David Rolfe's Wedgewood Partners 2nd-Quarter Letter: 'Apple of Our AI' – GuruFocus.com
Top performance contributors for the second quarter include Taiwan Semiconductor Manufacturing (TSM, Financial), Alphabet (GOOG, Financial), Apple (AAPL, Financial), Motorola Solutions (MSI, Financial) and Meta Platforms (META, Financial). Top performance detractors for the second quarter include PayPal (PYPL, Financial), Pool Corp (POOL, Financial), CDW (CDW, Financial), Old Dominion Freight Line (ODFL, Financial) and Visa (V, Financial).
There has been no portfolio activity during the quarter to report.
Taiwan Semiconductor Manufacturing was a top contributor to performance during the quarter. The Company’s revenue growth continued to accelerate due to the rollout of its leading-edge N3 manufacturing node along with strong demand for chips used in artificial intelligence applications. Unlike in traditional CPUs, the Company has blue-chip customers, monopoly market share for manufacturing AI chips, such as GPUs. The Company’s aggressive investment in capital equipment several years ago should continue to pay off as fabless chip designers proliferate and require a manufacturing partner to shoulder capex risk. The Company’s continued aggressive investment and deployment in semiconductor manufacturing equipment is not an easily replicable competitive advantage.
Alphabet was also a top contributor to portfolio performance during the quarter. The Company’s core search business showed a healthy +14% growth, while its cloud infrastructure business grew +28%. The infrastructure business is at a nearly $40 billion revenue per year run-rate; however, we think it underearns compared to its peers as the Company has priced its services to take share from its two larger peers, AWS and Azure. Despite of this competitive stance, Alphabet has a differentiated service offering that it has have developed over the years, particularly related to AI, that should yield better returns as customers look to allocate more of their IT budgets to generative AI.
Apple also contributed to performance after unveiling its AI strategy to its software developers. The Company has been at the forefront of proprietary computer processor development for over a decade. Given the compute-intensive nature of AI applications, Apple is well-situated to develop a suite of compelling, consumer-friendly AI services that are also cost-effective. While revenue growth has been relatively flat post -Covid-19, we expect Apple’s AI value proposition will be compelling enough for consumers to continue growing their engagement in the Apple ecosystem over the next several years.
Motorola Solutions was a contributor to performance as the Company continued its steady execution with +10% sales growth and +20% operating earnings growth. Motorola also continues to grow its backlog due to its competively advantaged core land mobile radio (LMR) business is a critical long-term solution for emergency services around the globe. The technology behind LMR is relatively simple compared to current 5G wireless standards, but it is an extremely robust implementation that must withstand regular and even mega catastrophes to guarantee uptime to the emergency services that depend on it for communications. Motorola has unmatched competitive positioning in this core business and should be able to continue to expand value-added service offerings to LMR and drive attractive long-term growth.
Booking Holdings (BKNG, Financial) contributed to performance as travel spending across the U.S. and Europe remains quite healthy, whereas the Company took share in alternative accommodations, and looks set to expand margins after a few years of reinvestment. The Company has also been aggressively reducing its share count at reasonably attractive valuation multiples. Booking should be able to compound earnings at an attractive, double-digit rate for the next few years given these various initiatives.
PayPal Holdings detracted from portfolio performance during the quarter despite continued solid corporate performance. Revenues grew +10% (FX neutral), while adjusted operating income grew +15%, driven by higher transaction margin dollars and excellent expense discipline. The Company’s core branded payments volume accelerated compared to last quarter and continues to grow in line with e-commerce. PayPal has several investment initiatives that we expect will contribute to accelerating growth over the next few years to help take advantage of their leading market share in e-commerce payments. The Company serves over 35 million online merchants. PayPal’s large, online merchant acceptance base is a rare and crucial component to profitably monetizing payment volumes that many competitors lack. The Company trades at earnings multiples that we think are quite cheap, given its strong positioning in the long-term secular expansion of global e-commerce.
CDW’s gross profit dollar slightly declined compared to last year as small and medium-sized businesses; IT budgets remained languid after a boom during the Covid-19 years. Often, hardware and software cycles help drive small and medium-sized business investment activity. CDW should benefit from a couple larger upcoming cycles, particularly related to the proliferation of AI-enabled edge computing devices as well as the refresh of Covid-19-era hardware. CDW’s core customer typically has very limited IT department staffing and resources, making it difficult for large enterprise-focused IT vendors to reach those customers. As a result, there are plenty of proven technologies that have been adopted by larger businesses, often long ago, that will eventually find their way into small and medium-sized businesses with the help of CDW. CDW is agnostic to the consumption models or form factors of technologies, which is why the Company has been able to maintain superior returns over many different technology cycles and innovation trends. Helping small and medium-sized businesses set up and run their IT departments is more important than any specific technology that happens to enable those departments and should help the Company continue to grow and take share of IT budgets over time.
