Apple Inc. (AAPL) November 8, 2015

The Henry Fund

Henry B. Tippie School of Management Jon Kerr [jonathan-kerr@uiowa.edu]

Apple Inc. (AAPL)

Consumer Goods ? Electronic Equipment Investment Thesis

Apple has always been known as an innovative company giving customers the best possible user experience. The company has built a product ecosystem integrating their products into all aspects of people lives. The Apple brand image allows the company to charge premium prices for each of their products. The premium prices create high margins and high profits for the company. Recent enhancements to existing products and new product releases in new markets will generate continued growth. Increased investment in research and development will drive innovation into the future. Apple's brand image and continued innovation has Apple positioned well for future success.

Drivers of Thesis ? Apple has created a premium brand image and product ecosystem that is

difficult for competitors to duplicate. The product ecosystem gives Apple a competitive advantage in every market they compete in and will continue to drive company growth in the future. ? The iPhone is positioned as the premium brand of smartphone in a mature but still growing industry. Continued growth is expected driven by Asian countries such as China and India with relatively low smartphone penetration. ? Apple has released the Apple Watch, which enters them into the booming wearables market. This could be a huge revenue source in a market that is expected to grow 28.1% per year into 2019.

Risks to Thesis ? Apple is highly dependent on the iPhone product line, which consistently

accounts for more than 50% of profits. ? Apple competes in competitive and fast-paced industries. If consumers

begin to treat the markets Apple competes is as commodity markets, Apple will have a difficult time charging premium prices and maintaining high margins.

Year EPS Growth

2013 $5.72 -10.34%

Earnings Estimates

2014

2015 2016E

$6.49 $9.28 13.54% 42.95%

$9.70 4.51%

12 Month Performance

2017E $10.33 6.54%

2018E $11.02 6.68%

AAPL

S&P 500

25%

20%

15%

10%

5%

0%

-5%

-10%

Source: Yahoo Finance

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November 8, 2015

Stock Rating

Target Price Henry Fund DCF Henry Fund DDM Relative P/E Multiple Price Data Current Price 52wk Range Consensus 1yr Target Key Statistics Market Cap (B) Shares Outstanding (B) Institutional Ownership Five Year Beta Dividend Yield Est. 5yr Growth Price/Earnings (TTM) Price/Sales (TTM) Debt/Equity Profitability Operating Margin Net Profit Margin Return on Assets (TTM) Return on Equity (TTM)

Buy $145 - $155

$153.26 $149.46 $147.91

$121.06 $92.00 - $134.54

$148.88

$674.9 5.58

60.20% 1.09

1.84% 15.34%

12.44 2.87

54.0%

30.48% 22.85% 20.84% 46.25%

AAPL Industry Sector

50

40

46.3

30

20

10

17.1

12.4

14.2

0 P/E

31.2

22.9

16.3

13.0

5.2

ROE

Profit Margin

Source: Yahoo Finance

Company Description

Apple designs and manufacturers numerous

electronic devices including mobile phones,

personal computers, watches, portable

digital music players, and other media

devices, as well as software and services.

The cornerstone of the company is the iPhone product line, but other important product lines include the iPad, Mac, and iTunes. The company sells these products worldwide to individual consumers and in the enterprise and education markets.

Important disclosures appear on the last page of this report.

EXECUTIVE SUMMARY

Apple Inc. is a leader in consumer electronics, designing and manufacturing mobile phones, tablets, personal computers, and other devices. They continue to be at the forefront of innovation in each of the markets they compete in by investing in strategic research and development.

Apple has always been known for the superior user experience with each of their products. The company has built the Apple brand as a top-of-the-line brand and therefore can demand premium prices for their products. Apple has been able to generate consistent profits in fastpaced and evolving industries. This is due to the Apple ecosystem the company has created. The core product of Apple is the iPhone. However, consumers get more and more benefits from other Apple devices and services when used along side the iPhone. The true value Apple gives consumers is the Apple ecosystem amongst all its products.

The mature but growing smartphone market will continue to be Apple's main source of revenue. The iPhone is expected to account for 66% of the company's total revenue in 2015. Due to the increased adoption of smartphones, industry wide units sales are expected to increase at 8.2% 4-year CAGR. (2) This increased adoption along with the company's new iPhone installment plan, we forecast iPhone unit sales to grow at a 3.5% CAGR into 2020 slightly decreasing their current global market share of approximately 16%.

