Quarz Capital pushes Tim Cook to split out Apple’s software and services operating numbers

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.

Dear Tim,

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[1] 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.

Sincerely yours,

Jan F. Moermann
Chief Investment Officer, Quarz Capital Management, Ltd.

Havard Chi
Portfolio Manager, Quarz Capital Management, Ltd.

[1] Including cost items

Assumptions:

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[2] 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.

[2] 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.

16 Comments

  1. Speculators and NOT investors!!
    They just are looking for a share jump to look and charge their customers.

    The more Apple breaks out info, the more anal….yst have to find made up fault.

  2. I wouldn’t mind seeing Apple valued better by Wall Street, but if the underlying is already in place, why bother to break it out. The only thing that really changes is investor’s perceptions of the company. If that’s the case they should simply take a closer look into how Apple operates as it does now. Are investors really that stupid or lazy. If a company is worth a certain amount based on total revenue, splitting it into parts shouldn’t help increase its value. Apple supposedly is currently valued based on the sum of its parts, so why should a split of those parts increase the total value.

    I suppose I really don’t understand Wall Street’s math. I know it worked for Google/Alphabet but it still doesn’t make sense to me. Maybe I shouldn’t care as long as I benefit. I just don’t know. It’s like these financial wizards are able to extract more value from a company out of thin air. I’d prefer Apple to stay as it is, but I also want to see Apple’s value on Wall Street increase so I’m puzzled. Maybe I can’t have it both ways. I personally don’t trust Wall Street when it comes to Apple so I hope Apple knows what it is doing in its own best interest. However, I’m not in favor of more buybacks because it currently appears as though the money is being thrown away for nothing in return.

    1. This letter is silly. Apple isn’t suddenly going to be valued differently because they break out Apple Pay vs Apple Music in their financials. There is nothing hidden in Apple’s financials that we don’t know about. Quite honestly I’d prefer if Apple gave out as little information as possible.

  3. No reason to do what they want. They should only tell their cost, gross profit, and profit. No breakouts of any product(s) or service(s). No crowing about one product over the other.

  4. It is a very sensible proposal that would help Apple shareholders tremendously. The Street looks upon Apple as an iPhone manufacturing company. Remember how the recent doctored reports of iPhone 6s grim prospects from “Asia teams” brought the stock down 4-5 % over 2 days. This game is played out each quarter. Yes, Apple reports all kind of information but when Apple reports 48 million iPhones sold and not 48.5 million all hell breaks loose for the stock. This perception of iPhone only company must end otherwise Apple stock is at the mercy of stock manipulators. When Apple is split into two business units with two top executives and all revenues and profits are reportedly separately the sky rocketing non-manufacturing business growth will dim lights for the likes of Google and Amazon. Also Apple must STOP giving out iPhone numbers. They should stick to one number for all internet connected devices that includes the phone, mac, iPad, watch, iPod, tv etc. Tim Cook should become CEO and Managing Director of Apple Inc. and should yield full authority to the heads of two business units. This will make positive difference for Apple as an enterprise as well as its stock.

  5. I don’t think that Apple would agree to provide this additional information, it would be too valuable for it’s competitors and very few comparable companies provide the amount of detail that Apple already does.

    If analysts were given more data, they would ‘discover’ even more mythical trends amongst that data and use them to destabilise the stock further. If the analysts had an established track record for intelligent predictions of Apple’s future performance, there might be some merit in releasing more information, but the reality is that analysts are hopelessly wide of the mark when it comes to predicting Apple and don’t even show signs of understanding much of Apple’s historical performance either. The less that Apple panders to the analysts, the better as they mostly work against Apple’s interests by circulating untrue rumours. More data would invite more rumours.

    It’s hard to see any way where Apple would benefit from this proposal. AAPL investors are best served by not releasing this data, but I can see why those who speculate in AAPL would benefit from it. Apple needs a more stable and meaningful valuation for AAPL, not one that fluctuates wildly for illogical reasons.

  6. He is correct, but do not listen to him as it will ruin Apple’s reputation as a company that goes its own way which is its charm.

    You lose that charm, you become 1984.

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