Neil Cybart 7/3/24 Neil Cybart 7/3/24

Wall Street Warms up to Apple, AAPL Valuation Update

Hello everyone.

Over at Above Avalon’s sibling site, Inside Orchard, my essay last week, "Big Tech Is Winning Over Wall Street," went over a Wall Street observation that has been on my mind for the past few weeks.

While NVIDIA was capturing many hearts and minds on Wall Street, a larger story was quietly unfolding in the background. Wall Street was turning decidedly more bullish on the broader Big Tech bucket (Microsoft, Apple, Alphabet, Amazon, Meta). The change in tone isn’t just attributable to AI either. That may come across as a shocking stance to hold - the Inside Orchard essay goes into more of my thinking.

For today, we will keep our focus specifically to how Wall Street is warming up to Apple. The discussion then turns to an examination of AAPL valuation metrics (forward P/E, EV/FCF, and free cash flow yield).

Wall Street Warms up to Apple

A few weeks back, we talked about the trading action seen in Apple shares following WWDC. The signs pointed to algorithm-driven program trading leading to a sudden move higher. It’s certainly possible that some market participants were swayed by other things like fundamentals, but the heavy trading volume suggests something more systematic. Another possibility that we did not explore was a pair trade involving

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Neil Cybart 6/13/24 Neil Cybart 6/13/24

How Apple Intelligence Was Developed, Ranking Apple Intelligence Features, AAPL’s Wacky Price Action

There is value found in spending time on the details regarding how Apple Intelligence was developed and functions. We will then go over my thoughts on the various Apple Intelligence features, ranking the features from most impressive to most concerning. We will then address AAPL price action.

Happy Thursday. It’s been a very busy week. As a reminder, we still have some WWDC news to go over early next week.

There’s a lot to cover today, so let’s jump right in.

How Apple Intelligence Was Developed

During Apple’s Platforms State of the Union presentation (available to view here), which is aimed at developers, the company went into detail regarding how Apple Intelligence was developed.

Apple Intelligence began with an on-device large language model that Apple built to achieve a certain power/size balance that allowed it run on device yet power the experiences Apple wanted to offer. Apple relied on fine-tuning to “teach” the model certain tasks such as text summarization, proofreading etc. Instead of producing different models with different expertise objectives, Apple relied on adapters which basically gave the foundation model specialization capabilities.

Apple then compressed the model (16-bit per parameter down to 4-bit) with on-device being the goal.

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Neil Cybart 12/18/19 Neil Cybart 12/18/19

Apple's $500 Billion Year on Wall Street

Since the start of 2019, Apple’s market capitalization has increased by $500 billion or roughly the equivalent of Facebook’s market cap. For the first time with Tim Cook as CEO, Apple shares are trading at a premium to the overall market. Something has clearly changed when it comes to the way Wall Street is treating AAPL. However, the items that analysts, pundits, and the media positioned as catalysts for this dramatic change (Apple Services, iPhone sales rebound, 5G, improving U.S. / China trade sentiment) likely have little to nothing to do with Apple’s share price outperformance in 2019. Instead, changing behavior as it relates to passive versus active investing may be creating a type of perfect storm for AAPL shares.

Outperformance

It’s difficult to put a $500 billion market capitalization increase in context. Here are a few attempts:

Disney ($262B), Netflix ($146B), and three Spotifys ($78B) combined.
AT&T ($282B), Comcast ($196B), and a Spotify ($26B) combined.
Nearly two ExxonMobils ($588B).
Three Boeings ($558B).
Six Goldman Sachs ($498B).
Sixteen percent of the entire energy sector.
The market caps of the bottom 12% of the companies in the S&P 500 (60 companies in total).

When looking back over the past ten years of stock price performance, 2019 is on track to be the best one for Apple this decade (barring a stock market implosion in the next two weeks). Apple shares are up a whooping 77% in 2019. Comparing the S&P 500’s performance with that of AAPL, we reach Apple’s outperformance / underperformance relative to the broader market:

2010: 40%
2011: 26%
2012: 19%
2013: -22%
2014: 29%
2015: -2%
2016: 3%
2017: 29%
2018: 1%
2019: 50%

Apple shares have outperformed the market by 50% in 2019. For a company of Apple’s size, such outperformance is noteworthy.

Valuation

On a forward P/E multiple basis, Apple shares now trade at a 20% premium to the S&P 500. My preferred valuation metric for Apple is free cash flow yield, or the amount of free cash flow relative to enterprise value. Free cash flow is the amount of cash left over after management has paid all of the bills and maintained / funded capital investments. Enterprise value is market capitalization minus net cash (debt - cash).

In FY2019, Apple reported $58 billion of free cash flow. Apple is a free cash flow machine given its capex light business model. (More information on Apple’s free cash flow advantage is found in the Above Avalon daily update from March 13th available here.) While Apple’s free cash flow will fluctuate given the various moving parts, the combination of a stabilizing iPhone business and no major change in capex spending supports the idea of similar levels of free cash flow over the next 12 to 24 months. Accordingly, we can use $60 billion of free cash flow and Apple’s current enterprise value of $1.1 trillion. Apple is currently trading at a 5.2% free cash flow yield. The higher the yield, the lower the stock valuation.

One way of interpreting a 5.2% free cash flow yield is to compare it to other instruments such as government bonds and high-yield corporates. With those yields closer to 2.5%, a 5.2% yield suggests that Apple is still fairly attractive from a free cash flow yield basis. However, the days of Apple trading like a steel mill with just a few years left of operations are in the rear-view mirror. As recently as 2016, Apple was trading at a 17% free cash flow yield. For discussion purposes, AAPL would need to trade at $100 per share for free cash flow yield to once again be at a 17% yield.

