Krause Fund Research Fall Technology. Action: BUY. Apple Inc. (NASDAQ: AAPL) Current Price: $ Target Price: $

Transcription

1 Krause Fund Research Fall 2015 Technology Apple Inc. (NASDAQ: AAPL) Action: BUY Current Price: $ Target Price: $ Analysts Noah Kirschbaum Nick Sulentic Garrett Moreland Ryan Wettengel November 13, Month Stock Performance Financial Ratios Debt to Equity Ratio 52.91% Current Ratio 1.11 Return on Equity 44.74% Gross Margin 44.88% Key Investment Information Source: Bloomberg Data Company Overview Apple Inc. (NASDAQ:APPL) is a leading provider of consumer technology products including smart phones, computers, and other personal computing devices. Apple s product segments include the iphone, ipad, Mac, Software and Services, and Accessories. Notable products include the iphone 6s, iphone 6s Plus, ipad Pro, MacBook Pro, as well as a number of other products and services. Stock Performance Highlights 52 week High $ week Low $92.00 Beta 1.25 Share Highlights Market Capitalization $626.3 B Shares Outstanding 5.58 B 2015 EPS $9.28 P/E Ratio Dividend Yield 21.34% Apple s new financing program for iphones will help provide growth for the segment by pressuring phone carriers to implement similar programs that will shorten the product replacement cycle for iphones. This will ensure that consumers are updating to the newest iphone model every year which will provide for continually growing revenue streams. Apple s penetration of the Chinese smart phone market is a reason to invest in the company now. In 2015, Apple saw 84% revenue growth in China because of increasing demand from millennials. Apple has been increasing investments in China to expand its retail presence and to help facilitate this rising demand. We expect Apple s release of the ipad Pro will revitalize the ipad segment of Apple s operations. Apple has seen a decline in ipad sales due to consumers demanding larger enterprise tablets that can fully replace the functionality of a personal computer. The release of the ipad Pro is the answer to this, and we expect to see modest revenue growth for the ipad segment in the next five years. Page 1

2 EXECUTIVE SUMMARY We are initiating our coverage of Apple Inc. with a BUY rating. Shares are currently trading at $112.24, but we believe that this is undervaluing the company. Our Discounted Cash Flow Analysis, Dividend Discount Model, and Relative Valuation suggest a valuation range of $ $ Apple is positioned to capture growth from a number of different markets in the short and long term and that value should be reflected in its current trading price. We will show that Apple will see continued growth in the iphone segment by shortening the product replacement cycle and utilizing consumer trends in foreign markets including China. Additionally, it is yet to be seen how much market penetration Apple will have in the wearables market with the Apple Watch, but we believe this could be an opportunity for growth, as consumers behavior favors products that are integrated in the Internet of Things. high interest rates. We believe that the capital markets have fluctuated recently due to the uncertainty around an interest rate rise. If interest rates do rise, we see the capital markets stabilizing and returning to growth after 6 months, which will coincide with growing Real GDP. We predict short-term Real GDP growth to be around 2.25% in In the longer 2-3 year horizon, we see Real GDP growth increasing to 2.5% as the capital markets return to steady growth. Source: Federal Reserve Economic Data 3 Consumer Confidence / Consumer Sentiment Consumer Confidence Index (CCI) ECONOMIC OUTLOOK Real Gross Domestic Product (GDP) Gross Domestic Product measures the total value of the US Economy s production of goods and services. Real GDP is an inflation-adjusted indicator that that gauges the United States production level, which is an important driver of the technology sector. Above-average Real GDP Growth indicates that the US economy is healthy, and as the economy grows, consumers will be willing to spend more on consumer electronics in the future. This increased consumption expenditure is important for Apple because they produce a number of consumer electronics goods. In Quarter 2 of 2015, there was a 2.71% increase in Real GDP, coming in at a level higher than analyst predictions. 12 The Real GDP growth has given the US economy momentum during the recent market turbulence. This turbulence has caused Real GDP growth to decline to 2.02% in Quarter 3. With a potential rise in interest rates in Quarter 4, we could see a decrease in consumption and investment as a result of those Source: Bloomberg Data Consumer confidence is an economic measure that analyzes the degree of optimism that the people of the United States hold towards their own personal financial positions and the health of the overall economy. Consumer confidence affects the way in which people react to certain economic situations such as spending and borrowing. It is a very important factor affecting corporate profitability, which drives business capital spending. As the economy expands and grows, as it has since the financial crisis of 2008, we often see an increase in consumer confidence and the opposite is true during times of economic pull back. There are many ways in which consumer confidence is documented and Page 2

