US Equity Research July 26, 2015

Michael Lin, 614-264-0145

mlin1120000@gmail.com

Student Investment Management Report

Ticker: NASDAQ: AAPL
Current Price: $124.50 (July 26, 2015)
Target Price: $125.66 (1.0% upside potential)
Recommendation: HOLD

Sector: Information Technology

Apple Inc.

Company Description
Market Profile (as of July 26, 2015)
52-Week Range
$93.28 - $134.54
Avg. Volume
48.57M
Beta
1.13
P/E (ttm)
14.4
Dividend Yield
1.7%
Market Cap.
$709.99B
Diluted Shares Outstanding
5,773.01M
EPS
$8.65
ROE (FY14)
33.61%
ROA (FY14)
18.01%
Source: Yahoo! Finance
Stock Price Performance
April 2014 April 2015

Source: Yahoo! Finance

Performance v.s. S&P 500
April 2010 April 2015

Apple Inc. (Apple) designs and markets consumer electronic devices,

including personal computers, mobile phones, tablets, portable
digital music players. The company also provides its own operating
systems on each products and allows customers to purchase and
storage a variety of accessories, services and digital contents through
its iCloud and iTunes stores. Apple is the pioneer in information
technology sector which re-defined several industries through its
Mac, iPod, iPhone, and iPad.
Investment Thesis
I issue a HOLD recommendation for Apple. My valuation yield a
fair value of $125.66 as of 07/24. I believe the companys advantage
of current strong product portfolio is offset by the uncertainty of
future product initiative.
Apple launched its latest version of iPhone iPhone 6/6+ last
September which generated the highest additional customers in
one quarter. Given only 10-15% of iPhone users have upgraded
to iPhone 6 as of Q2 FY15, I believe there is still more room
for iPhone 6 to grow.
The company is sitting on $32B cash & equivalent and
possesses $110B net financial asset as of Q2 FY15. It is
planning to pay back $65B of cash through share buyback and
dividend in CY15. This set a buffet for downside potential.
Currently, I could not see a clear strategy for the long-expected
Apple Watch. There is no certain function or business need that
distinguishes the product from good-to-have to must-have. The
long term growth concern will remain an issue if the company
could not figure out a more sustainable business model.
Risk to Recommendation
-

Source: Yahoo! Finance

Failure to successfully launch new product will impact top and

bottom line of the company.
Similar function of different products could lead to selfcannibalization.
Strong dollar and weaker economy outlook in major oversea
market can affect the companys performance.

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July 26, 2015

Table of Contents
Company Overview3
Business Segments3
Business Model.4
Industry Overview and Competition Positioning......5
Current Issues....7
Business Trend..9
Investment Thesis.....10
Economic Analysis..10
Financial Analysis...11
Risk........................12
Supply Chain Risk.......12
Competition Risk.12
Currency Risk..12
Valuation...............12
DCF Valuation.12
Relative Valuation...14
Risk to Target Price.15
Conclusion............15
Appendices............16
Works Cited..............20

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July 26, 2015

Figure 1: Revenue Breakdown by Region

Company Overview

Source: Company Data

Founded at 1977, the Cupertino, California based consumer electronic

provider is now the largest public company in the world with $710B market
cap at the end of Q3 FY15. The companys revenue can be broken down
into six regions: Americas: 46.3%, Europe: 28.1%, Greater China: 21.0%,
Japan: 13.7%, Rest of the Asia Pacific: 6.9% and Retail: 8.9% (Figure 1).
Apple designs and markets its product and outsources the manufacturing
process. While most of its peers use Windows and Googles operation
system and follow the open source strategy, Apple provides its own
operating system and leaves less room for programmers to adjust to its
system. Similarly the company put more control on the hardware; for
instance, instead of using Intel or Qualcomms processor, the company
design its own CPU. This strategy leads to better integration between
software and hardware which leads to the companys 30% installed base
market share in premium smartphone market. Another obvious advantage of
the closed platform strategy is that there are less viruses on Apples platform.
Unlike its competitors, Apple operates its own retail stores that accounts for
28% of the companys revenue. The companys revenue and net income are
$182.8B and $39.5B in FY14; the growth rates are 7.1% and 6.8%
respectively (Figure 2).

Figure 2: Revenue & Net Income/Growth

Business Segments
Source: Company Data
Figure 3: Revenue Breakdown by Product

Apple currently reports six product segments iPhone, iPad, Mac, iPod,
Accessories, and iTunes, Software and Services (Figure 3). The new
products such as Apple Watch and Apple Pay will be discussed in Current
Issues.
iPhone
iPhone is the most important product for Apple which represents 55.8% of
revenue. This segment enjoyed 41.9% CAGR in sales for the past five years.
Thanks to constant upgrade of its product, the ASP remains constant. iPhone
is estimated to have 20% unit sales market share by Q4 CY14. The company
sold 169M units of iPhone in FY14 at an average price of $602 (Figure 5).

