When you think of the phrase “victim of its own success” and you might think about consumer technology giant Apple Inc. (Nasdaq: AAPL). The company’s track record of groundbreaking innovation has set the bar of expectation at such a high level that even its billions in annual R&D research struggles to meet expectations.

What Have You Done For Me Lately?
Apple’s status as the world’s most valuable brand, not to mention its position as the largest publicly-traded company, makes Apple an unusual case for an investor to consider. Whether fairly or unfairly, Apple must always answer the question, “What have you done for me lately?” That said, the company’s estimated $237 billion in cash on the balance sheet, which is more than even the U.S. Treasury ever hopes to amass, gives Apple plenty of resources to answer that question multiple times each year.

Estimates from International Data Corporation (IDC) suggest that 1.45 billion smartphones will ship in 2016, a rise of less than 1% year-over-year. That compares to a rise of over 10% in 2015 and represents a huge fall from the 47% rise in 2012. Right now, the market values Apple on the assumption that it won’t grow in 2017. It’s easy to see why, given that Apple’s bread and butter, the iPhone, has been on the decline…

Can’t Live By iPhones Alone
Apple, which holds roughly 14% of the 2016 global smartphone market, is estimated to suffer an 11% decline in iPhone shipments — the first full year of iPhone sales declines since the product’s debut in 2007. The main reason for the smartphone decline? The hardware subsidy model has ended. Since wireless carriers such as AT&T, Inc. (NYSE: T) and Verizon Communications (NYSE: VZ) no longer offer discounted subsidized smartphones, consumers now have to bear the absolute cost of the device.

#-ad_banner-#As a result of the new pricing structure, consumers are now less likely to upgrade to the newest iPhone unless it comes with game-changing feature. Things like a higher resolution camera, force touch, and higher storage capacity are nice. But are they worth paying $700 or $800 for a new phone when the old one, which may already be paid for, is functioning as it should? Such decisions have contributed to the recent declines in iPhone sales. And when iPhone sales suffer, the familiar criticisms about Apple’s lack of innovation emerge. For a company that is so reliant on that one product, these criticisms translate to Apple stock, which often seems undervalued.

The market is not willing to apply multiple expansion to an electronics company, which, in essence, is what Apple is. The stock, currently around $110, is priced at just 12 times fiscal 2017 earnings estimates of $9.05 per share, which is about six points below the S&P 500 average. On a trailing basis, Apple stock has a P/E of around 13, which is about nine points below the rest of the market. If Apple stock were priced on par with the S&P 500, the shares would trade today at around $150, or 36% higher than current levels. And here’s the thing: Apple shares are even cheaper when you take out its cash.  

Why does Apple have such a cheap valuation? Given that it is so reliant on the iPhone, the fear is that Apple may one day become the next BlackBerry (Nasdaq: BBRY) or Nokia (Nyse: NOK).

I mentioned Apple’s cash and the billions it has devoted to R&D, but the returns on those R&D investments have been low, dating back five years. Those R&D investments produced the Apple Watch, but the product done little to move Apple’s top line. And Apple has yet to disclose how many watches it has sold.

Can Services Fill Revenue Gaps?
Apple’s services business is now even more critical, as it has become clear that many of Apple’s core products have reached maturity. Using recent average selling prices for iPhones and MacBooks, Apple would need to find almost 3 million new customers for the company to grow annual revenue by just 1%. So its services business, which includes Apple Music, the App Store, iCloud, Apple Care, and Apple Pay, has to step up to create new growth.

The good news is that the services side of the company, which grew 24% year over year in the fourth quarter to $6.3 billion, has picked up the growth pace. CEO Tim Cook boasted that Apple Pay transactions surged 500% year over year in the last quarter of 2016. In fiscal 2017, Apple expects the services segment to grow at a level close to the size of a Fortune 100 company. It remains to be seen the extent to which services will drive growth in the quarters ahead.

But assuming Apple, which is approaching 1 billion users on its iTunes platform, can convert its services business to a recurring model like that of Netflix, Inc. (Nasdaq: NFLX), the Street would be more willing to apply a higher multiple to those revenues, as it would represent a reduction in Apple’s reliance on iPhones. And even a small increase could mean a big boost in share price. A two-point multiple expansion on the fiscal 2017 estimate of $9.05 puts Apple shares at around $135. Apple, however, would need to convince the market that it can maintain its high-margin structure as it grows the services side of the business.

Risks To Consider: Declining iPhone sales will remain a headwind in 2017. Apple stock price will move based on product launches, but management will remain conservative with quarterly forecasts, increasing pressure on the shares.

Action To Take: Keep Apple on your watch list if you are looking for an undervalued technology stock that is trading at a meaningful discount to its long-term potential and also pays out a decent yield.

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