Apple's iPhone 16 Strategy: Balancing Hardware, Software, and Services

Apple: Secret Weapon Driving The Super Cycle (NASDAQ:AAPL)

Warren Buffett's recent Apple stock sales pose a psychological risk, but Apple's focus on AI and software services supports a strong buy rating. Going into the event last week, the market had high expectations around the new iPhone 16 given this is one of the first AI-enabled devices that Apple Inc. (NASDAQ:AAPL) has ever launched. I think the stock's rally in the months leading up to the launch showed that investors are betting on a wave of upgrades this cycle, particularly given that a portion of the current installed base has not been upgraded in four years. Some analysts are bullish, projecting a "supercycle" that could break previous sales records, with an estimated 300 million users primed for upgrades. What's odd about this iPhone cycle is the division in opinions among investors and analysts. Some analysts (like Dan Ives) are bullish. However, not everyone has joined the hype and some are not convinced that this new AI phone cycle will be influential. Herein lies the opportunity, in my opinion. A lot of news headlines tout the bullish forecasts. But I think it's clear that the overall investor community is not nearly as net bullish. This represents a tranche of capital that could be unlocked and could buy Apple shares if they surprise to the upside. Although Apple shares have slumped more recently heading into this long-awaited product launch last week, I still think they can exceed market expectations, and closely mirror the success seen with the iPhone 6 in 2014. Back then, the larger-screen iPhone 6 triggered a massive upgrade cycle, selling 74.5 million devices in just one quarter and successfully pushed Apple's profits to record levels at the time. In fact, the iPhone 6 has still not been passed as the best-selling touchscreen smartphone lineup ever. That is until this latest iPhone came out. This year's launch has similarly high expectations, with UBS recently raising their price target for Apple to $236 because of the integration of advanced AI features, including Apple Intelligence, and other features like enhanced cameras, faster chips, and improved user experience will spur demand for the new devices. I think that with a user base of over 1.32 billion iPhones, Apple will likely benefit from a strong upgrade even if just a fraction of these users opt to do so. With this, I think Apple is still positioned as a strong buy. Despite recent slower iPhone sales, the potential for another major upgrade cycle gives Apple an edge in the smartphone market over their competitors, all powered by AI. Apple's shares have slightly beat the broader market, up by 4.38% since my last coverage in June, post-WWDC, where initial enthusiasm centered around the AI software updates that Apple is launching natively on their iPhone lineup. So while expectations were high going into the event Monday and a lot of the new AI features were already known, the new iPhone 16 arguably surpassed many of those expectations since the device's AI-powered capabilities, such as Apple Intelligence, go beyond incremental software upgrades and make the company capable of capturing strong demand across their large installed base. Don't get me wrong here, I know Apple is probably one of the most efficiently priced stocks on the street right now, given they're one of the world's largest companies. But despite being one of the most closely monitored stocks on Wall Street, probably second only to NVIDIA Corporation (NVDA) in tech circles, the market actually appears to be inefficiently pricing Apple here because the investor community is so divided on this equity. As I mentioned above, UBS's recent price target shows that the market has not fully priced in the potential impact of this launch. I think shares remain undervalued, even after a ton of publicity after the event. With their strong AI integrations, consumer excitement for the new iPhone model, and the company's user base that is ripe for an upgrade, the stock is positioned for further upside. The purpose of me doing follow-up coverage is to show that because the investor base is so divided, investors have a unique opportunity. Apple's latest updates from their September 9th event refreshed a lot of their consumer lineup (across their iPhone, AirPods, and Apple Watch product lines). I think what's telling here is that while the innovations are incremental, they're also valuable at the same time, and show Apple's durable innovation pipeline with the iPhone lineup now entering its 17th year as a product line. The iPhone 16, which is powered by the A18 Pro chip, is designed for enhanced AI tasks such as personalized recommendations and improved camera performance. The company also claims that the device's ultra-wide camera captures 2.6 times more light, which is ideal for low-light photography, while the new "Fusion Camera" feature allows for more granular control over photo settings. Along with the new iPhone, the Apple Watch Series 10 got a strong series of upgrades with a larger OLED display for more screen space, and advanced health monitoring features, including sleep apnea detection and heart rate monitoring. The device is also thinner by 10% for better wearability. The AirPods 4 now feature personalized spatial audio and adaptive noise cancellation, powered by the H2 chip. These features allow the device to adjust to environmental noise and conversation settings in real-time which, I think, is a huge upgrade for Apple. I, personally, call a lot of people that talk to me through their AirPods. I find the current AirPods excellent at capturing background noise (from simple wind noises outside to the sounds of cooking when they are in their kitchen). As a listener, I find this painful. These new AirPods solve for this. Beyond this, the AirPods Pro 2 introduces hearing aid functionalities, which have already impacted the hearing aid market by offering a more affordable, over-the-counter solution for users with mild to moderate hearing loss. They recently became FDA-approved which is a huge milestone for Apple. The AirPods Pro update is projected to disrupt the $13 billion hearing