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We add APPL to the Conviction Buy List. Shares are trading at a CY16 P/E of 11X (10.5X on GSe), a 30% discount to the S&P 500 multiple of 16X despite a 9% EPS CAGR in FY15-17 (GSe 14%) as the market views it as a “hardware” stock – a transactional model with limited recurring revenues and with visibility that extends only to the next product cycle. We expect that over the next year, the focus will shift from unit growth (which is slowing given a maturing smartphone market) to installed base monetization and recurring revenues (“Apple-as-a- Service”). Apple’s model has already tilted that way with its new iPhone 6s installment plans, and we see the upcoming TV service as a powerful next step.

With an estimated installed base of 500mn loyal iPhone users, we see a significant multi-year opportunity for Apple to increase monetization through  (1) increased attach of services such as TV, Music, and Pay, and  (2) increased attach of additional hardware such as Mac, iPad and Watch. The size and quality of the iPhone installed base is the glue behind this virtuous cycle, as it is very loyal (estimated churn <10%) and monetizable (80% higher app store sales than Google). In a recurring revenue framework, we have constructed an average revenue per user (ARPU) metric that captures the installment plan pricing of the iPhone ($32/month), assumed installment plans for the other hardware products, and services (e.g. Music at $10/mo, TV at $40/mo). We calculate a current ARPU of $42/mo per iPhone user, pro rata for the current adoption rates of Mac, iPad, Watch, and services. The theoretical ARPU (assuming every iPhone user has all other Apple hardware products and services) is $153/mo, implying significant growth as the adoption of Apple hardware and services increases within the user base.

Our 12-month $163 price target is based on 15X our CY16E EPS of $10.71.

Product cycle execution, end demand, and a slower pace of innovation.