3 analyzed including the Consumer Confidence Index (CCI), the University of Michigan Consumer Sentiment Index (MCSI), the Bloomberg Consumer Comfort Index, the Consumer Confidence Average Index, and the Gallup Economic Confidence Index. CCI data is collected and reported on a monthly basis, and is considered a lagging indicator of economic health, which responds only after the economy has already changed. Opinions on current conditions make up 40% of the index, with expectations of future conditions comprising the remaining 60% of the overall index. The CCI hit its lowest point in February 2009, when its rating touched as low as From 2009 and on, the Index has seen an upward trend and it reached the 100 level for the first time in January 2015 since it last achieved similar levels in September The CCI increased moderately in September 2015, but has since declined in October. The index now stands at 97.6, down from in September. Although the index saw a decline in the last month, consumers still rate the current market conditions favorably, but for the most part do not anticipate the economy strengthening much in the near term. A less then positive assessment of the job market and other present-day conditions are relevant reasons for this decline in confidence among consumers. Strong consumer confidence is very important for Apple and the sale of their products. As the U.S. economy continues to develop and real GDP growth becomes increasingly steady we believe that consumer confidence will also stabilize. We predict that the index will hover around 96 points moving into Year Treasury Yields Year Treasury Bond Yields Source: Bloomberg Data Treasury yields are the return on investment on the U.S. government s debt obligations (bonds, notes, and bills). The higher the yields are for the 10, 20, and 30 year Treasuries, the better the economic outlook. Treasuries are considered a very low-risk investment because they are backed by the full faith and credit by the U.S. government. 4 Under normal circumstances, Treasuries with longer maturities often have a higher yield than shorter-term Treasury securities. Treasury yields increase when the Federal Reserve increases its target for the federal funds rate, or when investors expect that the federal funds rate will increase. When the demand for Treasury bonds decreases, Treasury yields increase. Treasury yields have a significant impact on the way in which firms choose to set up their capital structures and as the Treasury yields rise, firms are expected to produce higher rates of return relative to the increase seen in the Treasury yields. Treasury yields are used to derive the cost of equity for the firm which then is used as one of the components needed to derive the weighted average cost of capital (WACC) for the individual firm. The WACC that is calculated for the individual firm is then used in the discounted cash flow analysis (DCF), as the discounting factor. In the assumptions that we used to derive our intrinsic stock price using a DCF analysis, we used the current 30-Year Treasury bond yield of 3.06% to calculate Apple s cost of equity. Currency Exchange Rates Source: Bloomberg Data US Trade Weighted US Dollar Exchange rates represent the value of one currency against that of another currency. The trade-weighted US dollar index is a measure of Page 3

4 the value of the United States dollar relative to other world currencies and it includes a larger collection of currencies compared to the US dollar index. Its numerical value is determined as a weighted average of the price of various currencies relative to the dollar. For large multinational companies, like Apple, exchange rates can impact a company's profit and its ability to transfer money between countries. The dollar approached a seven-month peak on November 16, 2015, as hedge funds increased wagers the US currency will strengthen amid speculation that the Federal Reserve will raise interest rates as soon as December The Trade Weighted US Dollar Index has climbed 13.39% YOY as of November 16, The strengthening of the dollar will hurt US based tech companies ability to sell their hardware and software overseas. As global economies recover, we will look for the dollar to stabilize relative to other currencies by A strong US Dollar means that it will be cheaper to import foreign goods. Due to Apple s large production efforts in China, a strong US dollar allows for products like the iphone to be produced using cheap Chinese inputs and then be exported cheaply to foreign markets. If interest rates rise by the end of the year through a decision by the Federal Reserve, the US Dollar will continue to strengthen, as foreign money will flow into the US as investments will achieve higher yields. According to fed fund futures contracts, the market believes that there is a 70% chance of the Fed hiking rates in December Q15 Sales Revisions Source: FactSet, BofA Merrill Lynch As Quarter 3 earnings have been released, most sectors have seen negative revenue revisions as more information has been gathered. The Technology Sector, however, outperformed all others with 0% change after revisions. 8 This indicates the Technology Sector will continue to perform well during times of uncertainty compared to that of the S&P 500 and other sectors. We conclude that the Fed will raise rates by the end of 2015 and this will cause the US capital markets to stabilize. In the short-term, we believe the capital markets will return to positive growth, but at more conservative levels that have been seen in the last year. The strength of Quarter 3 earnings in the Technology Sector leads us to believe that there will be higher growth in Technology companies in the near and long-term. Capital Markets Outlook The outlook of the NASDAQ is tied closely with the Technology Sector. Analyzing the NASDAQ will serve as a useful reference point for the performance of the Technology Sector as a whole. In August of 2015, the NASDAQ saw a significant downturn, which indicates that the rapid growth seen in the Technology Sector earlier in 2015 may slow to more conservative levels in the near future. We believe that the market turbulence seen since August has been caused by the uncertainty around the potential of a rise in interest rates in Quarter 4 of With a strong US Jobs report in October, the likelihood of an interest rate rise has increased significantly. INDUSTRY ANALYSIS Apple s Industry Overview Apple designs and manufactures a large assortment of products including smartphones, personal computers, tablets, and a variety of software and services. Given Apple s breadth of revenue streams, the company operates in several industries. The following are the primary industries Apple operates within, and the corresponding products the company provides within those industry classifications: Page 4