aid market, with its added capacity to serve as an over-the-counter hearing aid for users with mild to moderate hearing loss. This feature alone can increase accessibility to hearing support, helping to normalize hearing aids by blending them into everyday consumer tech. I believe Apple's strong AI integrations on the iPhone 16 will drive a suite of AI-powered software tools into consumers' pockets that will help the company generate increased recurring revenue from these services to support their market leadership beyond hardware. The new AI features on the iPhone are more than just the hardware. It's about Apple growing their software business. This leads me to one of the biggest (and I think under-discussed) footnotes from the Apple Event. Apple is offering a powerful iPhone trade-in program that, I think, is key to driving the upgrade cycle for the iPhone 16. U.S. customers trading in an iPhone 12 or newer can receive up to $1,000 in credit towards a new iPhone 16 Pro when purchased through major carriers like Verizon, AT&T, or T-Mobile - a move to encourage more consumers to adopt the latest hardware while Apple continues to upsell through their expanding ecosystem of apps and services. Keep in mind that the new iPhones are in the $799-$999 range. This could mean that some consumers pay net-zero out of pocket for a new iPhone. Who wouldn't want to take this offer? In essence, I think the upgrade costs are going to be very low for many consumers. This is big. I think Apple is planning to hook consumers with a new AI-enabled iPhone, but then upsell new AI features on their iPhones, especially with the introduction of Apple Intelligence during WWDC this year. Keep in mind that Apple makes up to 30% commission on in-app sales from apps listed in the Apple app store. Any new AI app in the App Store that consumers pay for (only because they have the new iPhone which was almost zero out of pocket) has to give up to 30% of their revenue to Apple. To be clear, Apple shares right now are not a buy when we compare their P/E to the sector median P/E. After all, Apple's forward P/E ratio of 33.27 remains higher than the sector median of 23.53, a 41.40% premium. But Apple is no ordinary company (no sector median company), and I think they deserve to trade at a premium. The question is how much. Apple's management is an excellent capital allocator with the company sporting a return on equity (ROE) of 160.58%, which outpaces the sector's 4.65% by a whopping 3,353.03%. Even though Apple is one of the world's largest companies, it continues to find places where a single dollar of equity at the beginning of the year yields roughly $1.60 in additional returns by year-end. That's incredible. As the company dives deeper into AI with their product launches this past week, I think their consumer-facing focus will help them actually do well in capitalizing on AI's potential in the long term. Analysts are currently projecting 9.11% YoY EPS growth for the fiscal year ending this month (September 2024), and 10.83% for the year after (FY 2025). I think these estimates may be conservative, even though the company is one of the largest by revenue, and it's hard to grow significantly at such a scale. The increasing role of software revenue in Apple's business model, particularly the upselling of AI-driven services, enhance margins and cause better-than-expected EPS growth. As I mentioned before, the investor community is highly polarized right now on this Apple launch. I think when the results start to come in from this AI-driven strategy, many investors will be surprised. I think Apple should be trading closer to a 50% premium to the sector median forward P/E to represent their unique business model that combines hardware and now AI software revenue. They are figuring out how to monetize AI for consumers. A 50% premium to the sector median would represent roughly 6% upside from here in shares not including dividends, and the powerful buyback programs that Apple has in place. A 6% upside is my conservative estimate, but I think there is room for a lot of variance to the upside. Ironically, I think the biggest risk to this thesis playing out is not actually within the company, but actually from one of their largest shareholders. Warren Buffett's recent sales of Apple stock puts a lot of pressure on shares as the market absorbs the supply, and psychological pressure on the iPhone giant since Warren Buffett has proclaimed previously that his favorite holding period is 'forever.' The Oracle of Omaha, known for his long-term investing approach, has been systematically reducing his holdings in Apple and other stocks over the last several quarters. When Buffett starts selling, it often signals his belief that future performance may not justify holding such a large position. This case may be the exception, however. Buffett acknowledged these sales at the Berkshire Hathaway investor conference earlier this year, which it appears was largely driven by tax considerations rather than a bearish outlook on Apple itself. I believe he is aiming to capitalize on historically low corporate tax rates to realize gains on the highly appreciated stock. In essence, selling from Buffett is often a psychological and financial strain on a company's investor base. This may be a rare exception. I think the fundamental performance of Apple here will outweigh the sales. Apple's focus on AI software services, using the latest iPhone as a high-margin product to drive consumer software spending, offers a unique market edge, and helps solve the division in the investor community surrounding the release of this product. The company's ability to upsell through their ecosystem, along with their extremely strong trade-in program, supports strong consumer demand. I still expect the iPhone 16 launch to trigger an upgrade cycle, driven by AI-enabled features like Apple Intelligence and a trade-in program that sweetens the offer. With an estimated 300 million users primed for upgrades, this rollout could replicate the success of the iPhone 6 a decade ago. With this, I think shares are still a strong buy with a direct path to some upside in the near term, and the potential for much more over the long run.

