Trifecta: Stable Device Base, Growing Services, and Buybacks

  • Shares of AAPL were up ~4% in the aftermarket because investors had been expecting below-consensus guidance, but the company guided in line to slight upside for the Jun-18 quarter. (revenue guidance of $51.5-$53.5B vs. the Street at $51.5B)
  • The iPhone business is becoming increasingly predictable, which should ease quarterly investor anxiety.
  • The Services business is building muscle, up 31% y/y vs. 18% y/y in Dec-17.
  • While the capital return update of $100B was in line with expectations, the theme of capital return will play a greater role in the future Apple story.

Conclusion: The Apple story is intact. Near-term, investor optimism will rise going into the summer as anticipation grows ahead of 3 new iPhones in the fall. Long-term, Apple’s loyal active base of ~800m iPhones should yield a predictable 215-225m in annual iPhone unit sales that will drive Services growth of 13-15%. Allocation for share repurchases should increase annually, and lastly, the company is a safe haven in terms of protecting user privacy.

We’ve entered a period of greater visibility in the iPhone business.

  • iPhone stability. Implied in the Jun-18 guidance is ~2% iPhone unit growth, which compares to 3% in Dec-17 and -1% in Sep-17. This suggests that the iPhone business is becoming more stable, albeit at a lower growth rate. While investors will always have some anxiety regarding the quarterly iPhone number, the results and guidance suggest we’ve entered a period of greater visibility in the iPhone business.We expect the iPhone to be flat to up 5% per year over the next 4 four years.
  • Service’s growing and stable. Another aspect of improved visibility to the Apple story is Services, which were up 31% compared to 18% growth in Dec-17. The company now has 270M subscriptions, up from 240M last quarter. We believe the Services segment will grow between 13% and 20% per year over the next five years driven by continued growth in existing services along with new, innovative services.
  • Capital returns rising tide. The company announced a $100B capital return target (in line with Street thinking), but, for the first time, did not give a timeline. While the update to the capital return program is not impacting AAPL shares in the aftermarket, we believe buybacks will play a central role in investor thinking around the Apple story over the next 5+ years. Apple will generate between $40B – $60B in annual free cash flow that will effectively be given back to investors with the majority (85%+) allocated to buybacks. Buybacks could increase earnings and share price by 2-5% in each of the next several years. If Apple shares were to gain a valuation closer to other FANG stocks, the company would likely slow its buyback and increase its dividend. The fact that CFO Luca Maestri indicated that buybacks will be the focus of the capital return is a sign that Apple sees its share price as undervalued in the near term.

Other notable takeaways:

  • China. China revenue grew 21% in Mar-18, compared to 11% in Dec-17. Tim Cook mentioned four reasons for the strength in China including, Services, wearables, iPhone, and Mac. We believe the iPhone X was the clear driver in China given our observation that Chinese consumers tend to upgrade at a higher rate when there is a more measurable change in the iPhone form factor (as with iPhone X). This is the first time since 2014 that we’ve seen a meaningful change in the hardware design.
  • Apple Watch. We estimate Apple Watch accounts for about 3% of Apple’s overall business, but it is growing at close to 50% y/y compared to the iPhone at 3% growth. After Apple Watch debuted with disappointing results, the product has slowly climbed into favor with consumers as the theme of wearables becomes more mainstream. Note that the company does not report Apple Watch results, but did mention the wearables category, which includes Apple Watch, AirPods, and Beats headphones, was up 50% y/y. Since the Beats business is still likely flat to down, we think it’s a safe assumption that the Watch grew as fast as the overall wearables business.
  • See our Apple model here.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make. 