5 Mobile Communication/Media Devices iphone, ipad, Apple Watch, and ipod Personal Computers MacBook and imac Software/Services The App Store, Apple Music, itunes, ios, and MacOS Recent Developments and Industry Trends Mobile Communication/Media Devices: A significant trend we see for smartphones is a decrease in product replacement cycles. Smartphone carriers have been hedging against potential declines in innovative technology in smartphones by offering incentives to replace their old phone with a new phone. These 12 or 24 month programs have replaced traditional 2 year contracts and allow consumers to pay for their phone on a monthly basis, and upgrade their phone by simply paying the remaining balance. Carriers such as AT&T, Verizon, and T-Mobile have all implemented programs like this. 9 Chinese Millennials are increasingly spending money on smartphones as their income rises. Goldman Sachs analysts predict that Chinese millennial income will rise by $3 trillion in the next 10 years, and will disproportionally spend their disposable income primarily on smartphones. 10 The tablet market has seen growth and as a result has created displacement for commercial notebooks and personal computers. Tablets shipments as a percentage of total notebook shipments sit at 20% in 2015, up from 19% in This suggests that as the technology improves in tablets, we will see continued displacement in the notebook and personal computing market. Average Selling Prices (ASPs) have steadily been falling for smartphones which has allowed for smartphones sales to increase in China, albeit at a slower rate compared to that of years past. Smartphone shipments consumed by China are forecasted to increase by just 1.2% in 2015 compared to 19.7% in This indicated a trend of a maturing smart phone market in China that will force smart phone manufacturers to find ways to maintain smartphone sales growth. Wearables have been a consumer technology opportunity that many companies have been capitalizing on. According to the International Data Corporation (IDC), wearable device shipments will reach 76.1 million units in 2015, up 163.6% from 2015; and wearables have seen a five-year CAGR of 22.9%. 13 We see this trend of high growth continuing for up to five more years until the wearables market matures to more conservative growth levels. Personal Computers: There is a trend of declining sales and displacement by tablets for personal computers. In Quarter 2 of 2015, personal computer shipments fell by 9.5% from Quarter One primary reason for this is the lengthening of the PC lifecycle. As the technology used for inputs in to computers has improved, it has lengthened the amount of time between a consumer s purchases of personal computers. While it was expected that the release of the Windows 10 operating system would bolster sales, the reality was that in Quarter 3 of 2015, sales declined by 10.8% year-over-year; this was 1.6% worse than analysts had predicted. 15 Software/Services: The primary trend within Software and Services is the growing significance of the Internet of Things (IoT). The IoT is the idea that all technology that consumers use is connected in some way through networks. This connectivity can be seen through hardware such as wearables and smartphones, but also in the software that integrates these products. Research indicates that there will be nearly $6 trillion spent on IoT solutions in the next five years. 16 This indicates a significant opportunity for technology companies to create software that is interconnected with multiple devices. Streaming services are yet another area that has seen growth recently in the Software and Services industry. For music streaming alone, there were over 1 trillion songs streamed in the first half of 2015 and $1.87 billion in revenue produced in In 2014 there were 92.1 million Page 5