Apple's mature products will continue to grow into the future but the new products and services such as the Apple Watch and Apple Music will drive the incremental revenue growth for the entire company going forward. The Apple Watch enters the company into the Wearable's market, which is expected to increase at a 28.1% 4-year CAGR. Apple Music gives the company a solution for consumers following the trend of switching from downloaded music to streaming music.

The iPhone, iPad, and Mac are proven, premium products. These products are the base of Apples revenue which we have modeled to increase at a 3.8% CAGR into 2020. The new products and services, along with consistent innovation, will drive Apples success in the future and therefore, we recommend a buy rating.

COMPANY DESCRIPTION

Apple, headquarted in Cupertino, California, was founded in 1976 as a computer company. With the release of the iPod in 2001, the company began to transform itself to a mobile device company, integrating its products into everyday life. The company now designs and manufacturers numerous electronic devices including mobile phones, personal computers, watches, portable digital music players, and other media devices. Through the transformation, the company has created an ecosystem of innovative products, most notably the iPhone and the iPad. These two products account for nearly three-fourths of the company's revenue.

Revenue Types

FY 2015 % Revenue per Segment

4%

9% 11% 10%

66%

iPhone

iPad

Mac

iTunes, Sogware and Services Accessories

Source: Apple 2015 10-K (1)

Apple's main revenue generator is the iPhone, which is the company's line of smartphones that combines a phone, music player, internet device, camera, and a voice activated intelligent assistant into one product. In 2015, iPhone sales were $155.0 billion, which accounted for 66.3% of revenue. (1) The number of iPhones sold in 2015 was 231.2 million units, a 36.8% increase from 2014. We expect the number of units to increase at a 5-year CAGR of 3.5% to 274.3 million units in 2020. However, due increasing pricing pressure from growing competition, we believe Apple will begin to decrease the average price from $671 in 2015 to $630 in 2020. While unit sales are forecast to grow at a 3.5% CAGR, we forecast iPhone revenues to only grow at 2.2% a CAGR into 2020.

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Apple also has a line of multi-purpose tablets called the iPad. The iPad generated $23.2 billion in 2015, 9.9% of the company's revenue. The iPad was released in 2010 and had seen tremendous growth until 2014 when unit shipments dropped from 71 million to 68 million with iPad revenues decreasing 5.3%. Apple is still the global leader in the tablet market, maintaining the highest market share of tablet shipments for all tablet manufacturers. However, due to the increasing number of players in this market, Apple's market share has decreased from 61.5% in Q2 2011 to 24.5% in Q2 2015. (3) No one company has been the main catalyst for Apple's decreased market share; it has been numerous companies that have chipped away at their market dominance. We expect revenue from the tablet to reverse the decreasing trend in 2016 and have a slight increase in revenue of 2%. Overall, we forecast the iPad revenues to increase at a 5.9% CAGR from 2015 to 2020.

Mac is the company's line of laptop computer and desktop computers. Mac computers contributed $25.5 billion to the company's revenue in 2015, 10.9% of total sales. Mac sales have been fairly steady for the company since 2008 with revenues and number of units shipped increasing each year except in 2013. We expect sales to increase 3% to $26.2 billion in 2016. We expect Mac sales to grow at a constant 3% into 2020.

The company also generates revenue through the sale of digital media via online stores as well as through licensing and other services. The iTunes, Software and Services segment accounted for 8.5% of revenue in 2015. In June of 2015, Apple announced that since the launch of the iTunes store, 100 billion apps had been downloaded from its App Store and 25 billion songs have been sold in iTunes. The App Store and iTunes will continue to maintain revenue for the segment. Growth in this segment will come from new initiatives Apple has released such Apple Music and Apple Pay. We expect 8% growth for this segment in 2016, with a 5-year CAGR of 5.8% into 2020.

Apple's Accessories segment includes the Apple TV, the Apple Watch, Beats Audio headphones, and Applebranded third-party accessories for the iPhone, iPad, Mac, and iPod. This product category accounted for only 4.3% in 2015. We expect large growth in the segment with the release of the Apple Watch driving the majority of the growth in 2016. Apple also recently released the generation 4 Apple TV that will boost revenues in 2016 and beyond. We forecast 40% growth in this segment in 2016. We expect revenues for the Accessories segment

to increase at a 17.4% CAGR into 2020 and become 8.0% of total revenue.

