1. BABSON
COLLEGEFUND
1
(NASDAQ: AAPL)
Rating: BUY Apple (AAPL)
Price Target: $153.62 Industry: Consumer Electronics
Close 03/06/15
Price $126.60
52 Wk. $73.05 – $133.60
Shares Outstanding 5.8B
Market Cap $753B
Source: Yahoo! Finance, Bloomberg
Source: Company Filings, Research Reports
Investment Action & Thesis
We are initiating coverage on Apple with a BUY rating and a target price of $153.62
representing a potential upside of 21.3%. Apple is the largest consumer electronics company in
the world and has shown significant signs of improvement in its Q1-2015 earnings results.
The primary tenants of our investment thesis are as follows:
1) “Watch” out for Apple, in this new report we have modelled in potential earnings
from Apple watch sales that will begin in Q3-2015. Even with conservative estimates,
this new product line may be adding up to $20Billion in revenues to Apple by 2017 and
will have a non-negligible positive impact on EPS in 2015 and 2016.
2) iPhone gaining back market share , the data from the latest earnings quarter has
shown the iPhone re-covering lost market share across all of its geographies through
the iPhone 6 product line. The larger screen of the iPhone 6 model has been a major
driver for gaining back customers.
3) Share repurchase program likely to increase in 2015, through an increase in leverage
or potential tax reform changes, Apple is well poised to increase its share repurchase
program to $50 or $70 billion which will increase the shareholder yield significantly.
4) Major part of the Benchmark, given that Apple is 20% of the IYW (iShares US Tech)
benchmark and 4% of the S&P 500 benchmark, not holding this stock in our portfolio
would inherently indicate that we have a rational to be short on Apple. This report was
intended to validate this thesis and the conclusion is that we should in fact be long
Apple.
Basic Information
Beta 1.02
EV/EBITDA 2016 7.4x
P/E 2015 14.5x
Cash $177B
Dividend Yield 2.2%
Source: Bloomberg, Company Filings
Company Overview
Apple Inc. designs and sells
consumer electronics
(smartphones, tablets, and
mp3 players), computer
software and personal
computers globally.
Source: Company Filings
Analysts
BCF Technology Sector
Sanjay Zimmermann
szimmermann2@babson.edu
Joseph Winn
Jwinn1@babson.edu
Gaurav Makkar
gmakkar1@babson.edu
invest.babson.edu
AAPL Earnings Model
($ in millions except per share items) FY 2013 FY 2014 FY 2015 FY 2016 FY2017
Total Revenue $170,910 $182,759 $225,489 $237,582 $252,444
Total Y/Y Revenue Growth % 9.2% 6.9% 23.4% 5.4% 6.3%
Cost of Sales $106,606 $112,258 $135,293 $140,174 $146,417
Gross Profit $64,304 $70,501 $90,195.5 $97,409 $106,026
Gross Margin % 37.6% 38.6% 40.0% 41.0% 42.0%
Operating Income $48,999 $52,467 $68,315.5 $74,584 $82,338
Operating Margin% 28.7% 28.7% 30.3% 31.4% 32.6%
Net Income $37,037 $39,474 $51,382.2 $56,243 $62,240
Profit Margin 21.7% 21.6% 22.8% 23.7% 24.7%
EPS $5.68 $6.45 $8.86 $10.12 $11.72
Consensus EPS $8.61 $9.37 $10.16
Variance $0.25 $0.75 $1.56
2. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Product Segment Analysis
iPhone
iPhone revenues beat expectations in Q1 2015, with a
QoQ growth of 57.5%, part of this increase can be
attributed to the record amount of unit sales in this
quarter (75 million) and another part can be explained by
the higher average selling price. The success of the iPhone
6 is a very positive indicator for Apple’s continued ability
to grow unit sales with its products. The higher price
point of the iPhone 6 plus contributed to the increase in
average selling price from $603 in Q4-2014 to $687 in Q1-
2015. As a result of these factors and the gaining market
share (discussed in the industry overview section), the
iPhone product line revenues are expected to increase
45% YoY in 2015.
iPad
iPad sales have been declining as phablet devices such as the
iPhone 6 plus are starting to cannibalize this market. iPad
revenues were down 21.7% QoQ in Q1 2015. This decline is
mainly attributed to a decline in unit sales of iPads as well as a
small decline in average selling price as more consumers are
shifting towards the mini, lower-priced version of the product.