6 subscribers to video streaming services, this number is expected to rise to million by These trends indicate that consumers are shifting away from traditional models of media consumption, toward new subscription models. Markets and Competition Due to Apple operating in multiple industries, their competitors also have a variety of industry classifications. Apple s business lies primarily in the Mobile Communication/Media Devices industry, as iphones represent the majority of Apple s core business at 66.3% of total revenue. As the largest publically traded company, we are constrained by looking at other large technology companies as they operate at the most comparable capacity to that of Apple. For our competitive analysis, we are looking at large publicly traded US companies that have operations relating to smart phones, tablets, or personal computers. Alphabet Inc. (GOOGL) competes against Apple s ios with the Android operating system and the Google Play store. Microsoft (MSFT) creates the main operating system that competes against Mac OS, as well as a number of consumer electronics products that compete for market share against Apple. International Business Machine Corp (IBM) is a large technology company that produces computing hardware. Cisco Systems (CSCO) is a company that has a large presence in the networking equipment industry. Qualcomm Inc (QCOM) is company that produces semiconductors and telecommunications equipment. Company Market Cap Gross (bn) Margin Debt/Equity AAPL $ % 52.9% GOOGL $ % 5.0% MSFT $ % 44.1% IBM $ % 343.8% CSCO $ % 42.5% QCOM $ % 34.9% Source: Bloomberg Data Catalysts for Growth/Change Within the landscape of the broader market, Apple continues to operate as one of the strongest and most well-known players in the mobile communication/media, personal computer, and the software & service spaces. The company has established themselves within the larger market through the ecosystem that they have created among their expansive and diverse product offerings. When considering mobile communication/media, personal computers, and software & service industries there are a few catalysts that are going to have a large impact on the rest of the market moving forward. These catalysts are the evolution of the personal computer market, the development of the wearables space, and the increasing significance of the stabilizing smartphone market. Personal computers and tablets are an area of the technology sector that can be actively viewed as a catalyst for growth and change moving forward. The personal computer market is one that is slowing in terms of growth and PC shipments are falling. In the first quarter of 2015, worldwide PC shipments amounted to 68.3 million units falling 7.0% YOY. 19 This is the 12th consecutive quarter of contraction and a reason for why we believe the tablet market is a large potential catalyst for change for the technology sector. We foresee wearables being another area for potential growth as connectivity among devices continues to improve and more devices come to market. S&P Capital IQ expects that wearable device shipments will more than double in both 2016 and 2017, compared to 26.4 million shipments in 2014, revealing the magnitude of this potential catalyst. Large growth will be realized once more wearable devices with the standalone ability to connect to the internet come to market, as most require connectivity through an Internet-enabled device, such as a smartphone at this point in time. As the IoT market continues to develop it will contribute to a much broader expansionary market for the wearables space. The mobile phone market is still one that is very important in terms of revenues for the technology sector overall. In terms of operating systems, Google s Android and Apple s ios platforms Page 6

7 currently account for more than 90% of total market share in this space. 20 Given this information, we believe there is little that can disrupt the dominance these two firms share in this space. Global smartphone adoption is something that has continued to increase and will remain true moving forward. Smartphone penetration reached 68% of total mobile phones in 2014, compared with 55% in 2013 and less than 20% in The growth in penetration levels is something that will continue to increase as innovation increases and consumers look for more ways to gain and retain connectivity among devices and media platforms. As the penetration levels increase, so will revenues in the mobile communication/media space. We estimate that the penetration level could reach 75% by To capture this growth, smartphone manufacturers must penetrate global markets and increase sales to maintain market share. Key Investment Positives and Negatives Positives: There are a number of trends that technology companies are capitalizing on that create a positive investment outlook. The decline of the product replacement cycle for smartphones creates an opportunity for smartphone manufacturers to increase revenues. This shortening of the product replacement cycle also prevents the decline seen in personal computer sales due to longer product replacement cycles. Apple is proactively doing this by implementing an internal financing program that will insure consumers will purchase new phones regularly. The IoT creates tremendous opportunities for companies to create technology that integrates with other existing technology. Companies that are proactively doing this will have a competitive advantage over those that are not. We have displayed the increasing market for content streaming services and how much of a market there will be in this space. Companies that take advantage of this will likely see significant growth in the short-term. Negatives: Companies that rely heavily on the sales of personal computers will likely see declining future revenues. Some companies that are producing both tablets in addition to personal computers may see cannibalization in their product lines, as users switch from buying personal computers to tablets. While the markets are growing for the IoT as well as streaming, there will be heavy competition which could potentially displace revenue to companies that have existing platforms that can more effectively capitalize on the growth. Overview Apple Inc. is the largest consumer electronics manufacturing company and largest publicly traded company in the world. The company is based in Cupertino, California and currently employs 92,600 people across the world. 22 Apple Inc. was founded in 1976 by Steve Jobs and Steve Wozniak and originally operated exclusively in the personal computer market. The company later developed the ipod music player, the iphone, as well as a number of other devices. Apple Inc. grew their market share to a point where, in 2012, they became the largest publicly traded company in the world. The current CEO of Apple Inc., since 2011, is Timothy Cook. Ownership COMPANY ANALYSIS Apple Inc. is predominately owned by various institutional investors. The company has seen low levels of activism from these investors recently, with the exception of Icahn Associates Holdings LLC. 23 In April of 2015, Apple announced a share buyback program that authorized the repurchase of $140b in shares, this was primarily done to make use of excess cash, but will also shift ownership of the company over time. The five largest shareholders are as follows: Page 7

