Why Apple became a $2 trillion company in 2020, and what could come next

Signs of a pricey stock market are not hard to find for investors fearing a repeat of the dotcom bubble. The speculative edges of the market, like the booming IPOs and SPACs, or Tesla, get a lot of attention when investors are looking for indicators that the market is due for a correction. But at the very top of the market, there’s evidence of how far and how fast stocks, and in particular technology companies, have run: Apple.

The market’s biggest company easily topped the $2 trillion mark in 2020, and Apple, along with the other trillion-dollar-plus tech leaders like Microsoft, Alphabet and Amazon that have dominated S&P 500 gains, together grew to represent between 20-25% of the entire U.S. large-cap stock index through the pandemic year. For Apple, there’s also a basic, stand-alone stock market metric that shows a big bullish change in the way Wall Street and investors viewed the technology company in 2020. Apple’s three-year price-to-earnings ratio is roughly 19 times. But in 2020, its P/E ratio went up to over 43 times earnings.

Wall Street analysts aren’t running scared. Even after the big year, many see more room for the iPhone maker’s shares to run higher, and they point to an evolution in how investors are defining Apple. There’s was a major re-rating of Apple shares by investors in 2020 focused on one growing part of the business, the analysts say: services.

For years, Apple was viewed as a hardware company and its P/E held in check by that commodity business profile, and for years, Apple CEO Tim Cook has been pushing the narrative that the company’s iOS operating system services ecosystem, built around a base of roughly one billion device users, was a big part of the future. In 2020, that evolving mix of hardware and software in the Apple story got its biggest endorsement from Wall Street and investors.

Some analysts now see Apple’s services business representing half of the $2 trillion-plus market valuation.

“For a long time, investors bought Apple at 12x P/E and sold it 16x, and that was it,” said Dan Ives, Wedbush Securities analyst. He now values the services business at roughly $1 trillion of Apple’s market cap and he compared what happened with the re-rating based on services to another market high-flyer he covers: Tesla. “Tesla isn’t valued as an auto. Apple is no longer a hardware company.”

“The multiple expansion for the stock was the big theme of 2020,” said Krish Sankar, senior research analyst at Cowen, who covers Apple. “It was always viewed as a hardware name and that that sentiment started shifting. … Services drove the multiple higher,” he said.

Pre-Covid, in early 2020, Apple’s forward P/E ratio was still in the low 20s, Sankar noted, and that grew over a period of four to five months. “If you look at Apple historically, it is an iPhone story that traded as low as 12x, ex-cash.

The services, led by App Store, iCloud storage, Apple Music and Apple Care, are now a $60 billion-plus revenue stream growing in the mid-teens on a percentage basis annually.

“When you look back at the disaster stories in phone hardware, like a Blackberry or Nokia, at the top of mountain they were not able to monetize an ecosystem. Apple still only has about 15% to 18% penetration of its installed based on the services side. The installed base makes it the most-valued company in world,” Ives said.

All the conversations the Wedbush analyst was having with investors back in March were about stress testing the Apple model and how bad the numbers could get with iPhones to take a hit and stores around the world closed during lockdowns. Wall Street could do no better than play darts, he said, into the April earnings period for Apple, and then services beat by 5%. And then in June, services beat again.

Cowen’s sum of the parts analysis now places the services business as the majority component in Apple’s valuation, at 53%. Sankar stressed that services is not a single line time, and that may make it harder to grasp than a product homerun. As an example, he said many people don’t realize Apple Pay became one of the top fintech players in the world during the pandemic.

“It was a major inflection point,” Ives says. “Bulls like myself and others argued that for years, but felt like we were yelling into an empty forest.”

The bullish take on the services opportunity worries some tech investors.

Paul Meeks, portfolio manager of the Wireless Fund, says the big move in Apple propelled more by multiple expansion than underlying earnings per share growth should be a concern for shareholders. “Has it achieved a metamorphosis into a services company? I’m not so sure about that. Yes, it is growing, but it is growing essentially no faster than most software companies and you can buy those directly if you want,” he said, adding that many trade at lower multiples when measuring price to sales.

“You have a company that did aggressively go into a faster growth, higher margin business and investors have congratulated them for it, but I think it is precarious in the valuation,” he said. “It grows faster than hardware, but it is not explosive,10%-15% from the year before and that’s slower than some software companies.”

Cowen’s Sankar says that investors can find software names growing faster on a sales basis, but Apple looks much better than many of these companies when taking into account its margin profile. “Its compound annual growth rate may be lower than a classic software as a service company, but at high gross margins,” he said. And there is also the market’s biggest cash cow of all, the iPhone, which will continue to generate more cash than any other product and serve as an “annuity” as services grows.

A significant source of Apple services growth, though, faces a new risk into 2021: the billions in licensing fees Alphabet pays to have Google as the search engine default on iPhones.

The Google licensing fees are attractive for Apple because there is no cost associated with the revenue. It is 100% gross margin to the company, whereas the gross margins on phones can range from 20% to 30%.

“Lots of investors don’t realize a good chunk of the success of services propelling the multiple expansion has come from that Google relationship,” Meeks said.

Cowen estimates the Google licensing fees in fiscal 2020 at 17% of Apple’s services business. But the services revenue overall has been growing, from $37 billion a few years ago to $56 billion this year. That makes the Google revenue, estimated at as much as $9 billion to $10 billion annually, a much smaller percentage than it was just a few years ago.

“That is coming down and that is good news for Apple,” Sankar said. “But the flip side is that it is high margin, 100% margin, so if it goes away or gets cut in half, you’re looking at a gap in gross profit dollars of $9 billion to $10 billion and that hits the overall margin profile,” Sankar said.

