Episode 10 | Apple Under the Microscope: Innovation, Management, and Valuation

In Episode 10 of "Market News with Rodney Lake," Rodney Lake, the Director of the GW Investment Institute, examines Apple’s current performance and prospects. He discusses the company’s innovation in chip design and its AI challenges, commends Tim Cook’s management while noting succession planning concerns, and evaluates Apple's strong balance sheet and high valuation. Professor Lake emphasizes the need to reassess Apple's investment potential and future growth, offering insights into its strategic position and financial health. Tune in for a concise analysis of Apple's strengths and areas to watch.

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to Market News with Rodney Lake. This is episode ten. I'm your host, Rodney Lake. Let's get started today. What are we going to talk about?

We're going to talk about Apple. I'm sure you probably heard about this company. It's the second largest holding at the GW Investment Institute, and I thought it was a good time to start talking about Apple, because somebody that you might know, Warren Buffett sold a 50 plus percent stake from Berkshire Hathaway in Apple. Should we be concerned? So maybe time to revisit and certainly our students in the fall semester, we're going to be asking them to look at Apple and really understand what's going on.

But let's do a little bit of an overview today using our framework business management price valuation and balance sheet. So let's start talking about Apple. So let's kick it off the business of Apple. What is it. I think most of you probably know a big part of it which is the phone. Many of you probably have an iPhone right.

And so that is a critical part of their business. And that is a platform for so many other things. There's a billion phones installed throughout the world. So that's a really big platform for them to push other products on. And we'll talk a little bit about that. But that's sort of the basis of what they're doing. But they have other services.

They certainly have the Mac, which is a very popular laptop, and other, you know, iPads and wearables and other things. And so those are all important parts of the business. But really, the iPhone is the centerpiece of the business, and all of those things sort of are in orbit around that business. So first, let's maybe think about, you know, what are some of the reasons why Berkshire might sell such a big stake?

Well, it's an enormous stake in their portfolio in any case. And maybe they thought, okay, it's time to take some profits around that. And Buffett has mentioned something about that before that with, you know, tax rates possibly going up, that maybe it's time to take some profits around that. Maybe that's not the only reason. Maybe they're concerned about the business.

Certainly the outlook for Apple's business doesn't look quite as rosy as it has in the past. And maybe Buffett is concerned about that. Maybe he thinks the valuations are a little too high. Well, we'll talk a little bit about that. And maybe he just wants to redirect some of that cash and put it somewhere else where he thinks that the return on invested capital, despite the big taxable gain on that position, is worth it.

So we don't know that Buffett doesn't talk about that. But what we can see is December 23rd filing and the June 24th filing for Berkshire Hathaway. Is that app the reduction in Apple is approximately 55% at Berkshire. Now, it still remains their largest equity position, so it's still a very important position. They certainly didn't sell their entire position.

That would definitely be a different story. But what can we glean from that part? You know, exactly without speaking to Buffett directly? Buffett if you'd like to talk to us, please reach out and talk to us and let us know what you're thinking. Maybe he won't do that. But in any case, let's then go through the framework and see is there something that we can understand?

Maybe this is a good time, because Buffett did such a dramatic move that we should better understand our position in Apple. It's our second largest position. It's one of the first positions. That's actually one of the very first positions that remains in the portfolio for the first fund, the Ramsey Student Investment Fund, back in 2005. Now, if you're playing along at home, if you bought Apple in 2005 for the Ramsey Student Investment Fund, that's over a 100 X return.

Not too bad. So but we own the company today. What does it mean to own the company today. Let's go through it. So let's go first through the business. Well let's look at some of the stats. So if we look at stats and I'm going to refer to my laptop in this episode a little bit different than the past, but changing it up here a little bit for the format.

So revenues. Right. What are the revenues for Apple in this last period. So you're talking about revenues of 385 billion. So that is a significant revenue number. So it's really hard to grow revenue when the revenue is that high. So that's the last 12 months through June, they're filing. So it's very challenging. now they grew that a little bit.

But it's not a dramatic increase year over year. But it is an increase but not a dramatic increase. And many people are expecting that that number will fall. You know, what's the installed base in the U.S.? How quickly are those things turning over? you saw some drop in the demand in China, and people are concerned about okay.

Well, the Chinese government restricting people from using iPhones for official, government business that may be putting a dent in demand there and possibly people switching to other products that are lower costs, in China that are widely available and are probably, you know, in, in some cases comparable with some functionality, but certainly don't have all of the functionality, that an iPhone has.

