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Guner Soysal

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Summary

Apple is increasingly moving towards a subscription-based business model for both its hardware and services.

On the one hand, the shift towards a subscription-based business model can put pressure on the company’s operational performance in the short to medium term.

On the other hand, this approach can lead to steady and sustainable growth in the long term.

In this article, I want to discuss why Apple is becoming a subscription-based company and what implications this policy shift could have in terms of opportunities and risks.

1. Introduction

Apple (AAPL) is currently the world’s most valuable company in terms of market capitalization and the most profitable company in terms of profits.

As I have already mentioned in my article “Torn Between Overextended Valuation And Stunning Results“, Apple reported stunning quarterly results with growth in each geographic region, product segment and financial metric. In the long term, the company has very solid fundamentals and should continue to expand its business.

Nevertheless, there is also a slow but sure shift in the company’s sales strategy. We know this sales strategy in particular from Software-as-a-Service companies called subscriptions.

While most people argue that Apple offers its services to generate more hardware sales, I think the opposite is true. Apple is increasingly offering its hardware on a subscription basis and reportedly plans to launch new product bundles in order to convey the perception that it is becoming a subscription-based company and therefore deserves a higher valuation.

In this article, I will show you why I think this way. Additionally, I will discuss the implications of such a strategy concerning potential opportunities and risks.

2. Apple’s shift towards a subscription-based company

As you can see in the following graph, service revenues in FY 2019 accounted for 18% of Apple’s total revenues with rising tendency.

(Apple’s revenue breakdown. Source: Annual Statement FY 2019)

Furthermore, hardware sales of iPhones, iPads and Macs have been more or less stagnating for years, while sales of wearables and services have shown very high growth rates.

(Apple sales by category over time. Source: Annual Statement FY 2019)

Additionally, the following illustration visualizes the rapid surge in Apple’s services revenues over the past few years.

(Apple’s rapid growth in services revenues. Source: Statista)

In Q3 FY 2020, paid subscriptions grew more than 35 million sequentially to over 550 million paid subscriptions across the services on Apple’s platform, up 130 million from a year ago, according to CFO Luca Maestri’s statements during the earnings call. Management aims to reach 600 million paid subscriptions before year’s end.

Now comes the interesting part. While Apple’s revenues in FY 2019 consisted of 82% of hardware sales, the gross margin percentage of services is with 64% much higher than hardware sales.

(Apple products and services gross margins. Source: Annual Statement FY 2019)

So, what would you do if you would have a rapidly growing service with an increasing customer base and much higher gross profits compared to your former product categories? Right, you would search for ways to upsell your services by, at the same time, increasing the turnover rate and subsidizing your existing product categories. So, how is Apple’s approach in this context?

First, Apple offers interest-free financing for its products. At the same time, the company makes it possible to trade-in older product models to make the purchase price of a new product more affordable; even for people with low budgets. Trade-in is becoming a more common trend, as according to CEO Tim Cook during the earnings call. That gives the customer the feeling that the products are more affordable and, as with a normal subscription model, pays for them in monthly installments.

Second, Apple is rumored to be getting ready to launch new bundles of its different subscription services, according to Bloomberg. The bundled services offerings, rumored to be called “Apple One,” will offer Apple services consisting of Apple Music, Apple Arcade, Apple TV+, Apple News+ and iCloud. The bundled subscription is said to be cheaper for customers than buying each service individually.

I could even imagine that in future Apple could offer its hardware in combination with its services in a package for a monthly fee with the possibility to renew these products every year or every two years. The more hardware the customers buy, the higher monthly installments they have to pay.

Third, Bloomberg reported that Apple acquired Mobeewave. Mobeewave is a startup with technology that could transform Apple’s iPhones and other hardware into payment terminals. By incorporating Mobeewave’s technology into its hardware, Apple would be able to offer fast and easy payments with no other apps needed.

Apple’s own Apple Pay technology in combination with Mobeewave’s technology could be a way for Apple to bypass conventional payment and banking infrastructure by offering customers their own payment processing.

The advantage for Apple could be the elimination or reduction of transaction costs to banks or third parties as well as a better understanding of consumer (payment) behavior, and on that basis, providing consumers with new services and product offerings.

The advantages for consumers could be a fast and easy in-store processing of trade-in and subscriptions for Apple’s coming bundled hardware and services offerings.

Even merchants could potentially benefit from lower transaction costs through the use of Apple’s payment technology, depending on Apple’s ultimate goal with implementing Mobeewave’s technology.

