The Henry Fund Henry B. Tippie School of Management Jon Kerr

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1 The Henry Fund Henry B. Tippie School of Management Jon Kerr Apple Inc. (AAPL) November 8, 2015 Consumer Goods Electronic Equipment Stock Rating Buy Investment Thesis Target Price $145 - $155 Apple has always been known as an innovative company giving customers the best possible user experience. The company has built a product ecosystem integrating their products into all aspects of people lives. The Apple brand image allows the company to charge premium prices for each of their products. The premium prices create high margins and high profits for the company. Recent enhancements to existing products and new product releases in new markets will generate continued growth. Increased investment in research and development will drive innovation into the future. Apple s brand image and continued innovation has Apple positioned well for future success. Drivers of Thesis Apple has created a premium brand image and product ecosystem that is difficult for competitors to duplicate. The product ecosystem gives Apple a competitive advantage in every market they compete in and will continue to drive company growth in the future. The iphone is positioned as the premium brand of smartphone in a mature but still growing industry. Continued growth is expected driven by Asian countries such as China and India with relatively low smartphone penetration. Apple has released the Apple Watch, which enters them into the booming wearables market. This could be a huge revenue source in a market that is expected to grow 28.1% per year into Risks to Thesis Apple is highly dependent on the iphone product line, which consistently accounts for more than 50% of profits. Apple competes in competitive and fast-paced industries. If consumers begin to treat the markets Apple competes is as commodity markets, Apple will have a difficult time charging premium prices and maintaining high margins. Earnings Estimates Year E 2017E 2018E EPS $5.72 $6.49 $9.28 $9.70 $10.33 $11.02 Growth % 13.54% 42.95% 4.51% 6.54% 6.68% 25% 20% 15% 10% 5% 0% -5% -10% Source: Yahoo Finance Henry Fund DCF $ Henry Fund DDM $ Relative P/E Multiple $ Price Data Current Price $ wk Range $ $ Consensus 1yr Target $ Key Statistics Market Cap (B) $674.9 Shares Outstanding (B) 5.58 Institutional Ownership 60.20% Five Year Beta 1.09 Dividend Yield 1.84% Est. 5yr Growth 15.34% Price/Earnings (TTM) Price/Sales (TTM) 2.87 Debt/Equity 54.0% Profitability Operating Margin 30.48% Net Profit Margin 22.85% Return on Assets (TTM) 20.84% Return on Equity (TTM) 46.25% Month Performance Company Description AAPL S&P 500 N D J F M A M J J A S O AAPL Industry Sector Apple designs and manufacturers numerous electronic devices including mobile phones, personal computers, watches, portable digital music players, and other media devices, as well as software and services. The cornerstone of the company is the iphone product line, but other important product lines include the ipad, Mac, and itunes. The company sells these products worldwide to individual consumers and in the enterprise and education markets. 5.2 P/E ROE Profit Margin Source: Yahoo Finance Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY Apple Inc. is a leader in consumer electronics, designing and manufacturing mobile phones, tablets, personal computers, and other devices. They continue to be at the forefront of innovation in each of the markets they compete in by investing in strategic research and development. Apple has always been known for the superior user experience with each of their products. The company has built the Apple brand as a top-of-the-line brand and therefore can demand premium prices for their products. Apple has been able to generate consistent profits in fastpaced and evolving industries. This is due to the Apple ecosystem the company has created. The core product of Apple is the iphone. However, consumers get more and more benefits from other Apple devices and services when used along side the iphone. The true value Apple gives consumers is the Apple ecosystem amongst all its products. COMPANY DESCRIPTION Apple, headquarted in Cupertino, California, was founded in 1976 as a computer company. With the release of the ipod in 2001, the company began to transform itself to a mobile device company, integrating its products into everyday life. The company now designs and manufacturers numerous electronic devices including mobile phones, personal computers, watches, portable digital music players, and other media devices. Through the transformation, the company has created an ecosystem of innovative products, most notably the iphone and the ipad. These two products account for nearly three-fourths of the company s revenue. Revenue Types FY 2015 % Revenue per Segment The mature but growing smartphone market will continue to be Apple s main source of revenue. The iphone is expected to account for 66% of the company s total revenue in Due to the increased adoption of smartphones, industry wide units sales are expected to increase at 8.2% 4-year CAGR. (2) This increased adoption along with the company s new iphone installment plan, we forecast iphone unit sales to grow at a 3.5% CAGR into 2020 slightly decreasing their current global market share of approximately 16%. 4% 9% 11% 10% 66% iphone ipad Mac itunes, Sogware and Services Accessories Apple s mature products will continue to grow into the future but the new products and services such as the Apple Watch and Apple Music will drive the incremental revenue growth for the entire company going forward. The Apple Watch enters the company into the Wearable s market, which is expected to increase at a 28.1% 4-year CAGR. Apple Music gives the company a solution for consumers following the trend of switching from downloaded music to streaming music. The iphone, ipad, and Mac are proven, premium products. These products are the base of Apples revenue which we have modeled to increase at a 3.8% CAGR into The new products and services, along with consistent innovation, will drive Apples success in the future and therefore, we recommend a buy rating. Source: Apple K (1) Apple s main revenue generator is the iphone, which is the company s line of smartphones that combines a phone, music player, internet device, camera, and a voice activated intelligent assistant into one product. In 2015, iphone sales were $155.0 billion, which accounted for 66.3% of revenue. (1) The number of iphones sold in 2015 was million units, a 36.8% increase from We expect the number of units to increase at a 5-year CAGR of 3.5% to million units in However, due increasing pricing pressure from growing competition, we believe Apple will begin to decrease the average price from $671 in 2015 to $630 in While unit sales are forecast to grow at a 3.5% CAGR, we forecast iphone revenues to only grow at 2.2% a CAGR into Page 2