Segment Revenue Growth

iPhone iPad Mac iTunes, Software and Services Accessories Total Revenue

2015 Revenue $155,041 $23,227 $25,471

$19,909 $10,067 $233,715

2016 Revenue $159,692

$23,692 $26,235

2015 % Total Revenue

66.3%

9.9%

10.9%

2016 % Total Revenue

65.1%

9.7%

10.7%

Rev. Growth Rate

3.0%

2.0%

3.0%

$21,502 $14,094 $245,214

8.5%

8.8% 8.0%

4.3%

5.7% 40.0%

100.0% 100.0% 4.9% Source: Apple 2015 10-K (1)

Geographic Diversification

Apple generates revenue through six different operating segments. The segments are broken down into regions based on the nature and location of its customers.

FY 2015 Regional Sales

6% 7%

40% 22%

25%

Americas Greater China Europe Japan Rest of APAC

Source: Apple 2015 10-K (1)

The Americas segment is the highest revenue segment and includes both North and South America. Europe includes the European countries, India, the Middle East, and Africa. Greater China includes China, Hong Kong, and Taiwan. The "Rest of Asia Pacific" includes Asian countries and Australia.

All of the company's operating segments had increased revenues in 2015. The greatest growth came from the Greater China region. In 2015, the Greater China region has revenue growth of 84%. In contrast, the Americas only had growth of 17%. In 2015, China is expected to have a smartphone penetration among all mobile phone

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users of 45% (excluding Hong Kong), compared to penetration rates of 81% in the US and 80% in the UK. (4) We believe the Greater China segment will continue to generate a larger percentage of revenue for the company as the release of the iPhone 6, with a larger screen, will continue to drive demand in this region.

Since Apple has 60% of revenue in foreign sales, currency exchange rates have a major impact on company profits. Apple CFO Luca Maestri said in the 2014 earnings calls, "We prefer to adjust local pricing at the time of new product launches." So if currency fluctuates after a product has been launched, Apple would rather have reduced revenue and margins than reduced unit sales due to higher prices. Maestri did say the company has currency hedges and as their current hedging contracts expire, the company will entire into new hedging contracts at current levels. Maestri also stated that revenue growth in Q1 2015 would have been 4% higher had currency not affected results. (5)

RECENT DEVELOPMENTS

In late 2014, Apple released their largest iPhone yet, the iPhone 6 and iPhone 6 plus. The phone added addition functionality to previous models but biggest difference was the screen size, which increased to 4.7" and 5.5" responding to consumer demand for larger screens. On September 9, 2015, Apple had its new product release event. The company released a new iPhone 6s and 6s Plus with some enhanced features but the iPhone product line is already seeing tremendous growth. We do not expect the new phones to significantly increase that growth. Apple also released a 12.9" iPad Pro to target the enterprise market. An updated Apple TV was unveiled as Apple attempts to become an integral part of consumers living rooms.

Apple has expanded its product ecosystem in 2015. The biggest move from the company was the release of the Apple Watch to take advantage of the booming "wearable's" industry. As well, using their 2014 Beats Audio acquisition, the company has started competing in the streaming audio market with Apple Music.

Q4 and FY 2015 Earnings

On October 27, 2015, Apple announced their most successful year ever with revenue growing 28% to nearly $234 billion. The company had quarterly revenue of $51.5 billion and quarterly net profit of $11.1 billion, an increase of 21.4% and 30.6% from Q4 2014, respectively.

Gross margin increased to 39.9% in the quarter compared to 38.0% a year ago. For the quarter, the earnings per diluted share were $1.96, an increase of 38.0% from the corresponding quarter a year ago. The growth was attributed to record sales of iPhone and Mac products, as well as expanded availability of the Apple Watch. (6)

Apple is expecting 2016 Q1 revenue to be between $75.5 billion and $77.5 billion, a slight increase from 2015 Q1 revenues of $74.6 billion. They expect to maintain their current gross margin between 39% and 40% and have operating expenses of $6.35 billion. We have modeled 2016 revenue to be $245.2 billion with net income of $52.7 billion, growth of 4.9% and -1.3%, respectively. We expect net income to decline slightly due to an increase in operating expenses.