What’s Driving AAPL?

Longtime Above Avalon readers and listeners will be familiar with my consistent stance on how to determine what is behind a stock price’s move. Unless every market participant is interviewed, we are unable to know the exact reason why a stock price behaves the way it does. Given the sheer difficulty found with such an exercise, the task of determining specific reasons behind a stock price move is ultimately a fool’s errand. The activity is nothing more than an attempt to add manufactured clarity to what is ultimately a lot of unknown. It is humans’ discomfort with the unknown that plays a role in the financial press’ never-ending quest to come up with exact reasons behind stock price moves.

When it comes to Apple, the list of “reasons” that analysts and reporters claim are behind the stock’s 77% move in 2019 continues to grow:

A stabilizing iPhone business.
Stronger services growth.
Apple management successfully navigating a tumultuous geopolitical landscape in both the U.S. and China.
Wearables momentum.
Continued ecosystem momentum with ongoing growth in terms of new users and the number of devices.

There is a rather glaring problem found with the preceding list of factors: None are significant enough on their own to justify a $500 billion increase in market capitalization.

Using a conservative measure as to what the iPhone business was previously valued at, Apple’s market cap increase would represent the iPhone business seeing its valuation double in just 11 months. That is unrealistic for a mature business like the iPhone. Expectations would have had to move from Wall Street thinking the iPhone was dead with just a few years of sales remaining (which was never the case) to the business demonstrating some kind of free cash flow bonanza (also not the case).

As for the idea that Services is somehow behind Apple’s spectacular rise, I’m skeptical. The problem with that theory is that there continues to be a lack of consensus as to what that narrative may even be. Apple isn’t becoming a services company, and there remains quite a bit of hesitation around that idea in terms of buy-side investors.

My suspicion is that Apple’s stock price run isn’t driven by any single business-related item. The move is simply too large. Instead, a $500 billion market capitalization increase points to a wide variety of investors wanting greater Apple exposure. This increased interest results in higher stock prices since a stock price is nothing more than the spot where demand for shares equals the supply of those shares.

Why do these investors want more Apple exposure? Instead of looking at Apple’s business for potential answers, we have to look at the multifaceted dynamic found with passive versus active investing.

Passive investing (index funds) are on the rise as investors are becoming increasingly disenchanted with mutual funds and active funds charging for underperforming the market. As more funds are poured into passive investment vehicles, all of the Wall Street giants (Apple, Microsoft, Amazon, Alphabet) benefit. By accounting for 4% of the S&P 500, 4% of every dollar put in an S&P 500 index fund is allocated to Apple. While this mechanism doesn’t necessarily lead to Apple’s share of the overall market increasing over time, it can lead to sustained demand for shares regardless of business fundamentals. This is key as active investors, and their constantly swinging perspectives on stocks, lose power to sway stock prices. While passive investing on its own doesn’t explain a $500 billion increase in Apple market cap in 2019, it likely is a contributing factor to what may be happening.

In a scenario where active investors (hedge funds, mutual funds, pension funds, etc.) were running with historically low exposure to Apple for whatever reason, a scenario in which Apple began to materially outperform the market would place pressure on these active investors given how they are often graded against a market benchmark. Given how Apple represents 4.3% of the overall S&P 500, a 77% move in the stock will likely make or break an active investor’s year depending on whether or not they own the stock.

The most likely explanation for Apple’s run up - however simplistic it may sound - is that active investors have been desperately trying to increase their exposure. The stronger demand for shares leads to higher stock prices in order for demand to match supply.

A crucial piece of evidence for my theory is found with Microsoft. The company is up 52% in 2019 with market cap gains of approximately $400 billion. We know Microsoft shares aren’t up that much because of iPhone sales. Instead, Microsoft is likely experiencing the same situation as Apple. Having shares of the two largest companies go up by 77% and 52% respectively means that active investors need to be overly exposed to these companies or risk underperforming benchmarks. For those active investors late to the party, the need for exposure only intensifies. Some may call this situation FOMO (fear of missing out). Others may call this forced buying - the opposite of forced selling.

Warren Buffett

Warren Buffett ends up being a symbol of this development. Back in 2016, Buffett began building his Apple stake after one of his portfolio managers introduced him to the idea. Buffett has been uncharacteristically quiet about his Apple investment. However, the past few Berkshire annual reports provide enough clues to suggest he is ultimately attracted by Apple’s robust free cash flow and balance sheet strategy in which free cash flow is poured into share buyback and dividends. Buffett took advantage of active investors shunning Apple to increase his own exposure. Buffett’s Apple stake is now worth $70 billion, marking an unrealized profit of approximately $34 billion (not including dividends).

During the period when Buffett was acquiring his Apple stake, the two largest Apple buyers in the market were Apple (via stock buyback) and Buffett. In some quarters, the buying from Apple and Buffett alone totaled as much as 10% of shares traded. That is astounding. As Apple and Buffett were buying shares, many other market observers remained on the sidelines for likely a variety of reasons (unease surrounding Apple’s business model, Apple’s exposure to China, and the list goes on).

What Next?

As for how this situation will end, no one knows. If someone proclaims to know, caution is needed. We can have much more confidence in saying that valuations will matter, eventually. It is also safe to assume that passive investment momentum will continue, which will likely only exacerbate current trends (both to the upside and downside).

Listen to the corresponding Above Avalon podcast episode for this article here.

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