3 Apple also has a line of multi-purpose tablets called the ipad. The ipad generated $23.2 billion in 2015, 9.9% of the company s revenue. The ipad was released in 2010 and had seen tremendous growth until 2014 when unit shipments dropped from 71 million to 68 million with ipad revenues decreasing 5.3%. Apple is still the global leader in the tablet market, maintaining the highest market share of tablet shipments for all tablet manufacturers. However, due to the increasing number of players in this market, Apple s market share has decreased from 61.5% in Q to 24.5% in Q (3) No one company has been the main catalyst for Apple s decreased market share; it has been numerous companies that have chipped away at their market dominance. We expect revenue from the tablet to reverse the decreasing trend in 2016 and have a slight increase in revenue of 2%. Overall, we forecast the ipad revenues to increase at a 5.9% CAGR from 2015 to Mac is the company s line of laptop computer and desktop computers. Mac computers contributed $25.5 billion to the company s revenue in 2015, 10.9% of total sales. Mac sales have been fairly steady for the company since 2008 with revenues and number of units shipped increasing each year except in We expect sales to increase 3% to $26.2 billion in We expect Mac sales to grow at a constant 3% into The company also generates revenue through the sale of digital media via online stores as well as through licensing and other services. The itunes, Software and Services segment accounted for 8.5% of revenue in In June of 2015, Apple announced that since the launch of the itunes store, 100 billion apps had been downloaded from its App Store and 25 billion songs have been sold in itunes. The App Store and itunes will continue to maintain revenue for the segment. Growth in this segment will come from new initiatives Apple has released such Apple Music and Apple Pay. We expect 8% growth for this segment in 2016, with a 5-year CAGR of 5.8% into Apple s Accessories segment includes the Apple TV, the Apple Watch, Beats Audio headphones, and Applebranded third-party accessories for the iphone, ipad, Mac, and ipod. This product category accounted for only 4.3% in We expect large growth in the segment with the release of the Apple Watch driving the majority of the growth in Apple also recently released the generation 4 Apple TV that will boost revenues in 2016 and beyond. We forecast 40% growth in this segment in We expect revenues for the Accessories segment Page 3 to increase at a 17.4% CAGR into 2020 and become 8.0% of total revenue. Segment Revenue Growth 2015 Revenue 2016 Revenue 2015 % Total Revenue 2016 % Total Revenue Rev. Growth Rate iphone $155,041 $159, % 65.1% 3.0% ipad $23,227 $23, % 9.7% 2.0% Mac $25,471 $26, % 10.7% 3.0% itunes, Software and Services $19,909 $21, % 8.8% 8.0% Accessories $10,067 $14, % 5.7% 40.0% Total Revenue $233,715 $245, % 100.0% 4.9% Source: Apple K (1) Geographic Diversification Apple generates revenue through six different operating segments. The segments are broken down into regions based on the nature and location of its customers. 22% FY 2015 Regional Sales 7% 6% 25% 40% Americas Greater China Europe Japan Rest of APAC Source: Apple K (1) The Americas segment is the highest revenue segment and includes both North and South America. Europe includes the European countries, India, the Middle East, and Africa. Greater China includes China, Hong Kong, and Taiwan. The Rest of Asia Pacific includes Asian countries and Australia. All of the company s operating segments had increased revenues in The greatest growth came from the Greater China region. In 2015, the Greater China region has revenue growth of 84%. In contrast, the Americas only had growth of 17%. In 2015, China is expected to have a smartphone penetration among all mobile phone

4 users of 45% (excluding Hong Kong), compared to penetration rates of 81% in the US and 80% in the UK. (4) We believe the Greater China segment will continue to generate a larger percentage of revenue for the company as the release of the iphone 6, with a larger screen, will continue to drive demand in this region. Since Apple has 60% of revenue in foreign sales, currency exchange rates have a major impact on company profits. Apple CFO Luca Maestri said in the 2014 earnings calls, We prefer to adjust local pricing at the time of new product launches. So if currency fluctuates after a product has been launched, Apple would rather have reduced revenue and margins than reduced unit sales due to higher prices. Maestri did say the company has currency hedges and as their current hedging contracts expire, the company will entire into new hedging contracts at current levels. Maestri also stated that revenue growth in Q would have been 4% higher had currency not affected results. (5) RECENT DEVELOPMENTS In late 2014, Apple released their largest iphone yet, the iphone 6 and iphone 6 plus. The phone added addition functionality to previous models but biggest difference was the screen size, which increased to 4.7 and 5.5 responding to consumer demand for larger screens. On September 9, 2015, Apple had its new product release event. The company released a new iphone 6s and 6s Plus with some enhanced features but the iphone product line is already seeing tremendous growth. We