My bite of the Apple

updated: 9/27/2011 (fall 2011)

The Outline
1. 2. 3. 4. 5. 6. 7. 8. The theme-Great company, Cheap price. Business analysis Financial analysis Stock valuation The moat Risk Bulls vs. bears Investing strategies

The theme-business
With the dropping of Computer from its name, and the introduction of iPhone, the era of Apple is coming back, at a larger stage. Apple now is a 4-cylinder engine: Mac, iPod, iPhone and iPad lines, and each is a power house. Each segment is a $10-20 billion business.<overview> As the only vertical integrated PC software and hardware maker, Apple had lost itself in the WinTel world for more than one decade. iPod saves and lifts this company, causing so called Halo effect and helped increase Apples market share in PC from less than 3% to 10% ( in US). However, it is iPhone that is the real game changer, for Apple as well as for cell phone and PC industry. iPad is yet another evidence of Apples strength in innovation and yet another indication that next big thing from Apple could be around the corner. <some details> Apple is the only $200+ billion company(market value) that still grows at 50% rate. Apples unique tracking record of innovating into a new field and dominating that category defies the rule of too big to grow fast to some degree. <uniqueness>

The theme-stock
As of 9/27/2011, the market stock price is around $400, and we believe its fair value is around $500. Considering its potential growth in next 5 years, continuous growth from innovation in the long term, and rich free cash it has accumulated and continue to generate, it is still very cheap with a 15 PE. AAPL has been a very volatile stock for the last three years and will continue to be. The combination of its risk and return offers great opportunity for patient investors who buy growth at value price. Recommendation: BUY
Disclaimer: this is an example of stock analysis for educational purposes. The professor is not endorsing any stock in this class.

Business Analysis-Macro Economy

The state of our economy (also see separate slides). The state of the overall stock market.(see stock history) The impact of slowing economy on AAPL
products
Products sold at premium price would suffer Some purchases will be postponed, but not discarded Innovative products at its early life cycle will still grow

Financial strength
A strong balance sheet with enough cash is an important competitive advantage

Business Analysis-Industry Analysis

See separate slides for smart phone and PC industry analysis

Business Analysis-The Products

Overview: Segments, size, market share and growth.
Mac (hardware and software): 14M units ,4% PC share; 30+% growth, 3 times industry average. Down to single digits during recession. Rebounded to 32% growth in 2010. iPod (also iTune, and accessories): 50M units, 70% US market, negative growth. Down 7% June09 Q , first decline since introduction. Will decline at 10% rate iPhone: 10M + units 2008, 20M 2009, 40M 2010. huge growth potential, might reach 100M in 2013, and 150M 2015. The King of the iEmpire. iPad: 10M first year of introduction, 20M 2011, 50M 2015

Business Analysis-The Products-iPad

Tablets Demand-why users want it?
When
Travel, at home or in class

What
Web Email Video (youtube, Netflix, iTune, Hulu) Ereader, enhanced books, textbooks (interactive features) Create documents Other: games, music

More for individual than for business use(?).

Realtor, Spaceship Conferences

Business Analysis-The ProductsiPad

Tablets Demand-more on e-textbook
The rising e-textbook tide
Publishers are embracing e-textbook at a very fast speed. In fact, many text books now have a e-version E-textbook has very little marginal cost E-textbooks are not resalable (unlike used books, publisher and authors always get paid) E-textbooks offer interactive features for homework and exams, and many more.

A hardware is needed, cheap and capable. (iPad?)

Business Analysis-The ProductsiPad

Tablets Demand-Addressable Market
Tablet offers portability and size that is between PC and smart phone Tablet is a complement of PC, not a replacement(?). The addressable market is big in absolute size (150million users), but smaller than PC (1 billion user) Annual sale will be around 50 million units in 5 years Pending demand is high

Business Analysis-The ProductsiPad

Potential Supply (tablet industry)
PC makers (HP, Dell, Acer..) Smart Phone makers (NOK, Samsung) Ereader (Sony, AMZN)

Business Analysis-The ProductsiPad

Post iPad launch and the users
Users love their iPads 3.2 Million sold in June Q Production cannot meet demand

Business Analysis-The ProductsiPad

Post iPad launch and the tablet industry
The surprise
$500 is a bad surprise for competitors iPad an extension of phone OS, not Mac OS
Always on, long battery, not Hot!