But people are concerned about that. One of the other growth markets that people talk about is India on the business side. Now, the price points in India typically are much lower than the iPhone. So people are concerned about what is the real growth from India, what can it be. Because the market's a little bit different and the price points are a little bit different India than they certainly are in the US or even in China.

So people have their concerns about that. Now, even with all that said, just the law of large numbers makes it difficult to continue to grow this number when you have a billion phones installed against a seven plus billion dollar, seven plus billion person population, excuse me, in the world. And so how many iPhones is everyone going to have?

Well, you know, some people do have two phones and maybe three sometimes. But really, is that going to grow? So now you talk about the refresh cycle. And I think that's the impetus for, the iPhone 16. And you talk about Apple intelligence. And people were growing concerned that Apple was not moving fast enough in the AI world, the artificial intelligence world.

Now, it looks like they're putting in some of this functionality. They have delayed some of that already. So that already puts some concern. And I don't know if that weighed on, Buffett's outlook of how AI is factoring into that equation, but it looks like compared to others, you could pick Microsoft as an example that Apple is possibly falling behind.

Now you'd have to tease out what exactly do you mean when you say it is falling behind? Is Microsoft really getting revenue generation from their AI products? You know, is the integrated features that Microsoft has pulled in from the open AI world, like Copilot, making a difference? I think it's a little bit difficult to tell at this point, but there are strong arguments that they really don't have that functionality at Apple.

They're not building it in-house. And that's why they did this partnership with OpenAI as well. And they said they're going to open their platform for others. And so why didn't they build that in-house? They seemed like they could have those experts on the software side. Why don't they have that? That's also a concern that other people are saying in the market.

Well, Apple is falling behind. So is that something that we should be worried about? What's the future outlook and how can they integrate that? And if they don't really own that technology, how are they going to monetize that? Who is going to control the economics? If you're vertically integrated, you control all of the economics. If you're partnering with others, you're going to have to share those economics.

And who's really going to be the owner of those and who's going to dictate the terms of those? Is OpenAI going to do that? And by the way, Microsoft owns 49% of OpenAI. So they're controlling some of those economics. And so Microsoft ends up benefiting from this partnership. And others might want to compete in that market as well.

And possibly if you fast forward, you could think about, well, if they still control the billion-plus space of phones, installed base, they control that piece and it's harder for people to infringe on that. And so they're going to continue to extract the economics associated with their users being loyal users. Well, that might happen. But if the functionality doesn't come through or if it's different from what other people experience, and it's much better than on the other phones, let's say an Android phone, you might actually have people switch, which really then puts a dent in Apple's economics or their ability to extract economics from their environment because people maybe aren't as loyal and

they certainly then don't have that pricing power. So when we talk about the business, it's a fantastic business. Again, you have a very loyal customer base, and it is an enviable position for really anyone. But it does look like the innovation curve has slowed down. And Apple it looks like they're having trouble with the AI piece.

And so should we be concerned? Well, it looks like now I think it is time for us to monitor. It is time for us to really think about and ask our students this fall semester as we start the semester off to say, we want you to look at Apple. We want you to really think about Apple's future.

And do you think they're being innovative enough? Some counter-arguments might be the M-series of chips that they developed. They brought that in-house, not the fabrication but the design of those chips. And so they got rid of Intel and they put their own chips in. And now those Macs are leading in the market as far as functionality as far as battery life.

And they have the iOS system, which, by the way, evaded this security problem with CrowdStrike, which happened recently, which is another portfolio holding for us. Oh, maybe we should be really concerned about that one. But the Apple OS system skipped all of that. So that's a security benefit. So Apple is still innovating in the chip space.

And they're a leader in that chip space even with the M-series chips. And you would give them great credit for being on the edge, for that tech and for being more vertically integrated by taking out Intel and putting their own chips in for very powerful Macs, which historically had to use Intel chips, at least for the past several years before that.

And so you got to give Apple credit there. That would be a counter-argument that they're still leading in some areas that are hard to do. Chip design is something hard to do. And they're leading in that area and they've made big strides in that area with performance and battery life in particular on those laptops.

They're market leaders in that area. You're having other companies come in now to try to do this. Snapdragon would be a competitor trying to get into the Windows business with an ARM chip as an example. Those are ARM chips, just to be clear. And so Apple has been innovative on that platform with those ARM chips and with that design, and that would be an argument that innovation is alive and well at Apple.