Posted in Apple  • 

Apple Preview: Story Is Intact Despite Near-Term Risk

Apple reports on Tuesday, May 1st. Here’s what we expect:

  • Modest risk (about 3%) to the Street’s Jun-18 revenue estimate based on negative comments from two suppliers. Jun-18 revenue guidance of $48-$51B vs. Street at $52.2B.
  • The company to announce an increase in the buyback by $70B over the next 3 years, a 15% dividend increase, and a one-time cash dividend of about $12B.
  • Mar-18 iPhone units of 53m, in line with the Street, and Services growth consistent with last quarter at 18%, also in line with the Street.
  • The Apple story is intact. Near-term, investor optimism will rise going into the summer as anticipation grows ahead of 3 new iPhones in the fall. Long-term, Apple’s loyal active base of ~800m iPhones should yield a predictable 215-225m in annual iPhone unit sales that will drive Services growth of 13-15%. Allocation for share repurchases should increase annually, and lastly, the company is a safe haven in terms of protecting user privacy.

Here are 3 key topics, in order of importance:

  1. Jun-18 Guidance. Why it’s important: Recall that Mar-18 guidance revealed demand for iPhone is declining. This is the 3rd time in the last 4 cycles (5S, 6S, 8+X) the iPhone tail has disappointed investors. Current investor thinking: Nervous based on TSMC 3% guide down and cautionary comments from chipmaker AMS. What Loup expects: Revenue guidance of $48-$51B. This implies the high end would be 3% below the Street at $52.2B. This should be good enough, given investor expectations are generally low. Rationale: TSMC’s and AMS’s comments.
  2. Mar-18 iPhone Units. Why it’s important: iPhone revenue will be about 64% of sales in Mar-18. Apple already set the tone for the downward slope of the iPhone X and iPhone 8 cycle. Current investor thinking: 53m units, up 5% y/y, compared to down 1% in Dec-17. This is in-line with the Street. What Loup expects: 53m units. Rationale: 53m iPhones is effectively the midpoint of Apple’s Mar-18 guidance. The Street is at 53m iPhones with a $735 ASP, which implies $61B in revenue compared to guidance of $60-$62B. In the past 6 quarters, Apple has essentially met the high end of revenue guidance every time.
  3. iPhone ASP. Why it’s important: Higher ASPs yield higher margins and, more importantly, show a willingness of the iPhone base to pay more. Current investor thinking: $735, up 12% y/yWhat Loup expects: $753, up 15% y/y. Rationale: We have the same iPhone units as the Street for Mar-18, but we are modeling a higher ASP based on higher iPhone X mix. We believe iPhone X will account for 29% of the mix in Mar-18.

Other, less important topics:

  • Services. Why it’s important: Services revenue will be about 14% of sales in Mar-18. Given the weak tail of the iPhone X cycle, Services revenue is increasingly important. Current investor thinking: $8.3B in Services revenue, up 19% y/y. What Loup expects: $8.4B, up 19% y/y, compared to 18% in Dec-17. Rationale: Services growth has been relatively predictable. Over the last 9 quarters, Services have grown between 19-26%, and between 18-22% over the past year (excluding one time benefits).
  • Gross Margin. Why it’s important: Stating the obvious, gross margin is always important given it’s a read on iPhone demand, strength of brand, and manufacturing efficiencies. Current investor thinking: 38.3% for Mar-18, in-line with Dec-17 at 38.4%. What Loup expects: 38.4%. Rationale: Apple guided gross margin for Mar-18 to be between 38-38.5%. The company has reported gross margin at the high end of guidance in 5 of the past 6 quarters.
  • Mac. Why it’s important: Mac revenue will be about 9% of sales in Mar-18. Current investor thinking: 4.2m units, flat y/y. What Loup expects: 4.2m units. Rationale: The Mac number could disappoint given that it is going up against a tough comp vs. Mar-17.
  • iPad. Why it’s important: iPad revenue will be about 6% of sales in Mar-18. Current investor thinking: 9.1m units, up 1% y/y. What Loup expects: 8.9m units, flat y/y. Rationale: iPad has grown units for the past 3 quarters by an average of 7%, after being down for 13 consecutive quarters. We see the iPad as a replacement business, and we’re modeling for 1% growth for the next 3 years.
  • Watch. Why it’s important: Apple does not break out Watch but we estimate Watch revenue to be 3% of sales in Mar-18. Current investor thinking: 3.0m units, up 20% y/y. What Loup expects: 3.3m units, up 30% y/y. Rationale: Apple Watch is going up against a difficult comp in Mar-18 given the spike in Watch growth in Mar-17. We expect unit growth to moderate in Mar-18 to 30%, down from about 50% over the previous 3 quarters. We continue to expect Watch to grow around 20% y/y for the next 3 years.

