AAPL. Apple Inc. Sector: Information Technology BUY. Applied Portfolio Management. Analyst: Samir Hailkal, Michael Stephens

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1 Applied Portfolio Management Analyst: Samir Hailkal, Michael Stephens AAPL Apple Inc. Sector: Information Technology BUY Report Date: 5/12/2014 Market Cap (mm) $519,129 Annual Dividend $ Yr Beta (S&P 500 Index) 0.90 Return on Capital 161.1% Dividend Yield 2.1% Annualized Alpha 6.2% Compared With: EPS (ttm) $40.49 Price/Earnings (ttm) 13.9 Institutional Ownership 5.0% Google Inc. Current Price $ Economic Value Added (ttm) $34,254 Short Interest (% of Shares) 2.6% Oracle Corporation 12 mo. Target Price $ Free Cash Flow Margin 26.1% Days to Cover Short 2.0 and the S&P 500 Index Business Description Apple Inc. and its wholly owned subsidiaries design, manufacture, and market mobile communication and media devices, personal computers, and portable digital music players. It also sells software, services, peripherals, networking solutions, and third party digital content and applications related to its products. The company offers iphone, a line of smartphones that comprise a phone, music player, and Internet device; ipad, a line of multi purpose tablets based on Apple s ios Multi Touch operating system; Mac, a line of desktop and portable personal computers; and ipod, a line of portable digital Investment Thesis After much research, we concluded that the U.S. economy is headed toward a bull phase. This led us to dig deep into the information technology sector, which is underweight in the student portfolio, and find a company with a strong competitive advantage. Apple, with its innovative culture, has shown in our analysis to be an excellent fit. Apple is able to grow EBITDA at a faster rate than total revenue, indicating improving efficiency. With a strong cash position, low leverage, and commitment to dividend growth, Apple is able to create and return value to investors. After conservative forecast assumptions, Apple s intrinsic value modeled to be greater than the current market price based on the PV of future FCF. ANNUALIZED 3 YEAR CAGR Total Revenue 37.9% Free Cash Flow 57.5% EBIT 38.6% Total Invested Capital 25.6% NOPAT 37.6% Total Assets 40.2% Earnings Per Share 37.5% Economic Value Added 38.4% Dividends Per Share N/A Market Value Added 17.2% 60% 50% 40% 30% 20% 10% 0% 10% 20% 35% 30% 25% 20% 15% 10% 5% 0% 5% 10% 15% 300% 250% 200% 150% 100% 50% 0% AAPL GOOG ORCL AAPL ^SPX ROA ROE ROIC Margins and Yields Operating Margin Free Cash Flow Margin Earnings Yield Dividend Yield % 28.2% 31.2% 35.3% 28.7% 20.9% 25.3% 27.8% 26.5% 26.1% 4.4% 4.8% 6.9% 8.4% 7.1% 0.0% 0.0% 0.0% 0.5% 2.0% $60,000 $50,000 $40,000 EBIT Net Operating Profit After Tax Per Share Metrics Earnings Dividends NOPAT Free Cash Flow $30,000 $20,000 $10,000 $0 $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 Economic Value Added Market Valued Added $450,000 $400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $ Price/Earnings Price/Free Cash Flow Datasource: Capital IQ

2 Investment Thesis Apple shows excellent total revenue growth the past 5 years. Apple s EBITDA has grown at a faster rate than total revenue indicating improving efficiency in the company. Apple s profit margins are a substantial percentage of total revenue. Their high gross and operating margins indicate that a greater percentage of revenue is available to flow towards bottom-line profits. Apple s average ROIC for the past 5 years is far greater than the WACC. As one driver of ROIC, Apple plans to continue growing net PPE. Based on our forecast assumptions, Apple s stock is undervalued. 1