8 Institution Percent Ownership The Vanguard Group, Inc. 5.9% BlackRock Fund Advisors 3.9% Fidelity Management & Research 2.9% Northern Trust Investments, Inc. 1.4% Wellington Management Co. LLP 1.0% Source: Factset Data Life Cycle Apple currently operates in the stable part of its life cycle. They have continued to see growth through the consistent release of new products. This allows them to remain competitive, in an industry with shortening product replacement cycles. We believe Apple Inc. will stay in the stable phase for the foreseeable future, as there are no known companies that could potentially displace Apple products in their entirety. Financial Summary Apple saw net sales of $233.7b in 2015, 28% higher than 2014 sales at $182.8b. A large portion of this growth comes from China, which saw 84% revenue growth in The highest growth segment in 2015 was the iphone, which saw 52% revenue growth. Apples margins improved in 2015 slightly to 44.88%, up from 38.6% in This increase in margin can be attributed to Apples largest operating expense other than COGS, SG&A, which grew by less than sales at 19%. 24 Products and Markets Product Segments Sales (bn) % of Total iphone $ % Mac $ % ipad $ % Other $ % Source: 2015 Apple 10k iphone: The first iphone was released in 2007, and has since seen 11 more iterations following the initial release. The iphone has consistently been Apple Inc. s largest revenue driver since iphone s portion of revenue has increased steadily to 66.3% where it sits currently. 25 ipad: While the ipad earns less revenue for Apple Inc. than the iphone, it still serves as a significant portion of revenue for the company. The first ipad was released in 2010, and new models have been released on a yearly basis. Apple Inc. recently announce the ipad Pro which will serve as an update to the ipad line. The ipad has seen a decrease in revenue from $30.3b in 2014 to $23.2b in 2015, as consumers demand tablets that can fully replace a personal computer. This is something that Apple did not offer in FY15. With the release of the ipad Pro, we expect ipad revenue to increase steadily in the next five years. Mac: Macs were the initial and main product that Apple Inc. delivered until the release of the first ipod. While personal computers were the core of Apple Inc. operations for the majority of the company s existence, the new products previously mentioned now comprise the majority of Apple Inc. s sales. The current offerings for the Mac brand are the MacBook Pro, the MacBook Air, imac, Mac Pro, and Mac Mini. While personal computers sales industry-wide have been struggling, Apple has managed to see revenue growth of 5.78% for Apple computers in Other: While Apple Inc. provides a number of different products that make up 12.8% of their revenue, individually they are minor in comparison to the previously mentioned products. Some of these other products include: Apple Music, Apple TV, itunes sales, App Store sales and commissions, and various accessories. Our industry analysis indicates that Apple s introduction of a music streaming service could provide revenue growth, but it remains to be seen if this will be a significant portion of revenue. New Products: Apple Inc. s most recent new product line has been the Apple Watch, which was released in April The company recently released two new iphone models in September 25, 2015, as well as the ipad Pro Page 8

9 released this week. These product releases will serve as an update to Apple s products that are key revenue drivers for the company. Production and Distribution Although Apple does produce some of their Mac computers in the United States, nearly all of their products production is outsourced to their partners in Asia. Apple does not own these facilities, allowing them to save a significant amount in costs that would otherwise decrease their margins. Most of the components that are essential to the company s business are generally available from multiple sources within their broad and comprehensive supplier network, but there are still a number of components used in the production of their products that are currently supplied by single or limited sources. When a component or product uses new and innovative technology, initial capacity constraints may exist. If the supply of these components is constrained or delayed, Apple s operating margins could be adversely affected. Apple places a lot of concentration on its engagement with their outsourcing partners and their efforts to fulfill agreements regarding manufacturing schedules so that the firm is able to operate efficiently within the market to meet consumer demand expectations. Cost of Goods Sold (COGS) represent the largest expense the business faces, accounting for a significant portion of revenue. COGS represented 59.94% of revenues for fiscal year 2015, down from 62.38% in 2013, revealing that Apple is consciously focused on increasing the gross margins they achieve through the sales of their products. 27 According to Apple s Fiscal Year results for 2015, Apple sells and delivers digital content and applications through the itunes Store, App Store, Mac App Store, ibooks Store and Apple Music (collectively Internet Services ). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. 28 The Company sells to consumers, small and midsized businesses, education and government customers across the globe. Apple strives to maintain a very high-quality buying experience and as a result invests a lot of capital into building and expanding their own retail and online stores in addition to its 3rd party distribution network to ensure that they reach customers as effectively as possible. During 2015, the Company s net sales through its direct and indirect distribution channels accounted for 26% and 74%, respectively, of total net sales.1 Apple also believes that their marketing efforts are pivotal in the development and sale of their innovative products and technologies. 29 Competition Apple is very unique in the fact that the firm operates within many different industry verticals within the broader and more comprehensive scope of the technology sector. Of the total net sales, $233.7, Apple generated in 2015, 66.3% or $155b of total net sales were generated through the sale of iphones alone. Within the global smartphone market, Apple directly competes most aggressively with Samsung and their Galaxy line of smartphones. The Android operating system that Samsung s smartphones use to operate along with the ios operating system that Apple uses in conjunction with its product offerings account for 90% of total market share in this space. 30 Given this information, it is easy to see that Apple and Samsung are the market leaders in the smartphone market. Both companies actively look to increase their market share through rapid and continuous software development and improvement. Samsung faced significant market share loss in 2014, hurt not only by the success of Apple on the higher end, but also by emerging competitors such as Xiaomi on the lower end of the smartphone market. Most recently, the two firms have adopted larger screen sizes for their devices and this helped Apple reach its highest revenue and shipment levels ever, also allowing them to recapture market share loss experienced in prior years. 31 Page 9

