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Apple Preview: The Only Consumer Staple With AI Upside
Apple, Themes
Apple reports March results on May 4th. Outside of the typical focus on iPhone and Services revenue and guidance there will be increasing attention on the company's active installed base, which grew 8% y/y in the Dec-22 quarter. A growing base means the Apple product flywheel is working. That base is the foundation for the Apple investment case to shift to a consumer staples company that should yield a higher multiple. On top of that, Apple is making meaningful progress in AI, a dynamic that is under-appreciated by investors.

Key Takeaways

Apple's growing active installed base is the substance of why it's becoming a consumer staples company.
Apple is a leader in AI both with its Neural Engine and building AI horizontally into products.
Expect an inline March quarter and slight guide down for June revenue.
Key earnings commentary includes AI impact, the India opportunity, China diversification, and financial services roadmap.

The next chapter in the Apple investment case

Every 5-10 years the Apple investment thesis changes. Twenty years ago it was a hardware product company that launched into new markets with the iPod, iPhone, and iPad. Ten years ago it was the start of recurring revenue with Services. While services added visibility to earnings, the hardware segment was still a nagging concern for investors given the hard lessons of the past when must-have consumer device companies broke, notably Sony, Nokia, and Blackberry.

I believe we are entering a new chapter in how investors view Apple. Over the next five years, I expect investors will increasingly see Apple as a can’t live without consumer staples company. The best evidence that this investor shift is happening was the December 2022 quarter when Apple missed expectations. Not only did they miss, but they missed the miss given in November analysts cut their estimates when Apple warned of a shortfall due to iPhone production shutdowns in China. Since then shares of AAPL are up ~12% vs. the Nasdaq which is flat. I believe the reason for the strength of the stock is investor optimism around the active device number which reached 2B in December, up 8% y/y and doubling over the past seven years. It’s hard to grow a number that big that fast. Just ask Meta which grew its DAUs in March of this year by 4%, to just over 2B. Investors can see the Apple flywheel is alive and well, following a 20-year success story in which consumers buy one Apple product, fall in love, buy another product, add a service, upgrade, and repeat.

Apple updates its active installed base about once a year, which means we may have to wait nine months for the next data point. In the meantime investors will likely be increasing their focus on the metric given if it keeps growing, investors can sleep well at night.

I believe Apple should trade at a premium to other consumer staples given it has both earnings stability along with optionality to accelerate revenue growth. Coke, Clorox, and P&G currently trade at 26x 2024 EPS. AAPL trades at 24x with the optionality to reaccelerate revenue around wearables, health, financial products, and auto along with adding AI to the fabric of all of its products.  Some of that is already baked into estimates, with consumer staples companies expected to grow revenue at 1.7% y/y in 2024 compared to Apple at 7%.


Apple and AI as horizontal technology

While most public investors’ AI attention has been focused on Microsoft and Nvidia, Apple’s March quarter conference call is an opportunity for Apple to highlight how far along they are with the tech, where it impacts the business today, and what to expect from the theme in the future in terms of investment levels and products.

For starters, Apple has been thinking about AI for a long time.  In a 2017 interview with Bloomberg, Apple CEO Tim Cook confirmed Project Titan, Apple’s car project. Cook referred to this as “the mother of all AI projects.” In 2018 Apple hired John Giannandrea to head Machine Learning and AI Strategy. Previously he was at Google running Machine Intelligence, Research, and Search. In other words, he is one of the world’s smartest people when it comes to AI. Since his joining, Apple has shared little about what he is working on.

What we do know about Apple and AI is that in 2017 they announced the Apple Neural Engine (ANE). Apple Wiki describes ANE as ” the marketing name for a group of specialized cores functioning as a neural processing unit (NPU) dedicated to the acceleration of AI operations and machine learning tasks. They are part of system-on-a-chip (SoC) designs specified by Apple and fabricated by TSMC.”

The ANE is a glimpse into the potential for the AI movement to advance beyond Nvidia GPU chips. Deepwater believes there is an opportunity to develop a next-generation chip that’s native to AI and is an investor in Rain Neuromorphics, which began building a chip optimized for AI in 2018. When complete, their chip will require less power than current chip architectures which means companies can build bigger data centers that run AI models faster.

Over the past two years, investors have learned that Apple uses AI in organizing photos, Siri speech recognition, Apple Watch fall detection, and spam filters, to name a few areas. I believe these AI integrations understate the company’s progress to date and their long-term opportunity to leverage the technology.

On the December 2022 Apple earnings call, there was only one question related to AI and no mention in the company’s prepared remarks. Cook responded to the question that AI is a “major focus of ours. It’s incredible in terms of how it can enrich customers’ lives. And you can look no further than some of the things that we announced in the fall with crash detection and fall detection or Watch with ECG. I mean these things have literally saved people’s lives. And so we see an enormous potential in this space to affect virtually everything we do. It’s obviously a horizontal technology, not a vertical one. And so it will affect every product in every service that we have.”