(Apple hardware products soon available as a bundle on a subscription basis? Source: Pixabay)

3. Potential implications of the expansion of subscription-based hardware sales

First, the increasing sale of hardware on a subscription basis could result in stagnating or declining overall sales in the short to medium term, which could be partially offset by increasing wearables sales and services revenues. Consequently, with this change in business model, Apple could sacrifice short-term revenue for long-term subscription income.

In this context, Adobe (ADBE) can be used as an example. After the company announced the “subscription only” business model in 2013, revenues and profits fell for two years, but increased rapidly thereafter (see following figure).

(Adobe revenues and profits after switching to “subscription only”. Source: Morningstar)

Adobe’s growth in paid subscriptions in 2013 is also reminding of Apple’s growth in paid services subscriptions (see figure below).

(Adobe subscriber growth in 2013. Source: Image taken from Tech Crunch)

Second, as can be seen in the following figure, Apple’s operating income and cash flows were stagnating during the last few years.

Apple(Apple’s operating income and free cash flows over time. Source. YCharts)

Nevertheless, Apple’s market cap more than tripled over the same time period which cannot only be explained by Apple’s massive volume of stock buybacks and announcement of a stock split (see following figure).

apple(Apple’s market cap over time. Source: YCharts)

While the shift in Apple’s business model could lead to stagnating or declining overall revenues as well as stagnating operating income and cash flows in the short to medium term, investors seem to anticipate increasing operational performance in the future.

Third, Apple’s shift towards a subscription-based business model will make revenues and cash flows more reliable and stable. This could also be the case during economic downturns.

Fourth, Apple could see disproportionately high growth in its hardware and services revenues due to new technologies such as 5G and AR/VR if the company launches complementary offerings. These include the upcoming 5G-capable iPhone. In addition, there are frequent rumors of AR/VR glasses being developed. A hardware bundle consisting of these products could become a real blockbuster.

On the other hand, Apple could suffer disproportionately if the company offers its own financial services and thus bears the risk of default of its customers by bypassing banks and financial institutions in order to save (transaction) costs.

4. Apple’s current valuation seems to be extended but the stock could move higher with the current momentum

In my last article about Apple I presented my fair value calculation on a very detailed basis, which is $338-366 depending on the calculation method. Based on the closing price of $499 on Friday, this represents a current downside potential of 27-32%.

Nevertheless, I wouldn’t be surprised if Apple is going to have a double-digit P/S ratio of up to 16 with the current market momentum, which is the current P/S ratio of most SaaS companies. This would mean that the stock would double again. On the other hand, the company’s overall growth is far too low to justify such a valuation.

A very big risk, which the market seems to ignore absolutely at the moment, is the Apple App Store practices and revenue cut amounting to 30%. My personal fear is that Apple has too much market dominance here and is abusing its market dominance too much, so Apple could be forced to make concessions in this regard.

With Facebook (NASDAQ:FB), Spotify (NYSE:SPOT) and Epic Games, more and more companies are coming together to criticize Apple’s practices. A corresponding court decision could put massive pressure on the stock.

Investors should therefore keep an eye on two metrics in particular, which might help to assess Apple’s operational performance. These are the active installed base for hardware (iPhones, iPads, Macs) and the development of services revenues.

According to the management’s statements during the earnings call for Q3 2020 results, the active installed base for iPhones, iMacs and iPads reached a new all-time high. Additionally, the company set a new June quarter record in terms of services revenue.

5. Conclusion

As presented in this article, Apple is increasingly moving towards a subscription-based business model for both its hardware and services.

In this context, trade-in and interest-free monthly payments in the form of a subscription model play an important role. This policy shift could lead to product bundles consisting of various packages of hardware and services with different price ranges.

The advantage for Apple is that the company has the opportunity to keep consumers in its own ecosystem and upsell various products and services.

The advantage for consumers is that the purchase price for new products would be more affordable; even for people with low budgets.

Investors should attach increasing importance to this policy shift when evaluating Apple and no longer simply treat Apple as a conventional hardware company and based on previous valuation models.

While the shift towards a subscription-based business model can put pressure on the company’s operational performance in the short to medium term, this approach can lead to steady and sustainable growth in the long term.

Based on my valuation model, Apple’s current fair value is between $338-366 depending on the calculation method, which would correspond to a downside potential of 27-32%.

Nevertheless, with the current market momentum, I wouldn’t be surprised if Apple is going to have a double-digit P/S ratio of up to 16, in line with the most SaaS companies.