10 Research and Development The Technology Sector is a highly competitive environment characterized by continuous change and rapid advancement. Innovation and market share is key for Apple to maintain its leadership position within its respective industries. Due to this, research and development is a critical business activity for Apple. Apple s total R&D expense for 2013, 2014, and 2015 were $4.5b, $6b, and $8.1b, respectively. While Apple s gross margin has increased from 2014 to 2015, R&D expense increased by 34% in 2015, greater than the revenue increase of 28%. 32 As a percentage of sales, R&D has been increasing yearly, and sits at 3.45% of sales in This increase in R&D will be necessary for Apple to capture organic growth in consumer electronics sales. Catalysts for Growth/Change As Apple s largest segment, it is important that Apple continues to focus on increasing iphone sales. While Apple has increased R&D expenditures significantly to create organic growth, it will be essential for Apple to capture growth in other ways. The advent of the iphone financing program for Apple will be an opportunity to see continued growth in iphone sales by decreasing the product replacement cycle. Analysts estimate that half of iphone sales are from consumers who are upgrading from a previous iphone model. 34 It is beneficial for Apples top line growth to incentivize upgrading to the newest model on a yearly basis. The iphone Upgrade Program offers customers the ability to pay for their phone monthly with no upfront cost and be eligible to renew this plan every year with the newest iphone. This program will put pressure on carriers to implement and improve similar programs to remain competitive. Regardless of who which carrier offers the best price for these plans, Apple benefits when consumers upgrade their phones to the newest iphone model. In our industry analysis, we discussed how Chinese millennial disposable income will rise with the corresponding $3 trillion rise in net income. 35 This is a catalyst for growth that Apple has already begun capturing, as can be seen in the 84% increase in iphone sales in Apple is also capturing this growth with significant investment in retail stores in China. Apple is on track to have 40 retail stores by mid-2016 in China, up from 22, and currently has access to 365 cities through two-day shipping. 37 As there has been increasing displacement of personal computers by tablets, consumers demand devices that serve as a complete replacement of those personal computers. While ipad sales have been declining, we expect that the release of the ipad pro will allow Apple to capture the benefits of the shift in consumer behavior. We predict that the ipad segment will return to positive growth around 4% in the five-year time horizon. While this may cannibalize the Mac segment of Apple, we believe this will be an opportunity for growth, as consumers demand is shifting to enterprise tablets with larger screens. Key Investment Positives and Negatives Positives: The primary reason why we have placed a BUY rating on Apple is due to our financial analysis of the company. Our Discounted Cash Flow analysis suggests that Apple should trade at $150, compared to its current price of $ This implies that Apple is undervalued and has significant growth potential. In conjunction with our DCF model, our Dividend Discount Model provides an intrinsic value of $ and our Comparable Company analysis provides a price range of $ $ Our valuation models all suggest that now would be a good time to purchase Apple stock as it will likely increase in value within the next year to reflect the company s intrinsic value. Apple has been successfully capturing growth in a number of areas, and particularly in areas that we discuss as trends in the technology sector as a whole. To reiterate, Apple has captured iphone revenue growth from by shortening the replacement cycle, increasing retail presence in China, offering streaming services, and integrating all of their products to better compete in the IoT market. We predict that the release of Page 10