do not expect the new phones to significantly increase that growth. Apple also released a 12.9 ipad Pro to target the enterprise market. An updated Apple TV was unveiled as Apple attempts to become an integral part of consumers living rooms. Apple has expanded its product ecosystem in The biggest move from the company was the release of the Apple Watch to take advantage of the booming wearable s industry. As well, using their 2014 Beats Audio acquisition, the company has started competing in the streaming audio market with Apple Music. Q4 and FY 2015 Earnings On October 27, 2015, Apple announced their most successful year ever with revenue growing 28% to nearly $234 billion. The company had quarterly revenue of $51.5 billion and quarterly net profit of $11.1 billion, an increase of 21.4% and 30.6% from Q4 2014, respectively. Gross margin increased to 39.9% in the quarter compared to 38.0% a year ago. For the quarter, the earnings per diluted share were $1.96, an increase of 38.0% from the corresponding quarter a year ago. The growth was attributed to record sales of iphone and Mac products, as well as expanded availability of the Apple Watch. (6) Apple is expecting 2016 Q1 revenue to be between $75.5 billion and $77.5 billion, a slight increase from 2015 Q1 revenues of $74.6 billion. They expect to maintain their current gross margin between 39% and 40% and have operating expenses of $6.35 billion. We have modeled 2016 revenue to be $245.2 billion with net income of $52.7 billion, growth of 4.9% and -1.3%, respectively. We expect net income to decline slightly due to an increase in operating expenses. Apple Watch Shipments During the 3 rd quarter of 2015, Apple began shipping the Apple Watch. The Apple Watch will provide large growth in revenue in the accessories segment of the company. As well, the watch will help drive revenues of other Apple products and help enhance the Apple ecosystem of products. The Apple Watch allows the company to enter a previously untapped and growing wearables market and compete against the Samsung Gear, Pebble Steel, Sony SmartWatch, and others. The number of devices sold in the smart wearable market is expected to grow at a 28.1% CAGR into 2019 and reach 89.4 million units. (7) Analysts estimate that apple sold 3.6 million units in the quarter. This equates to approximately $1.6 billion in revenue. After selling the watch in a test market of 100 stores, Best Buy has announced they will begin selling the device in all 1,050 of its stores because of the better than expected demand. An issue of the Apple Watch is that it has limited functionality when not paired with a cell phone. Therefore the Apple Watch is a phone accessory and is only compatible with the iphone 5 and newer. This compatibility issue limits the customer base of the Apple Watch. Since 2012, the iphone has averaged approximately 16% market share of new smartphone shipments. Therefore the watch is limited to only 16% of the smartphone market size. (8) Page 4

5 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Global Smartphone Operabng System Market Share held by Apple ios 23.0% Q1 ' % Q2 ' % Q3 ' % Q4 ' % Q1 ' % Q2 '13 Source: IDC (8) Even with the limited market, we expect total revenues for the watch in 2015 to be $3 billion with that number growing to $6 billion in We expect Apple Watch revenues to reach $14 billion in With an average price of $450 for an Apple Watch, this would equate to 31.2 million units sold in 2020, approximately 11% of iphone unit sales. We feel our estimation of Apple Watch sales are reasonable as a Credit Suisse survey of iphone 6/6Plus owners indicates that 18% of the respondents would definitely buy the watch. (9) 12.8% Q3 ' % Q4 ' % Q1 ' % Q2 ' % Q3 ' % Q4 '14 iphone 6/6+ Users Who Will Buy an Apple Watch 18.2% Q1 ' % Q2 '15 Apple Music In July of 2014, Apple acquired Beats Music for $3 billion. Along with the entering the company in new markets with the Beats headphones, this acquisition helped Apple create a subscription based streaming audio music service to compete with Pandora and Spotify. The music service, called Apple Music, was launched at the end of June Apple Music differentiates itself from Spotify and other competitors by offering three additional features other than just streaming music. Apple Music has a radio service called Beats 1, which is an around-the-clock global live broadcast from DJs located in Los Angeles, New York, and London. The second feature Apple Music uses to differentiate itself is curated playlists created by real people. The playlists are built for the listener based on the users favorite genres and artists. The last unique feature is Connect. This is a social networking feature, which lets fans follow artists. Apple Music has the potential to cannibalize revenue from Apple s itunes music store, as some customers will no longer buy music through itunes a la carte style. Instead customers may only pay the $9.99 monthly subscription fee for Apple Music and stream their music rather than owning it. This subscription fee is equal to Spotify s Premium subscription of $9.99. Also equivalent to Spotify is Apple Music will allow users to download albums for offline listening. We believe Apple Music will over take the itunes Music Store as the biggest revenue generator in the itunes, Software, and Services segment and we have forecasted revenue for the segment to grow at a 5.8% CAGR into Definitely Not 18% Probably Not 27% Yes, Definitely 18% Maybe 27% Yes, Probably 11% Source: Credit Suisse (9) Apple Pay On October 20, 2014, Apple released Apple Pay. This is a mobile payments service which is designed to allow users to make payments for good and services in retail stores using an iphone 6, iphone 6 Plus, or Apple Watch. For security, Apple uses tokenization, which prevents actual credit card numbers from being sent over the air. Apple Pay aims at replacing the wallet. Apple CEO Tim Cook has said that Apple Pay will forever change the way all of us buy things. (10) Apple Pay has seen some early success with a growing list of partners. On July 7, Apple added 23 more U.S. banks and credit unions, which brings the total to 461 Apple Pay partners in the United States and 9 in the UK. (11) Page 5

