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Apple, Inc. AAPL
Last Price 325.90 USD Fair Value 475.00 USD Consider Buy 332.50 USD

[Nasdaq]
Consider Sell 665.00 USD

|

QQQQQ
Uncertainty Medium Economic Moat Narrow
TM

Stewardship B

Morningstar Credit Rating Industry Computer Systems .

First Take on Apple’s 2Q--Blowout. Operating Income Up 98% off of 83% Revenue Growth.
by Joseph Beaulieu Senior Stock Analyst Analysts covering this company do not own its stock. Pricing data through June 10, 2011. Rating updated as of June 10, 2011. Currency amounts expressed with "$" are in U.S. dollars (USD) unless otherwise denoted.

together and operating margins rose to 31.9% from 29.5% in the year-ago quarter.

Analyst Note Apr. 20, 2011

Thesis Apr. 05, 2011

We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results. Revenue increased 83%, driven by 126% iPhone revenue growth, 32% Mac revenue growth, $2.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010), 23% in iTunes revenue, 17% growth in software sales, and 23% growth in revenue from peripherals. This growth was partially offset by a 14% decline in iPod revenue. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod, which is being cannibalized by the iPhone); based on second-quarter results we think our thesis remains intact. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. Apple actually saw a small amount of gross margin contraction, to 41.4% from 41.7% in the year-ago quarter. However, it is important to note that although software and iTunes revenue grew an impressive 17% and 23%, respectively, this was much slower than the revenue growth of 93% for the the combination of iPod, iPad, iPhone, hardware peripherals, and Macs. Given that we think software and iTunes have significantly higher gross margins than hardware, our guess is that gross margins improved for most (if not all) categories, but the overall gross margin decline was from the mix shift. Apple also beat our expectations on operating expenses. We’ve been modeling long-term selling, general, and administrative expenses at about 8% of sales, and R&D at 3%-3.5% of sales. In the second quarter, those figures numbers were 7.1% and 2.4%, respectively. These represent a significant improvement over the prior year’s 9% and 3.2%. Put gross margins and operating expenses

Stock Price
281.0

193.0

In the past decade, Apple has transformed itself from a niche computer company into an integrated consumer electronics and media distribution powerhouse. It is now one of the most valuable companies in the world, achieving this position through a combination of product innovation, strategic foresight, and careful management of its brand image. We believe Apple has dug itself a narrow but widening economic moat that is based primarily on iOS, the operating system behind the iPhone and the iPad. While iOS is now the primary driver of Apple’s growth, we are excited to see that the firm is applying what it has learned from iOS to its OS X operating system for desktops and notebooks. In our view, the seeds of Apple’s success were sown in 2001 with the March release of OS X, the May launch of the first Apple retail store, and the October release of the first-generation iPod. The retail stores gave potential customers a place to gain hands-on experience with Apple’s products; the iPod gave the uninitiated a reason to go to the Apple store; and the launch of the robust, intuitive OS X helped Apple to gain market share in desktops and notebooks. From there, new products and services appeared to just fall into place--the iTunes Store for purchasing music; new iPod models for different purposes; video playback on the iPod combined with the distribution of video content on the iTunes Store; and finally, the iPhone, which leveraged Apple’s experience in developing handheld electronics, software design, and media distribution. We think the iPhone cemented Apple’s economic moat. The iPhone and now the iPad run on iOS, which we believe has the potential to hold nearly as strong a position in high-end portable computing devices as Windows has in the desktop market. (We use the modifiers "potential" and "nearly" here, as iOS has a much stronger competitor in Android than Windows ever had.) Already, iOS has a

