PDF Technology Apple, Inc. - Tippie College of Business

Krause Fund Research Fall 2017

Technology

Recommendation: Buy

Analysts

John Duzansky john-duzansky@uiowa.edu

Tyler Welter tyler-welter@uiowa.edu

Jack Duffner jack-duffner@uiowa.edu

Mohammed Hardan mohammed-hardan@uiowa.edu

Company Overview

Apple Inc. designs, manufactures, and sells mobile and media devices, computers and a number of other accessories, software, and services. Company products include the iPhone, iPad, Mac, Apple Watch and Apple TV. Software and services include iOS, iCloud, Apple Pay, and a number of other software, accessories, and services. The Company sells its products and services globally through its online, retail stores, and direct sales force, along with cellular network carriers, wholesalers, and retailers.

Stock Performance Highlights 52 week High 52 week Low Beta Value Average Daily Volume

Share Highlights Market Capitalization Shares Outstanding Price/Sales (ttm) Price/Book (mrq) EPS (2017) P/E Ratio Dividend Yield

Company Performance Highlights Profit Margin ROA ROE

Financial Ratios Current Ratio Debt to Equity

One Year Stock Performance Data from: Fact Set

$174.67 $104.08

1.18 28.54M

$896.81B 5.13B $4.01 $6.82 $9.27 18.8 1.37%

26.76% 13.87% 37.7%

1.28 86.3%

Apple, Inc. (NSDQ: AAPL)

November 10, 2017

Current Price $174.87 Target Price $200-210

Apple Firing on all Cylinders

Investment Thesis

Apple is a proven leader in the technology and smart phone industry with the largest market cap that has reached over $900 billion. Apple has a variety of products and services that continue to generate strong revenues. Apple also uses ongoing innovation and new growth opportunities in emerging markets to stay ahead of its competition and retain its premium valuation. We recommend a BUY rating for Apple as they continue to produce strong sales and create new products and services.

Drivers of Thesis Apple reported all-time high revenue for 2017 behind growth in all segments except the iPad

Services revenue reached an all-time quarterly high of $8.5B and the Apple Watch had unit growth of over 50% for the third consecutive quarter

iPhone sales exceeded expectations behind the launch of the 8 and 8 Plus heading into the iPhone X release

Apple's revenue from emerging markets (outside of greater China) was up 40% this past quarter

Revenue doubled year over year in India, where Apple products are slowly penetrating the developing market

Revenue grew more than 30% in Mexico, the Middle East, Turkey and Central and Eastern Europe

Apple continues to innovate and develop new products and services

iPhone X incorporates new Face ID features and augmented reality (AR) applications

Apple is integrating AR with both its hardware and software

Risks to Thesis Apple faces product-concentration risk with over 60% of revenues coming from iPhone sales in the past three years. Smartphone growth has also slowed in recent years due to highly saturated markets in the U.S. and Western Europe.

Apple expects new tax reform legislation to pass allowing them to bring back $252.3B in cash (94% of total cash) at a lower corporate tax rate. If tax reform fails to pass, Apple will have to either continue to hold their cash overseas or bring it back to the U.S. at a higher tax rate.

Executive Summary

With exceptional integration of its product and services as well as ongoing technical innovation, Apple has turned into one of the most valuable companies in the world. In more developed regions, product acceptance is continuously growing with over 56% of individuals owning one or more Apple products in the U.S., 40% of which are iPhones1. Customer interest and satisfaction was also extremely high this past quarter, with an iPhone satisfaction rating of 97% across all models. Apple is able to retain a vast majority of its customers once they are introduced to the Apple brand. Customer loyalty ratings for Apple were at 95% this past quarter, 42% higher than its next closest competitor10. While the iPhone has been the flagship of Apple for the past decade, accounting for more than 60% of revenues, the increasingly saturated smartphone market along with fierce competition has induced Apple to diversify their product line. Other business segments such as the Mac, Apple Watch, and Services all hit record high revenues in 2017. Apple's tablet, the iPad, reported a record high 54% share of the U.S. tablet market in the September quarter10.

