combined with the various growth catalysts and a continued capital return program can potentially deliver an upside of 60% to Apple’s share price, yielding an attractive return to long term shareholders.
Jan F. Moermann
Chief Investment Officer, Quarz Capital Management, Ltd.
Portfolio Manager, Quarz Capital Management, Ltd.
 Including cost items
Apple Hardware – We forecast revenue growth of 7.8% resulting in a total revenue of $230 billion in FY2016. Revenue growth rate of individual product lines, namely iPhone, iPad, Mac and Other Products are projected to be 5.9%, 6.0%, 5.8%, 46.1% respectively. We see Net Income for this segment to increase by 10.8% in FY2016 to $53 billion. The tremendous growth in Other Product category is driven by the full year consolidation of Apple Watch sales and the launch of Apple TV. The faster growth rate of the bottom line in FY2016 is attributed to our estimate that iPhone margins will improve in FY2016 due to the ‘S’ cycle. We also expect iPad margins to improve slightly due to higher iPad Pro’s ASP and the continuing sale of existing iPad models.
Apple Software & Services – After modest growth of 10.2% in FY2015, we forecast strong revenue growth of 36% to $27 billion in FY2016. We expect Net Income growth to trend higher at 38.9%, yielding a Net Income contribution of $7.4 billion.
• App Store – We estimate this unit to comprise ~60% of S&S’s sales in FY2015. With the addition of new product platforms such as Apple Watch, Apple TV, iPad Pro, and strong China sales, we forecast revenue to grow at 40% in FY2016, exceeding FY2015 growth rate of ~28%.
• Apple Music – Apple Music currently has 6.5 million subscribers since it was launched in End-June 2015. We expect subscriber count to grow to an average of 12 million in FY 2016 with an ASP of $100/year/user (including family memberships). We project revenue of $1.2 billion from Apple Music in FY2016.
• Apple Pay – We are bullish that Apple Pay will build its dominant market share versus other mobile payment alternatives due to critical security advantages of Apple devices. With the systematic roll out of Apple Pay in both the US and internationally, and increase in penetration rate of NFC enabled POS (Point of Sales), we project that Apple Pay will increase its share of retail transaction in the US and Europe to 2% and 0.4% respectively in FY2016. We forecast a revenue of $150 million for this unit in FY2016.
• iTunes Store – We estimate iTunes to comprise ~18% of S&S’s sales in FY2015. We forecast negative revenue growth of 5% in FY2016 as healthy sales growth in video content is offset by lower ‘pay per download’ music sales.
Share buyback – We forecast that Apple will execute $35 billion of share buyback in FY2016 at an average price of $130 per share, buying back 270 million shares.
Average shares outstanding – We estimate that Apple’s average diluted share count will be at 5.44 billion in FY2016 after factoring in the share buyback program.
Net Cash Flow – We project that FY2016 net cash flow to be $24 billion in FY 2016 after the deduction of $12.5 billion for Capex and $35 billion for the share buyback program.
Net Cash – We project net cash balance to be $156 billion after applying 6% to the entire cash balance to account for tax effect on international cash repatriation.
 Apple has a remaining amount of $56 billion (as of End-Sept 15) from its current capital return program, with $36 billion allocated for share repurchase.
Read more in the full press release here.
Source: Quarz Capital Management, Ltd.