Jefferies takes deep dive, finds treasure in Apple's Services margins

Even as he slashes his price target, analyst Tim O’Shea sees Apple building “a massive, high margin, high multiple Services business over time.”

From a note to clients that landed in my desktop Wednesday:

We head into ’19 focused on Services as Apple is on the cusp of disclosing its gross margin for the first time ever. Our detailed, bottoms-up Services build suggests a 5-year revenue CAGR of 19% (vs -1% for iPhone) with gross margin of 60-66% (vs 35% for hardware), above 56% consensus. While we are reducing iPhone and EPS ests for F’19, Apple’s iPhone business still looks sufficient to build a massive, high margin, high multiple Services business over time.

Ahead of this event, we are publishing our detailed revenue and gross margin assumptions for each key Service. Our findings suggest Services has a 19% 5-year revenue CAGR with gross margin between 60-66%, above consensus of 56%. The setup resembles when AMZN first disclosed AWS margin back in ’15, a positive for that stock. [emphasis mine]

Our optimism around Services is offset by reduced expectations for iPhone. We are lowering F’19 iPhone unit, iPhone revenue and EPS estimates by 3%, 3%, and 4%, respectively. We now expect Apple will sell 71.7MM iPhones in 1Q’19 and 206MM for full year, below 74MM/210MM consensus.

Despite our conservative view on iPhone, we model EPS nearly doubling by F’23, growing from $11.91 to $22.19. This will be fueled by the aforementioned Services growth, wearables growth, higher ASPs, and of course the massive buyback. In F’4Q, AAPL delivered 41% EPS growth despite iPhone units being flat.

Jefferies’ margin estimates:

Click to enlarge.

Maintains Buy rating, lowers price target to $225 from $265.

My take: Talk about a spoonful of sugar to make the medicine go down! Or maybe a lot more than a spoonful, if Apple’s Services disclosures really are comparable to the revelation that most of Amazon’s operating profits come from its Web services business.