Ivan-balvan
Investment Thesis
My iPhone X, which I purchased in 2017 when Apple (NASDAQ:AAPL) (NEOE:AAPL:CA) first rolled out the face recognition feature, has been with me through thick and thin. I did change a broken screen a few times, and at one point, my insurance got me a replacement; a refurbished iPhone X, but thanks to the magic of iCloud, it kept its essence, maintaining the settings, apps, photos, documents, etc. of the original iPhone.
I recently learned that the iPhone X won’t support the new Apple Intelligence features, which will most likely mean that I will part ways with my trusty iPhone X. My mobile carrier has been trying to hook me up for a new iPhone for some time now (with a compelling discount I should add), and I think I’ll finally take them on that offer.
The iPhone’s durability, combined with Apple’s consistent iOS updates, has created a large base of older models users. Apple Intelligence’s rollout could be a catalyst for many of these customers, including myself, to upgrade their devices, potentially creating one of the largest sales Supercycles in the company’s history. This, along with Apple’s strong brand loyalty and growing service revenue, reinforces our buy rating.
FQ2 2024 iPhone Sales Decline
iPhone’s success partly hinges on what is known as Supercycles, a period of rapid sales growth triggered by significant product innovations. These Supercycles typically spark a wave of upgrades, followed by a return to more normalized demand. The iPhone X launch was one such Supercycle, thanks to the face recognition feature and design overhaul. iPhone 6 also brought wider screens that created a surge in iPhone upgrades. One of the most robust Supercycles was the iPhone 12, the first to support 5G.
In recent quarters, Apple iPhone sales declined, drawing criticism from some fellow analysts. In Q2 2024 (three months ended March 2024), iPhone sales were down 10%. However, when zooming out and looking at the bigger picture, one quickly realizes that this decline comes on the heels of a really solid 2023, fueled by the extended iPhone 12 Supercycle, as shown in the chart below.
iPhone Supercycles (SEC filings. Chart created by the author.)
Valuation
Apple’s PE ratio now stands at 34x, far exceeding its pre-pandemic valuation average of 15x. This significant increase has drawn criticism from many fellow analysts, who raised concerns about the sustainability of such a high multiple, especially in light of the iPhone’s sales cyclicality.
My view is that Apple’s current valuation better reflects its fundamentals, and that earlier valuations at 15x PE have simply underestimated the company’s worth. One should also note that at the time, services revenue wasn’t big enough to influence valuation, as opposed to today, where services are growing to be one of the most important sources of earnings. It is also possible that in the past, the market placed a discount on Apple’s shares because there was simply not enough data to predict iPhone upgrade cycles.
In terms of relative valuation, when looking at Apple’s valuation compared to Microsoft (MSFT), we actually see that it remains close to historical averages.
I just can’t imagine Apple trading at 15x price multiples, especially when looking at how fast its services revenue is growing and the opportunity poised by Apple Intelligence to boost the capabilities of our phones, integrating them further into our lives.
Services Revenue
Apple isn’t just about iPhones anymore. The services they offer, like Apple Music, Apple TV, and iCloud, are becoming huge money-makers. These services made up a whopping 42% of Apple’s total gross profits last quarter.
With Apple diving into AI, the company’s service revenue potential is greater than ever. The new iOS will be released later this year, and while no one can be sure exactly what the new operating system will look like, or its capabilities and features, it’s easy to imagine Apple making a lot of money from it.
For example, similar to Samsung (OTCPK:SSNLF), Apple can potentially create a chatbot that translates calls in real-time, allowing users with different languages to communicate each in their own language, with a real-time transcript of the call showing on the screen, but with much more better accuracy than Samsung. They could offer some basic features for free, but charge for unlimited use, or additional features.
The most obvious way to monetize AI is by processing subscription fees of ChatGPT or Google’s (GOOG) Gemini purchases made on its devices. With a robust developer community building Apps for the iOS operating system, and now for Apple Intelligence, the potential is just too big to ignore.
How I Might Be Wrong: Rising R&D Expenses
Apple’s Vision Pro hasn’t enjoyed the spectacular commercial success many hoped for, failing to reinvigorate the Wearables and Home Accessories segment sales growth. Still, in absolute terms, the relatively consistent sales levels point to a steady increase in market penetration. Every dollar in sales means a new Apple Watch customer or a new Apple TV device installed.
Some analysts are particularly critical of Apple’s Vision Pro, highlighting the impact of R&D on profitability, drawing parallels with Meta (META) Oculus VR segment, and the associated R&D requirements. In the past ten years, Apple’s R&D expenses as a percentage of revenue have increased consistently. So there are some merits to this argument. On the other hand, I believe that this effort will eventually pay off. VR is an expanding market, and arguably the most important segment in the consumer electronics industry. With higher volumes, these R&D expenses will benefit from economies of scale. After all, what is Apple if not a market innovator of the products of the future?
Summary
Apple has been facing a lot of criticism from fellow analysts lately. One common criticism is that Apple is just catching up with MSFT and Google regarding AI. I agree that Apple dodged a bullet, but I don’t believe they are playing catch-up. Apple already has the AI infrastructure that allowed it to quickly roll out Apple Intelligence. At the same time, if it wasn’t for the fact that OpenAI is independent of MSFT and that it has an altruistic mission to democratize the technology at low prices for the benefit of humanity and as accessible to each person as is possible, Apple wouldn’t have had the opportunity to have access to the cutting-edge tech that power Apple Intelligence. I think the recent AI developments will extend the lead of first-tier smartphones.
The recent decline in iPhone sales has also been a point of contention. However, when looking at the bigger picture, the decline follows a period of exceptional growth. iPhone sales will always fluctuate with the rollout of new iPhone innovations.
The increase in Apple’s PE ratio to 33x from its pre-pandemic average of 15x has been one of the strongest arguments against Apple. Yet, I believe this current valuation more accurately reflects the company’s fundamentals and the prior valuation is simply an underestimate. I can’t imagine Apple now trading at 15x PE ratios. On a relative-value basis, Apple’s relative EV/EBITDA multiples to MSFT’s are close to historical average.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.