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Is Apple About to Break Out Again?

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Just a month and a half ago, we pondered whether Apple (AAPL - Free Report) would be the first company to get to a trillion dollars in market capitalization and concluded that it probably would, but that passing an arbitrary number didn’t matter all that much.

Since then, we’ve seen the broad markets trend sideways as tariffs and trade wars have investors spooked about the possibility of a global slowdown. The S&P 500 is up 1% since June 5th and AAPL is down 1%.

Most of the big cap tech names have failed to gain any traction lately with Microsoft (MSFT - Free Report) , Alphabet , Amazon (AMZN - Free Report) , and Facebook (FB - Free Report) all up or down less than 2% over that same period.

The lack of interest in Apple has been in contrast to steadily improving fundamentals - specifically the growth of services as a component of revenues. The services segment includes digital content and apps sold through the Apple store as well as Apple Pay and AppleCare.

In Q2, revenue from iPhones was up 14% year over year, iPad revenue was up 6%, Mac revenue was flat but revenue from services was up 31%. At $9.1B, this was a record number, both nominally and as a percentage of revenue.

It’s often stated that growth in services will boost the company’s margins, and while this is not technically true, services are likely to boost profits in the long run.

Apple’s gross margins across the company were 38% in Q2. This number has been remarkably consistent over time. Strictly measured, margin in services is likely to actually be less than 38% because Apple pays out 70% on sales and 85% on subscription services.

The margin situation is complicated because of the accounting of the payments received in services. If Apple sells an iPhone for $1000 that cost $700 to produce, package and ship, the margin is 30%. Similarly, If Apple sells a song on iTunes for $1 and pays the owner of the content $0.70, the margin is also 30%.

That gross margin calculation ignores the fact that all sales and costs are not equal.  Apple has to develop, manufacture, ship, store and sell the iPhone. There is a physical limit to how many they can make. With apps and digital content, Apple exerts almost zero effort and pays nothing until a unit is sold – other than operational and administrative costs. Also, there is no physical limit to how much digital content can be sold. Once the infrastructure has been established, the marginal cost of selling each additional unit is negligible. So in a sense, you could say the margin on digital content gets close to 100%, though that’s not how it looks on the consolidated statement of operations.

It’s been stated before, but is still worth mentioning that Apple operates a “sticky” ecosystem in which sales of hardware begets sales of content and services. What do you do after you unwrap that shiny new iPhone? Buy some apps and content, of course. The hardware purchase doesn't represent the end of your interactions with Apple, it's really the beginning.

Impressively for a company of Apple’s size, estimates for earnings continue to grow. The Zacks Consensus Estimate for Q2 is $2.19/share – 31% higher than a year ago – and the full year estimate for 2018 is $11.42/share, an increase of 24% over 2017. AAPL is a Zacks Rank #1 (Strong Buy).

Apple is scheduled to report Q3 earnings on July 31st. As you can see from all those small green arrows on the Price, Consensus and Earnings Surprise chart above, they have a long history of slightly exceeding estimates (19 quarters out of the last 20), so a big surprise in either direction is unlikely, but all eyes will be on the contribution of services to the total revenue figure.  If Apple can continue to grow the service segment like they did in Q2, it will be very bullish for the company and that $1 trillion market cap number – and beyond - won’t be far off.

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