Apple iPhone 16 Release: Don't Forget Software And Services (NASDAQ:AAPL)

I do much more than just articles at Envision Early Retirement: Members get access to model portfolios, regular updates, a chat room, and more. Learn More " I recently wrote an earnings review about Apple (AAPL). The article was titled "Apple Q3: I Disagree With Bears' Interpretation Of Berkshire Divestiture" and was published on Aug. 9, 2024. As you can already guess from the title, the article was motivated by Berkshire's holdings changes since the release of its FY Q3 financial results. More specifically, the article argued that: Many analysts issued bearish ratings on AAPL following Berkshire's divestiture and iPhone sales data reported in its Q3 earnings. These concerns overstated the risks or are simply misplaced, in my view. The prevailing interpretation of BRK's divestiture ignored some basic facts. For example, the remaining position is still ~30% of its equity portfolio and BRK enjoys cash deployment options inaccessible to individual investors. Since then, there have been a few new developments around the stock, and the most significant one was Apple's launch event last week. At the event, AAPL showcased several new products, and as usual, its new iPhones (iPhone 16) grabbed the attention of analysts the most. On the Seeking Alpha platform alone, several authors have reviewed the events with a focus on the new iPhones. In my view, the rollout of AI-related functionalities (see the next figure below) is likely to catalyze another upgrade cycle in the near term and create long-term opportunities. However, the discussion thus far has mostly focused on the hardware aspects of Apple's new devices. Thus, my goal here is to switch perspectives and discuss the software ecosystem surrounding the companies, especially the subscription-based services. My past investing and consulting experiences have taught me that software often creates a wider and more durable moat than hardware. Judging by the features of AAPL product's new features and recent financials, I believe AAPL is progressing on this front rapidly. Let me start with a broader picture to prime the discussion before I dive into specific examples. The Services category is now the second-largest income stream for AAPL already. Its topline increased 14%, to $24.2 billion, also an all-time high in the past quarter. The chart below provides a visual representation of Apple's service revenue growth in the past decade (including iTunes, software, and services). Starting at a relatively low point in the first quarter of 2013 ($3.69 billion), Apple's service revenue has steadily increased over the years. As a highlight of its impressive growth, the revenue from the segment experienced a 6.56x growth in this period, translating into an annual growth rate (CAGR) of about 20%. Looking ahead, I believe the company is on course to keep such strong growth rates in the years to come. Apple's installed base of active devices is at record levels in all geographic regions. And I expect this to keep growing thanks to platform updates announced recently. Apple Intelligence - AI - is a notable example. It incorporates OpenAI's ChatGPT across its operating systems. According to its release, a personal intelligence system is embedded in the iPhone 16 to help users "write, express yourself, and get things done effortlessly." I expect such features to evolve into a subscription-based revenue model quickly, like other Apple services. The growth of the software/service ecosystem does not stop with AI. Elsewhere, Apple continues to add immersive content to Vision Pro, such as concerts, films, and series. Even the AirPods have potential on this front (e.g., as part of a health monitoring plan). Shortly after its launch event, news also broke that Apple had gained FDA approval for its software to use AirPods as hearing aids. More specifically, Seeking Alpha News: The U.S. has granted Apple (NASDAQ:AAPL) approval for software that will allow for AirPods Pro to be used as over-the-counter hearing aids. The approval is for the Hearing Aid Feature medical app intended for use with certain compatible models of AirPods Pro. It's set up through an iPhone or iPad. A user can adjust settings without the need for a hearing professional. Admittedly, sales of its flagship iPhone have been slowing recently. In its FY Q3, for example, iPhone sales decreased 1% (although the growth is still positive on a constant currency basis). However, I expect the software/service growth to more than offset this. As a reflection of such potential, the following consensus estimates expect its EPS to grow from $6.69 in this fiscal year to over $12 in five years, translating into a CAGR of 12.5% in this period, a remarkable rate for a multi-trillion-dollar company. More importantly, I will explain next that the EPS growth rate is only one benefit from the software expansion. I also anticipate the expansion of its profitability. In the table, I combined its EPS estimates with the consensus revenue estimates to compute its profit margin. As seen, consensus estimates expect AAPL's revenues to grow from $390B in this fiscal year to $562 in five years. Such an increase