Repatriation impact. In January, Apple announced that they’re paying $38B in repatriation taxes, which implies they’re bringing $215B back to the U.S. If there was no tax holiday Apple would have paid about $80B in repatriation taxes, compared to the $38B they are actually paying. At the same time, Apple announced $30B in capex investment over the next 5 years, including a new Apple campus for technical support.

What to expect from capital return update. On the Mar-18 earnings report, we expect Apple to increase its buyback over the next 3 years by about $70B. We also believe Apple will announce a one-time cash dividend of $12B. Lastly, we anticipate a 15% annual dividend increase that will cost Apple about $10B over a 4 year period. We believe most of this is already priced into AAPL shares. As a point of reference, last year Apple added $35B to its buyback plan and increased its dividend by 10%.

Two negative data points from supply chain. As mentioned, we expect Apple to guide 3% below the Street for Jun-18. This is based on negative comments from two Apple suppliers, TSMC and AMS. That said, negative supplier comments are nothing new to the Apple story. Our level of concern jumps if three suppliers give a cautionary outlook and, to date, only 2 have given warnings:

  • Taiwan Semiconductor (TSMC).  Taiwan Semi is Apple’s supplier of A10 and A11 chips used in iPhone 7, 8 and X. Apple accounts for about 20% of TSMC sales. Last week the company revised its full-year revenue target to the low end of its earlier forecast. Specifically, revenue for 2018 is likely to grow 10% rather than the earlier forecast of 10-15%. TSMC highlighted the downtick was due to softer demand for smartphones, as well as uncertainty in the cryptocurrency mining market.
  • AMS. AMS produces 3D sensing modules for iPhone X. The company reported first-quarter sales toward the lower end of its guidance range on Monday and warned of a downturn related to weaker orders from one of its main customers. While AMS would not discuss the specific customer, we believe there is a greater than 50% chance that customer is Apple.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make. 

Posted in Apple  • 

Adrenaline Shots for Apple AI

  • Apple has been criticized for not doing enough in AI. Two recent announcements show the company is closing the gap.
  • In the past two weeks, the company has announced the hiring of Google’s AI head, and an AI partnership with IBM.
  • Google’s AI head (John Giannandrea) brings credibility to Apple AI, critical in recruiting, and is likely work on AI-powered interfaces and Apple’s self-driving car program.
  • IBM partnership allows iOS developers access to IBM Watson’s enterprise machine learning, and use it to make smarter AI apps.

Core ML 101. At WWDC 2017 Apple unveiled Core ML, a platform that allows developers to integrate machine learning into an app. The AI model runs locally on iOS and does not need the cloud. At the time of the announcement, Apple outlined 15 domains for which they have created ML models, such as face detection, text summarization, and image captioning.

IBM Watson and Apple announcement. Two weeks ago Apple and IBM announced they will integrate IBM Watson with Apple Core ML. Previously, developers could convert AI models built on other third-party platforms, like TensorFlow (Google) or Azure ML (Microsoft) into Core ML, and then insert that model into an iOS app. Now developers will be able to use Watson to build the machine learning model, convert it to Core ML, and then feed the data back to Watson’s cloud. The reason why this is important is it allows iOS developers to leverage Watson’s capabilities and ultimately improve the AI in iOS apps.

Watson works locally on iOS and improves apps. What’s unique about Core ML is it runs locally on mobile devices, meaning it doesn’t have to send data back to a server. This is different than other mobile AI approaches. Running locally is an advantage when the speed of AI is important, like image recognition in AR or natural language processing. What’s new is Watson will be able to “teach” Core ML to run the AI model built with Watson. Basically, Watson does the hard work of getting a usable AI model built and then teaches it to Core ML, who can then run the model locally on its own. The app can then send data on the model’s performance back to Watson, at any time, to be analyzed for available improvements.

