Slowing iPhone Growth Wont Hurt Apple, Inc.

By Markets Fool.com

Apple posted extraordinary results last quarter. iPhone unit sales surged 46% year over year and iPhone revenue grew at an even faster 57% rate.

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However, iPhone sales growth is virtually certain to slow to a crawl by 2016. Apple bulls who expect revenue and profit from iPhone sales to continue growing in a significant way beyond this year are likely to be disappointed.

iPhone sales soared last quarter, and the rapid growth should continue for a few more quarters. Photo: Apple

Luckily, this doesn't mean that Apple stock is doomed. Beginning later this year, sales growth in Apple's other product lines (including new products like the Apple Watch and Apple Pay) will start to offset slowing iPhone growth. As Apple starts to diversify its earnings away from the iPhone, its valuation should rise.

Strong growth in a limited market

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For the past couple of years, the conventional wisdom among many tech pundits has been that the high-end smartphone market is essentially saturated. This seemed to be confirmed by a drastic slowdown in iPhone unit sales growth from more than 70% in fiscal year 2012 to 20% in fiscal year 2013 and 13% in fiscal year 2014.

In this context, Apple's 46% iPhone unit sales growth last quarter was especially impressive. The key driver was the introduction in September of the iPhone 6 and iPhone 6 Plus, which have larger screens than previous iPhone models.

Anticipation of the new models caused some loyal iPhone users to delay their upgrades, which held back sales growth in fiscal year 2014 but then boosted growth last quarter. Apple also gained high-end market share from Samsung. Lastly, Apple benefited from growth in China's high-end market, driven by its year-old partnership with China Mobile and the ongoing rollout of 4G service in China.

Limited opportunities for further growth

New models like the iPhone 6 Plus could allow Apple to grow iPhone sales 30% or more in fiscal year 2015. Photo: Apple

Apple can probably ride the new iPhones' strong momentum to unit sales growth of 30% or so in fiscal year 2015, bringing total sales to about 220 million this fiscal year. Analysts at JPMorgan Chase have estimated that in a best-case scenario, Apple could sell 235 million phones in fiscal year 2015 -- that would represent 39% unit growth.

However, the pool of potential upgrades is not unlimited. Globally, there are about 400 million iPhone users today. Apple also won't win 100% of the high-end market -- plenty of Android fans will stay loyal to that platform. Furthermore, smartphone penetration is already very high among people who could reasonably afford to purchase a high-end phone.

Even bullish analysts like Mike Walkley of Canaccord Genuity -- who recently boosted his Apple price target to $145 -- think that 2015 will be the last year of big growth for the iPhone. Walkley estimates that Apple will sell 210 million-215 million iPhones annually through 2018 as growth in the user base is offset by a slowing replacement cycle.

Growth in existing product lines

Two of the big issues frequently raised by Apple bears are 1) Apple's reliance on the iPhone for the vast majority of its earnings, and 2) iPhone market saturation. The implication is that if market saturation causes iPhone sales to stagnate or fall, Apple's earnings will inexorably fall.

But if Apple can generate strong growth in its non-iPhone revenue in the next few years, it may be able to grow earnings despite stagnant iPhone sales. This would also reduce Apple's single-handed reliance on the iPhone for the vast majority of its profit.

Apple has significant growth opportunities in its existing non-iPhone product lines. The Mac has steadily gained PC market share in recent years, but still holds a small slice of the market, giving Apple plenty of future upside.

Meanwhile, iPad sales have hit a rough patch. One prominent analyst even expects iPad sales to drop 30% this year. However, rising replacement demand and growth in the business market could restart iPad sales growth later this year. For example, JetBlue Airways announced this week that it will deploy iPad Minis to more than 3,500 employees.

iPad sales have soured recently, but growth could return later this year. Photo: Apple

The App Store represents the biggest future growth driver among Apple's existing product lines. In 2014, App Store sales generated more than $10 billion of developer revenue. This means that Apple's cut was about $4.5 billion of high-margin revenue. Moreover, App Store billings grew 50% year over year.

New product lines will add to earnings

Apple will also be able to grow its non-iPhone profit by adding new product lines. The Apple Watch will go on sale in April. In the first year of sales, the Apple Watch could bring in $10 billion of revenue even if only 5% of iPhone users buy one. That's significant even by Apple's standards.

Apple Pay will take longer to mature. Apple gets 0.15% of the purchase price for Apple Pay transactions, so it would need to support $1 trillion in purchases to generate $1.5 billion in revenue. But global credit card/debit card payment volume is already well beyond $10 trillion annually and growing strongly. Apple Pay could conceivably process trillions of dollars of purchases a year a decade from now.

Finally, Apple almost certainly has other products in development today that will create new revenue streams in the future. While none of these other product lines has nearly the market potential of the iPhone, together they can become a meaningful counterweight.

If Apple can get all of its non-iPhone businesses growing later this year, it may be able to keep EPS growing at a high single-digit or low double-digit rate even with no iPhone sales growth. This would gradually reduce the iPhone's share of Apple's earnings from perhaps 70%-75% today to 50%-60% by the end of the decade.

Growth in Apple's non-iPhone businesses could thus address both of the bears' main worries simultaneously. It would allow Apple to keep growing earnings even as iPhone sales growth slows, and it would also diversify Apple's earnings stream away from its current reliance on the iPhone. This should drive Apple's valuation higher over time.

The article Slowing iPhone Growth Wont Hurt Apple, Inc. originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of JetBlue Airways. Adam Levine-Weinberg is long January 2016 $80 calls on Apple and short January 2016 $120 calls on Apple. The Motley Fool recommends Apple and China Mobile. The Motley Fool owns shares of Apple and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.