104.0 84.0 07 08 09 10 11

We still expect Apple’s share of the smartphone market to top out at around 15% by 2015.126 Net Income 19. While we believe the network effects and modest switching costs are partially responsible for Apple’s continued revenue growth and expanding profitability. and international launches of the iPad 2. To order reprints. Apple is already leveraging the success of the iPhone with the launch of the iPad. as consumers invest more money in iOS applications and media from the iTunes Store. and marketers.50 USD [Nasdaq] Consider Sell 665. This is why we think investors are right to be concerned about the potential for Steve Jobs’ permanent departure from Apple. The information contained herein is not represented or warranted to be accurate. and should not be considered a solicitation to buy or sell any security. is that the availability of third-party applications has been extremely limited compared with Windows. With the Mac App Store. correct. Morningstar data as of June 10. Data as originally reported. product managers.220 3. but we’ve also increased our expectation for PC sales. Moreover. we think Jobs’ leadership has been instrumental to pull those people together and prevent any truly bad products from making it out the door. Apple can now distribute third-party applications directly to consumers. We now expect 2014 iPad sales to come to about 75 million units (up from our previous 40 million estimate) and think iPad sales will hit 80 million units (about $45 billion) in 2015.451 68. Redistribution is prohibited without written permission. iPhone. complete. ß ® . Growth and Profitability We are increasing our fair value estimate to $475 per share from $460. which in turn increases the appeal of the iOS platform for consumers.637 Oper Income 25. To license the research. This report is for information purposes only. switching costs will grow. AAPL Last Price 325.00 USD Consider Buy 332. strong network effect.5 billion in 2010--despite the fact that the iPod. as the vast number of iPhones in customers’ hands has created a massive market for third-party applications. We’ve also modeled more rapid market share gains in Apple’s legacy desktop and notebook computer businesses. Currency(Mil) USD USD USD USD Market Cap 301. 2011. which has enticed a massive number of developers to create applications for iOS. engineers.899 73. Apple has steadily gained share in the notebook and desktop market throughout the past decade.Apple. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution.90 USD Fair Value 475. Inc. you may use this report only in the country in which its original distributor is based.552 21. Unless otherwise provided in a separate agreement. © 2011 Morningstar.615 127. Inc. call +1 312-696-6869.378 199. The biggest legitimate knock against Apple’s PCs. Although Apple’s desktop and notebook revenue is now only two thirds the size of iPhone revenue. and we think the launch of the Mac App Store could accelerate market share increases.239 easy for consumers to install applications and to keep their applications library up to date with one click. Most of this increase is due to higher expectations for iPad sales after the strong U. Although Apple has an abundance of talented developers. We therefore believe the Mac App Store has the potential to drive further market share gains. we think the intangibles associated with the Apple brand are just as important to the company’s ongoing success.114 29. call +1 312-696-6100. or timely.920 11.S. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve. All Rights Reserved. there is still the potential for things to go wrong at Apple.980 4.4 billion in 2006 to $17. Close Competitors Apple.794 9. Despite a full decade of continuous successes under its belt. which by some estimates accounts for more than 80% of the nascent tablet computing market.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . and iPad work in conjunction with Windows-based computers as well. it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely Valuation. Microsoft Corporation Hewlett-Packard Company Dell. in our view.185 TTM Sales 87.941 61. Inc.382 26. it is important to recognize that revenue from those products has been steadily growing--from $7. Additionally.