Other potential upside catalysts could be the upcoming holiday season, the release of the 5G-capable iPhone, the release of AR/VR glasses and the offering of additional product bundles.

Downside risks exist in particular due to the increasing criticism of Apple’s app store practices and the 30% revenue cut, which is being joined by more and more companies. I fear that a corresponding court order could put enormous pressure on Apple’s share price in the short term.

PS: If you liked my article and you want me to write more articles of this kind in the future, then like, comment and share this article. I intend to publish more about tech stocks in future. If you are interested in finding out my favorite technology stocks, just follow me on Seeking Alpha. Thank you for reading!

Author: Güner Soysal

Source: PJ Media: Apple Could Become A Pure Subscription-Based Company, Here’s Why

1. Introduction

Considering the latest developments, I decided to write an update to my previous Wirecard (OTCPK:WRCDF) (OTCPK:WCAGY) article from January 12, 2020 entitled “Wirecard: Why Patience Could Finally Pay Off In 2020″.

Furthermore, the company published its preliminary results for Q4 2019 and FY 2019 last Friday which also smashed revenue expectations of the analysts.

Since my previous article, the stock price surged from €110.90 up to €146 on Friday after publication of the preliminary results which corresponds to a return of 32% in approximately one month and a peak increase of nearly 40% year-to-date. The stock closed Xetra trading at €138,9 on Friday.

While Wirecard was last year’s worst performing stock in the Dax 30 index, it represents so far the best performing stock in 2020 together with Deutsche Bank (DB) outperforming the index by far (see figure below).

So, has the Wirecard stock exhausted its potential for 2020 now? According to my assumption, no! On the contrary, I assume that the actual outbreak is yet to come.

In this article, I want to discuss the preliminary results of Q4 2019 and FY 2019. Furthermore, in addition to my elaborations presented in my previous article, I want to discuss why the Wirecard stock could breakout soon despite a nearly 40% peak surge in 2020 based on fundamental reasons, recent short-selling data and technical analysis.

In this context, I would also like to thank some German stock market letters who used my calculations and elaborations for their own purposes without referring to my article. This confirms to me the high quality of my analyses and foresight of my investment ideas. Nevertheless, I would be more pleased in future if they make an appropriate reference.

2. Preliminary results for Q4 2019 and FY 2019

According to the preliminary results, revenues increased by 46% year-over-year to €835 million in Q4 2019 (Q4 2018: €571 million) and smashed analyst consensus of €774 million by around 8% or €61 million. EBITDA increased by about 41% to €232 million in the corresponding period (Q4 2018: €165 million). Adjusted for extraordinary expenses for audit, advisory and legal services which were incurred in Q4, EBITDA was €241 million, representing an increase of around 46% and slightly above analyst consensus of €240.7.

Correspondingly, consolidated revenues rose by around 35% to €2.8 billion in FY 2019 (FY 2018: €2.0 billion) and EBITDA rose by around 40% to €785 million (FY 2018: EUR 561 million). Adjusted for extraordinary expenses for audit, advisory and legal services in Q4 2019, EBITDA amounts to €794 million, representing an increase of 42%.

Compared to FY 2018, the company has maintained its growth level of 35%, which is impressive considering the much higher revenue base. At the same time, EBITDA growth has actually increased, which speaks for an increasing scaling of the business and selling higher margin services to merchants (see for comparison FY 2018 figures below).

On the one hand, the preliminary results show that Wirecard is full on track regarding its Vision 2025 and the company delivers unimpressed by several allegations raised through different media groups.

On the other hand, the preliminary results indicate that the earnings were reduced by another €9 million legal costs caused by the allegations. In my previous article I had already shown that the company was confronted with legal costs up to €9.7 as per Q3 2019 which reduced earnings per share by approximately €0.27 or 8.6%. Considering that the independent review by KPMG is still ongoing, further costs in Q1 2020 are to be expected.

In summary, the company had approximately €20 million additional legal and audit costs in FY 2019 in order to identify false bookings – not inflated sales as alleged – in the amount of €2.5 million based on the Rajah & Tann audit, so nearly ten times the amount of false bookings.

As already mentioned in my previous article, as long as this cat-and-mouse game with the allegations of the media and disproving of these allegations by independent reviews continues, these additional expenses have a material (long-term) impact on the company’s earnings, shareholder value and shareholders’ equity, according to my opinion.

