Apple vertical integration could boost 'Apple Car' margins, threaten Tesla

In a web call with investors, Morgan Stanley lead analyst Katy Huberty spoke about rumors of an Apple-designed self-driving car or autonomous vehicle system. She answered questions alongside the bank's Chinese and European battery teams.

Speaking about Apple's vehicle opportunities, Huberty said that it makes sense for Apple to enter the car market because of the total size of the industry. Smartphones, Huberty points out, are a $500 billion total addressable market (TAM). Apple has about one-third of this market. But the mobility market is "$10 trillion."

"So Apple would only need a 2% share of this market to be the size of their "iPhone business," she points out.

One of the most important factors in Apple's potential entrance into the auto market is vertical integration, the analyst added.

"Apple really only succeeds when it's vertically integrated. This means designing the components and designing every part of the product how it looks and feels to the consumer, the software and the ecosystem that surrounds those products," she said.

Because of that, Huberty cast doubt on a partnership with another automaker. She also points out that Apple has already invested in areas relevant to an auto product, including operating systems, processors, batteries, cameras, and displays.

That vertical integration could even apply to Apple's extensive financing and trade-in service program, as well as AppleCare. "Financing and leasing and trade-in programs are incredibly important to a successful auto strategy," she writes.

If Apple controls every or most aspects of an "Apple Car," it'll have an opportunity to drive down the normally razor-thin margins of the auto industry. That's one sticking point confusing investors about the rumors.

"With respect to margins, investors frequently say that the current auto industry margins are highly unattractive compared with Apple's current mid-20% EBIT margins today. But I would remind everybody that when Apple entered the PC, handset and wearables market, the margins of competitors were razor thin," Huberty writes.

Through a vertical integration strategy and driving scale on a limited number of SKUs, Apple has shown an ability to "enter industries with low profitability and earn very strong margins. I don't see why autos would be any different."

"The auto market looks very similar to the industry structure and profitability of many other markets Apple has entered in the past," she adds.

Although the "Apple Car" story first surfaced years ago, Huberty says Apple is in a better position now because it's producing more of its components in-house. The move into a new market could also bring down Apple's churn rate to basically zero.

When it comes to the timing of an "Apple Car" release, Huberty notes that Apple is rarely first in an industry. A current timeline of four to five years out "makes sense, but it's certainly possible they come out a year or two later."

And it's possible that Apple could produce the car in the U.S.

"Tim Cook has said there will be other Apple products made in the US and a car would be a perfect example of that. When a product launches, usually over [half] of revenue would be in the US so you would want to manufacture locally in the US or Mexico from a logistics standpoint," Huberty says.

One of the bigger questions is whether Apple's vehicle would pose a threat to Tesla and existing automakers.

"The question is, is Tesla Blackberry or is Tesla Samsung? After the iPhone launch, Samsung was a very successful company alongside Apple for many years. And as the market shifted from feature phones to smart phones, Blackberry fell to the side even though they were early in the market," Huberty says.

The analyst adds that "there is an example where both Tesla and Apple could be successful for many years and help grow the market together."

Huberty maintains her 12-month AAPL price target of $144, based on a sum-of-the-parts model. She arrives at that estimate by applying a 5.5x enterprise value-to-sales (EV/Sales) multiple on Apple's product business and a 13.6x EV/Sales multiple on Services. That results in an implied 7x EV/Sales multiple for the 2021 fiscal year and a 32x enterprise value to free cash flow multiple.

Shares of AAPL were priced at $129.54 in intra-day trading on Thursday morning, up 2.33%.