much of its ability to open customers’ wallets is based on its brand image.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . Although it has a significant international presence. To license the research. call +1 312-696-6100. complete. but we think that Apple’s integrated control of both hardware and Financial Health: The company has $26 billion in cash and short-term investments.5% from 40%. If either the iPhone or iPad disappoints. The other major risk for shareholders is the firm’s heavy dependence on U. ß ® . we still think iPods will have a place in the iOS ecosystem. We continue to be surprised at the number of first-time Mac customers the firm adds every year. holds another $25 billion in long-term investments. but expect revenue to contract at about 18% per year as iPod average selling prices fall and more consumers replace their dedicated MP3 devices with converged devices such as the iPhone. If Jobs were to leave the firm on a permanent basis. Nearly 40% of Apple’s revenue comes from the iPhone line.00 USD Consider Buy 332. software puts iOS at less risk than Android. since the firm has gone a full decade without a significant flop.and user-focused vision has been instrumental to Apple’s renaissance and has served investors incredibly well. consumers and high-priced products. would probably weigh on sales growth. With less than 5% share worldwide. and our valuation assumes that the iPad becomes a significant growth driver. Data as originally reported. We think he deserves much of the credit for Apple’s tremendous success during the past decade. Apple’s success during the past decade is largely attributable to the leadership of Steve Jobs. we’ve boosted our long-term gross margin target to 42.5 billion in free cash flows in fiscal 2010.50 USD [Nasdaq] Consider Sell 665. all bets are off. the Mac computer can continue to increase its share as a capable Windows alternative. AAPL Last Price 325. Apple’s retail stores provide a platform for exposing new consumers to the breadth of the company’s expanding product line. Inc. we would expect a couple of years of smooth sailing. Redistribution is prohibited without written permission..90 USD Fair Value 475. but we’d worry about how long Apple’s winning streak could continue after that. the high price points of its products could limit growth in emerging markets. This report is for information purposes only. as it did in fiscal 2009. We don’t expect a significant change in the firm’s cost structure. Financial Overview Bulls Say The iOS mobile operating system is likely to be part of a duopoly with Google’s Android. call +1 312-696-6869. While we think Apple has an economic moat. or a worldwide economic downturn. We believe the iPod business will contract at a 10% per year on volume. As we believe the iPad will remain very successful and will drive increased sales of high-margin applications and media. and has generated $16. and should not be considered a solicitation to buy or sell any security. correct. We think the Mac App Store will accelerate share gains. so we think operating margins will hit north of 30%.S.Apple. But we also believe Jobs’ product. economy. and his long-term absence could deal a heavy blow to the company. To order reprints. our fair value estimate will fall. The information contained herein is not represented or warranted to be accurate. which runs the risk of fragmentation. It carries no debt. All Rights Reserved.S. A downturn in the U. We think this image is deserved. We think COO Tim Cook is an able manager and Apple has an extremely deep talent pool. Unless otherwise provided in a separate agreement. But if the brand becomes tarnished. Apple’s sales are concentrated in the U. or timely. you may use this report only in the country in which its original distributor is based. exposing the firm to significant customer concentration risk in the event of a big economic downturn. © 2011 Morningstar.S. Steve Jobs’ recurring health problems are a legitimate concern. However. Bears Say Risk In our view.

To license the research. including the appointment of lead codirectors in 2006. and most have worked with him for a long time. an online store that sells first. Its iTunes online store is the largest music distributor in the world. the iPhone. COO Tim Cook came to Apple from Compaq in 1998.90 USD Fair Value 475. ß ® . but the vast majority of compensation comes from equity as opposed to cash. call +1 312-696-6100. Apple launched the Mac App Store. Inc. it sells and rents TV shows and movies and sells applications for the iPhone and iPad.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems .50 USD [Nasdaq] Consider Sell 665. Data as originally reported. correct. AAPL Last Price 325. In early 2011. All Rights Reserved. Company Overview Profile: Apple designs consumer electronic devices. we believe aggressive moves by the board have enabled the company to turn the page.Apple. Apple has taken other steps in the right direction. The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance. Management: Steve Jobs cofounded Apple in 1976 and rejoined the company as CEO in 1997. The information contained herein is not represented or warranted to be accurate. Unless otherwise provided in a separate agreement. Though the stock-option backdating scandal raises our stewardship concerns. Jobs’ health is a significant concern. As such. Apple’s executives have been richly rewarded as a result of the company’s tremendous performance. but is somewhat alleviated by the fact that the company maintains a talented management bench and culture of innovation that will sustain it in the near term. complete. call +1 312-696-6869. To order reprints. you may use this report only in the country in which its original distributor is based. Redistribution is prohibited without written permission. and the iPod. Apple’s products are distributed online as well as through company-owned stores and third-party retailers.and third-party applications for the Mac line of desktop and notebook computers.00 USD Consider Buy 332. including PCs. This report is for information purposes only. the iPad. or timely. and should not be considered a solicitation to buy or sell any security. © 2011 Morningstar. He has personally recruited much of the current management team. CFO Peter Oppenheimer has been with the company since 1996.