Recent history of Apple and IBM. In July 2014, Apple and IBM partnered to create enterprise applications on iOS devices, leveraging IBM’s big data and analytics and Apple’s hardware-software integration. IBM started selling iPhones and iPads to clients that came with software and applications for enterprise designed with Apple’s help.

Summary of big tech’s machine learning services. 

Disclaimer: We actively write about the themes in which we invest: artificial intelligence, robotics, virtual reality, and augmented reality. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

Apple’s AI Coup

  • Apple has hired John Giannandrea who formerly served as Google’s head of AI and Search.
  • Given the industry’s shortage of AI talent, Giannandrea brings expertise along with credibility, critical in recruiting.
  • Giannandrea will likely be working on AI-powered interfaces that will replace the touchscreen and iOS, like augmented reality wearable. Separately, AI related to Apple’s self-driving car program (PAIL) will likely fall under Giannandrea.

What this means for Apple, recruiting more AI talent. It’s a win. Talent follows talent, and John Giannandrea will no doubt help to build Apple’s AI brand and enhance future recruiting efforts. His shared vision on privacy is good news for a company who claims to be the vanguard of user security. In the meantime, Google will maintain its strength in AI, given they are still an “AI first company” and have tremendous AI and deep learning horsepower with their Google Brain and DeepMind teams. Jeff Dean, the founder of Google Brain, has taken over as the head of their AI department in a “reshuffling” making AI a more central part of their business. Will Google employees follow in Giannandrea’s footsteps? There will probably be a few, but the competition is fierce, and this will not be the last major AI trade.

Why did Giannandrea come to Apple? Most likely – projects, pay, and privacy. As one of the most senior experts in arguably the most in-demand field in the world, the conversation around compensation was probably short. Giannandrea may be given freedom to work on projects he is more passionate about and have the chance to build something new. In an email obtained by the New York Times, Cook praised Giannandrea saying, “John shares our commitment to privacy and our thoughtful approach as we make computers even smarter and more personal. Our technology must be infused with the values we all hold dear.” That affinity for privacy may have steered him to Apple at a time when concerns have never been higher.

What will he do? It’s easy to think about how Google uses AI (search, image rec., voice, etc.) but Apple’s use cases are more abstract. If you consider the user interfaces that will replace the touchscreen and iOS, like augmented reality wearables, it becomes more clear why AI is critical. Just as multi-touch was a core technology enabling the iPhone, AI will be a core technology enabling the operating systems of the future. For example, wearables like AR glasses or even AirPods will heavily rely on AI-driven functionality like image recognition, ambient listening, and smart notifications. In other words, these devices need to know what you want and when you want it. With our phones, we directly control the information that we want when we want it; in the future of computing, AI will anticipate the same information. We expect Giannandrea to address these opportunities as well as bolster Apple’s overall AI prowess, overseeing AI initiatives like Siri, Core ML, and the deliberately under-the-radar autonomy project.

Disclaimer: We actively write about the themes in which we invest: artificial intelligence, robotics, virtual reality, and augmented reality. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

How To Think About Recent Volatility in Tech

Market decline does not change the mega growth opportunities. The heart rate of the market increased the past week because of fears of a trade war, Facebook data privacy, and broken market technicals, but the health of the market is unchanged and the health is good. Core underlying tech trends including artificial intelligence, robotics, big data, and autonomous transportation, will support continued growth.

Hold tech for the long-term. We believe that tech is essentially taking over the rest of the economy; therefore, investors should hold tech long term. Just as every company is now an internet company to some degree, we believe that eventually every company will be an AI company.

Market undervalued. From a valuation perspective, our view is undervalued. The market has rallied back to the old highs, but the S&P is up only 3% per year over the past 17 years, compared to the previous 17 years (1983-2000) when it was up 17% per year.