3 Economic Outlook The decision to invest into the information technology sector came from research we conducted about the current strength of the U.S economic activity. We analyzed each of The Conference Board s leading, coincidental, and lagging indicators and summarized our findings into a diffusion index for each of the three indicators. The ten leading indicators are expected to change prior to economic conditions. By looking at these indicators, it helped us forecast the future strength and directions of business cycles. The leading indicators diffusion index is shown below: Leading Indicators Score Weight Avg. Length Manufacturing Workweek ISM New Orders Index Consumer Sentiment Int. Rate Spread (10-yr minus Fed Funds) Manufacturers New Orders-Consumers Leading Credit Index Stock Prices, S&P Manufacturers New Orders-Capital Goods Avg. Weekly Initial Unemployment Claims Building Permits, New Private Housing Leading Indicators Diffusion Index 70% 66% Next, we analyzed the coincident indicators. These four indicators are expected to change in sync with economic conditions. We used these indicators to interpret current economic strength and weakness. The coincident indicators diffusion index is shown below: Coincident Indicators Score Weight Manufacturing and Trade Sales Total Nonfarm Payrolls Personal Income Less Transfer Payments Industrial Production Coincident Indicators Diffusion Index 25% 26% The last seven are lagging indicators. They are expected to change after changes in economic conditions. These indicators were used to support our previous analysis about economic conditions. The lagging indicators diffusion index is shown in the next page. 2

4 Lagging Indicators Score Weight Avg. Prime Rate Consumer Credit to Personal Income Consumer Price Index, Services Inventory to Sales, Manufacturing Commercial and Industrial Loans Unit Labor Cost, Manufacturing Avg. Duration of Unemployment Lagging Indicators Diffusion Index 14% 27% After analyzing the result of all three diffusion indexes, we concluded that past and current economic activity has been tepid, as demonstrated by coincident (25% index score) and lagging (14% index score) indicators, but future economic activity is expected to accelerate, as demonstrated by leading indicators (70% index score). The graph below show these results: 70% 60% 50% 40% 30% 20% 10% 0% Lagging Coincident Leading We concluded that the U.S economy will experience expansion in the next six to nine months, and the financial market will initiate a bull phase. This economic analysis leaded us to look into cyclical sectors. The next section of this paper performs an in-depth historical analysis of one of the leading stocks in the information technology sector, Apple Inc. 3

5 Global Positioning Apple has made moves recently to expand in global markets. In recent years, Apple has been able to increase sales dollars from the Americas, but decrease the Americas as a percentage of their global revenue. In 2011, Apple entered the Greater China market which is now nearly 15% of their revenue. The Japan market has been on a great incline over the last few years going from 5% ($5 billion) of Apple s revenue in 2011 to now 8% ($13 billion). Apple currently has retail stores in 18 countries worldwide and plans to continue to expand globally Americas Europe Greater China Japan Rest of Asia Pacific Retail Over the last few years, the iphone has been Apple s majority of product revenue. The iphone doubled in sales dollars from 2011 to The ipod has been declining in sales in recent years due to the fact that most ipod capabilities are available on ipad and iphone. There has been a big increase in itunes in the past few years driven by the success of the Net Sales by Product 2013 iphone itunes Store and App Store. The ipad growth in sales has slowed down mainly due to the competition in the tablet computer market. Apple shows plans to continue releasing and updating the iphone product while entering new product markets. ipad Mac ipod itunes, software, and services Accessories 4