Operating Income Up 98% off of 83% Revenue Growth. to 41.4% from 41. and R&D at 3%-3. This report is for information purposes only. as we view his leadership as an important factor in the firm’s success over the past decade. general. this was much slower than the revenue growth of 93% for the the combination of iPod. respectively. All Rights Reserved. AAPL Last Price 325. Inc. Revenue increased 83%.4%. ß ® . and administrative expenses at about 8% of sales. or timely. and 23% growth in revenue from peripherals. The information contained herein is not represented or warranted to be accurate.5% in the year-ago quarter. Analysts covering this company do not own its stock.5% of sales. Data as originally reported. correct. We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results. 18. The information contained herein is not represented or warranted to be accurate. This growth was partially offset by a 14% decline in iPod revenue. those figures numbers were 7. Apple actually saw a small amount of gross margin contraction. 32% Mac revenue growth. 17% growth in software sales. it is important to note that although software and iTunes Jan. This report is for information purposes only. To license the research. correct. We think Apple can function perfectly well in the near to intermediate term in his absence. and Macs. which is being cannibalized by the iPhone). Analyst Notes Apr.Apple. our guess is that gross margins improved for most (if not all) categories. 20.50 USD [Nasdaq] Consider Sell 665. 2011 Apple Under Review revenue grew an impressive 17% and 23%. To order reprints. iPhone.1% and 2.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems .7% in the year-ago quarter. 2011 First Take on Apple’s 2Q--Blowout. 23% in iTunes revenue. and should not be considered a solicitation to buy or sell any security. These represent a significant improvement over the prior year’s 9% and 3. hardware peripherals. complete. Given that we think software and iTunes have significantly higher gross margins than hardware. driven by 126% iPhone revenue growth. However. Unless otherwise provided in a separate agreement. complete. We’ve been modeling long-term selling.9% from 29. you may use this report only in the country in which its original distributor is based. $2. based on second-quarter results we think our thesis remains intact. Apple also beat our expectations on operating expenses. call +1 312-696-6100. We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst. Redistribution is prohibited without written permission. and should not be considered a solicitation to buy or sell any security.00 USD Consider Buy 332. © 2011 Morningstar. Steve Jobs’ second leave of absence is certainly a matter of concern. Morningstar Inc. but if he were to hand over leadership on a permanent basis. respectively. iPad. or timely. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. Put gross margins and operating expenses together and operating margins rose to 31. but the overall gross margin decline was from the mix shift. In the second quarter.2%. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company.90 USD Fair Value 475.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010). Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod. we’d have to reassess our long-term view. does not own more than 1% of the shares of this company. call +1 312-696-6869.

