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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

00 USD Consider Buy 332.941 61. 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 2015.899 73. Despite a full decade of continuous successes under its belt. To license the research. call +1 312-696-6869. which has enticed a massive number of developers to create applications for iOS. as consumers invest more money in iOS applications and media from the iTunes Store.451 68.980 4. but we’ve also increased our expectation for PC sales. we think Jobs’ leadership has been instrumental to pull those people together and prevent any truly bad products from making it out the door. With the Mac App Store.4 billion in 2006 to $17. we think the intangibles associated with the Apple brand are just as important to the company’s ongoing success. Apple is already leveraging the success of the iPhone with the launch of the iPad. Microsoft Corporation Hewlett-Packard Company Dell. and marketers.637 Oper Income 25.920 11. Anything that tarnishes the brand could quickly undo what it took the past decade to achieve.Apple. AAPL Last Price 325.382 26. The biggest legitimate knock against Apple’s PCs. and international launches of the iPad 2.615 127. and we think the launch of the Mac App Store could accelerate market share increases.552 21. in our view.378 199. Although Apple’s desktop and notebook revenue is now only two thirds the size of iPhone revenue. call +1 312-696-6100. Apple can now distribute third-party applications directly to consumers. Growth and Profitability We are increasing our fair value estimate to $475 per share from $460. Inc. there is still the potential for things to go wrong at Apple. as the vast number of iPhones in customers’ hands has created a massive market for third-party applications. This is why we think investors are right to be concerned about the potential for Steve Jobs’ permanent departure from Apple. © 2011 Morningstar. Although Apple has an abundance of talented developers.50 USD [Nasdaq] Consider Sell 665.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . We therefore believe the Mac App Store has the potential to drive further market share gains. which by some estimates accounts for more than 80% of the nascent tablet computing market. Unless otherwise provided in a separate agreement. Additionally.794 9. Currency(Mil) USD USD USD USD Market Cap 301. ß ® . and should not be considered a solicitation to buy or sell any security.90 USD Fair Value 475. Most of this increase is due to higher expectations for iPad sales after the strong U. it makes it easy for consumers to review applications (thus making it less risky to try new applications) and makes it extremely Valuation.5 billion in 2010--despite the fact that the iPod. engineers. Redistribution is prohibited without written permission.220 3. To order reprints. While we believe the network effects and modest switching costs are partially responsible for Apple’s continued revenue growth and expanding profitability.126 Net Income 19. correct. This was exacerbated by the fact that third-party software produced for the Mac got extremely limited retail distribution.239 easy for consumers to install applications and to keep their applications library up to date with one click. This report is for information purposes only. and iPad work in conjunction with Windows-based computers as well. We still expect Apple’s share of the smartphone market to top out at around 15% by 2015. Inc. The information contained herein is not represented or warranted to be accurate. iPhone. product managers. it is important to recognize that revenue from those products has been steadily growing--from $7. you may use this report only in the country in which its original distributor is based. Close Competitors Apple. Inc. Moreover. Morningstar data as of June 10. or timely. All Rights Reserved.S. which in turn increases the appeal of the iOS platform for consumers. complete. Apple has steadily gained share in the notebook and desktop market throughout the past decade. We’ve also modeled more rapid market share gains in Apple’s legacy desktop and notebook computer businesses.114 29. strong network effect. 2011.185 TTM Sales 87. Data as originally reported. is that the availability of third-party applications has been extremely limited compared with Windows. switching costs will grow.