Apple Watch Shipments

During the 3rd quarter of 2015, Apple began shipping the Apple Watch. The Apple Watch will provide large growth in revenue in the accessories segment of the company. As well, the watch will help drive revenues of other Apple products and help enhance the "Apple ecosystem" of products. The Apple Watch allows the company to enter a previously untapped and growing "wearables" market and compete against the Samsung Gear, Pebble Steel, Sony SmartWatch, and others. The number of devices sold in the smart wearable market is expected to grow at a 28.1% CAGR into 2019 and reach 89.4 million units. (7)

Analysts estimate that apple sold 3.6 million units in the quarter. This equates to approximately $1.6 billion in revenue. After selling the watch in a test market of 100 stores, Best Buy has announced they will begin selling the device in all 1,050 of its stores because of the better than expected demand.

An issue of the Apple Watch is that it has limited functionality when not paired with a cell phone. Therefore the Apple Watch is a phone accessory and is only compatible with the iPhone 5 and newer. This compatibility issue limits the customer base of the Apple Watch. Since 2012, the iPhone has averaged approximately 16% market share of new smartphone shipments. Therefore the watch is limited to only 16% of the smartphone market size. (8)

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Global Smartphone Operabng System Market Share held by

Apple iOS

23.0% 16.6% 14.4%

20.9% 17.1% 13.0% 12.8% 17.5% 15.2% 11.7% 11.7%

19.7% 18.2% 14.1%

25.0%

20.0% 15.0%

10.0% 5.0%

0.0%

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 '12 '12 '12 '12 '13 '13 '13 '13 '14 '14 '14 '14 '15 '15

Source: IDC (8)

Even with the limited market, we expect total revenues for the watch in 2015 to be $3 billion with that number growing to $6 billion in 2016. We expect Apple Watch revenues to reach $14 billion in 2020. With an average price of $450 for an Apple Watch, this would equate to 31.2 million units sold in 2020, approximately 11% of iPhone unit sales. We feel our estimation of Apple Watch sales are reasonable as a Credit Suisse survey of iPhone 6/6Plus owners indicates that 18% of the respondents would definitely buy the watch. (9)

iPhone 6/6+ Users Who Will Buy an Apple Watch

Definitely Not 18%

Probably Not 27%

Yes, Definitely

18%

Yes, Probably

11%

Maybe 27%

Source: Credit Suisse (9)

Apple Music

In July of 2014, Apple acquired Beats Music for $3 billion. Along with the entering the company in new markets with the Beats headphones, this acquisition helped Apple create a subscription based streaming audio music service to compete with Pandora and Spotify. The music service, called Apple Music, was launched at the end of June 2015.

Apple Music differentiates itself from Spotify and other competitors by offering three additional features other than just streaming music. Apple Music has a radio service called Beats 1, which is an around-the-clock global live broadcast from DJs located in Los Angeles, New York, and London. The second feature Apple Music uses to differentiate itself is curated playlists created by real people. The playlists are built for the listener based on the users favorite genres and artists. The last unique feature is Connect. This is a social networking feature, which lets fans follow artists.

Apple Music has the potential to cannibalize revenue from Apple's iTunes music store, as some customers will no longer buy music through iTunes a la carte style. Instead customers may only pay the $9.99 monthly subscription fee for Apple Music and stream their music rather than owning it. This subscription fee is equal to Spotify's Premium subscription of $9.99. Also equivalent to Spotify is Apple Music will allow users to download albums for offline listening. We believe Apple Music will over take the iTunes Music Store as the biggest revenue generator in the iTunes, Software, and Services segment and we have forecasted revenue for the segment to grow at a 5.8% CAGR into 2020.

Apple Pay

On October 20, 2014, Apple released Apple Pay. This is a mobile payments service which is designed to allow users to make payments for good and services in retail stores using an iPhone 6, iPhone 6 Plus, or Apple Watch. For security, Apple uses tokenization, which prevents actual credit card numbers from being sent over the air. Apple Pay aims at replacing the wallet. Apple CEO Tim Cook has said that Apple Pay will "forever change the way all of us buy things." (10) Apple Pay has seen some early success with a growing list of partners. On July 7, Apple added 23 more U.S. banks and credit unions, which brings the total to 461 Apple Pay partners in the United States and 9 in the UK. (11)

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