implies an annual growth rate of 7.7% in CAGR terms. If you recall, the earlier chart shows that its EPS growth rate is projected to be about 12.5%. Such a difference points to the expansion of its profit margin. As a simple (and crude) guesstimate shown in the table, A) I assumed its number of outstanding shares to remain constant at the current ~15.1 billion shares, and B) calculated the net profit margin implied by the above consensus EPS and revenue projections. The bottom line is that AAPL's net profit margin is projected to expand significantly from 25.96% in FY 2024 to an average of ~28.7% in the next few years. Similar to my thoughts on the EPS growth outlook, I believe that such an expansion of its net profit margin is highly possible. Software and services tend to recur much more reliably than hardware sales and enjoy far better margins. I could not find the data necessary to compute its segment net profit margins (please leave a comment if you know how/where to find such data). But I think gross margin can provide some insights already at a company-wide level, AAPL's gross margin is about 46% as shown (and 41.6% on average for the past 5 years). As of FY Q3, the gross margin from its service segment was close to 74% in comparison. Based on the catalysts mentioned above, looking ahead, I anticipate the contribution from its services/software to keep increasing in AAPL's income mix and thus pushing the margins up in tandem. In terms of downside risks, its current valuation is at an elevated level and entails some valuation risks as its stock price hovers around all-time highs. If you recall from an earlier chart, its FY1 FWD P/E currently is about 33.2x at the price as of this writing. Even considering the variation of consensus estimates and assuming its EPS reaches the upper end of their estimates, the FWD P/E is still close to 33x. Such a level is not only far above the sector median (by more than 40% as seen from the chart below) but also above its own historical average by about 20%. However, my view is that such a comparison of AAPL's P/E to the sector median or its past average should be taken with a grain of salt. As the company derives an increasing portion of its income from software and subscription services, a benchmark against only this particular type of company makes more sense to me. Microsoft (MSFT) and Adobe (ADBE) are the two examples that come to mind, given their heavy reliance on such revenue generation. As seen, both companies have traded at P/E far above 33x for extended periods in the past. Specifically, ADBE's P/E ratio has exceeded over 60 and MSFT's exceeded 40x many times in the past five years. The average P/E ratio for ADBE during this period is 46.8x and MSFT's average is about 33. I don't see AAPL's current valuation as too alarming when benchmarked this way. Overall, I see a favorable return potential in the next few years despite the potential for near-term valuation risks. Going forward, I urge investors to look past the growth of its hardware (not only with iPhone, but also with other things such as iPad, iMac, etc.) and pay more attention to its software ecosystem. I anticipate the growth potential on this front to more than offset any slowing down on the hardware front given its installed basis. This would not only catalyze earnings growth, but would also further improve the quality of its earnings in terms of stickiness and margins.

Apple: Not Ready To Glow Up (NASDAQ:AAPL)

The stock is overvalued at a 33x forward P/E multiple, with limited growth prospects and potential sales disappointments for the iPhone 16. Apple, Inc. (NASDAQ:AAPL) (NEOE:AAPL:CA) held their annual product release event last week and the market mostly yawned. The company launched the much-anticipated iPhone 16 with Apple Intelligence, yet the device will be mostly devoid of AI to start. My investment thesis remains Bearish on the stock, as the event failed to drive huge consumer excitement. As typical of the annual event, Apple announced new products, including the iPhone 16, Apple Watch Series 10 and AirPods 4. All of the products have new features, but the big question is whether AI can drive higher iPhone 16 sales. As usual, the newest iPhone versions have new chips, improved camera and more memory bandwidth while using the latest 3-nanometer tech from TSMC (TSM). The issue here is that Apple Intelligence only enters beta testing next month with a plan for full release in the following months, though other languages like Chinese and Spanish won't launch until next year. Considering the prime feature isn't even ready with the product sales starting on September 20, analysts are mixed on the sales impact. Influential Apple analyst Ming-Chi Kuo doesn't see iPhone 16 delivery dates matching the demand for prior hot Apple products in the iPhone 15 Pro Max and the Vision Pro. Ming-Chi Kuo had already predicted iPhone 16 sales to dip after an initial bump in comparisons to the iPhone 15 Pro Max production issues last year. The forecast is for iPhone units shipped in 2024 to dip slightly to 88-89 million units from the 91 million for iPhone 15. The major weakness is predicted for the December quarter with a 5% to 