With accelerating revenues, solid fundamentals, innovative products along with high customer satisfaction and brand loyalty, we believe Apple presents a great investment opportunity, hence our BUY rating. Our model anticipates a target price of $200-$210 with an upside potential of at least 14%.

Macroeconomic Outlook

S&P 500 Index

The Standard & Poor's 500 Index has become the renowned benchmark for the overall performance of the US equity market. Apple, Inc. is the largest company within the S&P 500 and accounts for over 80% of the value of the Technology Hardware Industry group13.

The S&P has reached economic records this year and is currently residing at $2,582. The annual historic returns of the S&P has between 10% - 12% and dividends of 3% - 4%. The annual return for 2017 is already at 16.91% following strong earnings reports from the technology hardware and services sector in the third quarter9.

Given strong Q3 earnings in the technology sector and in the S&P 500 as a whole, we believe that by the end of the year, the S&P will reach a measure near $2,650, a new record high. Apple will be at the forefront of this increase and their capital appreciation will display this as such.

GDP Growth US

Real GDP provides a good measure of the society's wealth and the rate at which the economy is growing. Real GDP has a strong correlation with consumer spending as well as corporate profits. In Q3, Real GDP entered into its historic average of 3% growth, as depicted in the graph below. In the same quarter, consumer spending came in at 2.4%11.

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With this quarter displaying 3% GDP growth as well as the S&P 500 and Dow Jones Industrial Average at all-time highs, we predict that the consumer spending will grow to 3% next quarter. Progressing forward, we predict that the by the end of the year the GDP will reach an annualized margin of 2.7%. In the shorter term regarding the technology sector, specifically Apple, the benefit will be much larger with the increased GDP due to people being more willing to spend money during the economic upswing and the rapid societal acceptance of technology hardware and software.

Inflation Rate (CPI & PPI)

Consumer Price Index (CPI) measures the changes in the prices paid for goods and services by consumers, on a monthly basis while the Producer Price Index (PPI) measures the average change in selling prices received by domestic producers of goods and services over time. Both indices are two of the top gauges used to measure inflation. PPI is a more fragile measure and is affected more harshly than that of CPI, as shown below. None the less, both are highly tied to the inflationary movements produced by the Federal Reserve12.

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Janet Yellen did not place a high importance on inflation, but more on unemployment and interest rates being low to spur the economy and consumer spending. When Janet Yellen is replaced early next year, interest rates are expected to rise up after the Fed's extended quantitative easing. This will influence

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companies like Apple to issue less debt and start saving funds given higher interest rates. This is reflected in our outlook for Apple's long term debt, with long term debt only increasing around 5% compared to 30% from 2016 to 2017.

Industry Analysis

$434.5 billion dollars worth of product and is on track to sell nearly a half trillion dollars by year end8.

Industry Overview

The technology hardware industry is currently comprised of highly elaborate and competitive companies and products that range from smartphones, computers, wearable technology, and the newest, a slow societal implementation of virtual and augmented reality. This industry aids in the overall growth of other tangent industries as well, supplying companies with the newest technological advancements to help further their efforts. Overall, the industry's revenue is expected to increase 1.3% by year end and 8% by year end 201813. The smartphone industry has outperformed the entire Technology Index and the S&P 500 in terms of returns.

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In the technology hardware constituents of the S&P 1500, Apple is a leader of total operating revenue by a substantial margin of 44% higher than the next competitor13.

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The historic revenue numbers can be attributed to a societal movement of consumers wanting the most updated and advanced technology possible.

Recent Developments and Industry Trends

After Apple's iPhone 6 recorded the highest revenue for a device in the history of the Technology and Hardware industry, it experienced its first YoY decline for its newest iPhone in 2016. All the while, Samsung's smartphone displayed the worst recall of a product in industry history as well13.