Stay tuned for May 4th to hear more. My guess: it gets mentioned 5 times on the call.


The March quarter and June guidance

Results. I expect slight upside to the Street’s $92.9B in revenue and $1.43 EPS driven by iPhone.

Guidance. We will have to wait for the earnings call to hear guidance, and I expect the high end of the June revenue range (investors typically consider the high end of Apple’s guidance range as the “real” guidance) to be $83.5B, slightly below the Street’s $84.5B. If I am correct, Street revenue numbers would settle at 0.5% growth in June compared to the current 2% y/y revenue growth target.

iPhone (53% of sales). The Street is expecting iPhone to be down 3.4% y/y including the impact of FX, which is an improvement from down 8.2% in the December quarter. I expect iPhone will be flat in March, driven by strength in iPhone 14 Pro/Pro Max and given the soft smartphone macro. A couple of notable data points on the topic come from research firm Canalys which estimates global smartphone units were down 12% y/y in March, while iPhone units increased 2%. They also estimate that Apple’s global smartphone market share increased to 21% from 18% a year ago, much of that coming from India and South East Asia. For June the Street is expecting iPhone revenue to be flat y/y which I see as slightly optimistic given the iPhone will likely lose more momentum in this year’s pre-iPhone quarter given the macro.

Services (23% of sales). The Street is expecting Services to be up 5.8% y/y compared to up 6.4% in December, which means growth would be essentially flat quarter on quarter which is a positive given Services growth declined in four of the past five quarters. The segment’s stability is driven by price increases in Apple TV+ and Apple Music back in October and the uptake of AppleCare. For June, the Street is expecting Services growth to tick up to 8%y/y, which I see as reasonable.

Mac (8% of sales). In December the Mac business hit the wall, down 29% y/y after being up 25% in September. For March I expect a slight downside to the Street’s $7.8B estimate which is down 25%. IDC estimates the Mac lost market share with units declining 40% y/y, vs. overall PC’s down 29% y/y. The good news for the Mac is the comp gets easy in June (-10%), which means the Streets 1% growth target is reasonable.

iPad (7% of sales). This quarter the iPad will be the segment hitting the wall, with Street estimates calling for a 12.5% y/y decline compared to up 30% in December. The business has been on a rollercoaster, with the December quarter benefiting from the October release of iPad 10 that boosted growth from down 13% in the September quarter. Overall, on an annual basis, the segment should grow in the 2-5% range.

Wearables (9% of sales). Wearables will likely decline in the March quarter, and be down around 3% y/y compared to the Street which is expecting down 4%. June quarter Street estimates call for 5% growth which I see as aggressive. Flat y/y wearables revenue in June would be a win given the segment is more sensitive to the macro slowdown given Watch and AirPods are not must-haves for consumers.


Key topics for the call

AI: How should investors gauge Apple’s investments in AI? My take is Apple is further along in AI than the company gets credit for.

India: How aggressively will Apple pursue the opportunity in India? I estimate India accounts for less than 3% of sales today. Long term, the India opportunity could be as big or bigger than Mainland China which I estimate was 12% of sales in FY22.

China diversification: It’s clear Apple wants to reduce its China manufacturing footprint. The question is how long will it take? With all of the geopolitical cross-currents, the topic of China manufacturing exposure is growing with investors. Deepwater estimates 52-55% of Apple’s FY21 revenue was made in China. Long term, I believe the goal is to reach 25% made in China, which at the current pace will take about 5-7 years.

Financial services:  What’s the company’s financial services master plan? Apple’s success in financial services has been under the radar. I estimate Apple Pay (launched in 2014) accounts for 1% of overall revenue (pure margin) growing at 40% y/y. Apple Card started in 2019 with limited commentary from the company on the product’s milestones. Apple Savings was launched last month with a 4.1% annual interest rate, compared to most big banks that offer around a 0.5% yield. These products are sticky with large addressable markets and the segment’s roadmap is slowly becoming more clear for investors; Apple wants to manage your money and is setting the table to add investment products (Apple Invest) in the next few years.

App steering: What’s the impact of steering? After over a year of absence from investor conversations, the topic of steering has re-emerged. The recent appeals decision in the Epic Games suit maintains that Apple will have to allow developers the option to move customers outside of the Apple pay wall to complete their purchases. Apple is appealing that decision. As for the impact, if Apple losses 15% of App Store revenue from steering, overall revenue would decline by 1%. I believe the impact will be less than 1%. It’s worth noting, there could be additional app store changes in 2024 from the EU’s Digital Markets Act.


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