Bears Say Risk In our view. we would expect a couple of years of smooth sailing. The other major risk for shareholders is the firm’s heavy dependence on U. which runs the risk of fragmentation. economy.5 billion in free cash flows in fiscal 2010. While we think Apple has an economic moat. we still think iPods will have a place in the iOS ecosystem.90 USD Fair Value 475. We think COO Tim Cook is an able manager and Apple has an extremely deep talent pool. much of its ability to open customers’ wallets is based on its brand image. 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. correct. exposing the firm to significant customer concentration risk in the event of a big economic downturn. but we’d worry about how long Apple’s winning streak could continue after that. Although it has a significant international presence. To license the research.S. the high price points of its products could limit growth in emerging markets. We continue to be surprised at the number of first-time Mac customers the firm adds every year. call +1 312-696-6869. A downturn in the U. would probably weigh on sales growth. Redistribution is prohibited without written permission. software puts iOS at less risk than Android.S. and has generated $16. We think the Mac App Store will accelerate share gains. We think he deserves much of the credit for Apple’s tremendous success during the past decade. and should not be considered a solicitation to buy or sell any security. and his long-term absence could deal a heavy blow to the company. If either the iPhone or iPad disappoints. Data as originally reported. the Mac computer can continue to increase its share as a capable Windows alternative. Apple’s success during the past decade is largely attributable to the leadership of Steve Jobs.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . However. We don’t expect a significant change in the firm’s cost structure. Apple’s retail stores provide a platform for exposing new consumers to the breadth of the company’s expanding product line. all bets are off.00 USD Consider Buy 332. 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.and user-focused vision has been instrumental to Apple’s renaissance and has served investors incredibly well. Apple’s sales are concentrated in the U. It carries no debt.Apple. consumers and high-priced products.5% from 40%. This report is for information purposes only. Financial Overview Bulls Say The iOS mobile operating system is likely to be part of a duopoly with Google’s Android.S. Steve Jobs’ recurring health problems are a legitimate concern.. Unless otherwise provided in a separate agreement. AAPL Last Price 325. But if the brand becomes tarnished. © 2011 Morningstar.50 USD [Nasdaq] Consider Sell 665. we’ve boosted our long-term gross margin target to 42. We believe the iPod business will contract at a 10% per year on volume. or a worldwide economic downturn. If Jobs were to leave the firm on a permanent basis. With less than 5% share worldwide. as it did in fiscal 2009. holds another $25 billion in long-term investments. As we believe the iPad will remain very successful and will drive increased sales of high-margin applications and media. Inc. ß ® . All Rights Reserved. To order reprints. But we also believe Jobs’ product. so we think operating margins will hit north of 30%. call +1 312-696-6100. complete. and our valuation assumes that the iPad becomes a significant growth driver. you may use this report only in the country in which its original distributor is based. our fair value estimate will fall. or timely. since the firm has gone a full decade without a significant flop. The information contained herein is not represented or warranted to be accurate. We think this image is deserved. Nearly 40% of Apple’s revenue comes from the iPhone line.

Data as originally reported. Apple launched the Mac App Store.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . it sells and rents TV shows and movies and sells applications for the iPhone and iPad. call +1 312-696-6869.00 USD Consider Buy 332. Inc. Unless otherwise provided in a separate agreement. Apple’s products are distributed online as well as through company-owned stores and third-party retailers. correct. Redistribution is prohibited without written permission. Though the stock-option backdating scandal raises our stewardship concerns. As such. The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance.90 USD Fair Value 475. The information contained herein is not represented or warranted to be accurate. All Rights Reserved. call +1 312-696-6100. Apple’s executives have been richly rewarded as a result of the company’s tremendous performance. but the vast majority of compensation comes from equity as opposed to cash. the iPad. This report is for information purposes only. Jobs’ health is a significant concern. including the appointment of lead codirectors in 2006. © 2011 Morningstar. Apple has taken other steps in the right direction.Apple. an online store that sells first. Management: Steve Jobs cofounded Apple in 1976 and rejoined the company as CEO in 1997. 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.50 USD [Nasdaq] Consider Sell 665. we believe aggressive moves by the board have enabled the company to turn the page.and third-party applications for the Mac line of desktop and notebook computers. AAPL Last Price 325. ß ® . To order reprints. or timely. Company Overview Profile: Apple designs consumer electronic devices. In early 2011. and most have worked with him for a long time. COO Tim Cook came to Apple from Compaq in 1998. including PCs. complete. Its iTunes online store is the largest music distributor in the world. To license the research. the iPhone. CFO Peter Oppenheimer has been with the company since 1996. He has personally recruited much of the current management team. and the iPod. you may use this report only in the country in which its original distributor is based. and should not be considered a solicitation to buy or sell any security.