PoolCorp preannounced second quarter sales that declined -7% due to lower-than-expected activity during the important summer selling season. After a few years of elevated sales driven by Covid-19 dynamics, PoolCorp has gone through a multi-quarter digestion period. The Company continues to maintain market share and excellent returns despite the difficult industry backdrop. PoolCorp differentiates itself by carrying a large array of industry-specific products compared to mass-market retailers that carry more standardized products or smaller industry competitors that have less availability or narrower selections. When financial conditions for consumers eventually ease, we expect PoolCorp will be able to leverage its leadership position, growing above the long-term normalized industry trend, with mid-to-high single digit revenue growth plus double-digit earnings growth from the increased penetration of private-label and supply chain efficiencies.
Old Dominion Freight Line detracted from performance during the quarter. The Company reported a tempered seasonal rebound early in the quarter, consistent with the weaker overall macroeconomic trends seen in the U.S. industrial economy. Despite continued weakness in the industrial economic environment, the Company continues to take pricing, which is a key testament to the high-valued nature of the prompt service they provide to their shipping customers. When the freight cycle gets back to normal, especially after the industry’s digestion of a large, bankrupt competitor, plus a growing list of smaller, debt-ridden trucking companies, Old Dominion should be able to resume its long-term trajectory of operating leverage and volume share gains relative to other modes of shipping.
Visa detracted from performance despite healthy corporate results. The Company grew earnings per share +12% as payment volume growth was up +8% and cross-border payment grew +16%, adjusted for currency. There are over 4.4 billion Visa debit and credit cards in circulation generating over $15 trillion in volume over the past 12 months. There is another estimated $10 trillion in cash and check volume, globally, which we think Visa can continue to move over to its electronic payment rails. In addition, the Company has spent the past several years extending its payment capabilities into new flows of commerce, particularly for business-to-business transactions. This is another, extremely large (+$200 trillion) long-term growth opportunity for Visa that we believe investors are ignoring.
Company Commentaries
Apple
Apple finally announced their AI initiatives at the Company’s Worldwide Developer’s Conference (WWDC) in mid-June. The preceding narrative on the ‘Street was Apple is woefully behind in “AI.” Never mind the fact the Company has been deep into AI for years. For example, two features built into the Apple Watch (fall detection and crash detection) are examples of AI “machine learning.”
Well.
Narratives can change in a heartbeat on Wall Street, and my, have they changed fast as Apple has brilliantly relabeled “artificial intelligence” as “Apple Intelligence.” No slouches these Cupertino folks.
We have owned Apple continuously since late 2005. While Apple is a quite a different company from what it was 18 years ago, in a key aspect, Apple is very much the same company. In preparing to write about Apple for this Letter, we traveled down memory lane to reread our first Letter on Apple way back in early 2006. And what a trip it was.
It would be 12 short months before Steve Jobs would introduce the world-changing, revolutionary iPhone, but in early 2006 the Company’s iPod “ecosystem” and overall company “halo-effect” were in full bloom. So much so, that we wrote back then, “The bottom line: iPod has become to mp3 players what Kleenex has become to tissue paper.”
Torrent iPod growth wasn’t the only story emanating from Cupertino then. Mac growth was up +38% in fiscal 2005. In the Company’s most recent quarter then, Mac shipments grew +48% the second-best quarter of growth on record at that time. Mac was taking swaths of market share. Such market share take would continue in the intervening years as the Company was rapidly transitioning its entire Mac lineup to the prolific Intel microprocessor.
The key competitive advantage of Apple circa-2005 – ecosystem, halo-effect – remains considerably stronger today. Once a new customer enters the Apple ecosystem they stick around for years, buying an ever-growing list of new hardware products and software services.
We wrote the following then:
Fast forward to the past 12 months. The Company reports the following:
So, what is Apple Intelligence? Apple Intelligence is Apple’s use of artificial intelligence (AI), specifically “generative AI,” in which the Company will imbed personalized, user-approved access of their respective data within email, messages and photos, enhanced then with generative AI content, including text, imagery, audio and synthetic data, including the integration of OpenAI’s ChatGPT into the Company’s operating systems – most notably Siri at first – powered by at least the iPhone Pro 15. The soon to be released iOS 18 and macOS Sequoia will leverage Apple AI silicon on-device processing across software products including Mail, Notes, Pages, Safari, Voice Memos and Photos across on-device iPhone, iPad and Mac.