Putting the size of tech into perspective. The tech sector’s growing clout is not just a U.S. story. Tech stocks have become so dominant in emerging markets that for the first time since 2004, the industry last year overtook finance as the biggest sector in the MSCI Emerging Markets Index. Tech had a 28% weighting near the end of 2017, more than double its level six years ago, according to data provided by MSCI. Facebook, Amazon, Netflix Inc. and Alphabet together account for a 7.8% weighting in the S&P 500, more than double from five years ago.

Company Updates:

Tesla. We remain positive on TSLA. Shares are down 20% in the past month mostly due to fears of another miss in Model 3 production. The recent stock dive is due to a combination of a Model X accident that is being investigated, Waymo’s partnership with Jaguar, which legitimizes a key competitor (the I-Pace electric SUV), growing concern among all companies testing self-driving vehicles amid the Uber fatality, and news that Moody’s has downgraded Tesla’s bonds to B3 from B2, citing significant shortfall in the Model 3 production rate and a tight financial situation. We continue to believe the Tesla story has the best risk-reward among tech companies over the next 5 years.

  • Model 3 production. We’re expecting another miss in Model 3 production in the March quarter but that does not change the story. There is more demand than supply for the Model 3 (about 400k preorders which is unheard of in automotive). It might take a year, but eventually, Tesla will get the Model 3 production right, and ramp output.
  • Model X accident. We see the recent Model X accident the same as accidents with gas cars. It is unlikely that the battery or Tesla’s advanced cruise control “autopilot” were to blame. Tesla disclosed that the autopilot feature properly functions 200 times a day on the same stretch of road where the accident happened.

Facebook. Limited upside to FB. Given the privacy issues, for the first-time advertisers have to think about Facebook as a liability. Separately, it’s unclear about how the recent privacy changes will impact Facebook’s ability to make money.

Nvidia. We remain positive on NVDA. Shares of NVDA dropped 11% in the past week following the announcement that they temporarily stopped autonomous testing, and in part because of the broader market sell off. While the company did not comment on timing, we expect testing to resume in the next 3 months. The big picture is the company is well positioned to capitalize on four mega trends, AI, autonomous cars, gaming, and blockchain through their dominance of GPU processors.

Apple. We remain positive on AAPL. Concern is emerging that iPhone demand in June will fall below Street expectations. We think iPhone demand over the next two quarters is not important to the story. What’s important is the share buyback, services, and the next iPhone.

  • Share buyback. Apple can add 4% per year to the stock price (assuming they use $40B of the $55B they generate in cash each year to buy back stock). Apple will give an update on the share buyback when they report the March quarter, likely late in April.
  • Bigger screen iPhone this fall. We expect Apple will announce a 25% bigger phone in the fall. This will be a positive for unit demand and average selling price.
  • Services. Services account for about 15% of revenue and are growing at 15-20% year over year. We believe this segment will continue to grow at a 15% or better rate over the next five years. This is important because the earnings multiple on shares of AAPL will likely increase as investors view the predictability of services are more attractive.

Google. We remain positive on GOOG. We expect the next six months to be rough for shares of GOOG as questions emerge about how the company uses data. Despite that negative potential, Google is too tightly woven into the fabric of the internet. The company is one of the best ways to invest in AI, given the company has a stated their intention to move from a mobile-first company to an AI-first company over the next several years. Lastly, the company has a stake in Waymo, the leading autonomous car company. We expect years of positive news to come from Waymo.

Amazon. We remain positive on AMZN. The company is best positioned for the future of retail. We see that future as a combination of both online and offline retail. Online sales account for about 15% of global retail, and in the future, we believe it will eventually reach 55% of sales. We also expect Amazon to do more with physical retail locations and we continue to believe the company will eventually acquire Target (TGT). The company’s AWS web hosting business is only 15% of revenue, but it is growing at greater than 30% for the next several years.

Twitter. Limited upside to TWTR. About 14% of Twitters 2017 revenue came from selling data, growing at 18% y/y, compared to Twitter’s ad business that declined by 6%. Selling private data is a toxic label, and this could limit the upside to shares over the next year.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.