6 Historical Performance Revenue Growth: Historically, Apple has been able to have top of line growth in revenue and net income. Apple is actually able to grow its earnings before interest, taxes, depreciation and amortization (EBITDA) faster than total revenue, which indicates operating efficiency that will lead to expansion of either gross and/or operating margins. The table below shows the compounded annual growth rates (CAGR) of revenue, net income, and EBIT. Net Income EBITDA Total Revenue $180,000 $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 (millions) CAGR s 3-yr 5-yr Total Revenue 37.9% 35.5% EBITDA 42.0% 44.7% Net Income 38.3% 43.4% Profit Margins: Profit margins are expressed as a percentage of total revenue. The graph below compares Apple s historical margins side by side. Apple s high gross and operating margins indicate that a greater percentage of revenue is available to flow toward bottomline profits, then to free cash flow that supports Apple s intrinsic value, and back to Gross Profit Operating Profit Net Profit investors in form of dividends. Although Apple s margins are 50.0% high, the table above shows a 40.0% drop in all margins from 2012 to Our research pointed out 30.0% that the decrease in margins was 20.0% driven by the following factors: 10.0% Introduction of new 0.0% versions of existing products with higher cost structures Shift in sales mix to products with lower margins Introduction of ipad Mini, with gross margin below Apple s product margin Higher expenses associated with products warranty Price reduction of ipad 2 and iphone 4 Unfavorable impact from foreign exchange fluctuations 5

7 Relative Valuation: Apple s relative valuation metrics are calculated in two ways. First, the multiples take the stock s price and divide it by fundamental measures, such as earnings, sales, and free cash flow. Second, the yields, are inverse to the multiples, in this case we divide fundamental measures such as dividend and earnings, to the stock price. Historically, Apple has kept its price to earnings (P/E) ratio within the desired range between 12 and 18. The P/E ratio was high in due to low earnings and an increasing stock price. Price to free cash flow (P/FCF) ratio is correspondent with P/E ratio, meaning that Apple s earnings are backed up by tangible free cash flow. The graph below shows yields moving inversely with multiples. Price/Earnings Price/Free Cash Flow Earnings Yield Dividend Yield % 5.00% % Liquidity & Debt: In this section, we look at Apple s ability to meet its short and long-term obligations. Liquidity and debt play a major role in a company s financial structure and future success. Apple s quick and current ratios, shown below, have stayed well above 1 over the years, showing that Apple meets its short term financial obligations. Prior to 2013, Apple had no outstanding debt. In the third quarter of 2013, Apple issued $17 billion of long-term debt due to the fact that most of Apple s cash is held overseas, and the cost of debt is lower than Apple s corporate taxes. Quick Ratio Current Ratio Long-term Debt to Equity Total Debt to Assets Another reason for Apple s debt issuance is to manage the risk of adverse fluctuations in interest rates associated with the floating rate notes. Apple entered into interest rates swaps for $3 billion, which, in effect, fixed the interest rate of the floating-rate notes. Part of this debt issuance is also to support the accelerated repurchase program, to retire outstanding shares up to 2015, in the value of $60 billion. 15% 10% 5% 0% 6

8 Profitability: The metrics in this section can be measured by the accounting profits generated by Apple relative to capital contributed toward financing the firm by investors. Apple s return on asset (ROA), return on equity (ROE), and return on invested capital (ROIC) as shown below have a positive 5-year CAGR s. However these metrics decreased from 2012 to 2013 due to: Decrease in net income over the same period; Increase in total assets, over the same period due to investments into property, plant & equipment (net PPE); Decrease in net operating profit after taxes (NOPAT). It is relevant to mention Apple s ROIC is over 150%, which plays an important role in value creation which will be presented in the next section % % % % 50.00% 0.00% ROA ROE ROIC NOPAT Total Invested Capital (millions) $50,000 $40,000 $30,000 $20,000 $10,000 $0 Value Creation: EVA is a year-by-year measure of how much economic profit a company has created. EVA is measured as the annual NOPAT Apple has generated minus the cost of capital (in dollars) it has to earn to satisfy the providers of capital. The graph below shows that Apple has grown its EVA each year from 2008 to The decrease from 2012 to 2013 was driven by the decrease in NOPAT (primarily driven by EBIT), and an increase in total invested capital (primarily driven by an increase in net operating working capital and net property plant and equipment). MVA is not a year-byyear number, but instead EVA MVA 50, ,000 40, ,000 measures value creation over the entire lifetime of a 30, ,000 company. MVA is the 20, ,000 ultimate bottom line measure 10, ,000 of value creation for a publicly traded company. 0 MVA is calculated by subtracting the market value of all the Apple s securities by the book value of Apple s securities. 7