Source: Company Data

Figure 4: Tablet v.s. Phablet

Source: IDC, Company Data

Macintosh (Mac)
This segment accounts for 13.2% of revenue. As a more mature product,
Mac segment saw more cyclical revenue growth with 8.3% CAGR for the
past five years. This segment is facing a decreasing ASP trend for the past
decade due to fierce competition and short product life cycle. The company
sold 18.9M units of Mac computer at an average price of $1,273 in FY14.
iPad
Since its debut in CY11, the iPad business had grown rapidly to become the
second largest revenue generator which contributes 16.6% of sales in FY14.
However, iPads market share dropped dramatically from 70% to 30%.
Furthermore, after three years of rapid growth, this segment faced a 4% sales
decline in FY14. The pale result of iPad is due to lack of innovation and
increasing competition. In addition, iPad mini could also be negatively
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July 26, 2015
impacted by the large iPhone 6+, which is similar to the mini tablet (Figure
4). In addition, the ASP declined constantly after its appearance. Unless the
company develop new function, iPad will stay as an accessory rather than a
necessity.
Figure 5: Product ASP (M)
2010

2011

2012

2013

2014

629.6

636.3

629.3

607.5

602.7

ASP Mac

1279.4

1301.6

1278.8

1314.7

1273.6

ASP iPad

664.8

628.4

530.7

450.2

445.5

ASP iPhone

Source: Company Data

Services
Due to the well-established ecosystem the company built and the
comprehensive compliment application, Apple has a 13.1% sales from
services, which cannot be seen in other handset providers. The revenue of
this segment come from sales on iTunes, commission from application
developers and most recently, the fee from Apple Pay.
iPod
The portable digital music device Apple created was once a disruptive
innovation that, along with the iTunes platform, has shaken the music
industry. However, iPhone is now replacing iPod in every aspect; therefore,
this segment only contribute 1.3% of sales and experienced 48% and 21%
sales decline for FY14 and FY13. The company sold 14M units of iPod at
an average price of $159 during FY14.
Business Model
Figure 6: Mac ASP

Source: Company Data

Apple achieves todays success through constant innovation. However, the

fact that it needs to continuously bring in groundbreaking products also
shows the companys dependent on unpredictable innovation to maintain
current size. For the growing segment such as iPhone, this drawback has not
affected current performance since the company only needs to upgrade and
add in more features to sell the product at a higher price. However, the short
product life cycle is hurting the mature businesses such as Mac and even
iPad. The company saw constant price drop and decline in units sold even
when it upgraded those products every year (Figure 6 & 8). This very
phenomenon is also due to pricing strategy, the premium consumer
electronic device providers usually set higher price on the debut of new
products to attract heavy users, lower the price when the product has become
less trendy, phase out the products when they cannot meet the new functions
that other products serve. Therefore, the assumption that the revenue or free
cash flow can grow in line with the economy is not suitable for this industry.

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July 26, 2015

Figure 8: iPad Units Sold and ASP

Figure 7: No. of App on each OS

Source: Statisita
Source: Company Data, Wells Fargo Security

Figure 9: Acquisition Larger than $100M

Date

Company

Price
(Millions)

Apple
Product

28-May-14

Beats Music &

Beats Electronics

$3,000

iTunes

2-Dec-13

Topsy

$200

22-Nov-13

PrimeSense

$345

26-Jul-12

AuthenTec

$356

20-Dec-11

Anobit

$500

14-Apr-10

Siri Inc

$200

27-Apr-10

Intrinisty

$121

A5

5-Jan-10

Quattro

$275

iAds

7-Jul-08

PA Semi

$270

A4, A5

2-Sep-97

Power Computing
Company

$110

7-Feb-97

NeXT

$404

Touch ID

Siri

OS X

Source: Company Data

Although facing harsh environment, Apple is the best among its peers to
widen the moat. The self-built operating system not only differentiates itself
from its peers by delivering first class user experience but also increases the
switching cost and network externality. Users are inclined to stick with the
same operating system which they are familiar with to save time.
Furthermore, consumers are likely to choose the platform with more
applications. Currently, there are 1.2M applications for iOS and 1.3M for
Android. In contrast, there are only 0.3M application for the third largest
Window operating systems users to download (Figure 7). Without many
popular applications in other operating systems, the current duopoly
situation in mobile OS is very likely to stay intact. Apple Watch is another
way to increase the network effect among devices; moreover, services such
as Apple Pay also aim at increasing customers stickiness through
memorizing users personal information.
Unlike many other mega-size corporations, Apple achieves todays scale
through organic growth and in-house development of most of its important
products. The company has seldom acquired other companies to seek
growth. Figure 9 lists all the acquisitions larger than $100M Apple made
since 1997. The only large acquisition the company made is the $3B deal to
purchase Beats Audio to enhance Apples audio quality.
Industry Overview and Competitive Positioning