2.99 0. 31640 .66 364. 4.6 1. 14532 .00 907 39.7 .5 4. 1.64 185 -232 -47 2001 5742 27.8 29. 21030 .0 03-11 USD Mil Cash Inventories Receivables Current Assets Fixed Assets Intangibles Total Assets Payables Short-Term Debt Current Liabilities Long-Term Debt Total Liabilities Total Equity Valuation Analysis Current 11261 1051 9924 41678 4768 1083 75183 12225 .8 43. 2003 4375 .5 0.0 3.8 10. .1 29.93 0. 13.0 18.5 4.4 Inventory Turns 68.8 11. 20722 .08 2002 3530 .9 3.46 31.08 0.4 42. 75997 190983 297089 301378 2008 2009 2010 TTM 5363 23. To order reprints. Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders 301378 199899 73114 87451 15.8 35.00 925 52.6 29.3 21.0 19. TTM data based on rolling quarterly data if available.7 38. Unless otherwise provided in a separate agreement.0 2453 12. 25893 2004 123.95 1.9 3.9 1.1 22.6 .0 Return on Assets % 25.2 -34. .59 93.8 .42 1.2 40.3 122.5 19.9 17 0.2 8.0 20343.8 19.8 44.1 -84.6 -0.451 Last Price Fair Value 301.56 10 Year High/Low 364.7 Sep 10 70.4 101.3 Dec 10 82.4 .5 13.5 54.0 3.6 36.09 0.apple. 48.3 .0 .2 0. TTM Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity Valuation 36.0 8. including PCs.7 50.1 9.3 65 0.0 Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364.9 16.0 22.2 30.5 0. Its iTunes online store is the largest music distributor in the world. 16.10 0.15 0.6 1.7 0.1 0.8 .and third-party applications for the Mac line of desktop and notebook computers.3 -1.48 26476 -3193 23283 TTM Revenue USD Mil Gross Margin % Oper Income USD Mil Operating Margin % Net Income USD Mil Earnings Per Share USD Dividends USD Shares Mil Book Value Per Share USD Oper Cash Flow USD Mil Cap Spending USD Mil Free Cash Flow USD Mil Profitability Return on Equity % 38.67 6. 2004 6816 .3 4834 5. 2010 22670 . 3.3 19.5 1.15 1.5 .00 691 5.5 1.08 2001 3730 316 4095 0.1 11.43 3.9 32.64 4.0 1.2 46. an online store that sells first.0 21.0 8337.7 17.7 Jun 10 25.1 0.68 12.9 39.20 934 -176 758 2004 13931 29.3 15. call +1 312-696-6100. 7466 . 3.6 4.2 16. 32.6 1. 0.8 .8 .6 2010 25. Data as originally reported.3 1.73 9596 -1199 8397 2008 42905 40.Morningstar ® Stock Data Sheet Pricing data thru Jun.9 .25 320.5 17.07 2220 -657 1563 2006 24006 34.4 Mar 11 % of shares Most Recent Period Prior Year Period 3.3 27.6 4.1 . 2006 12657 .0 15683. All Rights Reserved.3 7.9 27.06 1.84 1.1 22.4 26. 61477 .4 35.6 2. Apple’s products are distributed online as well as through company-owned stores and third-party retailers.61 6. Market Price/Sales Price/Book Price/Cash Flow Quarterly Results Revenue USD Mil Jun 10 Sep 10 Dec 10 Mar 11 Industry Peers by Market Cap Mkt Cap USD Mil Rev USD Mil P/E ROE% Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Price/Book Price/Sales PEG Ratio 15.6 2005 13.3 1.5 17.0 59.0 . Redistribution is prohibited without written permission.Market +/.7 42.Industry +/.0 Current 39.4 52.4 10. otherwise most recent annual data shown.7 38.7 956.3 120. 5076 .8 22. 7859 2003 201.9 53.4 8235 9. .34 1.47 10159 -1144 9015 2009 65225 39. 2005 8038 .0 57.com 6.00 931 66.5 12.3 1137. Inc. 9. The information contained herein is not represented or warranted to be accurate.7 Most Recent Period Prior Year Period Earnings Per Share USD 88.5 .4 130. 10.Industry Dividend Yield % Market Cap USD Mil Financials Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/.00 902 25. 46.0 4409 18.00 75.7 2007 14. .36 0.09 6.1 1.8 1335 1.1 1.1 25382 29.0 56.8 . 42.8 7. and should not be considered a solicitation to buy or sell any security.2 60.00 878 13.4 28.0 1.89 289 -164 125 2003 8279 27.8 .90 475. 6.9 2008 18.36 34.00 724 5.7 25.33 .5 2009 22.40 3.4 127941 8. correct.0 1650 11.1 30.4 13. 2007 20598 . Inc.3 16. 2.10 18595 -2005 16590 2010 87451 39.96 200.56 7.4 1.6.5 40.9 1. you may use this report only in the country in which its original distributor is based.0 13499.0 -344 -6.2 20. 5146 2002 49.90 50.0 Revenue/Employee USD K1770.9 5.2 1.4 21. 10.3 1. .7 5.9 Mkt 47.78 10.1 .3 326 3.5 0.8 . 2011 Rating updated as of Jun.36 0.5 Price/Earnings P/E vs.9 .1 146.5 12. 60587 2005 18.5 15.3 11.1 11740 27. 4. 4223 .7 1989 2.0 -18.19 5470 -986 4484 2007 32479 34.25 81.5 03-11 Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health 3625 317 3920 0.9 . 24327 .6 12. 9984 .5 .8 22. 2011 Fiscal year-end: September Apple.3 14.0 26741. Apple launched the Mac App Store.7 65.4 200.4 192.1 1.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: A 09-10 USD Mil 35.1 .0 56. 47791 .16 Price Volatility 199.6 2003 3.8 30. 2009 20956 .9 31. To license the research. 2008 20049 .6 .73 89 -174 -85 2002 6207 27.3 1.11 1.9 146. call +1 312-696-6869.0 54.6 -11.5 -1 0 69 0.0 Growth Rates Compound Annual Grade: A 1 Yr 3 Yr 5 Yr 10 Yr 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 YTD Stock Performance Total Return % +/.00 775 7.94 2535 -260 2275 2005 19315 29.00 889 19.7 1. In early 2011.6 .2 14013 15.9 11.1 29.26 213.3 20.5 5 Yr Avg 36.30 2:1 Medium Narrow B per share prices in USD Annual Price High Low Recent Splits 13. the iPad.0 24667.4 18385 28.0 133.3 1.8 19.235.27 0.95 326. *3Yr Avg data is displayed in place of 5Yr Avg © 2011 Morningstar.0 19. complete.20 190. 14.4 30.16 202.5 2002 1. AAPL Apple designs consumer electronic devices.3 15.0 19552 20.4 -25 -0.0 57.4 3496 3. CA 95014 Phone: 1 408 996-1010Website: http://www.4 Fixed Asset Turns 17.1 19.2 4.4 39.1 5.3 6275 19. 23. 23.5 61.6 21.90 79.8 .9 41.56 0.4 -0.04 0.5 12.1 40.0 16238.36 Bear-Market Rank 6 (10=worst) Trading Volume Million 1 Infinite Loop Cupertino.378 Uncertainty Computer Systems Economic Moat TM Technology Stewardship Grade QQQQQ 13.99 1.0 Jun 10 Sep 10 Dec 10 Mar 11 Apple.2 20.9 2. and the iPod.Market Profitability Analysis Grade: A 52.2 38.3 11. Morningstar Rating Sales USD Mil Mkt Cap USD Mil Industry Sector 87.6 12.7 2006 16. the iPhone.4 123.51 1.9 276 0.00 727 5.6 66.5 1.90 .6 2004 13.5 14.7 48.3 3.5 68615 9. 7703 2001 -34.1 Ind 23. it sells and rents TV shows and movies and sells applications for the iPhone and iPad.2 62.0 1.3 105.9 13.51 6.3 9.93 1.00 857 9.13 1. ß ® .8 7.14 78.5 2001 1.9 0.0 .00 1.22 325.7 10. 33427 61477 Mkt -0.7 11. This report is for information purposes only. 72901 173427 2006 2007 -56.90 .3 . 27392 47791 5 Yr Avg Ind 15978 930 11095 46997 6241 1248 94904 14645 . 1.0 17.2 14.4 0.35 4.6 6. . or timely.5 Most Recent Period Prior Year Period Rev Growth % 15700.0 39.7 . 6.5 11.3 33.8 0.