9 As of fiscal year end of 2013, Apple had total equity on the balance sheet of $123,549 million. This is all the capital shareholders have contributed to financing Apple s assets over the lifetime of the company, unadjusted for the time value of money. As of end of 2013, Apple had an equity market capitalization of $519,129 million. This means that the stock market valued Apple s shareholders $123,549 million of contributed capital at $519,129 million. Apple therefore has a 2013 MVA of $395,580 million. This is pure value creation. INCOME STATEMENT: Forecast Assumptions Total Revenue: Based on this history, in fiscal year 2014, a growth rate of 10% was chosen for a few reasons; to remain conservative in the modeling, to reflect the news of Apple opening 30 new retail stores worldwide, and to express Apple s commitment to releasing a new product in Revenue growth from 2014 on is then tapered down to a conservative long-term growth of 2.5%, as shown below. Forecasted Revenue Growth 2014E 2015E 2016E 2017E 2018E 10% 8% 6% 4% 2.5%* (millions) $188,001 $203,041 $215,224 $223,832 $229,428 * Growing perpetuity rate Profit Margins: Apple has had a recent history of producing excellent profit margins. As discussed in the historical performance, Apple s margins recently declined a bit from 2012 to 2013 due to multiple factors. Due to these multiple factors and to stress Apple s valuation model, we dropped each of these margins down another 1.7%. Our research has determined that Apple will have a some difficulty in the future, with competitive pricing, keeping their margins at such high levels like Forecasted Profit Margins Gross Margin Operating Margin Net Margin 36% 27% 20% Common Shares Growth: In 2012, the Board of Directors announced a program to repurchase up to $60 billion in shares until This usually happens when management believes that shares are undervalued, thus, by reducing the number of shares outstanding, Apple increases EPS and market value. Apple s common shares growth is forecasted below. Forecasted Common Shares Growth 2014E 2015E 2016E 2017E 2018E -1.2% -1.4% -.8% 0% 0% 8

10 Dividend Growth: Apple started paying dividends in 2012 after Apple s CEO announced a significant increase to its program to return capital back to shareholders. Apple paid a total of $2.5 billion in dividends in 2012, and $10.5 billion in Apple expects to pay quarterly dividends of $3.05 per common share each quarter in 2014, subject to the declaration by the Board of Directors. Apple is forecasted to continue to grow the dividend with a 2014 forecast of 25% growth then tapering down to a long-term growth rate of 3%. Forecasted Dividend Growth 2014E 2015E 2016E 2017E 2018E 25% 15% 10% 8% 3% $14.25 $16.39 $18.03 $19.47 $20.05 BALANCE SHEET: Cash, Receivables, & Inventory: Cash, receivables, and inventory are all drivers of total invested capital. With this in mind, our forecasts for these balance sheet metrics were stressed on our model. Cash is forecasted to increase from 2013 as a percentage of sales to 8.7% in From then on, cash is to remain at a constant 9% of sales. For receivables and inventory, our forecasts have these metrics staying consistent with the past two years for two reasons. First, we forecasted very little dollar growth in order to stress the valuation on Apple. Second, after extensive research, we felt that there was no new information available to forecast these metrics increasing or decreasing. 2014E 2015E 2016E 2017E 2018E Cash 8.3% 8.7% 9.0% 9.0% 9.0% Receivables 12% 12% 12% 12% 12% Inventory 1% 1% 1% 1% 1% Other Asset Forecasts: Total current assets, net PPE, and total assets are forecasted in this section. For total current assets, we forecasted a 45% constant percentage of sales. Total current assets has been increasing the past two years to nearly 43% in Our analysis determined that growth would slow down and remain around 45% in the future. Net PPE has been growing the past few years to 9.7% in Due to Apple s plan to open 30 new stores worldwide, we forecasted net PPE to continue growing to 12% in Based on these assumptions and on recent years, we forecasted total assets to stay at a constant 118% in the future, decreasing slightly from 121% in E 2015E 2016E 2017E 2018E Total Current Assets 45% 45% 45% 45% 45% Net PPE 10% 10.5% 11% 11.5% 12% Total Assets 118% 118% 118% 118% 118% 9