Siri, employing Apple device generative AI small language models, will offer the most comprehensive Apple Intelligence at first, with a deeper dive in time into Apple apps. For example, the Company states, “Siri will be able to deliver intelligence that’s tailored to the user and their on-device information. For example, a user can say, ‘Play that podcast that Jamie recommended,’ and Siri will locate and play the episode, without the user having to remember whether it was mentioned in a text or an email. Or they could ask, ‘When is Mom’s flight landing?’ and Siri will find the flight details and cross-reference them with real-time flight tracking to give an arrival time.”
The rollout for Apple Intelligence will be modest in scale, scope and pace and will be presented first in English. Hardware requirements for AI will require the latest and greatest Apple silicon, plus a heavier dosage of on-device memory. The iPhone upgrade cycle will certainly get an AI upgrade tailwind, but that too will be modest after the usual earlier adopter’s upgrade and first -time buyers to the iPhone. Indeed, Bloomberg reports that Apple plans to ship at least 90 million iPhone 16s in the latter half of this year, +10% above prior launches, as the Company counts on artificial intelligence (Apple Intelligence) services to drive demand.
We expect other collaborations with AI large language modeling tools from Alphabet and Anthropic. Please note, Apple is in the enviable position for consumers to access AI as any number of AI providers would be first in line to collaborate with Apple and its gold mine of soon to be millions of active AI purposed devices – yet another lock in feature of Apple’s ecosystem. Note too that just as Apple partners with Alphabet with Google Search, Apple, at least in its AI early innings, may never need to expend countless billions building its own AI large language models, so it will choose best-in -class partners and others in time in AL. At the end of the day, we expect Apple Intelligence to be an evolutionary rather than a revolutionary feature in terms of enhancing the user experience, allowing Apple users their ability to “step their toes in the water” of the new, uncertain world of Artificial Intelligence.
Future iterations of Apple Intelligence that may surprise could well be centered not on off-device ChatBots, which are large language models, but rather silicon developments within Apple’s “edge” devices (e.g., iPhone, Mac, iPad), in addition to significant silicon developments within Apple Cloud, particularly in the realm of Apple’s obsession with customer security and privacy.
A few years ago, in our fourth quarter 2021 Letter we commented on Apple’s often overlooked semiconductor design superiority, about which we expect to hear much more over the next few years. Given the interplay between semiconductor design and software in AI, we’d like to again share our thoughts on Apple’s silicon prowess:
And from a more recent Letter is the following:
In our last Letter we chronicled the incredible performance of a select number of AI-related technology companies and its outsized impact on market indices. Well, these stocks didn’t skip a beat during the quarter. (As of this writing, the so called Magnificent Seven are up +47 year-to-date, while the rest of the S&P 500 Index is just up +7.5%.) Indeed, some of the “diversified” benchmarks stock weightings have reached absurd levels. Take the Standard & Poor’s 500 Index, by far the money management’s most common benchmark. The S&P 500 Index is currently composed of 503 constituent stocks. As of this writing, the top six stocks make up 31% of the index. If that isn’t extreme enough, consider the Russell 1000 Growth Index. This index is currently made up of 440 stocks. The same top 6 stocks make up 50% of this benchmark!
The raison d’être of our investment philosophy is that to improve the odds of outperforming any benchmark, an active equity manager must build a portfolio that looks different from its respective peers and associated benchmarks – in our case, we are quite different. That’s why we invest in only 20 or so stocks. For example, currently our top four holdings, all technology stocks (Alphabet, Meta Platforms, Taiwan Semiconductor Manufacturing and Apple), make up nearly 32% of our portfolio. We do live (and invest) in interesting times when our focused, 20-stock portfolio is arguably as diversified (if not more) than our benchmarks that carry hundreds of stocks.
According to Bloomberg, there is over $30 trillion invested in passive index related funds and ETFs – and growing by billions per day. They note that the NASDAQ 100 market valuation was just over $12 trillion as recently as the first quarter last year. Fast forward a quick 15 months and that valuation figure has surpassed $24 trillion! The wonderful feature of most indexed funds and ETFs (and most successful investors we follow) is that such vehicles “let their winners run.” Most investors, both professional and lay find this to be quite difficult. As the late, great Charlie Munger has often quipped, “The waiting is the hardest part.” That said, the downfall of indexation is the complete absence of any valuation strictures or discipline. Today, every new dollar allocated to a S&P 500 Index fund; $.31 cents goes into just 6 stocks – regardless of valuation. Passive aggressive, indeed.