Going forward, the company expects EBITDA in a range of €1.0-1.12 billion in FY 2020, corresponding to a growth rate of 27-43%.

3. Further potential factors for an inevitable breakout

a) Fundamental situation

In my previous article I already presented my (conservative) fair value based on DCF method amounting to €214.55, corresponding to a current undervaluation of the stock of 54%, and based on EPS method amounting to €198.72, corresponding to a current undervaluation of the stock of 43%.

The following chart from Ortex illustrates the over- and understatement of the share price in relation to EPS growth and analysts’ EPS forecasts. The blue line represents the 12-months forward EPS based on analysts’ estimates. The green line represents the stock price.

Accordingly, the share would be fairly valued at €195 (ratio of the current price and the 12-months forward EPS), which corresponds to an upside potential of at least 40% (under the condition, of course, that the company or the analysts reveal no downside guidance and downward revision).

b) Short-selling near potential inflection point

Turning to short-selling figures, it looks like short-selling is near a potential inflection point. The last time the short quote was similarly high was in January 2017 as a result of the so-called “Zatarra” allegations. As a result of the disproving of the allegations at that time as well as the resulting short covering and momentum, the share price more than quadrupled by September 2018 (which should not be understood that the share price will quadruple again after the current allegations have been disproved; see following figure).

Additionally, as the chart below reveals, borrowing costs also increase which makes short-selling increasingly unattractive and expensive. Assuming that the price is the result of supply and demand, rising borrowing costs suggest that supply is diminishing and the shares are increasingly in the hands of hard-boiled investors, making it increasingly difficult to borrow stocks for short-selling purposes. Current borrowing costs stand at 4.77% and more than doubled since December 2019, according to data provided by Ortex (see figure below).

In April 2019, when borrowing costs were similarly high, the share price rose from €109 to over €150 by May 2019 (see figure below).

In summary, taking into account the current short quote and borrowing costs, it could become increasingly difficult to put pressure on the stock solely on the basis of speculation and without proven wrongdoing by the company.

c) Technical analysis

In terms of technical analysis, the stock is currently stuck between a horizontal and vertical resistance, according to Bastian Galuschka from Godmode Trader (see figure below). A breakout above €143 could result in a (short-term) upside potential to around €160 or even €198, which is why bears and short-sellers will try to defend this resistance. Instead, a drop below €126.9 could mean additional pain for long investors.

4. Conclusion

As presented in this article, Wirecard posted increasing revenue and margin growth in connection with its preliminary Q4 and FY 2019 results despite the allegations made by various media groups. So, CEO Braun is keeping its promise to shareholders regarding accelerating growth and increasing scaling.

Additionally to the strong fundamentals, it looks like the stock is near an inflection point considering the ongoing KPMG review, which could be published at any time, the record-high short quote and borrowing costs as well as the technical analysis.

Consequently, a breakout seems inevitable and to be just a matter of time once the allegations are disproved.

My (conservative) fair value based on DCF method still indicates an undervaluation of the stock of 54%, while my fair value based on EPS method indicates an undervaluation of at least 43%.

While I trust the Wirecard management and even if the share appears fundamentally undervalued, surprising events are always to be expected on the stock market and there is no guarantee of rising share prices. Investors should always bear in mind that stock prices are volatile and should not be influenced by price movements alone, but rather should pay attention to the underlying fundamentals. In this respect, investors should always pay attention to their individual risk tolerance.

Beyond that, I think that German authorities and financial supervisors (e. g. Bafin) should play a more active role to prevent potential misleading allegations and increase shareholder protection as well as market transparency by revision of capital market supervision, starting with the disclosure requirements for short selling and media coverage which could influence the share price.

As long as this cat-and-mouse game with the allegations of the media and disproving of these allegations by independent reviews commissioned by the company continues, the additional expenses have a material (long-term) impact on the company’s earnings, shareholder value and shareholders’ equity, which is not acceptable from a shareholder’s point of view.

As outlined again in this article, the company had approximately €20 million additional legal and audit costs in FY 2019 in order to identify false bookings – not inflated sales as alleged by the media – in the amount of €2.5 million based on the Rajah & Tann audit, so nearly ten times the amount of false bookings.

P.S.: I intend to publish more about my favorite tech stocks in future. If you are interested in finding out my favorite technology stocks, just follow me on Seeking Alpha, my personal blog or on TipRanks.

Author: Güner Soysal

Source: Seeking Alpha: Wirecard Nears Inflection Point, Could Break Out Soon

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