We forecast this trend to continue and iPad revenues to
decline 14% YoY in 2015.
Driver: Stronger iPhone and MAC revenue growth expectations
Source: Filings, Estimates
Source: Filings, Estimates
Q1-2014 Q1-2015 Change
Units Sold 51,025 74,468 46%
Average Selling Price $637 $687 8%
Revenues $32,498 $51,182 57%
Q1-2014 Q1-2015 Change
Units Sold 26,035 21,419 -18%
Average Selling Price $440 $419 -5%
Revenues $11,468 $8,985 -22%
3. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Mac
Mac sales also beat expectations in Q1 2015 with a QoQ growth of
8.6%. Mac revenues are expected to grow 14% YoY in 2015 as more
corporate clients are switching to the iOS platform. A positive sign for
Mac is that since 2006 sales of these computers have been outpacing
the total industry growth. The growth however from this segment will
not reach further than low teens due to the overall decline in the
industry growth for laptop and desktop computers.
iPod
iPod sales have been declining since 2011 and this trend is expected to continue into the future as this product line becomes
increasingly less popular. In 2014 iPod revenues declined 48% YoY. Due to the declines in this product line, as of Fiscal Year
2015, Apple does not disclose figures for this product line anymore and simply includes these revenues as part of its
accessories revenue segment.
Adding Apple Watch to the model
The Apple watch or iWatch (https://www.apple.com/watch/) is expected to go for sale after Q2-2015. Several analysts have
started to model out the potential revenue contributions from this new product line and include these in their estimates. We
have therefore updated our BCF financial model to include estimates for the iWatch as well and the conclusion seems to be
that if the iWatch product line is moderately successful it could have a significant impact on Apple’s EPS, increasing it by 2.4%
in 2015 and 10.4% in 2016. Our model estimates that by FY2017 the iWatch could bring in as much as $20 billion in extra
revenues for Apple.
Given that the iWatch works with any iPhone 5 or later device, the addressable user base for this product is limited by the
amount of owners of these devices. The street estimates Apple Watch to penetrate 5% of this user base by CY15 and 13% of
this base by CY16, this translates into sales of 26 million watches in 2015 and 55 million in 2016 (see figure below).
Q1-2014 Q1-2015 Change
Units Sold 4,837 5,519 14%
Average Selling Price $1,322 $1,258 -5%
Revenues $6,395 $6,944 9%
Source: Filings, Estimates
Driver: iWatch expected to increase FY’15 EPS by 2.4% and FY’16 EPS by 10,4%
4. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Impact on Margins
The Apple watch will sell as three different
models: sport, stainless and gold. The sport
model will be the most popular version due to its
low starting price of $349. This product line is
expected to have a gross margin of 45% which is
6% over Apple’s group average of 39%. The
implied EBIT margin of the sport model is 31%
which is in line with Apple’s group margin.
The two other versions of the Apple watch will
have much higher margins but are also expected
to have much lower sales volume.
For this reason the overall impact on Apple’s margins from the Apple watch is to be only slightly margin accretive.
Industry Overview
Apple has been able to reverse the trend of unit share market loss with the introduction of the iPhone 6 models. Since
December 2012, Apple had been losing market share to competitors mainly due to its smaller display size. Apple has evened
the playing field on this characteristic by increasing the screen size in the iPhone 6 line. The graph below displays Apple’s
market share over time, although their share seems to be cyclical, the latest Dec-14 data seems to indicate that they have
gained back 2 basis points from the Dec-13 results.
Driver: iPhone is gaining back market share with the iPhone 6 and 6 plus
iPhone market share over time
5. BABSON
COLLEGEFUND
5
(NASDAQ: AAPL)
The December 2014 data also showed Apple gaining back market share across all geographic regions. This is a promising sign
due to the recent fears of Apple loosing significant market share in China to Xiaomi and other new lower price smartphone
producers. North America and Japan remain the strongest markets for iPhone market share. EMEA has been improving and
this is good news considering that in revenue terms this is the second largest market for Apple. China and APAC have struggled
over the last few quarters as low-end smartphone devices have started take market share away from Apple. Fortunately the
iPhone 6 has reversed this trend in the most recent quarter.
iPhone revenues – vital driver for Apple
In 2014, iPhone revenues made up over 55% of Apple’s total revenues and in 2015 they are expected to make up 63% of firm
wide revenues. For this reason the success of the iPhone product line is crucial to the overall success of the stock. For this
reason these recent increases in market share are a promising sign for the company and is a key part of our investment thesis.
iPhone market share across geographies
6. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Share buyback program will boost shareholder yield
Apple currently has over $177 billion in cash and over the last two years several activist investors have been urging the firm to
return part of this cash to shareholders through dividends and share repurchases. In April 2014, the board agreed to raising its
quarterly dividend by 8% and increasing its share repurchase program by $30 billion. The issue with Apple’s cash however is
that over 90% or $160 billion of its cash is overseas and current tax laws make it costly for the firm to repatriate this cash.