In light of the historically concentrated benchmark weightings, it is important to mention that in our technology-related holdings, we are currently only overweight in our Alphabet, Meta Platform and Taiwan Semiconductor Manufacturing holdings. Of significant note, our +8% weighting in Taiwan Semiconductor Manufacturing is rather unique in that this +$980 billion market cap company (and arguably the most critical cog in the global technology sphere) is not represented at all in either of these two benchmarks. Thus, we are beneficiaries of huge active share in a single portfolio holding. However, each of these three holding are approaching our self-imposed maximum weight, so future likely weights will be lower, rather than higher still. Our biggest concerns with the current AI-hype, as it pertains to our few holdings that are spending billions in AI, specifically Alphabet and Meta Platforms, are the current and nearer-term returns such billions in capex are and will generate for shareholders. Bernstein Research illustrates this below on Meta Platforms.
The good news for these two companies is they both have been utilizing AI for some years now with concomitant profitability. The more concerning reality is both companies, plus the entire AI space are spending at levels indicative of an “AI arms race.” At this stage of the AI boom (mania?), woe to the company that chickens-out and isn’t aggressively competing in the trillion-dollar AI spending sprint. As such, the lines between maintenance capex and growth capex have become blurred. We expect much more scrutiny from investors on this conundrum in the quarters and years ahead. This much is certain: The moment any one of the largest data center providers suggest a “pause” in its AI spending to “digest” the many billions already spent, then investors (speculators) will suddenly discover just how cyclical the AI race really is.
Yardeni Research reports the following:
The following is a sober reflection of the AI boom circa-2024 from Sequoia Capital (July 2024):
"What has changed since September 2023?"
“One of the major rebuttals to my last piece was that “GPU CapEx is like building railroads” and eventually the trains will come, as will the destinations – the new agriculture exports, amusement parks, malls, etc. I actually agree with this, but I think it misses a few points:”
“A huge amount of economic value is going to be created by AI. Company builders focused on delivering value to end users will be rewarded handsomely. We are living through what has the potential to be a generation-defining technology wave. Companies like NVIDIA deserve enormous credit for the role they’ve played in enabling this transition and are likely to play a critical role in the ecosystem for a long time to come. Speculative frenzies are part of technology, and so they are not something to be afraid of. Those who remain level-headed through this moment have the chance to build extremely important companies. But we need to make sure not to believe in the delusion that has now spread from Silicon Valley to the rest of the country, and indeed the world. That delusion says that we’re all going to get rich quick, because AGI is coming tomorrow, and we all need to stockpile the only valuable resource, which is GPUs. In reality, the road ahead is going to be a long one. It will have ups and downs. But almost certainly it will be worthwhile.”
Blackstone: On AI:
Indeed, the road ahead, circa-2024, looks quite long as industry adoption of AI thus far doesn’t match much of the Wall Street hype.
The following charts illuminate the continuing, extraordinary dominance of technology stocks. Please note the last two charts. It goes without saying that our new idea buy list is dominated these days by non-tech stocks.
David A. Rolfe, CFA, Chief Investment Officer
Michael X. Quigley, CFA, Senior Portfolio Manager
Christopher T. Jersan, CFA, Portfolio Manager
1 Portfolio contribution calculated gross of fees. Contribution to return calculations are preliminary. The holdings identified do not represent all of the securities purchased, sold, or recommended. Returns are presented net of fees and include the reinvestment of all income. “Net (actual)” returns are calculated using actual management fees and are reduced by all fees and transaction costs incurred. Past performance does not guarantee future results. Additional calculation information is available upon request.
2 https://www.counterpointresearch.com/global-handset-market-operating-profit-q2-2021/
3 https://www.apple.com/newsroom/2005/06/06Apple-to-Use-Intel-Microprocessors-Beginning-in-2006
4 https://bits.blogs.nytimes.com/2008/06/10/apple-in-parallel-turning-the-pc-world-upside-down/
5 https://techcrunch.com/2011/10/09/apple-1000-engineers-chips/
6 Mobile Payment Authentication: Biometrics, Regulation & Market Forecasts 2021-2025
7 From 2014 to 2018, Apple reported more than 250 million total iPhones and iPads per year; In 2020, Apple spent $11 billion at TSMC to procure its custom chips, according to filings, or about $44 per processor.
8 https://www.bloomberg.com/news/articles/2020-12-10/apple-starts-work-on-its-own-cellular-modem-chip-chief-says
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