$Apple (AAPL.US)$Recently, facing internal and external problems, abandoning car construction has made the market feel depressed. Demand for the new Vision Pro product has also been drastically slowed, and the mobile phone market share in the Chinese market has also been surpassed by Huawei. At the same time, the outside world is also facing anti-monopoly encirclement by various governments, whether it is the first time the European Union has launched a new digital law investigation against tech giants such as Apple, or the US Department of Justice's recent antitrust lawsuit. Due to a large amount of negative information, Apple's stock price has fallen by more than 11% so far this year, which is the worst performance at the beginning of the year in the past 10 years.

However, Morgan Stanley recently released a research report that continues to be bullish on Apple, reaffirming the “overrated” rating and target price of 220 US dollars. Damo believes that the market has underestimated Apple's Edge AI (Edge AI) plans, and that this year's WWDC conference and the AI-based iPhone upgrade cycle should be enough to offset concerns about second-quarter results and the negative impact of the US Department of Justice's antitrust lawsuit.

According to the research report, since the beginning of the year, Apple's stock price has lagged 18% behind the S&P 500 index. Currently, Apple's trading price is almost 1 standard deviation below its post-pandemic trading range, and the Relative Strength Index (RSI) shows that Apple is at its highest oversold level since 2018.

Damo believes that this has created a positively skewed risk/return. The bearish situation according to the research report has only 9% downside, while the target price of $220 has almost 30% upside. Although the report admits that the reversal of negative sentiment will not happen overnight, the WWDC conference and the new iPhone 16 will be an important catalyst to improve investor sentiment and re-energize gains.

In terms of AI, Apple had a chance to take the lead later

Damo said there is growing evidence that Apple will launch a new general artificial intelligence (Gen AI) function in June, and believes this can reignite iPhone growth in the 2025 fiscal year. Previously, one of the most common bearish opinions among investors was that among large technology companies, Apple is already lagging behind in terms of AI.

However, Damo believes that this view is misleading, and gives two major reasons.

First, unlike most big tech companies, Apple is not committed to developing comprehensive generic large-scale language models (LLM) with huge parameters, but rather focuses on smaller, more domain-specific and function-specific models that can run on devices and enable new features/features not previously available on the iPhone. For example, Siri 2.0 is the flagship “killer app”. Ferrret, MGIE, and MM1, which was newly released on March 14, are examples of this.

However, in order to enable this kind of functionality on the device, Apple needed to combine its software development with a hardware roadmap, specifically its internal chip updates. Damo believes that WWDC in June and the release of iPhone 16 in September will be key catalysts to highlight the capabilities and new features that Apple will bring to iOS 18 and iPhone 16.

Although Apple has been testing internal AI chatbots using its Ajax LLM framework, it has indeed seen the possibility that Apple is using cloud-based external partners to handle queries beyond the scope of its internal model, which means that the generic AI features announced by Apple this year are likely to be a hybrid approach. In this approach, users will mainly utilize LLM on the device and then push queries to the cloud when necessary.

Second, there are many signs that Apple has been and continues to invest in the tools and infrastructure needed to support its LLM ambitions. In addition to reports last summer about Apple's purchase of GPUs, the release of the MLX machine learning framework for developers, and the development of ways to use existing NAND flash memory to support LLM that could not run on devices before, Apple continues to buy tens of thousands of AI servers to establish its internal training capabilities.

Damo previously reported that TSMC found a “significant increase” in its InFO-LSI production capacity demand, mainly from Apple's M2 Ultra chip, which may suggest that Apple is using its internal M-series chips to power its AI servers. In addition, Apple's AI recruitment continues to increase. Damo estimates that nearly 20% of Apple's current recruitment positions are AI-related, compared to only 5% 8 years ago. Of these, 20-40% of Apple's AI jobs are related to natural language processing and deep learning.

Finally, Apple has already acquired 32 AI startups in 2023, the highest number among tech giants, and the recent acquisition of DarwinAI.

Damo said that Apple's Gen AI feature is expected to stimulate a significant increase in iPhone sales. According to estimates, iPhone shipments in China fell by almost 30% in the 2024 fiscal year, and this year's iPhone shipments were weaker than expected. As a result, the iPhone replacement cycle was extended to a record high of FY2024, reaching 5 years.

However, Damo believes that the introduction of new Gen AI features and the chip requirements required to process some functions may limit the compatibility of the new version of iOS with older devices, thereby shortening the iPhone replacement cycle and allowing more users who have been waiting for years to switch to the new phone.

Damo assumes that the iPhone replacement cycle will be shortened to 4.7 years in fiscal year 2025, which means that the iPhone shipped 230 million units, an increase of 11% over the previous year. However, if judged correctly, the software features supported by the new LLM will significantly accelerate the replacement cycle. Assuming that the iPhone replacement cycle is shortened by 0.6 years as the 5G iPhone cycle in FY2021, iPhone shipments in FY2025 are expected to increase by about 15%.

Although pessimists may argue that the continued weakness of the Chinese market may offset these factors, Damo said that the research forecast assumes that Apple will ship 35 million iPhones to China in fiscal year 2024, which is only 5 million units higher than the low in 2019. At that time, Huawei's high-end device shipments were almost double what they sold today, so the impact of the weak Chinese market on Apple is limited.