Figure 10: PC OS Market Share

Source: Ars Technica

Personal Computer
An ally among Microsoft, Intel and their downstream customers such as HP,
Dell, Asus is the primary competitor of Apple in the personal computer
industry. The user base of Apples OS is still significantly lower than that of
the Windows system as of February 2014 the OS X market share is a mere
7.69% compare to Windows 90.62% (Figure 10); however, the ASP for
Mac is twice as much as that of its competitors. Mac has grown faster than
its peers and has reached its highest market share record of 13.4% in Q3
FY14 in the U.S. market.

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Figure 11: Mobile OS Market Share

Source: IDC
Figure 12: Smartphone ASP

Source: BMO Capital Market, Company Data

Figure 13: High End Phone Market Share

(>$500)

July 26, 2015

Smartphone
The competition landscape is similar for the smartphone business. Google
and Qualcomm provide the operating system and chips for Apples
competitors such as Samsung, HTC and LG, etc. Apple loses its ground in
terms of OS user base market share to Android for the past three years,
which has grown from 50% to 80%. However, Apple maintains a significant
higher ASP than it peers, which is around $600 compared to $300.
Samsung is the only significant threat of Apple in high end smartphone
business. Those two companies together have captured more than 93%
market share of high end (price > $500) smartphone market (Figure 13). The
high end market is growing faster than the low end market (Figure 15).
Those two companies have filed over 40 patent lawsuits against each other
in many major countries for the past 4 years. However, they dropped patent
disputes outside of the U.S. as of last August. The fact that Samsung
produces and sometimes controls the market of several key components
such as CPU manufacturing, memory chips, LCD panel, and AMOLED
panel, makes the Korean conglomerate a real threat of Apple. Apple and
Samsung are the only two companies that can turn sales into profit Apple
dominates 81% of operating income of the whole smartphone industry while
Samsung takes the rest.
iPad
As the pioneer of tablet business, Apple once dominated this market;
however, without meaningful ways to bundle iPad with iPhone or Mac
together through exclusive function and low switching cost, the tablet
market has gradually become fragmented with many players fighting for the
market. Samsung is again the chief competitor in this field with other
traditional PC players such as Asus, Lenovo, and Hewlett Packard trying to
gain market share (Figure 14). However, the overall tablet market did not
see growth during CY14; moreover, with the market leader Apple setting its
iPads price in the range between $400 to $600, which is even lower than
that of its iPhone, this line of business is not lucrative for most players.
Figure 14: Tablet Market Share