© 2011 Morningstar. To order reprints. for a simple reason: We have more confidence in our cash-flow forecasts for strong companies. Unless otherwise provided in a separate agreement. so our ratings always reflect our analyst’s current opinion. We rate stocks 1 through 5 stars. it will receive a low star rating. or timely. Redistribution is prohibited without written permission. which is why the rating date on our reports will always be the previous business day. Cash generated next year is worth more than cash generated several years down the road. If a stock’s market price is significantly above our fair value estimate. many more will likely garner 5 stars. we monitor market events and all of our stocks every business day. we require a smaller discount than for mediocre ones. usually by virtue of some competitive advantage. call +1 312-696-6869. We think that purchasing shares of superior businesses at discounts to their intrinsic value and allowing them to compound their value over long periods of time is the surest way to create wealth in the stock market. rather than short-term movements in stock prices. and should not be considered a solicitation to buy or sell any security. correct. But when the market tumbles. This report is for information purposes only. We calculate our star ratings nightly after the markets close. we find assets more attractive when they’re cheap. but the shares are more attractive as an investment at $40 than they were at $50. Economic Moat Rating TM The Economic Moat Rating is our assessment of a firm’s ability to earn returns consistently above its cost of capital in the future. To license the research. with 5 the best and 1 the worst. you may use this report only in the country in which its original distributor is based. the star rating will go up. Analyst conducts company and industry research: Management interviews Conference calls Trade-show visits Competitor. Our star rating is based on our analyst’s estimate of how much a company’s business is worth per share. supplier. When stocks are high. We update the text of our reports as new information becomes available. no matter how wonderful we think the business is. Even the best company is a bad deal if an investor overpays for its shares. All Rights Reserved. at times we may appear out of step with the overall stock market. not as pieces of paper. Because we focus on the long-term value of businesses. If we think a stock’s fair value is $50. Our analysts arrive at this "fair value estimate" by forecasting how much excess cash--or "free cash flow"--the firm will generate in the future. ß ® . and thus in our value estimates. and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business. Our estimate of what the business is worth hasn’t changed. complete. Although you might expect to see more 5-star stocks as the market rises. The information contained herein is not represented or warranted to be accurate. and then adjusting the total for timing and risk. So. call +1 312-696-6100. and customer interviews The depth of the firm’s competitive advantage is rated: None Narrow Wide Analyst considers company financial statements and competitive position to forecast future cash flows. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. An uncertainty assessment establishes the margin of safety required for the stock rating. and issue them the following business day. Our fair value estimates don’t change very often. Competition tends to drive down such TM Morningstar Research Methodology for Valuing Companies Competitive Analysis Economic TM Moat Rating Company Valuation Fair Value Estimate Uncertainty Assessment QQQQQ Q QQ QQQ QQQQ QQQQQ The current stock price relative to fair value. Of course. we evaluate stocks as pieces of a business. That is why you’ll see two dates on every Morningstar stock report. but market prices do. which anchors the rating framework.Morningstar’s Approach to Rating Stocks Our Key Investing Concepts Economic Moat Rating Discounted Cash Flow Discount Rate Fair Value Uncertainty Margin of Safety Consider Buying/Consider Selling Stewardship Grades TM At Morningstar. usually about once or twice per quarter. determines the rating. adjusted for uncertainty. a stock may gain or lose stars based just on movement in the share price. and the shares decline to $40 without much change in the value of the business. distributor. relatively few will receive our highest rating of 5 stars. DCF model leads to the firm’s Fair Value Estimate. For high-quality businesses. Assumptions are input into a discounted cash-flow model. Data as originally reported.