Will iPhone revenue drop in the second quarter? Oma: Not important

Damo said in the research report that the current market consensus believes that the expected iPhone shipments and revenue are still too high, but this is not important.

Although it can be seen that Wall Street's forecast for iPhone shipments and revenue has room to decline, because the current consensus predicts the iPhone's expected shipment volume of 230 million in fiscal 2024 or 2024, which is 10-15% higher than the 200 million to 210 million shipments expected by Morgan Stanley and buyers. Specifically, Damo's forecast for the second quarter is the lowest. The estimated iPhone shipment volume is 39 million, 15% lower than the agreed 46 million, which is in line with the shipment volume implied by iPhone manufacturing volume.

Meanwhile, Damo estimates iPhone revenue for the second quarter to be US$35.9 billion, which is 8% lower than the agreed US$38.9 billion. Overall, Damo's estimate of Apple's total revenue for the second quarter was 4% lower than the Wall Street consensus, and earnings per share were 8% lower. This is one of the arguments most commonly cited by pessimists — recent estimates are still too high and need to be lowered.

However, Damo pointed out that Apple's service department's performance in the first quarter exceeded expectations, and the overall profit margin may bring positive surprises. Both should help offset the weak revenue in June. According to the data, App Store's net revenue continues to be higher than Damo's expectations for the first quarter. It has increased 13.5% since the quarter, which is 4.5% higher than Damo's forecast. Damo believes this trend is sustainable and will help ease weak product demand in the June quarter.

Furthermore, concerns about falling product gross margins due to rising raw material prices are still widespread, but Apple commented in the financial report that apart from memory accidents, most component costs are still falling, and the gross margin for the first quarter is expected to be 46-47%, setting a company record. In the past 14 consecutive quarters, Apple's gross margin exceeded expectations by an average of about 80 basis points.

Combined with the favorable overall investment cost situation and the strengthening of the US dollar, Damo believes that there is room for growth with 36.0% of Apple's product gross margin and 45.8% of the total gross margin in the second half of the fiscal year. This is important because it not only helps reduce the downside risk of earnings per share in June. Damo's research shows that there is a statistically significant positive correlation between Apple's gross margin and stock price, which makes the trend of Apple's gross margin an important factor in helping reverse recent poor performance.

Antitrust lawsuits? Non-immediate risks

Trump first initiated an antitrust investigation against Apple in 2019. The US Department of Justice recently filed a lawsuit accusing Apple of creating a smartphone monopoly market and suppressing competition/innovation by cutting off developers and creating a closed ecosystem, thereby becoming a monopolist of the smartphone market, claiming that this has harmed developers and consumers.

The Ministry of Justice cites examples of Apple's anti-competitive behavior, including: 1) blocking innovative “superapps” that give consumers a wide range of functions; 2) suppressing mobile cloud streaming services; 3) excluding cross-platform messaging apps; 4) restricting the integration of third-party smartwatches into the Apple ecosystem; and 5) restricting third-party digital wallets.

Damo believes that while the logic behind the lawsuit is understandable, it is very clear that Apple's competitive advantage is the seamless integration of its hardware, software, and services, which has created an unparalleled ecosystem of closed hardware and solutions. Damo said that whether this advantage can be called innovation is still debated, but it is not a monopoly act, and ultimately benefits consumers.

According to the Daimo survey, Apple has always led the customer retention/loyalty rate in the US, which shows that there is a reason why consumers continue to choose iPhones, and the consumer satisfaction rate of iPhones quoted by market research companies reached 99%, which is far from evidence that consumers have been harmed. Although this lawsuit is more complicated than this, Damo believes that the lawsuit is an attempt to demean the motives for most Apple customers to choose Apple, which is a closed, secure, and private ecosystem of hardware and solutions.

According to the research report, history shows that this lawsuit will continue for many years, and Apple has already won an antitrust case. It's unclear what form the lawsuit may result in any changes/restrictions, and whether Apple is willing to settle, whether it's forcing Apple to open up its smartphone ecosystem or trying to force the split of Apple like Microsoft did in 2000. All of this makes it almost impossible to quantify any financial impact of this lawsuit today.

Therefore, Damo believes that this lawsuit can only be described as a headline risk, not a risk of recent events. Past precedents include that the Google antitrust case was filed in 2020 and will be heard in 2023. Remedies and financial impacts may not be seen until the end of 2025 or even 2026; the 2012 Apple e-book pricing case was not completed until 2016. Also, Apple is likely to win because the court ruled in the 2021 Apple versus Epic case that Apple's App Store did not violate antitrust laws.

In other words, the lawsuit had an unresolved impact on stock prices, but the market's memory is short. Damo believes that compared to this lawsuit, fundamentals are more likely to drive Apple's stock price over the next 12 months and years.

Historical data shows that Apple's stock price performed well even at a critical time when lawsuits threatened their core product/differentiated value proposition. Damo believes that regulation/litigation is a greater long-term tail risk for Apple, but in the foreseeable future, the basic drivers of stocks will almost certainly be based on fundamentals. In particular, this lawsuit may not be resolved until at least 2028 or even 2030.

Apple's stock price closed down 0.83% to $170.85 on Monday.

Editor/Somer