Growth is accelerating while expenses are as well, says Morgan Stanley's Erik Woodring

Key Concepts

• AI Spending: Apple's increasing investment in artificial intelligence, encompassing infrastructure and headcount.
• iPhone Revenue Acceleration: Double-digit growth in iPhone revenue, with the fastest growth since 2021 in the second half of the year.
• Hybrid Model: Apple's approach to AI development, combining internal building with strategic partnerships.
• Opex vs. COGS: Operating expenses (opex) related to AI infrastructure and training, distinct from cost of goods sold (COGS).
• Services Growth: Consistent and strong annual growth in Apple's services segment.
• China Market Dynamics: Challenges and recovery signs in the Chinese market, influenced by subsidies and new iPhone demand.
• Valuation Argument: Justification for Apple's stock price based on accelerating iPhone growth, increasing services mix, and historical multiples.

AI Spending and Business Model

Morgan Stanley's Eric Woodring highlights Apple's significant increase in operating expenses (opex), projected to grow 18% year-over-year in fiscal year 2026. This accelerated spending is attributed to Apple's entry into the AI spending game, specifically on infrastructure and headcount. Woodring emphasizes that Apple's business model differs from other mega-cap companies, suggesting their AI spending might not be in the same vein.

Hybrid Model for AI Development

Woodring characterizes Apple's approach to AI as a "hybrid model." While Apple is building internal technology, they are also leveraging partnerships. A key example is their lucrative business as a distribution partner for Google Search, which accounts for 15% of Apple's operating income. Woodring suggests that Apple can achieve a high return on investment (ROI) by investing in distributing large language models (LLMs) through a similar partnership model.

Opex as an Indicator of Future Revenue

The transcript points out that spending on infrastructure and opex, as described by Apple, implies that this spending is not yet generating direct revenue. This suggests that Apple is likely training LLMs on third-party cloud services. While this spending indicates future potential, it currently manifests as an expense rather than a direct cost of goods sold.

iPhone Performance and Growth Drivers

iPhone Revenue Acceleration

A key takeaway from the report is the acceleration of iPhone revenue, which experienced double-digit growth in the December quarter. The iPhone is growing at its fastest pace since 2021 in the second half of the year. This growth is a significant factor in the positive trajectory of Apple's stock.

Services Outperformance

Beyond the iPhone, Apple's services segment is also outperforming, growing at 14% annually. This consistent growth in services contributes to the overall positive outlook for the company.

iPhone 17 and Future Innovations

The transcript discusses the iPhone 17's better-than-expected performance, providing confidence in the current cycle. Looking ahead, the potential release of the iPhone 18, featuring Apple's first foldable device, is seen as a major innovation. Despite its anticipated high price, Apple iPhone owners are generally willing to pay for premium features, supported by potential carrier discounts and a three-year advertising cycle. This innovation could drive the next growth cycle.

China Market Dynamics

Challenges and Recovery Signs

The China market remains a difficult environment for Apple. Subsidies are in place to support demand for lower-end phones, but not for higher-end models. While China declined 4% year-over-year in the September quarter, the company anticipates a return to growth in the December quarter. This is attributed to strong early demand for the iPhone 17 in China, though the transcript cautions against over-interpreting this as a full market turnaround.

Valuation and Stock Performance

Addressing Valuation Concerns

The discussion acknowledges that some analysts, like Stephanie Link, might consider Apple's stock expensive, especially given a perceived declining growth rate. However, Woodring presents a valuation argument based on historical data and the increasing contribution of services.

Historical Multiples and Services Mix

Woodring points out that in the 2021 cycle, Apple peaked at 35 times earnings. At that time, services represented 31% of gross profit dollars. Currently, services account for 43% of gross profit dollars. There is a "clear linear correlation" between the services mix of gross profit and the stock's multiple. This suggests that if iPhone growth accelerates and the company achieves two consecutive years of strong growth, the valuation can be supported. The argument is that while not cheap, the stock's multiple can expand if estimates continue to rise.

Conclusion

The transcript suggests a positive outlook for Apple, driven by accelerating iPhone revenue and strong services growth. The company's strategic entry into AI spending, characterized by a hybrid build-and-partner model, indicates a focus on future innovation and high-ROI opportunities. While challenges persist in markets like China, the overall narrative points to a company with multiple avenues for growth, supported by a valuation that can be justified by its increasing services contribution and potential for future product cycles.