And we shouldn't be quite as concerned. But I do think we should be really watching how this AI market is moving and how we're thinking about Apple with respect to how innovative they're being around that. Another argument to that would be that Apple tends not to be first; they were not the first with a phone, but they were first to really design a phone that people really wanted to use.

So in 2007, when they launched the iPhone, it wasn't the first smartphone, not even close, but it was the first smartphone that people really wanted to use. It was designed in a way that had the operating system built in. And so I think we also have to now pay close attention. I don't think that we should be panicking about the business.

Even if Buffett is selling half of his stake, what should we do with our stake? I think it is time to watch. But there are good arguments for Apple losing its edge, and there are good arguments for Apple having an edge and continuing to follow the same playbook that it has in the past, which is not being the leader but being a strong second and third, doing it better than everybody else. That is the reputation for Apple in the innovation space. And so are they going to continue to do that? We'll see. But I think it is time to pay close attention. The business remains very strong. So if you look at the revenue, again, you're talking about huge numbers.

And if you're looking at free cash flow in the last 12 months, you're talking about $100 billion. This puts them in a class really by themselves with very few companies producing that level of income. And if you look at the gross margins for Apple, 46%, this is a fabulous business. So this would be, when we're talking about rating the business, you're talking about an eight, nine type of business with gross margins at 46%, net margins at 26%, and generating $100 billion of free cash flow.

That's a fabulous business if you can own it. Now, what we're concerned about on the business side now is what's the path forward, where is the growth going to come from? Where is the innovation that we're expecting from this tech giant? And those are the things around the business. Now we may come back to the business now and again through the next segments here, but let's move on to the management.

There's not as much to talk about on the management side here. Good or bad? Mostly good. The mostly good is Tim Cook continues to deliver. We gave you the stats for the business, and it's really running this business well. Are we thinking that Tim Cook has a good successor? That might be the concern we really have about the management.

He's been doing a fabulous job running Apple and the management team that he has built around him for years now since Steve Jobs passed away. People were concerned when Steve Jobs passed away, wondering if Tim Cook was up to the job and if Apple would ever be the same. Well, it turns out Tim Cook was fantastic. He turned Apple into a printing press.

It has made more money than ever. Again, $100 billion in free cash flow now, and still generating 26% net margins on the business. So should we be concerned about that? I think it's another thing that we need to watch, and we need to have a good idea about how long Tim Cook might stay in that seat.

This is his management team that he's built up around him. I think it's not a concern, but it's something that we also need to watch and something that we're going to encourage our students to think about and have a view on what the succession looks like. Now, when we move over to the valuation side, you know, lots of the companies that are in the Magnificent Seven and generally in the tech sector have valuations that are extended.

So when we talk about Apple, what we're looking at is a forward price-to-earnings ratio of about 33 times. Well, that's not cheap. Historically, Apple is going to pull up historic PE for Apple over time. One second. The historical valuation is on the higher end for Apple. So if you're looking at it over time, this is going to be a peak period where you might think Apple is over its skis at 33 times forward. Historically, you're looking at a much lower number.

When Buffett started buying this in 2016, it was probably at 15 times or 20 times. But we really have to think about where the growth is coming from. So going back to the business, if we had concerns about that, then on the growth side, we probably should be concerned about the valuation at 33 times.

Maybe it should trade closer to 25 times. And, all else equal, that's going to come directly out of the valuation. There are two ways to value a stock: earnings growth and multiple expansion. If you do the opposite of that, if you have earnings that shrink or stay flat, you can have the multiple contract when people think it’s not going to grow into those numbers.

And so I think that's something that we should absolutely be concerned about over time. Again, this valuation doesn’t look extreme. You wouldn’t say that you’re really concerned about this over time. If you look at the median, it’s about 21 times. And so 33 is higher than that for sure.

But if Apple continues to be innovative and it continues to have this installed base, possibly it deserves this multiple. Part of that is also when you really start to describe the business, a higher portion of the sales are coming from higher-margin businesses like services than ever before. And so that continues to grow.

That mix continues to grow. So you also have to think about the mix of the businesses, and the higher-margin businesses are more recent for Apple. So that ten-year average I’m talking about at 21 times, well, we really have to deconstruct that and think about those things. And again, that’s something that we’re going to be asking our students to do.