11 the ipad pro will revitalize the ipad segment of Apple s operations. While it is a young market, Apple could capture growth in the wearables market with the newly released Apple Watch. Negatives: Due to recent instability in the capital markets, Apple has seen drastic swings in stock price recently, ahead of a potential interest rate rise. If interest rates do rise, this would likely increase the cost of Debt for Apple as the cost of borrowing increases. This could lower Apple s value in the short-term. Key Assumptions VALUATION Revenue Decomposition: To forecast Apple s future revenue, we first decomposed and analyzed Apple s historic revenue. For the iphone segment we saw that iphone sales have increased every year, but at a slower rate every consecutive year. We believe that iphone growth will slow to 5% growth year-over-year, coinciding with our estimates of slowing GDP growth, and built that into our estimate of growth. For ipad revenue, we expect to see positive growth due to the introduction of the ipad Pro to Apple s product line, we predict that ipad growth will reach steady state in the short-term and growth of 4% on a yearly basis. As discussed previously, Apple s Mac line has seen revenue increases despite a declining personal computer market. We believe that Apple will continue to see growth in Macs but at a low rate of 3%. Other segments include ipods, which will see a significant decline in sales as they are replaced by smartphones that will make the music players obsolete. Beyond ipods, there are segments that Apple reports together such as itunes, software, and services, that we predicted stable growth in. After combining these forecasts together we arrived at annual revenue growth rates that we benchmarked against consensus estimates. Our model estimates that revenue growth in 2016 will be 5.39%, and this will stabilize to near 5% over the next five years. Cost of Goods Sold: Through researching Apple s historical financial information, we recognized that there is a decline in COGS as a percentage of sales in years where there are incremental improvements to the iphone, such as this year s iphone 6s. This is due to manufacturing processes maturing for that model of phone and becoming cheaper. When Apple releases a new phone that is a completely redesigned model, the COGS will increase to facilitate new manufacturing processes. We predict COGS to grow by 5.24% to $135.6b in 2016, which will cause Apple s Gross Margin to improve slightly as goods become cheaper to produce. Discounted Cash Flow and Economic Profit Models Our Discounted Cash Flow analysis and Economic Profit model both yield implied stock prices of $150. We adjusted this value to reflect that some of the 2016 fiscal year has elapsed. Our adjusted value for Apple share price is $ as of November 13, This is 35% higher than Apples current share price of $ This difference in value is likely due in part to the turbulence in the markets surrounding potentially rising interest rates. We believe that Apple has successfully captured value in a number of ways discussed previously, and is currently undervalued as a result. Dividend Discount Model We used a Dividend Discount Model (DDM) as a benchmark for comparison against the DCF and Economic Profit analysis. The DDM calculates an intrinsic value of a company s stock based on the present value of a company s future dividends. This model yields an implied share price of $153.42, and $ after partial-year adjustments. Page 11

12 Relative Valuation We use a Comparable Company analysis as a form of relative valuation to see how Apple is valued relative to the companies that are similar in size and operations. To determine the value of Apple, we find the average P/E for 2015 and 2016 of our universe of comparable companies. We also look at EV/EBITDA ratios and adjust this to find the implied Equity Value. The comparable company universe we selected includes some of the largest publicly traded technology companies that have similarities in their product segments. These companies are, Alphabet Inc. (GOOGL), HP Inc (HP), Microsoft (MSFT), Cisco Systems Inc (CSCO), and Qualcomm Inc (QCOM). The implied current value of Apple s stock is $ for 2015 relative P/E, $ for 2016 relative P/E, and $ for 2015 EV/EBITDA ratios. Weighted Average Cost of Capital Our calculation of Apple s Weighted Average Cost of Capital (WACC) is 9.11%. We break down this calculation in the following sections. Beta: We calculated Beta by calculating the oneyear average of the raw beta for Apple calculated by Bloomberg. Cost of Equity: The Cost of Equity that we calculated for Apple is 9.75%. To calculate the implied Cost of Equity for Apple, we used the Capital Asset Pricing Model (CAPM). For our risk-free rate we looked at the yield of a 30-year Treasury bond as of November 13, 2015, which we found to be 3.06%. The Beta we used for the CAPM model is The equity risk premium we use is 5.34%. We used Damodaran s calculation of the equity risk premium of 6.12%, and adjusted it to reflect a risk free rate of the 30- year Treasury bond yield, rather than the 10-year Treasury bond yield used in his calculation. 38 Cost of Debt: Apple currently offers a bond due in 2045 that has a yield of 4.21%. 39 We use this yield as our cost of debt because it reflects the long term return on debt of Apple s outstanding bonds. Capital Structure: Apple s capital structure is comprised of simply equity and debt because they do not offer preferred stock. To calculate the market value of equity we multiplied the current share price of Apple by the shares outstanding at the end of We calculated the value of debt, by looking at the total book value of long-term debt, and used that as a proxy for the market value of debt. We found Equity to be 90% of the capital structure and Debt to be 10%. Sensitivity Analysis Cost of Debt to Cost of Equity: As mentioned previously, Apple s capital structure is skewed heavily toward equity. Due to this, our valuation model will be highly sensitive to changes in the Cost of Equity. We chose to run a sensitivity test to see how changing these variables will affect the intrinsic value of Apple s stock. Holding the Cost of Debt constant at 4.21%, and adjusting the Cost of Equity yields a valuation range of $ $ Conversely, holding the Cost of Equity constant at 9.75% and changing the Cost of Debt creates a valuation range of $ $ This clearly indicates that Apple is much more sensitive to changes in the Cost of Equity than it is to changes in the Cost of Debt. Equity Risk Premium to Beta: It is important to consider how changes in Beta and the Equity Risk Premium will affect our valuation. Due to both Beta and Equity Risk premium being subjective measures because the many ways they can be calculated, it is important to see how our model is sensitive to changes in assumptions regarding these two variables. When the Equity Risk Premium is held constant at 5.34% and Beta is changed, the valuation range is $ $ This range of Beta calculations is , which is not abnormal for technology companies. This large range indicates that Apple s valuation is highly sensitive to changes in the Beta. When Beta is held constant at 1.25 the change in Equity Risk Premium creates a valuation range of $ Page 12

