Credit Suisse Thinks Apple Can Hit Its Services Target, Ups Price Target to $170

By Evan Niu, CFA Markets Fool.com

Apple (NASDAQ: AAPL) has its work cut out for it if it hopes to hit its ambitious self-imposed goal of doubling its services business in four years. It can certainly be done, especially now that growing services revenue is a high priority at the company, but it won't be easy.

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Credit Suisse analyst Kulbinder Garcha has now put out a research note (via Tech Trader Daily), and he thinks Apple will be able to reach its goal -- and then some. Garcha is reiterating his outperform rating on Apple shares while boosting his price target from $160 to $170.

TV may be an important aspect of growing Apple's services revenue. Image source: Apple.

Services are super profitable

It's probably intuitively obvious, but Apple's services revenue is extremely profitable compared to its hardware-related revenue. Garcha estimates that the services business enjoys a gross margin of around 70%, compared to Apple's corporate average of around 39%. To the extent that Apple can grow this profitable segment, Apple's consolidated gross margin could potentially rise above 40%. Apple occasionally posts gross margin higher than 40%, but this is often a function of commodity pricing in component markets, which are inherently volatile and out of Apple's control.

Installed base growth is critical to the services business, and Garcha estimates that the installed base will grow from roughly 1 billion active devices currently to 1.5 billion active devices by 2020. The iPhone should expectedly drive most of that installed base growth as Apple's most popular product. Combined with a growing number of active devices, average spending per user is expected to rise from approximately $68 in 2015 to around $135 by 2020 -- effectively twice as much spending. Apple Pay, Apple Music, and iCloud should really help drive this increase in user spending.

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Stop me if you've heard this one before

There's been renewed debate regarding a blockbuster content-related acquisition, and Garcha brings up a familiar idea: Apple should acquire Netflix (NASDAQ: NFLX). That would fill an important "strategic gap" with Apple's TV offerings, and the analyst believes that buying Netflix is more compelling than alternative candidates like Time Warner Inc. or Disney (NYSE: DIS). However, the analyst confusingly says that a Disney deal seems unlikely "given Disney's expensive valuation currently."

Disney may be about three times as expensive as Netflix in absolute dollars, as measured by market cap, but it's significantly cheaper in terms of earnings power. As a mature media conglomerate, Disney trades at 20.6 times earnings; as a video streamer in high-growth mode, Netflix trades at 333 times earnings.

Beyond valuation concerns, there are operational ones. Apple could conceivably want Disney's media assets, but there's absolutely no way that Apple has any interest in operating resorts and theme parks, which are a key part of Disney's business and one of the most powerful ways that it monetizes its franchises. Netflix would be much easier to integrate as a services-only complement.

As usual, the biggest concern is the price. Netflix is worth roughly $60 billion right now before factoring in any type of offer premium, which would represent Apple's largest acquisition ever by a factor of 20. And $60 billion is an awful lot of money -- more than Apple holds domestically (if the theoretical deal were to be structured in cash). A giant acquisition of this nature would make it easier to double services revenue, but Apple could probably pull it off organically, which would be far preferable in terms of capital efficiency.

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Evan Niu, CFA owns shares of Apple, Netflix, and Walt Disney. The Motley Fool owns shares of and recommends Apple, Netflix, and Walt Disney. The Motley Fool recommends TWX. The Motley Fool has a disclosure policy.