However, over the past decade, the global market for smartphones has displayed staggering development. Smartphones, which offer more content and variability, have been replacing traditional phones at an exceedingly quick pace. In a six year time frame, smartphone penetration has gone from 20% in 2010 to 75% of all mobile phones in 2016. This growth is projected to continue and by 2021, it is estimated that 87% of total mobile phone shipments will be correlated with the smartphone industry13.

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Though all these companies and products are responsible for a portion of the industry's revenue, smartphones have proved to be the leading producer for the industry historically as well as forecasting outward. Smartphones have shown immense growth in both global revenue as well as global unit sales with little sign of slowing down. This past year, the smartphone industry sold

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During this technology upsurge, Apple and Samsung have proven themselves as the leaders of the premium phone market, while companies like Huawei and Oppo control the low-end smartphone segment of the Chinese market. These smaller sized companies operate in less developed regions where the smartphone market is not completely saturated.

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Market Share

In Q2 2017, the percent breakdown of number of units shipped by each company was nearly identical. Apple shipped half as many phones as Samsung across the globe, 41 million to Samsung's 79 million in Q2, but their market share of the total value of the industry would say otherwise5. Despite shipping less units, Apple has the highest percent share of total value of smartphone industry in the world. Apple is selling their product at a higher premium than that of Samsung, but that is not the sole reason for having the controlling market share value of the world. The other reason for Apple's dominance is market share is that even though they shipped half as many units at roughly twice the average price, their earnings are set to be $86.13 billion this quarter, while Samsung earnings this are estimated to be $60.61 billion4. This assists the idea that Apple is currently being accepted more globally and the societal shift towards smartphones is resulting in a more lucrative situation for Apple.

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Apple is widely considered throughout the US as the standard for the smartphone. However, Samsung is still posing a major threat to this idealism. Since Q4 of 2016, Samsung has increased their market share from 16.4% to the current 27.2% while Apple has stayed constant.5This increase is not as impressive once the other companies' market share is quantified. During this increase, all providers of smartphones labeled under "Other" displayed negative growth in market share posing the idea that Samsung is reliant on pushing out smaller competitors to gain traction in the US.

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Porter's 5 Forces

Threat of New Entrants: Low

Entering into the smartphone industry is extremely challenging and requires mass amounts of capital. The market is already heavily saturated, making it nearly impossible for new companies to acquire a customer base and provide a product superior to its competition. However, companies such as Amazon, Inc. and Alphabet, Inc., have been introducing a new product line of phones and exposing them to their already large consumer base. Forecasting these new products impact and acceptance from consumer base is nearly impossible because the phones were released just a few months ago. Nonetheless, Apple has already developed a mass base of reliant consumers, which will make it very challenging, even for companies like Alphabet and Amazon. Overall, the threat of new entrants is low because the only companies that can enter the market are ones similar to that of Google or Amazon, with large market caps and heavy resources, eliminating small companies from having a chance of entering the space.

Competitive Rivalry: High

Due to well established companies, the competitive nature of this industry is very high and intense. Premium smartphone providers such as Samsung and Apple are constantly fighting for market share all across the globe. These companies will compete in release dates to give their product the slight advantage of being the newest on the market. Apple and Samsung have established themselves as the giants of the industry.

Bargaining Power of Suppliers: Low

Smartphone production is often outsourced to other countries to construct the product at an extremely low cost. The suppliers fight to secure smartphone producers by using this low-cost method, leaving the power to the company. Majority of these countries need the infrastructure a well-established phone company can provide. Smartphone companies are starting to embrace a "zero waste manufacturing" idealism, where old products are being deconstructed and then recycled into creating new and updated versions. This allows companies to reduce their costs and allow for more spending in areas such as R&D, which is crucial in the technology hardware and smartphone industry. Also, the resources used to construct these products are readily available and can be bought in mass quantities, again lowering cost.