6 Apple generates money from Apple Pay by charging fees when consumers use the service in place of credit and debit card for purchases. Apple Pay does offer a benefit to both the transaction partner and the user. Apple pay offers an extra layer of security with a Touch ID fingerprint feature. This feature delivers proof that both the mobile device and the authorized cardholder are physically present in the store. However, we do not believe Apple Pay will make a significant addition to company revenue. Apple collects $0.15 on a $100 transaction. It is estimated that this fee will earn $118 million in revenue in 2015 and $310 million in 2016, only about a tenth of a percent of revenue. (12) We believe the purpose of Apple Pay is to help sell hardware and not generate revenue from transaction fees. Apple Pay is one more way the company can integrate its product offerings into everyday life, making consumers dependent on the iphone thereby making it difficult for consumers to exit the Apple ecosystem. iphone Installment Plans On September 9, 2015, Apple announced a payment plan for iphones in response to carriers no longer giving phone subsides. Customers can buy an unlocked iphone and pay for the device over a 24-month time frame. The customer has the option to trade in their current iphone for a new iphone at the end of 12 months, as long as they sign on for another 24-month agreement. Apple is catering to the consumers who prefer the newest model available but at the same time refurbishing and reselling the recently traded-in phone. For the consumer, a benefit of purchasing the phone using Apple s installment plan is that the phone is unlocked and can be used with any carrier without the need to sign a contract. For Apple, one benefit of the new payment plan could be that it shortens the upgrade cycle for the iphone. As well, it helps Apple keep customers in the Apple ecosystem. Customers who purchase phones through carriers can upgrade to any manufacturer s phone, but Apple customers only have the option of upgrading to another iphone. We believe the new iphone installment plan will increase customer upgrade cycles, thereby increasing iphone sales. INDUSTRY TRENDS The electronics industries that Apple competes in are fast paced and extremely competitive. Mobile devices including smartphones and smart wearables are seeing growth and increased penetration. The mobile phone market is by far the most important in the industry because of the volume of shipments and revenue. Smartphone Growth Worldwide Mobile Phone Shipments Source: S&P NetAdvantage (13) The smartphone industry has experienced a large amount of growth in recent years. In 2014, smartphone shipments grew 27.6% from the previous year. However, growth of shipments in the industry is expected to slow to an 11.3% increase in Even with slowing growth, global shipments are expected to reach 1.9 billion by 2019, an 8.2% 4-year CAGR. (2) The growth is being caused by the increased adoption of smartphones among mobile phone users. Smartphones are expected to account for 80% of mobile phone shipments in 2018 with Asia and other emerging markets being the largest contributors to the growth. (13) Tablet Sales Shipments in million units Projected Global Tablet Shipments * 2016* 2017* 2018* Source: Statista (14) Page 6

7 The tablet market had seen tremendous growth with worldwide shipments increasing from 19 million units in 2010 to almost 220 million units in However, the year-over-year growth rate slowed to 4.4% in 2014, compared to 100.7% and 53.3% growth in 2012 and 2013, respectively. The preference of consumers towards smartphones with larger screens is having a negative impact on tablet sales. IDC expects Tablet sales to continue to be slow in 2015 with shipments of 248 million units, an increase of 8%. By 2018, worldwide shipments are expected to reach 286 million units, a 4-year CAGR of 5.6%. (14) Mobile Phone Installment Purchase Plans As of August 13, 2015, new Verizon customers will have to provide their own phone or buy one under an installment plan. T-Mobile started this trend in 2013 and all four major cell phone providers are following suit. In the past, a consumer who signed up for a two-year contract could also purchase a new smartphone for a subsidized price typically around $199. Apple iphone, Samsung Galaxy or other devices retail for up to $700. The pricing model for the service provider s monthly fee had the cost of the phone built into it and the consumer would eventually pay for the remaining cost of the phone. However, the full price of the phone was usually unknown to the consumer. Without the subsidies, the full cost of the phone is more visible to consumer and price-sensitive consumers could change their buying habits. In Q the average Apple iphone cost was $687 while Android devices had an average price of $254. (15) This now visible price disparity could shift consumers away from the more expensive iphone. PC Sales The introduction of the tablet and large screen smartphones has had an adverse affect on PC and laptop sales, which have been declining since According to IDC, Q PC shipments for the top 5 vendors decreased 11.8% over the past year. Apple is the only company in the group to have a year-over-year increase in PC shipments with growth of 16.1% in Q IDC is forecasting overall PC shipments to remain steady in the near future with growth of zero to -3%. (16) Millions of units Global Desktop and Laptop Shipments Music Downloads vs Streaming * 2016* 2019* Source: Statista (17) In 1999, when the online music sharing service Napster was launched, consumers of the music industry shifted how they acquired their music from purchasing a physical product with recorded music to downloading songs and albums through the internet. A new transition is happening in the music industry with consumers changing how they access music. Rather than owning music by purchasing and downloading songs, customers are renting their music through ad-supported and subscription based streaming music services. In 2007, 3% of the music industry revenues were attributed to streaming music services. In 2014, that number had risen to 21% of total revenues. (18) According to PricewaterhouseCoopers, revenue from digital music streaming is expected to grow to $2.76 billion in 2018, a 13.4% CAGR. While digital music downloading revenue will grow at a rate of only 3.3%. (19) The number of users streaming music is expected to increase from million in 2015 to million in 2020, a CAGR of 5.4%. While the number of users downloading music is expected to decrease from 65.6 million in 2015 to 63.8 million in (20) Page 7