The Consequence
HP, Microsofts failed first strike Delayed launch of other tablets E-reader price war

Current competition (Lenovo, Dell, Android) Future competition

Business Analysis-The Products-iPad

How WinPad can win?
Match features
Price OS: Win 7 mobile OS, system always on, no starting time Battery Form-weight, thickness Apps

Differentiate
MS Office, Flash Connections with other devices, print Different forms (7, 5, 11..)

Business Analysis-The ProductsiPad

iPad
Strength<?>
Apps Price-$499 Battery-10 hours iPhone OS: easy to start, always on, low consumption of power Fast, no virus, no pop ups, no frozen screen No openness (store files, play video and music from other sources) No Flash No real keyboard No MS office

Weakness<?>

Business Analysis-The ProductsiPad

iPad sales, profitability and stock value added
Commands 30-50% share of tablet market 6 million units for fisical 2010 (twice the units of all kindles sold so far), 20 mil 2012. Gross Margin: 35% iPad standalone stock value: $45 B, or $48/share
Sales=$600*20M=$12b Operating Profit: 12*35%=$4.2b Net Profit: 4.2*70%=$3b Assuming PE=15 3*15=$45b market capitalization

Business Analysis-The Products-iPhone

Quick survey
satisfaction
Smart phone ownership and satisfaction iPhone ownership and satisfaction Other smart phones satisfaction

Plan to buy
Buy iPhone Buy other smart phones

Why like iPhone? Why not?

Business Analysis-The Products-iPhone

Strength

Non-defendable

Defendable

All-in-one pocket device Full screen Touch (vs. keyboard, tracking ball), (Win vs. Dos), important for applications (calculator, etc..) Ease of use An evolving phone: your phone gets better without hardware upgrade The brand (innovative, cool, high quality, premium brand) Multi-touch:

App store iTune Ecosystem: (medium file manager and on-line store)

Critical for small screen device, great for internet Protected with patent, challenged by Palm Pre, and more challengers to come. Just sued HTC, and Google could be next

Business Analysis-The Products-iPhone

Weakness Real issue
A closed system The exclusive carrier: smart decision or not? The data fee: an opportunity for a no-data fee competitor?

Non-issue
The battery: not enough for a heavy duty day The keyboard: Need hepatic feedback? The device price

The features: what should be included and what should not? Weakness from your user experience

 The iPhone-competition

Business Analysis-The Products-iPhone

Competition: Is the Storm coming? Is it time for Dream? New Entry:
Traditional phone makers Smart phone only makers New comers PC guys: Dell, HP, Lenovo, Acer

Create and continue dominance like iPod? Or fade away like Mac before Possible outcomes of smart phone industry
Co-existence of several major brands, hardware and platforms A dominant player (winner takes all) A universal operating platform ( Google, WinMobile)

Projection of smart phone industry market share in 5 years

Business Analysis-The Products-iPhone

The iPhone: sustainable competitive advantage
Strategic Strength
Strength
Software and applications: smart phones will be software centered Hardware: a fashion statement PC expertise: the phone feature is less important, and the computer features are the differentiator The App store and iTune The brand The customer loyalty: the highest among competitors, always The focus and economy of scale

Business Analysis-The Products-iPhone

Strategy It is the software!
Old game (hardware) vs. Apple (Software) I dont see new form factor in the near future

Using App Store to distinguish from competitors

Get iPhone/iTouch to mass market Making development tools easy to use More App, less in-house software

Using iTune content to distinguish ..

Business Analysis-The Products-the Mac

Strength
Software Relatively free from most viruses Fast speed Most applications are free Hardware Design driven (first all-in-one design) First to see the desktop to laptop trend Strong brand in US, especially college ( Hollywood?)

Business Analysis-The Products-the Mac

Weakness
Software Win compatibility, pose long term threat Lack of applications High price Less brand recognition outside US, especially developing countries Penetration in business not successful

Business Analysis-The Products-the iPod

Strength
iTune, a ecosystem, a plat form, not just device First mover advantage Brand,Design Economy of scale(cost),Marketing

Weakness
Does not own content Too strong brings too many enemies ( studios-NBC, digital distributors-Amazon, device maker-Microsoft, Dell) Low bar of entrance (digital retailer is easy to start) Converging to converged device ( the phone) Market Saturation

Financial Forecasting
Top-down product driven approach
Sales
Revenue driver Market share: (Too big to grow) Units Average Selling Price (declining ASP)