The grades are assigned on an absolute scale--not relative to peers--and can be interpreted as follows: A means "Excellent. with low expected returns relative to its risk. We use this technique to value nearly all of the companies we cover." B means "Good." Uncertainty To generate the Morningstar Uncertainty Rating. but companies that can earn them for an extended time by creating a competitive advantage possess an Economic Moat. and smaller margins of safety for more predictable stocks. Stewardship Grades We evaluate the commitment to shareholders demonstrated by each firm’s board and management team by assessing transparency.The margin of safety is like an insurance policy that protects investors from bad news or overly optimistic fair value estimates. call +1 312-696-6869. This report is for information purposes only. or Extreme. it’s an estimate of what the business is worth. and using the result to calculate the worth of the firm. Our fair value estimate differs from a "target price" in two ways." than for a firm in a cyclical business with fierce competition. Data as originally reported. since there’s less risk clouding the firm’s future." D means "Poor. and is our per-share estimate of a company’s intrinsic worth. The information contained herein is not represented or warranted to be accurate. For a profitable company in a steady line of business. © 2011 Morningstar. Conversely. whereas price targets generally focus on the next two to 12 months. First. Very High. analysts consider factors such as sales predictability. To license the research. and financial leverage. shareholder friendliness. We adjust our fair values for off-balance sheet liabilities or assets that a firm might have--for example. and thus the point at which we would consider the stock an extremely attractive purchase. We think it’s always prudent to buy stocks for less than they’re worth. Medium. ß ® . it’s a long-term estimate. operating leverage. we’ll use a lower discount rate. at which point we’d consider the stock overvalued. We require larger margins of safety for less predictable stocks. the greater the discount to fair value required before a stock can earn 5 stars." and F means "Very Poor. We aim to identify firms that provide investors with insufficient or potentially misleading financial information. and ownership. complete. High. All Rights Reserved. Discount Rate We use this number to adjust the value of our forecasted cash flows for the risk that they may not materialize. and should not be considered a solicitation to buy or sell any security. you may use this report only in the country in which its original distributor is based. we deduct from a company’s fair value if it has issued a lot of stock options or has an under-funded pension plan. consider selling is the price at which a stock would have a 1 star rating." C means "Fair. Second. also known as "cost of capital. call +1 312-696-6100. We see these companies as superior investments. whereas a price target typically reflects what other investors may pay for the stock. or which have management incentives that are not aligned with the interests of long-term shareholders. Redistribution is prohibited without written permission. Fair Value This is the output of our discounted cash-flow valuation models.Morningstar’s Approach to Rating Stocks (continued) economic profits. incentives. Analysts then classify their ability to bound the fair value estimate for the stock into one of several uncertainty levels: Low. or timely. seek to limit the power of minority shareholders. Consider Buying/Consider Selling The consider buying price is the price at which a stock would be rated 5 stars. The greater the level of uncertainty. correct. subtracting the amount of cash that the company will need to reinvest in its business. and the greater the premium to fair value before a stock earns a 1-star rating. This is the discount to fair value we would require before recommending a stock. Unless otherwise provided in a separate agreement. To order reprints. Discounted Cash Flow Margin of Safety This is a method for valuing companies that involves projecting the amount of cash a business will generate in the future. allow management to abuse its position.

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