8 MARKETS AND COMPETITION The markets that Apple competes in are characterized by constant innovation and short product life cycles. Due to these characteristics, products eventually face maturity and obsolescence. Smartphone Market The smartphone market is a massive and fast paced market with products constantly being updated and enhanced due to quickly evolving technologies. Product lifecycles are short in the industry with the major manufactures releasing new generations of products every year or two. Also, consumers usually have the opportunity to upgrade their existing phone to the next generation every couple of years when their contract with a service provider expires. Smartphone Market Share Samsung Apple Huawi Xiaomi Lenevo Others 2015Q2 21.4% 13.9% 8.7% 5.6% 4.7% 45.7% 2014Q2 24.8% 11.6% 6.7% 4.6% 8.0% 44.3% 2013Q2 31.9% 12.9% 4.3% 1.7% 5.7% 43.6% 2012Q2 32.2% 16.6% 4.1% 1.0% 5.9% 40.2% Source: IDC (21) The top five companies in the industry by market share are Samsung, Apple, Huawei, Xiaomi, and Lenovo. Samsung is the market leader retaining 21.4% market share in Q2 of However, the smartphone market is a competitive market with 45.7% of the market being served by companies outside the top five in the industry. (21) While all the companies compete on market share, Apple dominates the market in terms industry profits. In the first quarter of 2015, Apple recorded 92% of the total operating income from the industries top eight smartphone manufacturer s, up from 65% in Q Together, Apple and Samsung account for more than 100% of industry profits as other manufacturer s lost money in the quarter. (22) Source: WJS (22) Most companies within the market compete based on price and features, except for Apple who is able to charge a premium for the iphone. While other companies are decreasing smartphone sales prices, Apple is increasing. In FY2014 the average cost of the iphone was $603. In FY2015, that number increased to $671. The price of the iphone is expected to fall but only to $635 by Android, which has a much lower average price due to the wide range of high and low-end phones, is expected to have a similar trend dropping from $254 in 2014 to $214 in (23) These declining prices could indicate that the market has become commoditized and cost will become the main driver for market share as handsets begin to contain identical features. Even with falling average prices, growth is still available especially outside the US and Europe in countries with low smartphone penetration. We expect iphone unit sales to be million in 2016 with that number increasing to million in 2020, a 3.5% CAGR. Tablet Market The tablet market is very similar to the smartphone market. Companies compete in the market with features and price. The life expectancy of tablets is slightly longer than smartphones due to less usage, which leads to less damage. In 2015, the lifespan of a tablet is expected to be 26 months, compared to an 18-month life for smartphones in the US. Even with longer life cycles, Page 8

9 products are constantly being updated and enhanced due to quickly evolving technologies. Top Five Tablet Vendors Market Share 2Q15 Unit Shipments 2Q15 Market Share 2Q14 Unit Shipments 2Q14 Market Share Y-o-Y Growth Apple % % -17.9% Samsung % % -12.0% Lenovo % % 6.8% Huawei % % 103.6% LG Electronics % % 246.4% Others % % -9.3% Source: IDC (24) The top five companies in the industry are Apple, Samsung, Lenovo, LG and Huawei. Four of the top five companies in the industry are the same leaders in the smartphone industry, with the exception of LG replacing Xiaomi. Apple is the market leader with 24.5% market share in Q2 of However, Apple s market share has decreased from 61.5% in Q2 of Much like the smartphone market, the tablet market is a competitive market with 45.6% of the market being served by companies outside the top five in the industry. (24) During 2011 to 2013 there was steady growth in the tablet market. However, there was a market slow down in 2014 as smartphones screens have become larger. Millions of units Global Tablet Shipment Forecast Source: IDC (25) There are still growth opportunities in the tablet industry. Manufacturers are beginning to target the enterprise market to attempt to replace PCs. Apple just released their new 12.9 ipad Pro to compete with Microsoft s * 2016* * * 2019* Surface Pro 3 tablet. The new ipad was designed specifically with businesses in mind. Apple added a standalone keyboard to make this Apple s first 2-in-1. While only a small percentage of the overall tablet market, 2-in-1 s are expected to have a 5-year CAGR of 57% while traditional tablets will have a 5-year CAGR of 2%. We believe Apple will continue to lose market share but sales will begin to increase in 2016 due to the new ipad Pro. Overall we believe ipad revenues will have a 5.94% CAGR from 2015 to 2020, maintaining approximately 11% of total company value. Wearable Market Smart wearable technology refers to any electronic device, which can be worn by a person to integrate computing into daily activities. This can include devices such as eyewear, wrist wear, and foot wear. Companies compete in this industry with features and smartphone compatibility. Many wearable devices must be paired with a smartphone to take advantage of all the features of the device. The Samsung watch can only be paired with phones running the Android operating system. The Apple Watch can only be paired with an iphone 5 or newer. The market is in its early stage of development but is expected to hit an inflection point in 2015 driven by the Apple Watch. In 2014, approximately 4.2 million smart watches were sold. During 2015, Apple alone shipped almost 7 million Apple watches. (34) The total smart wearable s market is expected to increase from 4.2 million units shipped in 2014 to 33.1 million units in 2015, an increase of 688%. Shipments are expected to reach 89.4 million units in 2019, a 28.1% 4-year CAGR. (7) Unit Shipments in Millions Unit Shipment forecast basic/ smart wearables worldwide Basic Wearables Smart Wearables Source: IDC (7) Page 9