Source: IDC, Credit Suisse

Figure 15: Smartphone Growth Rate

Source: IDC, Credit Suisse

Source: Gartner, UBS

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July 26, 2015

Current Issues
Apple Pay
Apple announced its plan to penetrate into payment industry by providing
Apple Pay service through its iPhone 6/6+, Apple Watch-compatible devices
(iPhone 5 and later models), iPad Air 2, and iPad Mini 3. This service
enables users to make payment in both retail stores and online checkout.
Apple Pay adopts the near field communication (NFC) technology.
Different from Apples previous strategy of vertical integration and
unwillingness to collaborate, Apple Pay will join force with Visa's PayWave,
MasterCard's PayPass, and American Express's ExpressPay system. The
service was exclusive to the United States market initially with international
expansion plan in the future. Apple has entered into Canada in March 2015.
There was an estimated amount of 220,000 vendors participating in Apple
Pay at the services debut. Macys, Bloomingdale, Walgreen, Subway,
McDonalds, Uber, Groupon, Panera Bread, Target, and Wholefoods are the
initial vendors to team up with Apple while Walmart and Best Buy stated
they will not accept Apple Pay. The need to upgrade the Point of Sale (POS
system) in order to accept Apple Pay and the fact that there are many
alternative ways of payment might lower some vendors interest to join.
Unlike the traditional credit card transaction, Apple Pay does not require
users to transfer personal information; instead, Apple borrowed Bitcoins
idea of creating a single-used token and transfer the token to finish the
transaction. The information of the token (or dynamic security code) will
stay between the customers, banks and the vendors, Apple stated that they
would not track the usage to gather customers purchase habits. This method
is said to be safer than the tradition credit card.
Apple Watch
Apple Watch is the smart watch created by Apple, and announced by CEO
Tim Cook in September 2014. The main features that have been revealed
are health monitoring and fitness tracking. The smart watch is integrated
with iOS and other Apples services and products. Customers can perform
services such as Apple Pay, receiving phone call, sending iMessages and
SMS texts, map services and run third-party applications. Siri, the personal
assistant is also embedded on Apple Watch.
However, Apple Watch also depends on iPhone to conduct significant
functions. For instance, the Watch needs to pair up with iPhone to play the
music.
The screen of the watch is a pressure-sensitive touch screen that can detect
the difference between a tap and a press; only two buttons are designed on
the Watch. According to CEO Tim Cook, the Watch will be shower proof to
prevent water damage but water submersion is not recommended. All
versions of Apple Watch have 8GB of storage to store up to 2GB of music
and 75MB of photos. The device is also Wi-Fi and Bluetooth 4.0 connectible.
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There are three collections for Apple Watch Apple Watch Sport ($349 and
$399), Apple Watch ($549 and $1,049), and the 18-karat gold version Apple
Watch Edition ($10,000 and $17,000), each of them has two sizes (38mm
and 42mm) and two colors. Each collection has three to six bands for
customers to choose. The main problem for this product is the short battery
life, which is estimated to last for only 18 hours due to it needs to constantly
connect to iPhone and leading to battery drainage. Apple Watch is available
for sales online on April 24 in nine markets, including the United States,
Australia, Canada, China, France, Germany, Hong Kong, Japan and the
United Kingdom. This product is an indication to see whether the current
management team can take on revolution rather than evolution after the long
gone of its charismatic founder.
Several competitors, such as HTC, LG, Pebble and Huawei have also been
working on the smart watch product to compete with Apple (Appendix 1).
Without revolutionary functions (or even functions that could not be found
on iPhones), the future of the Watch is far from promising. Apple did not
disclose the shipment information during the latest earning release but since
CEO Tim Cook mentioned more than 100% of the growth in Other
segment is contributed by Apple Watch during Q3 FY15, we can estimate
the revenue from Apple Watch is somewhere above $900 million.
Apple TV
Apple TV is the unsuccessful product Apple has spent several years working
on. The first release of Apple TV was back in 2007; the company continued
on developing this product and launched the latest TV Apple TV Rev A in
January 2013; the company attempted to connect consumers TVs and
enables them to access iTunes content for Streaming video and all online
services that was accessible on personal computers, such as Netflix,
YouTube, Flickr, Disney Channel, Hulu, HBO GO and WatchESPN.
However, the idea to revolutionize the TV industry as a cornerstone of the
companys Internet of Things has not yet been realized.
Apple Auto
Apple is said to have hired hundreds of engineers specializing in Human
Machine Interface, EV batteries and autonomous driving from major auto
producers including former head of Mercedes Benzs R&D division
(Financial Times, 14, Feb). Although this news has not been confirmed by
the company, it is reasonable for the largest public company to seek growth
in the $1.6 trillion automobile market, which dwarfs the smartphone
industry at $400B and PC industry at $266B. Without legitimate information,
this part of information is not included in the valuation; however, it is
important to note that Apples ability to continue innovation is the key to
future success.

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July 26, 2015

Business Trend
Bring Your Own Devices (BYOD)
The rapid growth of cloud computing and the transformation to more
intellectual and information based working environment have made BYOD
possible. With the increase of cross devices interaction and more
personalized devices and software, employees are more inclined to use their
own devices. A survey done by Mckinsey shows that 44% of job seekers
view an organization more positively if it allows them to bring their own
device. According to industry estimates, the global market for BYOD
created $72B in revenue in 2013. This market is expected to have a 26%
CAGR during 2013 to 2019, which implies a $284B by 2019 (Figure 16).
This on-going trend is beneficial to Apple since the company has low
penetration rate in the corporate market, especially when massive purchases
from big corporation will probably hurt Apples high margins. The
popularity and the ecosystem of Apples products in consumers area is likely
to spill over into business world if the BYOD remains robust. Furthermore,
if the BYOD becomes a phenomenon, learning Windows system and related
products may no longer be required skills. This can lower PCs network
effect that prevents Apple from getting more market share. To enhance its
corporate footprint, the company announced an exclusive partnership with
IBM to take advantage of IBMs big data and analytics capabilities to
implement to iPhone and iPad.
Figure 16: BYOD Market Size and Growth
Rate

Source: Marketandmarket.com

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Investment Thesis
Economy Analysis
Apples premium products are considered more luxurious than that of its
peers. As a result, Apples performance should be highly cyclical and
depends on the well-being of consumers.
Figure 17: R&D/Revenue

The Consumer Confident Index (CCI) is the indicator to see how likely the
consumers are going to spend more in the future. Figure 18 shows the CCI
has raised dramatically from 20 to 90 from CY08 to CY14. This is a positive
sign for Apple since consumer are now more willing to pay for superior
products.
Source: Company Data

