This Analyst Is Betting on Apple's Services Business

Apple's (NASDAQ: AAPL) services business seems to be the talk of the month for analysts who cover the tech giant. This isn't surprising -- the iPhone business is reportedly seeing worse-than-expected sales, prompting analysts to lower their estimates for that important segment. This means investors should take a good look at the company's second-largest segment: services.

Will services be able to help make up for potential weakness in iPhone sales in fiscal 2019? Jefferies analyst Timothy O'Shea thinks so.

The Street may be underestimating Apple's services

In a note published Wednesday (via CNBC), O'Shea joined the growing ranks of analysts who are lowering their iPhone sales estimates and their 12-month price targets for Apple stock. He lowered his target for the stock from $265 to $225, citing his downward revisions to iPhone revenue in fiscal 2019.

O'Shea's price target, however, still implies significant upside versus the stock's $167 price at the time of this writing. In addition, he maintains a buy rating on the stock.

Some of his bullishness notably stems from an optimistic outlook for Apple's services business. O'Shea is betting that the Street is underestimating the segment's gross profit potential. He predicts the segment's gross margin will be between 60% and 66% over five years, easily beating a consensus analyst estimate for 56%.

Apple is set to report its services segment's gross margin for the first time when the company releases its financial results for the first quarter of fiscal 2019. O'Shea says he is betting that "Apple intends to tell a compelling Services story when it discloses gross margin for the first time ever next earnings."

A lucrative services business could help support a pricier valuation for the stock, making a case for Apple's ability to monetize its active users across its installed base of devices, O'Shea argues. "The opportunity for investors is that these higher margin, higher growth software businesses deserve a higher multiple vs. the lower margin, lower growth hardware business," the analyst said.

Why Apple's services business is so important

With the iPhone accounting for 63% of Apple's trailing-12-month revenue, weak sales from that segment could weigh meaningfully on the tech giant's business. It makes sense, therefore, to reassess the potential of the company's other segments -- services in particular.

As Apple's second-largest segment, services not only accounted for a meaningful 14% of its trailing-12-month revenue, but it's also growing rapidly. Trailing-12-month services revenue increased 24% year over year in fiscal 2018, or 26% when excluding one-time items in fiscal 2018 and the year-ago period.

Management is optimistic about the continued potential for its services segment, citing the company's large and growing installed base of active devices. "The installed base of all our major product categories is at an all-time high, and it's been growing over the last several quarters," CFO Luca Maestri said in the company's fiscal fourth-quarter earnings call. "So the opportunity for us to monetize our services business continues to grow over time."

Maestri also reminded investors that the company has added three meaningful services in the past three years alone: Apple Pay, Apple Music, and advertising within the App Store. "[A]nd we will want to continue to offer new services over time," he added.

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