UBS Global Research analysts Steven Milunovich and Peter Christiansen maintain a Buy rating for Apple Inc. (NASDAQ:AAPL), noting their strong ecosystem but also noting its limitations.

Apple

Does Apple have an annuity business?

The long-term bear argument on Apple Inc. (NASDAQ:AAPL) is that it can’t sustain a 25% operating margin as a device company if history is any guide. The bull argument, in addition to continued innovation, is that the ecosystem makes the customer relationship sticky, creating an annuity stream of device sales. An interesting way of thinking about the ecosystem view is that Apple offers Hardware-as-a-Service. We think Apple’s ecosystem is an advantage but not so strong as to assure recurring revenue.

A powerful but still limited ecosystem

Apple Inc. (NASDAQ:AAPL) generates a substantial $16bn in annual software and services revenue. Its value, however, is greater in stimulating device sales and creating customer loyalty. The company’s roughly 90% device retention rate indicates some success. The combination of moderate switching costs and a respected global brand points to greater staying power than Nokia Corporation (NYSE:NOK) (BIT:NOK1V) (HEL:NOK1V) and BlackBerry Ltd (NASDAQ:BBRY) (TSE:BB). However, the value of the ecosystem is limited by (1) the fact that hardware is a hits business; (2) Apple’s ecosystem is less powerful in non-Japan Asia; and (3) partners such as wireless carriers can have differing objectives.

iOS is a multi-sided platform with the attendant trade-offs

One way to analyse the ecosystem is to recognize that iOS is a multi-sided platform, which creates value by enabling direct interaction between two customer sets. Apple subsidizes developers and monetizes consumers through device sales. Although we expect Apple Inc. (NASDAQ:AAPL) to offer additional services, it may turn out that the primary benefit of these services continues to be to support the device infrastructure.

Valuation: New products a catalyst

Ecosystem success means that there are some 500mn users with a predisposition to buy Apple products. We expect new offerings to be a stock catalyst into 2015. The limits of the ecosystem, however, mean that the long-term remains uncertain, likely preventing a significant multiple re-rating. Our price target of $625 per share is based on a NTM EV/FCF multiple of 9.5x, more in line with other large cap tech names.