Last month, we published an article on Apple (NASDAQ:AAPL) arguing that India, which has received much media coverage as “the next China”, will likely disappoint investors. In my opinion, the media is focusing too much on something that doesn’t really matter and not enough on Apple’s impressive position as a leading AI investment.
We can partially “blame” Apple’s management for this lack of coverage: if there is a competition on how many times “artificial intelligence” or “AI” is mentioned during your earnings call, Apple would certainly rank dead last among the major technology companies. In fact, it was only mentioned on one occasion by Tim Cook during its Q1 2023 earning call:
… we’ve obviously made enormous progress integrating AI and machine learning throughout our ecosystem, and we weaved it into products and features for many years, as you probably know. You can see that in things like fall detection and crash detection and ECG. These things are not only great features. They’re saving people’s lives out there. And so it’s absolutely remarkable. And so we are — we view AI as huge. And we’ll continue weaving it in our products on a very thoughtful basis.
Meanwhile, the market is losing its collective mind trying to find the next AI play, and promotional management from certain companies, such as Marvell (MRVL) and Palantir (PLTR), are feeding the dream by making bold claims about their AI capabilities. Being a seasoned market observer who has witnessed numerous ups and downs, I greatly admire Apple’s subtle approach. The company allows its achievements to speak for themselves without any gimmicks or showmanship.
This article aims to assist shareholders in comprehending Apple’s remarkable positioning as a top investment option for the AI theme. Furthermore, we will present an updated analysis of the company’s financials and valuation.
Apple AI: Software
Apple’s strategic use of Artificial Intelligence and Machine Learning in its product upgrades indicates a determined push to create a more personalized, efficient, and innovative user experience. By embedding these technologies in its operating systems, Apple is positioning itself as a key player in the AI space while also enhancing its competitive edge.
The integration of transformer language and speech recognition models into iOS 17, macOS Sonoma, iPadOS 17, watchOS 10, and tvOS 17 exemplifies Apple’s commitment to AI-driven personalization. For example, the iOS 17 update showcases AI’s influence in its Live Voicemail feature, which transcribes voicemails in real-time for call screening and facilitates voicemail exchange over FaceTime. This is a significant advancement, enhancing user experience by increasing convenience and efficiency. Moreover, the “Check-in” feature in iMessage, which notifies contacts when a user reaches their destination safely, is a testament to Apple’s commitment to using AI to improve safety and reassurance for its users.
Similarly, the macOS Sonoma’s Presenter Overlay capability, which distinguishes the speaker from the shared screen in video conferencing, showcases AI’s role in enhancing professional communication. Apple is utilizing AI to create a seamless, intuitive experience that closely mimics in-person interaction, improving the virtual meeting experience.
Apple’s use of on-device machine learning is not only seen in iPhone and Mac updates but also extends to its iPad, where AI aids in the efficient completion and signing of PDFs. This application of AI contributes to a more streamlined workflow for users, exemplifying how Apple leverages AI for practical, everyday utility.
Apple’s use of AI is also evident in its innovative Vision Pro headset. Controlled by users’ eyes, gestures, and voice, the headset offers an immersive experience. The device’s ability to adjust its level of immersion based on the user’s surroundings and interactions shows how AI can foster more intuitive and responsive products.
Overall, in our view, Apple’s strategic integration of AI into its product line aims to create a more personalized, convenient, and immersive user experience. This highlights Apple’s ability to leverage AI to advance its product offerings and improve user engagement, thereby enhancing its competitive advantage in a fiercely competitive market.
Apple AI: Hardware
Apple’s strategic decision to design its own CPU and AI chips (A-series bionic neural engine) is a significant move that sets it apart in the tech industry. This approach enables the company to create a more seamless and efficient user experience by tailoring the CPU or neural engine to the needs of its operating system, thereby adding a level of product refinement that is unique to Apple.
The development and implementation of Apple’s Neural Engine in its silicon chips further amplify the company’s commitment to providing a superior AI experience to its users. The Neural Engine, a compilation of specialized computational cores, is designed for the fast and efficient execution of AI functions. Since its introduction in 2017, Apple has been continually improving the Neural Engine. The A16 chip in the iPhone 14, for instance, can deliver an astounding 17 trillion operations per second, a remarkable leap from the 600 billion operations per second achieved by the 2017’s A11 processor.
Apple’s utilization of the Neural Engine is manifested in various innovative features like FaceID, animated Memojis, and on-device search for images in Photos. Developers can leverage the Neural Engine while creating apps supporting CoreML, thus significantly enhancing their functionalities. In addition to this, Apple’s accessibility enhancements, such as Detection Mode in Magnifier and the new Personal Voice feature, are strong demonstrations of the power of the Neural Engine. These features, powered by the Neural Engine, take on-device intelligence and privacy to a new level, showcasing Apple’s technological prowess.
We believe Apple’s investment in its in-house semiconductors and AI chips is a powerful strategy to deliver an unparalleled AI experience, reinforcing its competitive edge. As we move towards a future where on-device intelligence becomes increasingly critical, Apple’s efforts in this domain underscore its commitment to leading the charge in AI innovation.
Why Apple Will Benefit From the General Rise of AI
Amidst the swiftly evolving landscape of artificial intelligence, Apple’s cutting-edge AI hardware and software are undoubtedly noteworthy. However, the company’s potential to benefit from the proliferation of AI transcends its in-house innovations. We posit that generative AI, exemplified by solutions like ChatGPT, signifies a continuation of the digital shift that has been shaping the technological landscape for years.