Another indicator is the U.S. unemployment rate, which has dropped from
10% to 5.5% from CY09 to CY14 (Figure 19). Since 46% of Apples
revenue are generated from the Americas, the improvement of the job
market in the United States will have positive impact on Apples customer
base. The macro economic factors send positive signal which provide a
tailwind for Apple.
Nevertheless, since Apple is still in its growth stage (for its main product
and future products), and involved in an ever-changing industry, the
innovation is still the single most important driver of growth. For instance,
during the financial crisis in CY08, Apple still grew its revenue thanks to
the launch of its iPhone. R&D is a barometer to see the companys
willingness to innovate. Figure 17 shows the company has increased its
R&D over revenue from 1.5% to 2.6% from FY12 to FY14. Its a signal that
even after giving back shareholders tremendous amount of cash, the
company still invested a lot on innovation.

Figure 18: Consumer Confidence Index

Figure 19: U.S. Unemployment Rate

Source: Conference Board

Source: Conference Board

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Financial Analysis

July 26, 2015

Figure 20: Gross Margin Comparison

Superior Gross Margin

Apple created significantly higher gross margin through its popular products.
The companys average gross margin of 40% is twice as high as that of
competitors average of 23% (Figure 20). There is also a trend that the
company earn a slightly lower margin on an s year, which the company
only upgrades the previous product and has less new product launches
(iPhone 4S, 5C).

Source: Bloomberg

Figure 21: Du Pont Analysis

AAPL

Peers

ROE

35.34%

11.64%

ROA

18.01%

4.11%

Asset/Equity

2.078

3.06

Turnover

0.788

1.45

21.61%

3.41%

NI Margin

Source: Bloomberg

Figure 22: Debt/Asset Ratio

Source: Capital IQ

Du Pont Analysis
The company keeps a trailing twelve months ROE of 33.61%, compared to
peers 11.64%. The astonishing return to equity could be contributed to its
six-time-higher-than-average net income margin, which is at 21.61%. On
the other hand, the companys leverage remains low the asset over equity
ratio is a healthy 2.078 times whereas its peers have an average of 3.06 times.
Increasing Leverage and Cash Payback
Through its premium products and rapid sales growth, the company now
possesses $32B of cash and equivalent and $110B of net financial assets by
the end of Q2 FY15. On top of that, as current management took over, the
company has been more willing to increase its leverage and payback the
cash to shareholders. As Figure 22 shows, the company has increased its
debt over asset ratio from 36.4% to 51.9% during the past five years. Apple
is planning to sell another $6.5B corporate bond for FY15. The company
has already paid back $33B and $56B to shareholders in CY13 and CY14
and has started paying dividend since FY12. In April 2014, the management
team decided to increase the companys cash return program. The company
expects to return over $130B of its cash by the end of CY15 under the
expanded program, with $40B in dividend and $90B in share repurchases.
The company started payback shareholder since CY12. Figure 23 shows
Apple is returning 73% and 112% of its free cash flow to shareholders
mainly through share buyback in CY13 and CY14.
One concern for Apples ability to payback shareholders is the repatriation
taxes, which is 30% by now. Since only 11% of the companys cash are in
the United States, the company will face the huge tax bill if they send the
money back.
Figure 23: Cash Distribution
($ in millions)
Net Income
FCF
FCF% of NI

2011
2012
2013
2014
2015
2016E
$25,922 $41,733 $37,037 $39,510 $49,064 $52,149
$33,269 $42,561 $45,501 $50,142 $66,567 $72,999
128%
102%
123%
127%
136%
140%