7% dip from last year. The amazing part on the stock is that consensus analyst estimates over time have only slipped since the peaks around the start of 2022. Once the Covid-19 boost ended, Apple has struggled to meet reduced targets with revenue estimates for FY25 dipping from $447 billion to only $420 billion now. Analysts had started boosting targets going forward due to excitement on AI, but the iPhone 16 Glowtime event doesn't provide any reason for this excitement. The majority of the iPhone AI features aren't presently available and will take up to at least 6 months to fully rollout. The consensus estimates have revenues growing in the 8% range for FY25 and FY26 now, but these estimates require Apple to produce some meaningful boost in sales from the iPhone and AI related products. The bull case requires significant upside in iPhone sales. Gene Munster from Deepwater Asset Management has sales actually growing 8 to 10% in FY25 requiring somewhere around 250 million units sold next fiscal year. iPhone sales in just ending FY24 are forecast to roughly approximate the 230 million units of the last couple of years. With iPhone 16 ASPs similar, Apple needs to hit at least 5% additional units sold from the roughly 230 million units sold the last couple of years. In FY21, Apple sold an estimated 242 million units from both the pull forward of demand due to Covid and the launch of the 5G iPhone. The iPhone 12 was launched in September 2020 and provided a huge boost to FY21 unit sales, which the tech giant has yet to top. A big part of the issue is the Asian market. In China, Huawei has quickly regained market share in the last couple of years and appears to be out innovating Apple with the release of a trifold smartphone only hours after the iPhone 16 release. The Chinese company now has 18.1% of the market, with 50% growth in Q2'24. Apple saw sales fall to 6th place, with other companies like Vivo and Xiaomi growing sales YoY. Apple saw June quarter sales in China dip over $1 billion to just below $15 billion. The tech giant barely grew total sales through FQ3 of this year due in large part to losing over $5 billion in sales from China. Apple has sold an estimated 43 million units in China the last 3 fiscal years. China accounts for nearly 20% of units sold and the competitive environment in the country has shifted in the last year to the point where sales likely dip during this holiday period. After all, Apple hasn't really announced how the company will offer generative AI on the iPhones sold in China. The rumor mill has the tech giant likely working with Baidu (BIDU) considering the CCP requires the data stay in the country. The issue with the stock for a long time is the valuation disconnect. Apple is valued at over 30x forward EPS targets, yet lots of questions exist on whether the tech giant can reach the targeted 10% EPS growth rates that don't even warrant the current stock price. Apple not only needs for iPhone sales to grow at a 5%+ clip in FY25 without any lingering impacts from China, but the tech giant needs sales to continue growing in future years. As the quarterly iPhone sales chart highlights, sales peaked back in 2021 and have failed to top prior year levels. Apple saw no follow through sales after the big 5G/Covid boost. And one really has to wonder how much of the boost was related to 5G and not pulled forward demand for Covid work-from-home policies. The tech giant hasn't shown any ability to grow at even 10% clips, yet the stock is currently valued at 3x growth rates. Despite all the excitement, Apple is only forecast to produce a $7.41 EPS in FY25, which would value the stock at only $111 based on a 15x P/E multiple. The actual risk is that Ming-Chi Kuo is right and actual iPhone 16 sales during the holidays disappoint. The stock would definitely rerate to a lower P/E multiple, if the iPhone 16 fails to drive sales growth after a couple of years with limited growth. If an analyst like Gene Munster is correct, Apple should produce 10%+ EPS growth in FY25. The question is what the company can do to continue growing beyond the initial bump in iPhone sales, with lots of questions on AI and how the tech giant can turn Siri into a money generating software tool while users already have several generative AI tools, such as ChatGPT from OpenAI. Our view is that Apple could grow sales in the 5% range, with EPS growth closer to 7% to 8% due to a small EPS boost from share buybacks. As mentioned above, this growth rate warrants a 15x P/E multiple. The lack of innovation and massive size with annual sales in the $400 billion range just doesn't add up to the growth rates warranting the growth stock valuation. The key investor takeaway is that Apple failed to deliver much excitement from the Apple Intelligence event launching the iPhone 16, primarily due to the fact that AI tools aren't ready yet. The stock is already priced for perfection, but the company isn't ready to deliver the growth warranting a forward P/E multiple of 33x. Investors should use the premium price to sell like Warren Buffett and not risk a scenario where sales fail to deliver growth and the stock is finally rerated much lower to a limited growth scenario.