10 PC Market The PC market is a very mature market and is on the decline mainly due to businesses extending their upgrade cycles. Life spans of PCs are increasing because the pace of change has slowed. The technology of computer hardware has outpaced the technology of computer software, which has extended the life of PCs. According to Daniel Research Group, the average lifespan of a desktop PC in 2012 was 3.97 years. The lifespan has increased to 4.6 years in Another reason for the decline in PC sales is consumers have been replacing PCs with tablets. In Q2 2015, shipments fell to 66.1 million units, an 11.8% year-over-year decline. The decline of PC shipments should slow with the total volume shipped forecast to be million in 2015, declining slightly to million in (26) PCs are becoming commodities as the feature set becomes more and more common among competing companies. Companies in the industry are now competing strictly on price. In 2009, the average selling price of a desktop PC was $605. In 2015, the price is expected to be $379. (28) The top 5 companies in the PC market are Lenovo, HP, Dell, Apple and Acer Group. Lenovo is the market leader with 20.3% market share in Q Other companies outside the top five hold 32.3% of the market. (27) Worldwide PC Shipments 2Q Q15 Shipments 2Q15 Market Share 2Q14 Shipments 2Q14 Market Share Y-o-Y Growth Lenovo 13, % 14, % -7.5% HP 12, % 13, % -10.4% Dell 9, % 10, % -8.7% Apple 5, % 4, % 16.1% Acer 4, % 5, % -26.9% ASUS 4, % 4, % -7.7% Others 17, % 21, % -19.7% Source: BGR (27) Apple was the only manufacturer to see year-over-year growth in the PC market. Apple saw a 16.1% increase in shipments in Q and increased its market share from 5.9% to 7.8%. Apple also does not compete on price within the industry. In 2014, the average price for a Mac was $1,274, much higher than the average desktop PC of $379. We believe the growth of the Mac computer is from the entire Apple ecosystem. Apple has an extremely large customer following with more than 800 million iphone s sold since it was first released in (1) The iphone has given the Apple experience to millions of customers. We believe these customers are continuing with the Apple experience by switching to a Mac when it is time to upgrade their PC. We expect Mac unit sales to be 21.5 million units in We then expect Mac unit sales to increase at a 4.5% CAGR into Peer Comparison Apple competes in multiple markets of the technology hardware industry. Apple competes in mature markets with its top revenue generating products. Therefore our peer analysis is focused on profitability metrics. Samsung is Apple s largest competitor in both the smartphone and tablet market. In Samsung s last fiscal year, they had sales of $195.9 Billion USD while apple had sales of $233.7 Billion. HP and Lenovo have the largest market share in the PC market and these companies had revenue s of $111.5 Billion and $46.3 Billion in A metric that stands out among the rest is the Net Profit Margin. The only market that Apple is the market leader in is the tablet market. Yet, they have a net profit margin that dwarfs all of their competing companies. Apple s net profit margin percentage is 22.9%, compared to 13.1% for Microsoft, second among the peer group. Samsung, Apples most formidable competitor, has a profit margin of 11.2%. The difference in net profit margin percentage is due to the brand image Apple has built which has allowed them to charge a premium for all of their products. This brand image is what sets Apple apart from their competitors. Sales (B) Net Profit Margin % ROA % ROE % P/E (ntm) Debt/ Equity Samsung HP Microsoft LG Lenovo Blackberry Apple Source: FactSet Not surprisingly, Apple s ROA and ROE are nearly double the next closest competitor in the group. Apple has an ROA of 20.8% and an ROE of 46.3% while Samsung has an Page 10

11 ROA and ROE of 10.4% and 15.1%, respectively. Lenovo has an ROA and ROE of 3.7% and 23.4%, respectively. Due to short product life cycles and constant threat of product obsolescence, companies competing in the technology sector must have high research and development costs. Samsung had R&D expenses of $13.8 Billion compared to Apple s $8.1 Billion in Billions USD $16.0 $14.0 $12.0 $10.0 $8.0 $6.0 $4.0 $2.0 $0.0 $ R&D Expenses 7.3% $ % $ % $ % $ % $ % 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Normalised (Normal = 100) Unite States Consumer Opinion Survey: Confidence Indicators Jan-10 1-Jun-10 1-Nov-10 1-Apr-11 1-Sep-11 1-Feb-12 1-Jul-12 1-Dec-12 1-May-13 1-Oct-13 1-Mar-14 1-Aug-14 1-Jan-15 Source: FRED (29) Many of the products that Apple produces are discretionary goods, such as smartphones, tablets, PC, and digital music downloads. When consumer spending is down, sales for these products will also be down. Personal Consumption Expenditures have followed the consumer confidence indicator as expenditures have been on the rise since 2009 and have maintained approximately 3% growth per year. R&D Expenses R&D % of Sales Source: FactSet These companies often compete against Apple, but they also sell a much wider range of products and services. Apple is only focused on innovating a small core group of products, which share much of the same hardware and many of the same features. Apple is therefore able to keep R&D expenditures low while these other companies must spread R&D expenses over a large set of products. ECONOMIC OUTLOOK While the ipad and MAC are becoming more and more popular in the business world, the majority of Apple s revenues are from sales to consumers. Therefore, a good indication of sales for Apple in the United States is consumer confidence. Consumer confidence is a strong indicator of consumer spending. Since the recession in 2008, consumer confidence has been steadily increasing. We believe consumer confidence will remain neutral for the next six months and begin to increase over the next few years. Percent Change from Year Ago Personal Consumpbon Expenditure - Percent Change from Year Ago Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Source: FRED (30) GDP is another driver that can give a good indication of future Apple sales. We expect Real GDP growth to be at 2.7% for the next 6 months before increasing to approximately 3% in the next two years. Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Page 11