Analysts covering this company do not own its stock. Apple also beat our expectations on operating expenses. To order reprints. 17% growth in software sales. respectively. Inc. correct. but if he were to hand over leadership on a permanent basis. 2011 Apple Under Review revenue grew an impressive 17% and 23%. Data as originally reported.50 USD [Nasdaq] Consider Sell 665. This growth was partially offset by a 14% decline in iPod revenue. © 2011 Morningstar. Apple actually saw a small amount of gross margin contraction.90 USD Fair Value 475. and R&D at 3%-3.7% in the year-ago quarter. but the overall gross margin decline was from the mix shift. and should not be considered a solicitation to buy or sell any security. The information contained herein is not represented or warranted to be accurate. those figures numbers were 7. call +1 312-696-6100. as we view his leadership as an important factor in the firm’s success over the past decade. and Macs. All Rights Reserved. This report is for information purposes only. general.2%. This report is for information purposes only. driven by 126% iPhone revenue growth. or timely. iPhone. We think Apple can function perfectly well in the near to intermediate term in his absence. based on second-quarter results we think our thesis remains intact. or timely. respectively.00 USD | QQQQQ Uncertainty Medium Economic Moat Narrow TM Stewardship B Morningstar Credit Rating Industry Computer Systems . it is important to note that although software and iTunes Jan. Given that we think software and iTunes have significantly higher gross margins than hardware.4%. our guess is that gross margins improved for most (if not all) categories.1% and 2. complete. Redistribution is prohibited without written permission.5% in the year-ago quarter. you may use this report only in the country in which its original distributor is based. $2. hardware peripherals. to 41. and should not be considered a solicitation to buy or sell any security. To license the research. Revenue increased 83%. Put gross margins and operating expenses together and operating margins rose to 31. which is being cannibalized by the iPhone). Steve Jobs’ second leave of absence is certainly a matter of concern.8 billion of iPad sales (there isn’t a year-over-year growth figure because the iPad was released later in 2010). does not own more than 1% of the shares of this company. One area in which our thesis appeared at first to not quite hold up this quarter was on the gross margin line. 20. However. call +1 312-696-6869.9% from 29. Morningstar Inc. 2011 First Take on Apple’s 2Q--Blowout. AAPL Last Price 325. The information contained herein is not represented or warranted to be accurate. this was much slower than the revenue growth of 93% for the the combination of iPod. complete. We’ve been modeling long-term selling. We are sticking with our $475 fair value estimate for Apple after reviewing the company’s second-quarter results.00 USD Consider Buy 332. 18. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company.4% from 41.5% of sales. iPad. 32% Mac revenue growth. Analyst Notes Apr. Operating Income Up 98% off of 83% Revenue Growth. 23% in iTunes revenue. These represent a significant improvement over the prior year’s 9% and 3. ß ® . we’d have to reassess our long-term view.Apple. We are putting our fair value estimate for Apple under review while we transition coverage of the company to a different analyst. and administrative expenses at about 8% of sales. Our investment thesis has been that the firm would see broad-based growth across its entire product portfolio (excepting the iPod. correct. and 23% growth in revenue from peripherals. In the second quarter. Unless otherwise provided in a separate agreement.

