A Look At Apple Pay And Its Valuation Impact On Apple

Apple (NASDAQ:AAPL) is slated to roll out Apple Pay, its mobile payments service, in the United States this month. The service will allow customers to make payments at both brick-and-mortar and online stores using Apple’s latest iPhone and the company’s forthcoming Apple Watch. While mobile companies have been venturing into the mobile payments space, none have been able to gain significant traction.  However, we believe that Apple – which has a history of redefining product categories – has a good shot of success, given its partnerships and the ease of use of its service. That said, we don’t think that the offering will move the needle much for Apple in terms of earnings or valuation, given the company’s already large size and the fact that the system is effectively an up-sell to the company’s existing user base. In this note, we take a look at the Apple Pay service and its possible impact on Apple’s financials.

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Apple Has Forged Key Partnerships, Needs Critical Mass of Vendors

Apple has been able to form key alliances that are required for a payments systems. For instance, Apple Pay will work with leading retailers including Macy’s, McDonald’s and Whole Foods in addition to other merchant locations across the United States that have contactless payments enabled. ((Apple Announces Apple Pay, Apple, September 2014)) The company has also partnered with the big three payment networks – American Express, MasterCard and Visa – as well as some of the country’s most popular banks, which together account for 83% of transaction volume. Unlike previous efforts in the mobile payment space, which were confined to particular handset models and cellular networks, ^[1] Apple Pay will be carrier-agnostic, and will use the company’s latest flagship phones which are likely to see a strong installed base going forward. However, scaling up the merchant base is likely to be a key near-term issue. While the company claims that it has lined up 220,000 merchants that will accept Apple Pay, this number represents less than 2.5% of all merchants who accept credit cards in the United States. ^[2]

Partners Could See Value In Apple’s Security Features

Apple is trying to make consumers more comfortable with the idea of paying with their mobile phones – while also addressing concerns of other parties facilitating the payment process – by offering strong security features on Apple Pay. The service is built on the company’s tightly integrated model of controlling both the hardware and software of the phone and also offers other security enhancements including Secure Element (a dedicated chip that stores encrypted payments information), tokenization and Touch ID authentication. The cost of credit card fraud in the United States has been on the rise, jumping by about 35% last year to around $11 billion. ^[3] Since a bulk of these costs are absorbed by credit card issuers, merchants and payment acquirers or processors, they could benefit from Apple Pay’s security features.

iPhone Customers Are An Ideal Base For Payments Business

Apple’s iPhone users are likely to be an ideal demographic for mobile payments for multiple reasons. Firstly, iPhone users are generally more affluent, and likely to spend more on retail and on e-commerce transactions. According to comScore’s U.S. Mobile App Report, iPhone users have a median income that is as much as 40% higher compared to Android users. This could translate to higher transaction volumes and revenues for Apple. Secondly, iPhone users are more engaged with their smartphones, spending more time on mobile applications compared to Android users. ^[4] This could make them more inclined to try out mobile payments. Thirdly, Apple has a large number of customers who have credit and debit cards attached to their iTunes accounts, making it easy for them to sign up for Apple Pay.

Room For Growth, But Don’t Expect Meaningful Value Upside

Apple’s Fee Based Model: Banks typically collect fees from merchants for each credit card transaction that they process. According to the Financial Times, Apple is believed to be receiving a transaction fee of about 0.15% from banks on purchases made through Apple Pay. While the fees may seem small, margins could be attractive given that Apple is unlikely to assume many financial risks (risks relating to fraud, for example) while its cost base is also likely to be relatively small and largely fixed.

Rapidly Growing Mobile Payments Market: According to BI intelligence, mobile in-store payments in the U.S. are set to rise from around $2 billion in 2013 to around $189 billion by the year 2018, translating to a CAGR of about 148%. ^[5] On the other hand, the mobile commerce market – which accounts for e-commerce carried out on mobile devices including smartphones and tablets – is expected to grow from around $114 billion in 2014 to over $293 billion in the United States over the next 4 years. ^[6] This translates to a CAGR of around 27%. While we do not have forecasts for the global mobile in-store payments and mobile commerce markets, we estimate that the size of Apple’s addressable market overseas could eventually be almost as large as the U.S. market.

Apple Pay Is Unlikely To Add Meaningfully To Apple’s Value: Despite the large addressable market, potentially high-margin fees and growth prospects, we believe that Apple pay will not make much of a difference for Apple in terms of revenues or valuation. If the company is able to maintain a 50% market share in the global in-store payments market, while growing its share of mobile commerce transactions to about 20% by the end of our forecast period in 2021 (assuming the company offers Apple Pay on its new iPads), this could translate to annual revenues of around $800 million by 2021, assuming a 0.15% transaction fee. Assuming gross margins of about 75% for the service through the forecast period, and accounting for other cash expenses, we estimate that the service would add under $4 billion to Apple’s market value, using a discounted cash flow valuation. This pales in comparison to our current market cap estimate of about $580 billion for the company. However, despite the minimal valuation impact, Apple Pay could prove to be another differentiating factor that draws more users to the company’s mobile ecosystem, thus improving its performance in other divisions.

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1. Apple’s Push Into Mobile Payments, New York Times, September 2014 [↩]
2. Apple Pay Is Here — and There’s Just One Big Problem, Time, September 2014 [↩]
3. Credit card fraud jumps, so what’s being done?, CNBC, April 2014 [↩]
4. iPhone Users Earn Higher Income, Engage More on Apps than Android Users, ComScore, August 2014 [↩]
5. THE FUTURE OF PAYMENTS: 2014 [SLIDE DECK], Business Insider, September 2014 [↩]
6. US MOBILE AND TABLET COMMERCE TO TOP $293B BY 2018; TOTAL ECOMMERCE TO HIT $414B, Forrester Research, May 2014 [↩]