12 One factor that affects consumer spending is the unemployment rate. Unemployed people are trying to stretch their financial assets for a longer duration due to the uncertainty of the end of their unemployment. This leads to a reduction in consumer spending due to financial limitations. We expect the unemployment rate to maintain a level around 5.1% in the next 6 months, which should keep consumer spending from decreasing. Percent Source: FRED (31) Exchange rates are a driver for companies competing in the technology industry. In 2014, Apple generated 62% of its revenue from international sales. As such, currency movements could have a large effect on sales and profits for Apple. In the graph below, the US dollar has been getting stronger in recent months. We expect exchange rates to maintain their current levels for the next couple years. (Index Jan 1997=100) Unemployment Rate: All Persons Aged 15-64: U.S Trade Weighted US Dollar Broad Index Source: FRED (32) iphone CATALYSTS FOR GROWTH Apple recently released the iphone 6s and 6s Plus. The most significant difference between the 6s and the 6 is the 3D touch technology that allows the 6s iphones to sense different pressures. The new phone have received great reviews from the public. The new iphone release and the recently announced installment plan could drive further growth in the iphone product line. The iphone product line accounted for more than twothirds of the company s revenue in The iphone will continue to be Apple s largest source of revenue. Because of the dependency on the iphone, the company must continue to make improvements to the phone while creating growth by innovating in other markets. Apple Watch The Apple Watch is a product that could provide the company with growth into the future. The Apple Watch competes in the wearable s market, which is a new market for the company. The wearable s market space is expected to see tremendous growth in the next few years. Apple Music Apple Music is not necessarily operating in a new market for Apple, but it is a new product offering that allows the company to compete in a different way in the digital media market space. Apple Music positions the company to serve the growing number of consumers who are switching from downloading their music to streaming it. This service gives the company another revenue source in a market they already have a significant presence in. Apple TV Apple recently released the upgraded Apple TV. Apple TV allows a user to watch Netflix and similar services as well as stream live TV channels, such as ESPN, if the user has a TV service provider login. In 2014, Apple sold almost 6 million units and that number is expected to reach 10 million in With the release of new Apple TV, shipments are expected to increase to 24 million. (33) The new version of Apple TV allows users to play games and is Apples first attempt to enter into the online gaming market. The most significant upgrade to the device has yet to be released. Apple plans to release a streaming TV Page 12

13 service that would bundle multiple television channels for a price around $40 per month, which would compete with cable television providers as well as DishNetwork and DirecTV. This service is expected to be released in 2016 and could be a significant revenue source as consumers are continuing to leave cable and satellite TV services for internet streaming services. INVESTMENT POSITIVES Apple has a competitive advantage in every market they compete in because of the product ecosystem they have created. The iphone is the core of the company. The integration of the iphone and Apple s other products and accessories is what creates value for users and is difficult for competitors to duplicate. Apple holds only 16% of market share in the smartphone industry but 92% of the industry profits. Apple has positioned the iphone as the premium brand of smartphone in a mature but still growing industry. Apple has a strong balance sheet which would all them to survive a downturn in the market. While the company did have a current ratio of only 1.17 in 2015, they do have $185 billion is cash offshore. Apple could easily become liquid and survive short-term issues even with having to pay a 35% tax on repatriated funds. The itunes, Software and Services segment has an estimated 90% gross margin. Apple music targets a growing segment of consumers streaming music rather than downloading it. The high margins along with continued growth of itunes and Apple Music adoption will drive profits in this segment. With the addition of the Apple Watch and Apple TV to the Accessories segment, Apple now has entry into growing markets with potential to generate significant revenue. INVESTMENT NEGATIVES Smartphones are becoming a commodity. Competitors quickly adopt features that distinguish any phone from another. Because of this commoditization, iphone margins could begin to decrease, as Apple would need to reduce the selling price to gain new customers. Apple is becoming extremely dependent on the iphone product line for revenue. Two-thirds of the total companies revenue came from the iphone in New products will need to generate a large amount of revenue to counteract any decrease in iphone sales. VALUATION We used a Discounted Cash Flow (DCF), Dividend Discount Model (DDM), and Relative Price to