Financial Forecasting
2008 Sales
Sept 2008: Mac 10M, iPod 54M; iPhone 10M Market share: 3.4%PC, 45%MP3, 1%Mobile,7%Smart ASP: Some Software sales are more related to the total installed base than new sales, like an operating system upgrading iTune revenue is more related with the installed base of iPod
iPhone, new accounting rule

Financial Forecasting
Profits and margins: from top line to bottom line
Gross margin
Competition will force price cut and reduced margin Component cost declines over time Mac, iPod: historical average iPhone:

Operating margin
Economy of scale. Fixed cost is fixed, average cost down, Net income increase faster than sales and profit margin gradually improves

Profit margin
Interest Tax

Financial Forecasting
EPS
EPS=Net Income/Number of shares outstanding Number of shares: SEO, normal Dilution, option grants

Stock Valuation
PE approach Forward PE Five year super growth P/E model
Simple and useful Financial forecasting beyond five years is of little value Five year super growth: growth will eventually slow down due to competition and rule of big numbers Assuming industry average P/E in five years

Stock Valuation
Sensitivity Analysis
Future=uncertainty Output depends on inputs and model Map possible inputs and output (price)

Stock Valution
Free Cash Flow(FCF) model
Consider FCF as the theoretical dividend that can be paid It works like a two stage dividend growth model

The moat
Definition of moat:
Long term sustainable competitive advantage Wide: The company still owns the market if it stands still for five years Narrow: The company can stay ahead of its competition if it keeps moving faster than competitors None: The company can be outpaced by competition any time

Components of moat: Switching cost, network effect, scale of economy, brand, intangible assets Google, Facebook, MSFT,NFLX,Railroad, Utility

The moat: Apple-Narrow but growing

The brand commands premium, and enjoys loyalty
Q: who is willing to pay premium for those brands
AAPL, Dell, SONY, Tiffany

The innovation is not a one-time wonder

Apple II, Mac OS, iPod, iPhone, iTune, App store

The moat: Apple-Narrow but growing

Is there a switching cost?
In class survey: will you switch? iOS: Users do not want to switch OS. There is a time cost of learning Apps: they cost money, contain personal data(1password, notes, iBook) and wont work on other OS. Content: music/video purchased from iTunes with protections.

The moat: Apple-Narrow but growing

Network effect: The value to individual users increases
as more users use the product/service.

the more users of iOS, the more developers, the more Apps and the more users. It is a good cycle, like a rolling snow ball. Facetime, Game center The gravity of mobile OS will concentrate on iOS and Android. Together, they may take 50%-75% of smart phone and tablet market

The risk
Steve Jobs: The priced in expectation is that he will stay active as CEO for a least 5 more years(60 years old) and probably less than 10 years (65). If he stops working for health reasons, AAPL might lose $25b to $50b value instantly. Any speculation of his health will also cause the stock price fluctuate in a large range Competition: AAPL is not Microsoft at any fronts it competes.
Enemies:
Enemy number 1: Google. Competes with AAPL on mobile OS, Tablets, internet TV, and possibly music. Enemy number 2: Microsoft Smart phone family: NOK, MOT, HTC, Samsung, RIMM

Price and margin pressure

The risk
Disruptive technology: like Cloud computing does to Microsoft, Smart phone does to Nokia. Double Recession: we should still see growth, but slowed down. Regulation: not a big concern as Soft or Intc, but a growing concern Quality issue, product failure
Antenna gate for iPhone4. Explosive iPod in Japan White iPhone delay

Lawsuit: patent lawsuit banned it from delivering smart phones.

Bulls vs. Bears

The Bear Too big: AAPL has a market cap higher than Soft, and the only direction from top is going down. Valuation: Current valuation is still high, compared with Soft and Intc. Android: Competition like Android is catching up Margin: Margin might collapse because of competition Growth: Growth will slow down. Rule of big numbers. Double dip

Bulls vs. Bears

The Bull
iPhone and iPad revolution, just the beginning. The halo effect The moat The vision and innovation into a different industry. FCF conversion, Large cash reserve Valuation still low

Investing Strategy
Ladder Approach
Buy at 20% discount Overweight at 30% dis Leap call option at 40% dis Short term call options at 50% discount

Notes-new developments since spring 2010

iPad sales exceeded expectation by wide margin Antenagate 2010March and June Q exceeded expectations