Buybacks
% FCF for Buybacks

$0
0%

$0 $22,860 $45,000 $49,925 $54,749

0%
50%
90%
75%
75%

Dividends
% FCF for Dividends

$0
0%

$2,488 $10,564 $11,126 $16,642 $18,250

6%
23%
22%
25%
25%

Total FCF Returned

% of Total FCF Returned

$0
0%

$2,488 $33,424 $56,126 $66,567 $72,999

6%
73%
112%
100%
100%

Source: RBC Capital Market and Company Data

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Risk
Supply Chain Risk
Apple outsources most of its components and manufacturing process to third
party Asian suppliers. For instance, four Taiwanese companies namely Hon
Hai Precision, Pegaton, Compal and Quanta together assemble most of
Apples products. For the companys state-of-art CPU, only Taiwan
Semiconductor Manufacturing Corporation and Samsung Electronic are
capable of producing the cutting-edge chips. The high definition camera lens
is largely provided by Largen, yet another Taiwanese company. The flash
and other memory chips are mainly from its main competitors Samsung. The
concentration on few providers in same region and the reliance on certain
competitor to provide key components can lead to supply chain risk if any
political or economic uncertainty were to happen.
Competition Risk
Apple faces fierce competition in each product segment. The premium price
the company charges position itself in a riskier situation if an economy
downturn were to happen. The closed platform strategy also puts more risk
on Apple. For instance, if Google stops providing all the services such as
Google map, YouTube, Chrome and its search engine, Apples user might
find difficulties in sticking with Apple without those services.
Currency Risk
The on-going strong dollar could be a potential threat to Apple. As EU and
BoJ planning to launch massive quantitative easing, and Peoples Bank of
China lowered its prime rate and is also likely to start a quantitative easing
program, the U.S. dollar becomes the strongest currency in the world.
Moreover, Feds intention to raise the interest rate almost promises a further
appreciation of dollar. Under this premise, Apples oversea revenue, which
is more than 60% of its total revenue could be hurt badly. Although Apple
is involved in currency forward to hedge the currency risk, it is hard for the
company to hedge the risk if the dollar appreciate significantly and stay at
the relatively high level for a long period of time.

Valuation
DCF Model
Although the future cash flow for Apple is more difficult to capture, the DCF
model is still the best and theoretically correct model to forecast the
companys value. I use a five year forecast period due to the fast-changing
nature of Apples business and difficulty to quantify innovation that has not
taken place. Each business segments revenue are forecasted separately. The
followings are the assumptions behind the model.
Revenue
Mac: The CAGR of this segment is 8.3% for the past five years, given that
personal computer is a more mature market and competitors keep competing
on price and features, I give this segment a 6% revenue growth for the
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following three years and 4% for the other two.

July 26, 2015

iPad: Without significant breakthrough in developing new function, the

market size for tablet is relatively limited. The sales for iPad grew at a mere
3% in FY13 and encountered a decline of 5% in FY14. Furthermore, the
larger phone is likely to be the mainstream in the future. This might sabotage
iPad minis sells, which accounts for 41% of total iPad sales. Thus, I give a
sharp decline for the forecast period for this segment.
iPhone: iPhone will still be the main driver of Apples growth in the
foreseeable future. Based on the companys past record to publish a new
phone every two years, and launch similar but upgraded version in between
(such as iPhone 4S and iPhone 5C), there is an obvious 2 to 2.5 year cycle.
Moreover, by adding more feature (larger screen), Apple raised its selling
price significantly and received best sales record in respond. However, I
expect its pricing power will deteriorate as the market mature. I forecast the
revenue growth will be 50%, 6%, 15% 6% and 8% for FY15 to FY19. The
huge increase in FY15 is justifiable since Apple sold 76M iPhone 6 during
Q2 FY15 yet only 10% to 15% of iPhone installed base had upgraded to
iPhone 6.Not to mention the company announced the highest additional user
in Q2 FY15. The iPhone 6/6+ is expected to have extremely high penetration
in the growing Asian market where larger screen is popular among
customers. The increase in shipment and price are both factored in to reach
the revenue growth numbers.
Apple Watch: Since the Watch has to pair with iPhone for significant
functionality, I use iPhone installed base (past two years shipment unit) to
estimate the Apple Watchs unit sales. The all-in cost I used for this product
is $450, which is higher than the retail price of $350 since users will need
two wrist straps to work with the watch, which will cost $100 extra. Without
too many wow-factors from the previous product announcement, and the
idea that this product can hardly be a necessity like mobile phones, I use
only 1%, 2%, 3%, 2%, and 2% of iPhones forecast installment as Apple
Watchs penetration into iPhone installed base for the forecast period.
Apple Pay: This segment plays a role to increase customers reliance and
would not be a major revenue driver in the near future. However, it could be
a more stable stream of revenue with extremely high margin business for
Apple. Apple charges a 15bps per transaction for interchange fee from banks.
The plastic card transaction volume (including both debit and credit card) is
estimated to be 200B and will grow to 240B by CY18. According to Cowen
and Companys survey, over 35% of iPhone 6/6+ owners used Apple Pay
service, and among them, 65% use it several times a week. Based on the
positive number, I use a 2% increase of non-cash transaction market share
each year for Apple Pay for the forecast period (exclude online payment
system), starts from a 2% at CY15. After CY19, I assume Apple will change
to a percentage fee of 0.3% commission for each transaction and have a
stable 10% market share of the non-cash transaction.
Services: The services sector includes all the revenue from application,
software and other service excluding the payment service (in my model). As
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a healthier stream of revenue, this segment grew by 13% and 25% for FY14
and FY13. An 8% revenue growth is expected for the following five years.
Others: This segment includes iPod and other accessories. Due to the sharp
decline of iPods sales has already taken place a 48% and 25% decrease
for FY14 and FY13, this segment is forecasted to decline by 2% each year
for the forecast period.
Operating Margin
Apple has the highest customer loyalty in the industry, thus the companys
ability to maintain margins is better than most competitors. Furthermore, the
increasing revenue from high margin segment such as Apple App store and
Apple Pay can offset the declining ASP for iPad segment. Therefore, I
estimate the company will have operating margin around 28% to 29.5%, and
maintain a 29.5% operating margin which is slightly lower than the past five
years average of 30.7%, at the end of forecast period.
Terminal Growth
As mentioned earlier, the consumer electronic products tend to have short
product life cycle and thus face price decrease; therefore the terminal growth
of these companies should be lower than average. As a result, I choose a 2%
terminal growth rate of free cash flow after the forecast period.
Net Financial Asset
Unlike most other firms which have to borrow money to sustain their
operation, Apple possessed an astonishing $110B net financial asset as of
Q2 FY15. The company can keep running without most of those financial
assets; furthermore, the management team is willing to pay back the excess
cash to shareholders. Therefore, I take $100B of net financial asset into
consideration and reduce the interest income the company will have going
forward.
Discount Rate
The industry Apple is involved in has less durable competitive advantage
and the players face rapid change constantly, which leads to higher business
risk. Companies such as, Nokia, Motorola, Sony and even Apple itself, have
once dominated the market but failed nevertheless; therefore, I believe the
discount rate for most companies in this industry should be higher than
average. Therefore, I use an 11.0% discount rate for Apple.
The model I built yield a target price of $124.88 with a price range from
$118.63 to $131.65.
Relative Valuation
For the relative valuation, I choose Microsoft, Lenovo and Asustek to
compare their operating system, laptop and mobile phone business with
Apple. I do not include Apples chief competitor Samsung in the
comparison since Samsung is involved in other businesses such as
semiconductors, which generates a substantial amount of profit for Samsung.
Price over earing (P/E) and enterprise over EBITDA (EV/EBITDA) method
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July 26, 2015
are used in the valuation. On the other hand, the price over book (P/B)
method is excluded, since this method fails to measure the enormous brand
name value Apple possess. The target price under this method will be
$128.77, ranging from $92.0 to $154.17
I weight 80% to the DCF and 20% to relative valuation since there are no
close comparison for Apple in the relative valuation model. Furthermore,
the relative valuation model also fails to capture Apples wider moat and
higher customers loyalty.
Risk to Target Price
The effectiveness of the DCF valuation depends on my forecast on the
companys revenue, margins, terminal income growth and cost of capital.
The assumption are made given my best knowledge of the company at this
stage. My estimated discount rate is higher than Bloombergs WACC.
Should my estimation fail to capture the companys fundamentals, Apples
shares could underperform or outperform.