5 1.8 0. TTM data based on rolling quarterly data if available.0 3.4 101.8 22. call +1 312-696-6869.6 2010 25.9 3.5 5 Yr Avg 36.25 320.8 22.20 934 -176 758 2004 13931 29.0 1650 11.7 956.4 3496 3. it sells and rents TV shows and movies and sells applications for the iPhone and iPad.3 27. otherwise most recent annual data shown. 2011 Fiscal year-end: September Apple. 47791 .16 202.1 19. 5076 . 33427 61477 Mkt -0.6 .4 192.93 1.00 925 52. 2010 22670 . 61477 .5 15.8 . 32.7 48. 24327 .09 6.0 .0 59. CA 95014 Phone: 1 408 996-1010Website: http://www.7 2007 14. 9984 .00 931 66.7 10.4 28. Data as originally reported.5 4.5 54.Industry +/.4 130.4 -25 -0.4 1.2 62.00 889 19.6 1.1 .4 127941 8.1 22.51 1.9 2008 18. 6.3 120.0 1. Microsoft Corporatio Hewlett-Packard Comp Major Fund Holders 301378 199899 73114 87451 15.66 364.8 19.6 2005 13. or timely.and third-party applications for the Mac line of desktop and notebook computers.00 1.04 0.1 1.3 .73 89 -174 -85 2002 6207 27. .3 326 3.8 1335 1.3 .07 2220 -657 1563 2006 24006 34. 14532 .0 20343. AAPL Apple designs consumer electronic devices.6 21.95 1. 14.7 .Market Profitability Analysis Grade: A 52.7 11. 10.7 5.5 2009 22.64 185 -232 -47 2001 5742 27. 2003 4375 . 25893 2004 123. 7859 2003 201.9 146.3 4834 5. 27392 47791 5 Yr Avg Ind 15978 930 11095 46997 6241 1248 94904 14645 .4 18385 28.3 7.0 26741. 2009 20956 .5 Price/Earnings P/E vs.5 0.0 18.90 .0 15683.6 .36 0.06 1.94 2535 -260 2275 2005 19315 29.9 3.8 44. Its iTunes online store is the largest music distributor in the world. Inc.5 .64 4.35 4.20 190.09 0. 2.4 42.3 122.2 38.0 8337. To license the research.7 1.0 21.00 727 5.0 . the iPhone. and should not be considered a solicitation to buy or sell any security. 31640 . complete.1 0.90 50.1 Ind 23.33 .1 .378 Uncertainty Computer Systems Economic Moat TM Technology Stewardship Grade QQQQQ 13.0 1. 1.56 10 Year High/Low 364. 60587 2005 18.9 2.Industry Dividend Yield % Market Cap USD Mil Financials Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % +/.6 1.00 724 5.5 . 72901 173427 2006 2007 -56.61 6.0 2453 12.4 39. .1 5.8 .4 Mar 11 % of shares Most Recent Period Prior Year Period 3.0 133.2 -34.9 53.4 26.0 Current 39.5 19.2 14.00 878 13.2 20.0 19. All Rights Reserved. 42.3 6275 19.9 16.68 12.4 -0.08 2001 3730 316 4095 0.9 41.8 7. an online store that sells first.4 52.7 2006 16.0 4409 18.1 .0 3.0 56.5 0. 2006 12657 .36 0.27 0.5 14.96 200. 2005 8038 . 16.4 Fixed Asset Turns 17.5 1.6 2003 3.9 0.7 50. TTM Working Capital USD Mil Long-Term Debt USD Mil Total Equity USD Mil Debt/Equity Valuation 36.2 20.7 0.2 46.7 38.8 .5 17.59 93. 2011 Rating updated as of Jun.56 7.15 0.19 5470 -986 4484 2007 32479 34. Unless otherwise provided in a separate agreement.34 1.2 8.4 200.48 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 % 38.3 Dec 10 82. 4.3 14.1 1.4 13. 23.3 15.9 . 4223 .3 1.0 8.00 857 9.6 .8 19.9 276 0.4 0.00 75.0 39.5 13.6.8 10. call +1 312-696-6100.8 29.1 30.8 30.2 14013 15. the iPad.0 Revenue/Employee USD K1770.0 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 % +/.3 16.3 1137.8 7.0 57. 9.4 21.56 0.8 43.1 22.5 4.0 1. .9 17 0.7 . 2. 0.0 54.00 902 25. Redistribution is prohibited without written permission. *3Yr Avg data is displayed in place of 5Yr Avg © 2011 Morningstar.3 3.2 30.3 11.com 6.0 Jun 10 Sep 10 Dec 10 Mar 11 Apple.3 19.1 40.7 Most Recent Period Prior Year Period Earnings Per Share USD 88. 3.6 6.3 105.5 Most Recent Period Prior Year Period Rev Growth % 15700.451 Last Price Fair Value 301.9 32.93 0.40 3.8 .99 1.2 1.1 146.99 0. 48.10 18595 -2005 16590 2010 87451 39. 2004 6816 .Morningstar ® Stock Data Sheet Pricing data thru Jun.5 12.3 21.1 9.5 11.11 1.26 213.2 40. To order reprints.46 31. In early 2011.6 4.9 11.4 123. 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 15.1 11.43 3. 7703 2001 -34.95 326.1 0.2 60. 10.3 9. 20722 .6 4.9 Mkt 47.0 Monthly High/Low Rel Strength to S&P 500 52 week High/Low 364.2 4.5 40.14 78.2 16.9 27.5 2001 1.5 61. 13.3 15.4 10.3 1.1 29.0 -18.6 29.15 1.84 1.1 25382 29.9 31. and the iPod.0 17.6 1.9 .3 1. The information contained herein is not represented or warranted to be accurate. Apple’s products are distributed online as well as through company-owned stores and third-party retailers. 21030 . 75997 190983 297089 301378 2008 2009 2010 TTM 5363 23.7 65.apple. This report is for information purposes only. 3.2 0.0 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 .5 1.7 Sep 10 70.51 6.3 -1.0 16238. 4.3 65 0.8 .13 1.67 6. 2007 20598 .08 2002 3530 .4 35.3 33.22 325.25 81.5 12.0 . 2008 20049 . correct. Apple launched the Mac App Store.42 1.5 0.0 24667.5 17.4 .3 11.4 Inventory Turns 68.7 42.0 56.3 1.90 79.9 1. .6 2004 13.1 11740 27.6 36.9 13.6 66.0 -344 -6.1 1.7 Jun 10 25.00 775 7.235.36 Bear-Market Rank 6 (10=worst) Trading Volume Million 1 Infinite Loop Cupertino.9 1.4 8235 9.7 17.08 0.0 13499.8 35.9 39.6 -0.10 0. 6. .5 2002 1.00 907 39. 23.8 11. including PCs.Market +/.7 38. Morningstar Rating Sales USD Mil Mkt Cap USD Mil Industry Sector 87. ß ® .73 9596 -1199 8397 2008 42905 40.7 1989 2. 