EQUITY RESEARCH REPORT ON APPLE INC

Haohan, Xu
JOHNS HOPKINS UNIVERSITY-CAREY BUSINESS SCHOOL 100 International drive, Baltimore, MD, 21202

Summary of Investment Thesis Sector: Global IT Hardware, Overweight Price target: $759 Current Share price: $521 on 02/07/2014 Ticker: AAPL-NYSEOutperform (Buy) Apple Inc. designs, manufactures, and markets personal computers and related personal computing and mobile communication devices along with a variety of related software, services, peripherals and networking solutions. The company sells its products worldwide through its online stores its retail stores, its direct sales force, third party wholesalers and resellers (Bloomberg, L.P.).

Source: Bloomberg, L.P. Company Description Head-quartered in Cupertino, CA, United States, Apple is one of the most iconic IT hardware companies. According to the company 10K, Apple had $170.9 billion revenue and $37.0 billion net income. As of the fiscal year end, 2013/09/28, Apple had $207 billion assets, and $434.1 billion market capitalization. The company manages its business primarily on a geographic basis. Note that the results of the companys geographic segments do not include results of the retail segment.

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Source: Bloomberg, L.P. Products Apple sells various products and services: iPhone is the companys line of smartphones; iPad and iPad Mini are the companys multi-purpose tablets; Mac is the companys line of desktop and portable personal computers; iPod is the companys line of portable digital music and media players; the other categories include iTunes and iTunes store, Mac App Store etc. (Company 10K)
Retail (U.S., Canada, Japan, U.K.) 10% Rest of Asia Pacific 5%

BY GEOGRAPHY
Japan 7% Americ as 30% iTunes/ Software /Services 9% Macint osh 13% iPhone 53% AsiaPacific (Australia & Asia) 18% Access iPod ories 3% 3%

BY PRODUCT

Great er China 12%

Europe 18%

iPad 19%

Source: Bloomberg, L.P. Industry analysis and Apples competitive positioning

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iPhone: Global Smartphone Industry The (including handset both

smartphones and non-smartphones) industry is

dominated by the top 10 handset They

maker.

accounted for 68% of total shipments Source: Bloomberg, L.P. in 2012 and 85% of total handset sales. Major Smartphone manufactures are Samsung (Korea) which in 2012 delivered 218 million shipments or 30% of global shipments. All other non-top 10 manufactures combined to deliver 138 million shipment, 19%; Apple (US): 138 million shipment, 19%; Nokia OYJ (US): 35 million shipment, 4.85%; Blackberry (Canada): 33 million shipment, 4.37%. According to IDC and Bloomberg, mobile phone industry outlook, global smartphone shipments are projected to increase at a 19% CAGR from 2012 to 2017. Future regional smartphone shipments CAGR is highest in Latin America (26%) and the Asia Pacific (25%), followed by EMEA (14%) and North America (8.9%). iPhone is the most important product for Apple as it contributes of revenue and of net income. Apple has great pricing power as evidenced in iPhones high gross margin ratio. Recent years incremental growth came from emerging markets, but it will likely plateau in a few years. Apples high gross margins ratios is unsustainable due to two factors:

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1. Pressure from customers: Apple has seen it is becoming increasing difficult to charge customers a high premium especially when other products are increasingly comparable in terms of hardware quality. 2. Threats from other operating systems such as Android, as we can observe from the chart below, sales of Android smartphones increased fivefold from 2Q11 to 3Q13. Though IOS smartphone also increased steadily. Apples biggest threat comes from lower priced Android phones and ever better Android app stores that provides software to compliment smartphones.

Source: Gartner

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Global Smartphone Shipment

1400 1200 1000 800 600 400 200 0 2014 2015 2016 2017 2018 North America Latin America EMEA Asia/Pacific

Source: IDC

APPLE'S SMARTPHONE MARKET SHARE BY REGION

50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% North America Latin America EMEA Asia/Pacific

Source: IDC, Gartner, TechThought Used historical shipments and

North America, 43.0%

industry forecast to add a step function to iPhones market share in each region. In summary, Apple is forecasted to lose 3% share every year in NA, gain 1% in LA, remain
EMEA, 15.0% Latin America, 7.0% Asia/Pacific , 10.0%

constant in EMEA markets, and gain 2% in Asia/Pacific.

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Source: IDC, Gartner, Bloomberg Mac and iPad: Global Computer Hardware Industry Based on the computer industry report from Bloomberg, the global computer hardware slump is unlikely to end in 2014, mainly due to Open Compute and slowing innovation. Consequently, computer hardware manufactures pricing power diminishes and growth outlook remain austere. Tablets are becoming more popular as a substitute for PCs and will grow at the expense of the PCs. Another trend in this industry is decreasing in average selling price (ASP), primarily due to intensified competition and lower manufacturing costs. Apple is a market leader in this industry with a dominating position in a set of large, growing and profitable markets. The sell price of its PCs will decrease in the future, as a continuation of past trends. Its PC, iPad and iPad Mini remain strong in terms of market share and pricing power, as shown from the below table. (share of tablets and ASP).