Conclusion
I believe the current market price of AAPL reflects the companys intrinsic
value and thus I recommend a HOLD on AAPL with a target price of
$125.66.
The latest iPhone 6/6+ is expected to generate significant revenue
growth for the company by attracting more new users and retaining the
old customers with a meaningful price increase.
I believe Apple Pay can increase its popularity and provide high margin
revenue for Apple. This service also increase users stickiness to iPhone
and its ecosystem.
Without irreplaceable function, I am not bullish on the long-expected
Apple Watch and assume it will become another expensive leisure
product.
The companys dependence on revolutionary innovation for significant
growth is the risk factor for investors.
The management looks to return $65B of cash to investors in CY15,
the frequent share buyback hedges the downside potential for near term.

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Appendix 1: Smart Watch Comparison

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Appendix 2: Income Statement

AAPL
Segment
(millions)
Sales
Mac
iPad
iPhone
Apple Watch
Service
Other
Apple Pay
Total
Cost of sales
Gross Margin

Historical
2012

2013

23,221
30,945
78,692
-

2014

21,483
31,980
91,279
-

12,890
10,760
-

Projected

24,079
30,283
101,991
-

16,051
10,117
-

18,063
8,379
-

2015E

2016E

2017E

2018E

2019E

25,524 27,055 28,678 29,826 31,019

24,226 22,288 19,614 18,437 17,331
152,987 162,166 186,491 197,680 213,494
1,675
3,801
6,277
4,554
4,874
19,508 21,069 22,754 24,575 26,540
8,211
8,047
7,886
7,729
7,574
600
1,296
2,070
2,880
8,750
232,731 245,722 273,770 285,679 309,582
143,403 154,607 171,066 177,268 190,757
89,328 91,116 102,704 108,411 118,825

156,508
87,846
68,662

170,910
106,606
64,304

182,795
112,258
70,537

Operating Expense
Research and development
3,381
Selling, general and administrative10,040
Total operating expense
13,421