7466 .5 03-11 Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health 3625 317 3920 0.47 10159 -1144 9015 2009 65225 39.8 .78 10.0 Return on Assets % 25.5 68615 9.5 -1 0 69 0.90 475.0 19.7 25. you may use this report only in the country in which its original distributor is based. 1.5 12. . 46.00 691 5. Inc.0 19552 20.0 22.3 20.8 .6 -11.6 12.89 289 -164 125 2003 8279 27.9 5. 5146 2002 49.0 57.5 .36 34.16 Price Volatility 199.8 .4 30.9 .3 1.30 2:1 Medium Narrow B per share prices in USD Annual Price High Low Recent Splits 13.90 .6 12.1 -84.2 * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: A 09-10 USD Mil 35.6 2.1 29.

For high-quality businesses. usually by virtue of some competitive advantage. Assumptions are input into a discounted cash-flow model. we evaluate stocks as pieces of a business. for a simple reason: We have more confidence in our cash-flow forecasts for strong companies. We update the text of our reports as new information becomes available. determines the rating. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. 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. All Rights Reserved. and then adjusting the total for timing and risk. and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business. but market prices do. That is why you’ll see two dates on every Morningstar stock report. many more will likely garner 5 stars. We calculate our star ratings nightly after the markets close. 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. The information contained herein is not represented or warranted to be accurate. Our estimate of what the business is worth hasn’t changed. call +1 312-696-6100. which anchors the rating framework. we require a smaller discount than for mediocre ones. To license the research. If we think a stock’s fair value is $50. distributor. An uncertainty assessment establishes the margin of safety required for the stock rating. and should not be considered a solicitation to buy or sell any security. Cash generated next year is worth more than cash generated several years down the road.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. a stock may gain or lose stars based just on movement in the share price. not as pieces of paper. Even the best company is a bad deal if an investor overpays for its shares. Unless otherwise provided in a separate agreement. which is why the rating date on our reports will always be the previous business day. Of course. So. call +1 312-696-6869. no matter how wonderful we think the business is. and thus in our value estimates. the star rating will go up. usually about once or twice per quarter. you may use this report only in the country in which its original distributor is based. 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. ß ® . 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. complete. Redistribution is prohibited without written permission. Analyst conducts company and industry research: Management interviews Conference calls Trade-show visits Competitor. it will receive a low star rating. or timely. and the shares decline to $40 without much change in the value of the business. adjusted for uncertainty. rather than short-term movements in stock prices. and issue them the following business day. we monitor market events and all of our stocks every business day. This report is for information purposes only. Our star rating is based on our analyst’s estimate of how much a company’s business is worth per share. 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. relatively few will receive our highest rating of 5 stars. We rate stocks 1 through 5 stars. correct. Data as originally reported. DCF model leads to the firm’s Fair Value Estimate. To order reprints. at times we may appear out of step with the overall stock market. supplier. But when the market tumbles. Although you might expect to see more 5-star stocks as the market rises. Because we focus on the long-term value of businesses. When stocks are high. If a stock’s market price is significantly above our fair value estimate. so our ratings always reflect our analyst’s current opinion. © 2011 Morningstar. with 5 the best and 1 the worst. but the shares are more attractive as an investment at $40 than they were at $50. we find assets more attractive when they’re cheap.

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