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Source: IDC, Gartner, Bloomberg

Others: Assumptions and Rationale Assumed iTunes/Software/Services, Accessories and iPods future revenue to be % of iPhone, iPad and Macs revenue, because those products are deemed as compliments to aforementioned products. Historical results also suggested strong correlation.

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Pricing Revenue forecast in the excel models were expressed as Unit shipment* ASP. As discussed above, the global IT hardware industry is fostering intense competition because of commoditization of the smartphone sector. In projection, a step function was used to reflect the ASPs downward trend over time. Annual step (% of increase or decrease) of hardware products are: iPhone -8%, iPad -5%, Mac -3%. In summary, Apple products selling price trend is in line with the forecast in the chart below, though in a higher degree, as Apples products are currently selling at higher premiums.

Source: IDC, Bloomberg Industries

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Profitability The overall gross margin ratio of Apple averaged 43% for the past three years, which is much higher than the industry average. The past three year gross margin for global smartphone comparables were 28%, and 17% for global hardware comparables. To simplify and to be reasonable, Apples overall gross margin should converge to the industry average. The gross margin ratio 23.2% was calculated based on the assumptions that iPhones account for 60%, and Computer hardware (Mac, iPad, iPod combined) for the remaining 40%.

Valuation

Fundamentals
250,000.0 200,000.0 150,000.0 100,000.0 50,000.0 FY 2014 FY 2015 FY 2016 FY 2017 FY 2018 Revenue Gross Profit Net Income FCF

5 year CAGR: Revenue -4.2%, Gross Profit -12.7%, Net Income -12.7%.

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Other Assumptions:

1. The cost of revenue included depreciation and amortization expenses already. In order to better reflect manufacturing costs, cost of revenue was categorized into: cost of revenue net of dep & amort, and dep & amort expenses. 2. CapEx, as a % of sales, used the past three years historical average as a drive. 3. Apple does not disclose depreciation and amortization separately. Depreciation was computed backwards from year end accumulated depreciation minus year beginning accumulated depreciation. Future depreciation expenses were forecast as a % of net fixed assets, because the historical ratios suggest strong correlation. 4. In the same manner, amortization was calculated from total depreciation amortization- depreciation expenses. Amortization was forecast as a constant number over the period because Apples net investment in intangibles was negligible, less than $1 Billion (according to the MD&A, most of the intangible assets were amortized using a straight-line method over 20 years). 5. Other investment activities include many types of different variables that were hard to forecast e.g., acquisition of business, proceeds and purchase of short term

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marketable securities; therefore, I assumed the investment to be a constant over the future periods. 6. Same applied to other non-cash adjustments on the cash flow statement 7. Other non-cash working capital and other non-cash adjustments deviated from historical trends as I reclassified some items in each category. 8. Dividend policy: from the 2013 10K, MD&A (p 19), management expected the cash dividend payout to remain constant or grow in the future. The Quarterly dividend is expected to be $2.65 per share and about $2.6 Billion to be paid out to all shareholders. Since, Apple has accumulated a huge amount of cash, it is like Apple will increase its dividend payout going forward. Opportunities 1. New products and innovations (MD&A): iPhone was an instant hit after its release in 2007, and the iPad introduction renovated the global hardware industry. iPad mini targets at price sensitive customers especially those in the emerging markets, and it has boosted the iPad sales in 2013. Apple is widely perceived as a technology innovator and game changer; surprise factors should be included in the valuation. 2. Market expansion: Apple already has leading market shares in developed countries, 43% in US, 37% in GB, 28% in Australia. These markets are saturating, and customers may switch to other brands. Emerging markets such as Latin America, China and India provide some room for its future growth. Apple products were recognized as a product of status, which means Apple can still charge a high premium. Moving forward, Apple will lose its pricing power, and therefore needs to stimulate sales with lower selling price.

Risks to the Thesis 1. The greatest risk comes from intensified competition by hardware producers such as Samsung, LG, and software platforms such as Android and Windows. These factors will put pressure on Apples future product shipments and gross margin.
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2. Product cannibalization: the global computer hardware is maturing, and customers have steered away from traditional PCs to portable devices such as ultra-books and tablets. Apples iPad and ultra-book sales may grow at the expense of its Mac PC sales. 3. Supply chain risk (from MD&A and Bloomberg): Apple has a total of 260 suppliers, but a few dominate, such as Hon Hai Precision, Pegatron Corp and LG display. In addition, rising material costs such as aluminum and labor costs will affect Apples bottom line. 4. Foreign exchange risk: 70% of Apples revenue came from non-US regions, therefore adverse foreign currency exchange rates in respect to US dollar will impact Apples net income. For the past three years, foreign exchange losses were immaterial due to hedging. (10K MD&A)

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