11 Debt & Equity: Payables & accruals and total current liabilities were forecasted to remain consistent with the past few years percentages. Our research did not show any major signs that these numbers would change much from recent years. As mentioned in the historical performance section, Apple first issued debt in 2013 worth $17 billion. Very recently, Apple issued another $12 billion in long-term debt, bringing there total debt to $29 billion. Total debt is forecasted below to decline as a percentage of sales, while keeping the dollar amount at $29 billion. 2014E 2015E 2016E 2017E 2018E Payables & Accruals 18% 18% 18% 18% 18% Total Current Liabilities 26% 26% 26% 26% 26% Total Debt 14.9% 13.8% 13.1% 12.6% 12.2% Total Equity 68% 68% 68% 68% 68% Total Equity is forecasted to decline a little from 2013 and remain constant at 68% in the future. This was due to the accelerated share repurchase program and Apple s plan to not issue any more common shares in the near future. VALUATION: WACC Assumptions: Cost of Capital 2013 Weight % Cost Wgt Cost Equity Capitalization 519, % 8.7% 8.5% Total Debt 16, % 5.0% 0.1% Preferred Stock 0 0.0% 0.0% Value of All Securities 536, % Effective Tax Rate 26.2% Long-term Growth Rate: Risk-Free Rate 2.68% 2.5% Beta (5-Yr) 1.01 Alternative Beta: Market Risk Premium 6.0% CAPM Cost of Equity 8.7% Weighted Average Cost of Capital: 8.6% An 8.6% weighted average cost of capital (WACC) was calculated based on these assumptions: A long-term growth rate of A cost of equity of 8.7% calculated 2.5% by highlighted numbers 10

12 Intrinsic Valuation: Based on our model assumptions, Apple s intrinsic value as of 2013 is $ compared with a year-end stock price of $ Apple s intrinsic value grows each year for the next five years with a 2018 intrinsic value of $ This undervaluation is driven by multiple factors including competitive margins, growing PPE, and very little long-term debt. After careful, conservative modeling assumptions, this stock is currently undervalued by $ Intrinsic Value of FCF s Valuation E 2015E 2016E 2017E 2018E Intrinsic Value $ $ $ $ $ $ Year-End Stock Price $ $ Porters 5 Forces Threat of New Competitors: The information technology industry has very high barries to entry. Smaller companies have a hard time entering the market and competiting with bigger companies because of their resources, capital, production, and innovation. History has shown that if a smaller company has special technology that could treaten the market, a bigger company, like Apple or Google, comes in and buys them out. Apple has had a great history of threatening a market rather than being threatened (i.e. Macintosh, ipod, itunes, & iphone). We gave this threat a rating of LOW. Threat of Substitute Products: Apple faces great threat in each of their product s markets. For the iphone market, competition like the Samsung Galaxy, Google Android, etc. is the biggest threat in the smartphone market. In recent years, the Samsung Galaxy has lead in unit sales worldwide, while the iphone has lead in sales dollars. The ipad market competition is pretty heavy with products like Windows Surface, Kindle Fire, and Samsung Tab. The biggest thing for technology companies is innovation. The first company to bring something exciting and new to the market, wins. We gave this threat a rating of HIGH. Power of Suppliers: Apple has a history of being over-dependent in offshore supplies. The main reason for this is to save money on cost. Their main supplies are two Taiwan companies, Foxconn and Pegatron, that are both dependent on Apple for sales. Samsung is a big supplier of Apple smart chips but Apple has been making moves recently to become less dependent on their competitor. Apple has been in the process of trying to buy a Japanese company for chip manufacturing. We gave this threat a rating of LOW. 11