Every year the court case is extended and services grows, the importance of the Google deal goes down. “But don’t get me wrong, in terms of profit dollars it is very important,” Sankar said.

The battle between Apple and Fortnite maker Epic Games which threatens the 30% fee Apple takes for App Store revenue to app developers is another risk, but Ives says what investors most feared, a ripple effect among all developers, hasn’t followed Epic’s bold move. “Epic played with firecrackers, but the Fort Sumter moment between developers and Apple never materialized.”

At least, it has not yet. The court battle is not over and if Apple loses any legal challenges related to Fortnite in the future and has to take down the commission rate it charges, every investor will be focused on it, analysts say. But for now, Apple only conceded in the form of a reduction in its fee schedule for smaller developers, and did not extend that olive branch to successes the size of Epic Games. Other tech companies have also attacked the App Store model, including Spotify, Match Group, and Facebook. Congress probed Apple CEO Tim Cook in a hearing in July about the App Store’s fees and policies. 

If commission rates are forced lower and it hits revenue for the App Store, which it will, that is a negative, but it is hard for analysts to forecast what the revenue reduction might be. Sankar thinks it will be manageable for Apple and among the two legal risks that are the most “imminent” threats to Apple, the Google case is the more significant.

“The App Store and services ecosystem stays intact and grows,” Ives said. “Services has to continue to grow or else.”

The core of the Apple story has not changed, and may not change for a long time. At its core, and as much as services has grown in investors’ estimation, the iPhone’s role in the Apple story is undiminished.

“The most successful consumer product ever, that is the heart of story for decades to come,” Ives said.

“Services, Airpods, Macs, the ecosystem, all of that is a major part of the rerating we have seen,” he said, but he added that amid a pandemic lockdown and consumers distress, the company sold close to 200 million iPhones.

Investors are the most bullish they have been for the iPhone cycle since 2015 when the company finally launched larger screen sizes. While China is the main source of the demand hopes, Ives noted that in the U.S. and Europe, 40% of the installed based, or 350 million iPhones, hasn’t upgraded in years.

The iPhone 12 5G will yield north of 240 million units sold in fiscal 2021, according to the Wedbush forecast, surpassing its previous record in fiscal 2015.

When Cowen initiated coverage of Apple in 2019, there were one billion iPhones and a five-year replacement cycle, or 200 million per year. Though Sankar’s current estimate is slightly below what would be a new record, at 215 million iPhones, he said the predictions for a record year in 2021 exceeding the fiscal 2015 level of 231 million units aren’t unreasonable, especially after a 2020 in which the final tally, while under 200 million units, will still be tens of millions of phones above what Wall Street feared during the worst of Covid.

“It is not a crazy number,” Sankar said, but he and other analysts say the timing of adoption is uncertain and will be key to the iPhone annual sales number. “If you go and look at the telecom history, all the 3G, 4G cycles last a long time and we’re at the beginning of 5G. It’s the next 10 years.”

Meeks said there’s a risk that a faster adoption rate is already baked into the stock price and leaves little margin for error in the hype about the “supercycle.” The iPhone is still the single-largest source of revenue for the company each quarter.

“There is a lot of pressure that it has to be the greatest product rollout of all time, and what if it is OK, 5G is cool, but not everyone is compelled to upgrade,” he said. “The supercycle theme being articulated, that phrase makes me worried. … Right now, in most parts of the U.S., if you bought a 5G iPhone, you’re not actually getting any benefit for another year or more.”

Even the bulls have their gripes about Apple, and the most obvious target is Apple’s laggard status in streaming video content.

“They have no furniture in the palace,” Ives said. “One-off projects won’t move the needle. Apple can spend billions on making a handful of movies and a dozen shows but when that is compared to Netflix, Disney+, Amazon Prime Video, Peacock and HBO Max, it won’t be enough.”

He and other analysts see a studio deal as a move that could change the trajectory of what now seems like an impossible task of catching competitors in breadth of content.

It is not a question of resources for Apple.

“They have billions, they can easily pump out content, but I think they should consider a joint venture because competition is so fierce,” Meeks said. “They can produce anything they want with the biggest stars on the planet whenever they want, but it will take a long time to crank out,” he said.

“It’s been on a treadmill approach and the window is closing to win in this area,” Ives said. “Unless the plan on buying a country, with all that cash after buybacks and dividends, it has to be a studio and content.”

The company’s cash balance gives them the ability to do many things across verticals, and for investors right now, the lowest marks Apple receives are on the media side of the services business. As many users come off a one-year free trial, Apple lacks a huge content library and content production remaining limited by the pandemic is a source of weakness.

“That’s the box investors haven’t checked for Apple yet,” Sankar said. “In services, they can do something bolder.”

If the EV market is a trillion-dollar market over the next decade, Apple has to be a player in it, but the recent, renewed rumors about Apple making cars which have circulated for years make less sense to many analysts than a strategic relationship with a major EV market player.

Apple glasses for virtual reality, and new iterations of AirPods and Macs, will continue to grind out incremental hardware success, as will its in-house chip production for multiple products which has been a recent focus and margin booster. There are some huge potential areas for Apple to jump across sectors, such as in health-care technology. But Apple has to be looking at the EV market as a game-changing product category for its own growth potential and EVs could be the product category which has the most potential to increase Apple’s share value.

Manufacturing cars would be a questionable move given the low margins, but the high margin software could be a big business. “If Apple said they were manufacturing cars I think analysts would sell,” Meeks said. “They need to JV with someone, but probably not Tesla. That ship has sailed.”

EV software could be key to maintaining and growing the valuation now tied to the services business. “Every part of that services group should be faster growth and higher margin, and EV software would be there,” Meeks said.