Threat of Substitutes: Moderate

The smart phone industry is already well established and highly competitive. However, providing the best and newest technology to consumers has proven to be a highly lucrative investment, other companies from different industries have already shown that they are willing to compete in the industry. As discussed earlier, companies like Amazon and Google have already released new smartphones. These companies are exploring on untouched paths for their respective businesses in hopes to gain traction in the ever growing smartphone market. These attempts are listed as moderate because Google and Amazon possess the

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capital and resources to support such an investment for an extended time to find out if the investment will pay off. However, it will be a challenge for these companies to acquire consumers from an already loyal consumer base. Consumers are not likely to switch over to a brand new operating system while they possess extensive knowledge and exposure to one they have already been using for a long period of time.

Bargaining Power of Buyers: Low The smartphone industry is an ever-changing and adapting environment. Therefore, companies like Apple and Samsung are constantly producing the best phones they possibly can to supply consumers. Apple and Samsung are the premium smartphone providers and have established themselves as such with the quality of their products. Consumers who want the newest phone are willing to pay a higher price because they increased technology and capabilities. Also, there are 2.1 billion smartphone users across the world, signifying that demand is very high, making it less likely that companies will reduce their price to increase demand further8. Also, buyers of Apple products have proven to be very price insensitive due to constant growth in number of sales and revenue, making the bargaining power low.

Company Analysis

Product Lines

iPhone

The iPhone is Apple's line of smartphones based on the iOS operating system that accounted for 62% of Apple's total revenue in 2017. Since the launch of the original iPhone in 2007, Apple has made significant improvements and updates to the iPhone included the recent release of the iPhone 8/8 Plus and the iPhone X in honor of the 10 year anniversary of the iPhone. This is the first time Apple has released 3 new phones within such a close window. There has been speculation on whether or not this would result in a cannibalization of sales; however, we see this as a positive approach by Apple giving consumers the option of three different devices heading into the holiday season and strong driver of revenues over the coming quarters. During Q4 17 the iPhone saw double digit growth in emerging markets and are starting to strengthen their market share in countries outside the U.S10.

The chart below is 451's latest survey of future smartphone buying which shows 18.6% of respondents plan on buying a smartphone in the next 90 days. This is the highest the survey has seen in three years which happens to be Apple's highest iPhone revenue year to date of $155B in 201510. This is a promising figure for Apple going into 2018 with three new iPhones on the market.

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In the U.S., 451 Research indicated that 69% of consumers planning to buy a smartphone in the next 90 days intend to purchase an iPhone, this is more than 5 times the next closest competitor. The iPhone also has the highest loyalty rate in the smart phone industry of 95% for current iPhone users with the next closet model having only 53%10.

Due to the competitiveness of the smart phone market and Apple's commitment to growing other product lines, our 2021 outlook only has the iPhone accounting for 53% of total revenue, compared to the current 62% of total revenue10.

2017 Revenue Distribution

6% 13% 11%

62% 8%

iPhone iPad Mac Services Other Products

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iPad

The iPad is Apple's line of the tablet devices that also operates through iOS. Although Apple had 54% of the tablet market share in the U.S. in the most recent quarter, it has seen a significant decrease in sales since its peak in 2013 when it sold over 70 million units and accounted for over 18% of Apple's total revenue. Apple's 2017 iPad sales were $19B, down 7% YoY and 43 million units, down 4% YoY. In 2017, the iPad accounted for 8% of total revenues and we only see that percentage getting smaller in years to come with only 5% of total revenues in 2021. The iPad did see a YoY increase in unit sales of 24% and 39% in China and India, respectively10.

Mac

The Mac consists of Apple's line of personal and desktop computers. The Mac has been a consistent revenue driver for Apple over the years and has revenue share in the low teens, recently accounting for 11% of total sales in 2017. The Mac just

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