4,475
10,830
15,305

6,041
11,993
18,034

6,490
15,346
21,836

6,997
16,545
23,542

7,742
18,307
26,048

8,022
18,971
26,993

8,633
20,414
29,047

Operating Margin

55,241

48,999

52,503

67,492

67,574

76,656

81,419

89,779

Interest and Other

522

1,156

980

800

400

200

200

200

14,030
41,733

13,118
37,037

13,973
39,510

17,756
50,536

17,673
50,300

19,982
56,873

21,221
60,398

23,394
66,584

Weighted-average Diluted Shares6,617.48

Diluted EPS
6.31

6,521.63
5.68

6,122.66
6.45

5,694
8.88

5,295
9.50

10.74

11.41

12.57

Taxes
Net Income

Source: Company Data, Analyst Estimate

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Appendix 3: DCF Model

Year

2014

($ in million)
Revenue

2015E

182,795

232,731

% Growth
Operating Income
Operating Margin

52,503
28.7%

Interest and Other

2016E

2017E

245,722

273,770

2018E
285,679

2019E
309,582

27.3%

5.6%

11.4%

4.4%

8.4%

67,492
29.0%

67,574
27.5%

76,656
28.0%

81,419
28.5%

89,779
29.0%

980

800

400

200

200

200

Taxes
Tax Rate

13,973
26.1%

17,756
26.0%

17,673
26.0%

19,982
26.0%

21,221
26.0%

23,394
26.0%

Net Income

39,510

50,536

50,300

56,873

60,398

66,584

% Growth

27.9%

-0.5%

13.1%

6.2%

Assumptions
Forecast Revenue Growth

2015

2016

2017

2018

Mac

6%

6%

6%

4%

4%

iPad

-20%

-8%

-12%

-6%

-6%

iPhone

50%

Apple Watch

6%

15%

6%

8%

127%

65%

-27%

7%

8%

8%

8%

8%

8%

-2%

-2%

-2%

-2%

-2%

56%

Service
Other
Terminal Discount Rate

2019

11.00%

Terminal Growth Rate

2%
DCF Output ($ in millions)

NPV of Cash Flows

354,701

NPV of terminal value

279,723

44%

Projected Equity Value

634,424

100%

Expected Excess Cash Return

100,000

Current Price

124.29

Implied equity value/share

124.88

Shares Outstanding

5,881

Upside/(Downside) to DCF

0.48%

Sensitivity Analysis
Discount Rate
$

T. Growth Rate

124.88

10.00%

10.50%

11.00%

11.50%

12.00%

1.00% $

131.65

125.36

119.70

114.59

109.95

1.50% $

134.96

128.20

122.16

116.72

111.81

2.00% $

138.67

131.37

124.88

119.08

113.86

2.50% $

142.89

134.94

127.93

121.69

116.12

3.00% $

147.70

138.98

131.35

124.62

118.63

Source: Company Data, Analyst Estimate

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Appendix 4: Relative Valuation

Price Multiples
Apple (AAPL)
Microsoft (MSFT)
Lenovo (0992)
Asustek (2357)
Competitors Average
Target Price
% chg from Current Price

Mkt Cap
Price-to-earnings (P/E)
(USD)
711.20B
17.04
369.40B
15.99
12.98B
18.29
7.23B
12.4
15.56
115.4552
-7.9%

Source: Bloomberg, Analyst Estimate

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EV/EBITDA
7.43
8.39
9.1
7.14
8.21
142.080315
13.4%

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Work Cited

1.
2.

Apple Q2 FY15 Earning Call

Apple, Larger base, longer cycle, Credit Suisse, Kulbinder Garcha, Achal Sultania, Vlad Rom, William
Chu, Ji Park
3. Apple, Sizing Up The Next Capital Allocation, RBC Capital Market, Amit Daryanani, Mark Sue, Mitch
Steves
4. Autos & Auto-Related, Apple Auto: Worlds Most Valuable Company Meets Most Disruptable Industry,
Adam Jonas, Katy Huberty, Ravi Shanker, Jerry Liu, Neel Mehta, Paresh Jain
5. Apple, Big and Loyal Installed Baes Helps, Keith Bachman, Jung Pal
6. Apple, Prolong Product Cycle at Play, Credit Suisse, Kulbinder Garcha, Achal Sultania, Vlad Rom,
William Chu, Ji Park
7. Apple, UBS, Steven Milunovich, Peter Christiansen
8. Lisa Ellis, Jeffrey Saret, and Peter Weed (2012)
9. Marketline, Datamonitor Independent Research 03/18/15
10. Financial Times, 14, Feb.
11. Apple, New Global Survey Says Set-Up Still Favorable; Target to $135, Cowen and Company, Timothy
Arcuri, Bryan Prohm, Karl Ackerman, Wayne Loeb

20