13 $ While this is still a large range, this indicates that our model is not nearly as sensitive to changes in the Equity Risk Premium as it is to changes in Beta. Risk Free Rate to Beta: Beyond our comparison of Equity Risk Premium to Beta, we wanted to isolate the Risk Free Rate from the Equity Risk Premium and test its sensitivity compared to Beta. Holding the Risk Free Rate constant at 3.06%, and testing the sensitivity of Beta provides a valuation range of $ $ Holding Beta constant and changing the Risk Free Rate gives a price range of $ $ Our conclusion is that our model is not very sensitive to changes in the Risk Free Rate, which implies that our model is most sensitive to changes in Beta in the Cost of Equity calculation. CV Growth of NOPLAT to Beta: Due to technology companies typically having high growth rates, we wanted to test the sensitivity to changes in the Continuing Value Growth of NOPLAT. Holding Beta constant, changes in CV Growth from 2% to 3% creates a valuation range of $ $ This range is not nearly as large as the range of prices that result when changing Beta, so this indicates that the growth rate in the terminal year of our Discounted Cash Flow analysis will not significantly impact our valuation. This is likely due to Apple being such a large company that operates with fairly steady growth. R&D Growth as a Percent of Sales to SG&A Expense as a Percent of Sales: Apple s two largest operating expenses are SG&A and Research and Development. We forecast both of these expenses as percentages of sales. To test our assumptions, we wanted to analyze the sensitivity 1 Federal Reserve Bank of St. Louis 2 Reuters Article < 3 Federal Reserve Data < > 4 Treasury Yields < of our model to changes in these assumed growth rates. Holding R&D growth constant at 10%, changing the SG&A Expense as a percentage of sales causes price variations of $ $ Conversely, holding SG&A Expense as a percentage of sales constant at 6.5% and testing the sensitivity of R&D growth creates a price range of $ $ Both of these ranges are not nearly as large as some of our previous sensitivity tests. Due to this we found that our model would not change significantly if we adjusted our assumptions for R&D growth or SG&A Expense as a percentage of sales. Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report 5 Bloomberg Data < 17/dollar-approaches-7-month-peak-as-hedge-fundsboost-bullish-bets> 6 < ange_index_major> 7 Fortune Article: Interest Rate Futures < Page 13

14 8 < 9 Goldman Sachs Analyst Report 10 Goldman Sachs Analyst Report 11 Goldman Sachs Analyst Report 12 < > 13 < > 14 < 15 < > 16 < rch-store?ir=t&#!/the-%e2%80%98internet- OF-THINGS%E2%80%99- REPORT/p/ /category= > 17 < 18 < million-will-subuse-to-streaming-video-by-2019/> 19 S&P Net Advantage Industry Report < ASApp/NetAdvantage/showIndustrySurvey.do?task= showindustrysurvey&type=pdf&code=coh> 20 S&P Net Advantage Industry Report < ASApp/NetAdvantage/showIndustrySurvey.do?task= showindustrysurvey&type=pdf&code=coh> 21 S&P Net Advantage Industry Report < ASApp/NetAdvantage/showIndustrySurvey.do?task= showindustrysurvey&type=pdf&code=coh> 22 Factset 23 Factset 24 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 25 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 26 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 27 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 28 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 29 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 30 S&P Net Advantage Industry Report < ASApp/NetAdvantage/showIndustrySurvey.do?task= showindustrysurvey&type=pdf&code=coh> 31 S&P Net Advantage Industry Report < ASApp/NetAdvantage/showIndustrySurvey.do?task= showindustrysurvey&type=pdf&code=coh> 32 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 33 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 34 Goldman Sachs Analyst Report 35 Goldman Sachs Analyst Report 36 Apple 10k < x0x857225/7D58F9C1-092A-42FC-8C55-4E8B647E5FE9/2015_Form_10-K_As-filed_.pdf> 37 Goldman Sachs Analyst Report 38 Damodaran Estimates < 39 Bloomberg Data Page 14