Apple’s vast ecosystem, with over two billion active devices worldwide spanning from the iPhone to the Mac to the Watch, predominantly appeals to premium consumers. This positions Apple uniquely as a key facilitator of digital experiences – the primary “on-ramp” into the digital world, if you will. As digital tools grow in power and sophistication, and economic activity continues to migrate online, a trend consistent over the past few decades, the strategic value of this digital gateway is poised to appreciate further.
Apple’s leadership, while maintaining an air of diplomacy, understands this underlying value. We interpret these digital gateways, or ramps, to the internet as veritable toll stations positioned to monetize the consistent online engagement of users. As long as customers maintain their affection for Apple’s devices, which indicators suggest is not just persistent but growing, Apple is well-placed to ‘collect its toll’ on the internet.
In essence, the company stands at the intersection of customer loyalty, product innovation, and the escalating value of digital access in an increasingly AI-driven world. This potent combination positions Apple uniquely to benefit from the sweeping rise of AI, irrespective of their own technological advances in the field.
Financial & Valuation
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
In our assessment of Apple’s latest earnings, we must note that while the Q2 report showed a year-over-year decline of 2.5% in revenue to $94.8 billion, which is in line with consensus estimates, the stock still reacted positively with a 4.7% gain post-announcement. The decline in operating margin from 30.8% to 29.9% year-over-year is a slight concern, although EPS outperformed consensus by 6.4%. That’s a testament to Apple’s ability to manage costs and optimize profitability.
When evaluating AAPL’s financial trends, the 14.9% CAGR in revenue over the past three fiscal years is quite impressive, despite sell-side consensus forecasting a contraction of 2.4% this fiscal year. However, the anticipated rebound with a growth of 6.6% in the following year is something to look forward to. The company’s EBIT margin improvement from 24.6% to 30.3% over the past three years, despite the consensus forecast of a slight contraction this fiscal year, is another demonstration of Apple’s effective management strategy.
Apple’s shareholder-friendly activities are also worth noting. Over the past three years, the tech giant managed to decrease its diluted outstanding common shares by 10.2% through aggressive share repurchases, which more than offset the effect of share-based compensation on shareholder dilution. Consequently, its EPS grew at a whopping CAGR of 27.1% over the past three years, considerably outpacing revenue growth.
Examining Apple’s cash flow, the consensus estimates of a free cash flow (FCF) of $100,528 million for the current fiscal year indicate a robust FCF margin of 26.1%. This represents a substantial increase from the 22.5% FCF margin four fiscal years ago. The impressive return on invested capital at 58.2%, coupled with a robust net cash position of $56,718 million, underscores Apple’s financial strength.
However, AAPL’s low dividend yield of 0.5%, which is 97 bps below the S&P 500, might not appeal to income-focused investors. Yet, its strong capital returns in the form of share repurchases could offset this for total return investors.
Looking at the company’s capital expenditures, we observe that capex as a percentage of revenue averaged 3.1% over the past four years, suggesting moderate capital intensity. This implies that Apple is capable of generating substantial free cash flow without needing to make heavy reinvestments into its business. It’s a testament to Apple’s strong business model, which allows for significant profitability even amidst cyclic fluctuations.
Taking a close look at Apple’s current valuation metrics relative to the broader market, we see a pronounced premium across all major multiples. The company is currently trading at an EV/Sales multiple of 6.9, a 204.0% premium over the S&P 500. Likewise, its EV/EBIT multiple stands at 23.4, reflecting a significant 44.9% premium compared to the market index.
The pattern continues when we examine earnings multiples. Apple’s P/E ratio currently stands at 27.9, which is significantly higher than the S&P 500, leading to a premium of 60.4%. The forward P/E of is also high relative to its 5-year mean of 23.5, falling towards the upper end of its 2-standard deviation range. Turning to the cash flow side, the FCF multiple of 26.9 also comes in higher than the broader market, representing an FCF premium of 33.7%.
Additionally, the stock’s projected earnings growth relative to its P/E ratio – or its PEG ratio – is currently 2.8, which is significantly higher than the S&P 500’s PEG ratio of 1.6, creating a premium of 70.7%.
This broad premium across all metrics indicates that the market has high expectations for Apple stock’s future performance, which must be factored into any investment decision. While the company’s strong historical performance and robust growth prospects could justify these higher multiples, investors should keep a close eye on these metrics as they may suggest a heightened level of risk.
Apple’s strategic integration of AI and machine learning throughout its product lineup exhibits an unwavering commitment to delivering a superior user experience, thus solidifying its market position as a premier technology company. The company’s strategic investments in its own semiconductor and AI chips fortify its ability to offer an unparalleled AI experience, bolstering its competitive edge. Coupled with its digital ecosystem of over two billion devices worldwide, Apple is poised to reap significant benefits from the general upsurge in AI.
Financially, Apple continues to demonstrate robust performance, showcasing strong revenue growth, impressive cost management, and healthy cash flows. Its strategic share repurchases and consistent growth in EPS bear testament to its investor-friendly activities. Notwithstanding, Apple’s premium valuation metrics suggest high market expectations for its future performance. Therefore, while Apple’s strong historical performance and robust growth prospects could substantiate these multiples, potential investors should factor this into their investment decisions, paying close attention to any indicators of elevated risk.
Our positive outlook on Apple remains unchanged, as we see the potential for the company to deliver impressive returns in the long run.