Maybe we should really be thinking about the margin that they should have now, given the mix of businesses. And does this deserve the current valuation? That's what we should be thinking about today and forward. None of the other stuff that's happened in the past really matters.

But it's instructive to think about where Apple has come from and how the market has viewed it. But really, we have to think about today. We have to think about tomorrow. We have to think about the future. That's what matters. That's how the price gets set. So you're always thinking about what the PE is moving forward. Now that's the valuation.

So another thing I think we're going to have to check out. This is all starting to add up that our students really have some work to do this fall semester on Apple. Again, it’s the second largest holding at the GW Investment Institute. I would say it's not a huge concern, but it is time for us to really evaluate this, really re-underwrite Apple, and make sure that we're comfortable with this stake in Apple.

Now that's part of the framework is the balance sheet for this. We get to sleep at night because Apple has $150 billion in cash. That's a net cash position of about $50 billion because they do have debt on the balance sheet, but a net of about $100 billion. So you're talking about $50 billion in net cash.

And so that helps you sleep at night. Apple pays a dividend, not a huge dividend, but it does, and it's been growing that dividend. It's been buying a lot of shares back. We can get into that in another episode when we talk about share buybacks. But Apple has been really responsible with the balance sheet. It continues to generate a ton of cash.

As we mentioned, $100 billion in cash. It has $50 billion in cash on the balance sheet. So that's going to help you sleep at night on the balance sheet. Zero concern. If we're rating that from 1 to 10, that is a ten. No concern at all. It's not something that we should be overly concerned about. We have to watch that.

It doesn't seem like they'll get irresponsible on issuing more debt, certainly ahead of their cash position anytime soon. And they haven't indicated anything that has been out in the markets or released. The management has really talked about it. But it's something that we should monitor, not something that we should be concerned about. So let's go through the whole thing now.

So we talk about the business. There are some great bright spots for the business. They continue to change the mix to have higher-margin businesses. That is on the services side. They continue to have a dominant platform with great pricing power and great brand loyalty. That is a positive. They continue to innovate in hard spaces like chip design and using ARM chips, replacing Intel chips.

That is a big asset. Now, some of the countervailing forces: people are concerned that they're behind in the AI race. We need to watch that. People are concerned that they're not going to grow in these markets like China and India. Something to be concerned about. And now you have Buffett selling approximately half of his stake in Apple.

Maybe he knows something that we don't. Maybe it's something to be concerned about. So on the business, it's a mix. There are some really good positives. They continue to be bright spots for Apple and make us really optimistic about Apple in the future. And then there are other things that we really have to work through and understand and make sure that we're comfortable with. We have a call on it; it doesn’t mean maybe we'll sell all of our stake if we get really concerned about some of these things, but maybe it means we need to trim. Who knows? Time will tell.

We have to figure that out. On the management side, it’s another thing where we need to monitor. Tim Cook has done a fabulous job. I would rate him really highly as well. You're talking 8, 9, to 10 for Tim Cook's management team, depending on how you would score it. But that is a fantastic management team that he has around him, and he has done a fabulous job.

The question really is around succession: how long is he going to stay at Apple, and who do we think might be able to take over and do exactly the same type of job, or even better than Tim Cook has done? That's something that we have to think about, and our students will really need to focus on. On the valuation side, that's another thing where it looks like historically Apple looks a little bit expensive on the PE multiple at 33 times forward versus a 21 to 10-year average.

Is that something we need to look at the mix of those businesses? Does it deserve that? Is the growth really going to be there? Can they sustain these net margins and gross margins that we mentioned? That's something that we'll have to think about. And then you get to the balance sheet. The balance sheet is 8, 9, or 10—something that we're not worried about really at all.

Something to monitor, but $50 billion in cash will help us sleep really well at night knowing that Apple has all that cash. So that’s the summary right now. I think that puts us in a place where we really need to look at Apple. Our students are going to have some work to do this fall semester to re-underwrite Apple.

Again, it’s the second-largest position at the GW Investment Institute. I want to say thanks to the Duquès family for this great studio. It's really wonderful to be in here. Make sure you know that this is not investment advice. As a disclaimer, we're talking about Apple in this case for educational purposes and for our portfolios at the Investment Institute.

I want to invite you to subscribe and make sure that you tune in for the next episode of Market News with Rodney Lee. See you next time.

Disclaimer: The content shared in the GW Investment Institute podcast is for informational and educational purposes only and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest and do not necessarily reflect the views of the GW Investment Institute or the George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor.

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