Earnings (P/E) analysis to value Apple Inc. The DCF and DDM models computed stock prices of $ and $ For the relative P/E analysis we calculated a price based on peers and another price based on industry leaders. These two approaches computed stock prices of $ and $180.68, respectively. We believe the true value of Apple stock is in between at $145 and $155. Apple has only been paying dividends since 2012 when they had a payout ratio of 5.9%. In 2013, the company increased that ratio to 28.5%, however, the dividend payment growth has been inconsistent. The company stated in their K that they expect dividends to continue at current levels or grow. We have modeled a constant payout ratio of 22.0% based on the quarterly dividends throughout 2015, but we do not have a lot of historical data to confidently make an assumption for the dividend growth. While the DDM model, does give us a relatively close price to our range, we do not put much weight on it. The Peer Comparison relative P/E analysis model computed a low price of $ Apple currently has a forward P/E ratio of 13.0 and the peer average forward P/E ratio is Because of Apple s premium brand status, we believe the company should not trade at a discount to its peers. The Brand Leaders relative P/E analysis model computed a relatively high price of $ The average P/E of the brand leaders was This peer relative P/E price is within our price range. A P/E of around 15.9 is justifiable for Apple because of the company s large cash balance and premium brands. The DCF model computed a price of $ This price is the basis for our price range. Our model was built assuming many different revenue growth rates for each area of business. The iphone product segment is the largest revenue generator for the company and we forecasted unit sales to grow at a 3.5% CAGR into However, we forecasted decreasing margins for the iphone due to pricing pressures from lower cost smartphones and therefore modeled revenue to grow slower than units sales a 2.2% CAGR for the next five years. Page 13

14 The next largest segment is the Mac computer, accounting for 11% of revenue in The PC market has been in decline since We expect the industry to have roughly zero growth into However, we believe the Mac will continue to steal market share from competitors and have modeled revenues to grow at a 3.0% CAGR for the next five years. The ipad line of tablets is the third largest segment for Apple, accounting for 9.9% of revenue in We expect revenues to begin to pick back up in 2016 as Apple targets the enterprise sector with the new ipad Pro. We expect revenues for the ipad to grow at a 5.9% CAGR for the next 5 years and accounting for 11.0% of revenue in Since 2009, the itunes, Software and Service segment has grown at 21% CAGR. With the addition of Apple Music, we expect this segment to continue to grow however we do not believe the segment will keep the same pace of growth it has had the last 6 years. We modeled revenues to grow at a 5.8% five-year CAGR. Most of the new growth for the company will come from the Accessories segment. The new Apple Watch and Apple TV will drive the growth for this segment. We have modeled revenues for this segment to increase at a 17.4% CAGR for the next 5 years. In 2015, the Accessories segment accounted for only 4.3% of total revenue, we expect this segment to increase to 8.0% of total revenue by Overall, we have modeled total company revenue to grow at a 3.84% CAGR for the next 5 years. For the last five years, Apple s gross margins have ranged from 37.6% to 43.9%. In 2015, the gross margin was 40.1%. The total gross margin is most affected by the iphone gross margin, which accounts for 66% of revenue. The iphone gross margin was approximately 47% in We expect company gross margins to decline slightly to 39% in 2016 as the iphone will face increased pricing pressure and the average sale price for an iphone will decrease from $671 in 2015 to $645 in We expect company gross margin to decrease to 37.5% in 2020 as the average cost of an iphone drops to $630 and iphone gross margins drop to 43.5%. In Apple s 2015 annual report, they state that R&D is critical to the survival of the company. From 2008 to 2014, the R&D expenses averaged 2.7% of revenue. However in 2015, Apple had a record R&D investment of $8.0 billion, or 3.45% of revenue. This R&D expense as a Page 14 percent of revenue is low when compared to peers. Samsung, Apple s biggest rival in the smartphone market, has an R&D expense as a percent of revenue of 7.3%. We expect Apple to continue increase their level of R&D. We have modeled the R&D expense to be 3.9% in 2016 and 4.2% into We have also modeled SG&A expenses to begin to increase to 2011 levels, accounting for 7.5% of revenue in With the increase in operating expenses and decrease in gross margins, we have modeled Apple s operating income to decrease from 30.5% in 2015 to 28.9% in 2016 before declining to 25.8% in Operabng Profit ($ Billion) Operabng Profits Op Profit Op Margin % 38% 36% 34% 32% 30% 28% 26% 24% 22% 20% Source: Apple 10-K In the third quarter of 2015, Apple s Board of Directors increased the share repurchase program to $140 billion, which has $36 billion remaining for repurchases. We expect the board to announce another share repurchase program and average around $30 billion in repurchases each year through With these share repurchases and the dividend payments, we have modeled the total payout ratio to increase slightly in 2016 from 87.4% to 88.4%, with the payout ratio totaling 74.6% in With these payout ratios, the company will have average cash flows of $3.4 billion per year from 2016 to 2020, which is more than the average cash flow per year of $1.97 billion from 2011 to With the release of the Apple Watch and the new Apple TV, as well as the new iphone and ipad releases, we expect inventories to rise slightly in 2016 and into We expect inventories will increase to 2008 levels when the ipod was at its peak. Therefore we have modeled inventories to increase to 1.35% of revenue in 2016 into Operabng Margin %

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