13 Power of Buyers: More and more consumers worldwide are paying for high priced iphones and ipads every year. Apple will most likely need to lower prices in the future to remain competitive but consumers have shown that they are still willing to pay high prices for Apple products. Apple has had trouble, specifically with the iphone, of keeping up with demand for their products. We gave this threat a rating of MEDIUM. Extent of Rivalry Among Existing Firms Information technology is a very competitive industry. Apple has been leading the race for the past few years with total revenue having a 38% 3 year CAGR. In terms of innovation, Google is Apple s main competitor in the future. Recently, Apple has beaten Google in market share, revenue per share, and nearly every other value creation metric. We gave this treat a rating of MEDIUM. SWOT Analysis The purpose of a SWOT analysis is to analyze the opportunities and threats that exist in Apple s external environment and the strengths and weaknesses of their internal operations. STRENGTHS - Strong brand - Customer experience - Loyal customers - Financial performance - Multiple patents - Largest market cap. in the industry WEAKNESSES - Recent change in leadership - Product recalls (early generation of MacBook batteries, and a few cords that connect MacBook to a TV) - Patent Infringement (Intertrust Technologies suing Apple) OPPORTUNITIES - New Apple TV with video streaming (to compete with Google and Samsung smart TVs, and Netflix, Amazon Prime, and Hulu s video streaming) - iphone 6 (longer battery life, bigger display) - Home Automation (voice controlled thermostat, bluetooth unlocking/locking doors, lights on self-learning timers, etc.) THREATS - Intense competition (The Great Tech War) - Declining PC and ipod sales - High product substitution effect (hard to predict future of technology) - Apple s products being leaked before announced. Summarizing our analysis of Apple into the grid, the company faces high external threats, mainly because of the high competition in the industry, but we see great future opportunities for Apple to remain a leader in the market. Moreover, Apple s strengths out weights its internal weaknesses. 12

14 Conclusion The Conference Board s leading indicators showed us that the market is bullish about the future strength of the U.S. economic activity. Cyclical stocks like Apple tend to perform better in such circumstances. A majority of Apple s revenue comes from the Americas and Europe. Apple has been expanding its global presence by increasing revenue in Japan and Greater China. Apple s primary product, the iphone, has been growing substantially the past few years. Now accounting for over $90 billion of Apple s total revenue. Apple s financial history has shown us excellent growth in revenue (5 year CAGR of 35.5%), net income (5 year CAGR of 43.3%), and EBITDA (5 year CAGR of 44.7%). Gross, operating, and net profit margins are a substantial percentage of total revenue. This allows Apple s revenue to flow down towards bottom line profits enabling management to return capital to investors. The P/E has stayed between the range the past 3 years, with a current P/E of Apple s strong cash position over time has given them the opportunity to choose between the cost of taxes of revenue earned abroad and the cost of issuing longterm debt to satisfy current commitments of dividends and share repurchase. This is backed up with a 12.6% total debt to assets ratio. Apple s average ROIC for the past 5 years has been greater than 150% with this being a main driver to creating value. In order to stress our model, we gave Apple a conservative long-term perpetual growth rate of 2.5%. In response to competitive pricing, we have forecasted Apple s margins to decrease a little, with a net profit margin of 20%. Apple has indicated that dividends will increase or stay at current levels for the future. Our forcasts grow net PPE as a percentage of sales while decreasing debt as a percentage of sales. In our pro-forma valuation, Apple s beta is consistent with the market at just Our weighted average cost of capital (WACC) of 8.6% is proven to be insignificant with such a large historical and forecasted ROIC. Apple s intrinsic value per share concluded to be $709.50, which is over $100 undervalued compared to today s market price. 13