We expect that in 2015, Apple will further increase the size of its share repurchase program through an increase in leverage
and/or tax reform changes.
Increase in leverage
In order to increase its share buyback program to $50 billion or $70 billion, apple could take on debt against its overseas cash
reserves and use the proceeds to buyback additional shares. This would however limit the share repurchase program to $70
billion as the company seems to be concerned about maintaining its high grade debt rating. In order to maintain this (AA/Aa)
rating Apple needs to maintain a debt to EBITDA multiple of 1.0x or below. The table below illustrates two scenarios that Apple
could take to increase its share buyback program while raising its leverage.
Driver: Leverage increases or tax reform may allow Apple to increase share repurchase program
7. BABSON
COLLEGEFUND
7
(NASDAQ: AAPL)
Tax reform changes
Under current tax laws, if Apple were to repatriate its $160 billion abroad, this would cost the firm around $50 billion in taxes.
However recently, tax reform for corporations holding cash overseas has become a key topic in politics. President Obama has
proposed a 14% tax on accumulated overseas earnings. Senators Paul and Boxer have proposed an even steeper decrease,
proposing a bill that calls for a 6.5% repatriation rate over the next 5 years to encourage companies to bring back capital to the
U.S.
There is a 5-6 month window according to political analysts for either of these new policies to be implemented before the 2016
presidential election season kicks off. If this happens, it would significantly benefit Apple and allow them to further increase
their share repurchase program.
Investment Risks
iPhone losing market share to competitors
Given that over 50% of Apple’s revenues come from the sale of iPhones, any significant decline in iPhone market share would
have a major impact on the stock. Competitors such as Samsung, HTC, Xiaomi, Sony, LG etc. are constantly trying to come up
with new products and marketing campaigns to steal market share from Apple. Given that the prices of smartphones from
competitors are all relatively cheaper than the iPhone, Apple needs to continuously innovate and improve its iPhone models in
order to maintain its product leadership position.
Apple Watch Failure
The Apple watch product line is a brand new segment for Apple and our financial model is built on this line succeeding
moderately well. If the watch fails to deliver for whatever reason (battery life, style, defects, recalls etc.) and sales for the
watch do not increase as planned then future earnings may be significantly affected. As currently there is a built in expectation
that by 2017 the Watch segment will deliver around $20 billion in revenues.
Macroeconomic conditions
Any slowdown in the U.S. or global economy could have negative consequences for Apple. Given that the company sells
relatively high end consumer electronic goods at average selling prices that are far beyond competitors. An economic
slowdown would either have consumers hold back on upgrading their devices or opt for lower-end smartphones. Either of
these scenarios would hurt Apple.
8. BABSON
COLLEGEFUND
8
(NASDAQ: AAPL)
Company insights
While researching the stock, we reached out to Ashwin Kesireddy, an analyst at J.P. Morgan who has been covering the stock
and recently published a complete model for calculating the potential increase in earnings from the Apple Watch. Given that
his model was the starting point for our new model on Apple’s watch product line, we wanted to reach out in order to get
sense for how bullish he actually was on the product, here are the key takeaways from the conversation.
• He mentioned that his estimates were conservative given that in his model the watch just need to reach 5% of the
reachable customer base by 2015 and 13% by 2016, which he viewed as quite realistic
• The health tracking features and Apple pay functionality may be the key drivers attracting customers to buy this
product
• Good battery life from the watch will however also be crucial for the success of this product
• The majority of the investment community is rather bearish on the Apple Watch, which is why the potential upside of
this new product has not yet been priced in to the stock.
Ashwin Kesireddy
Analyst – J.P. Morgan
(415) 315-6756
ashwin.x.kesireddy@jpmorgan.com
Professor Jonathan Sims
In addition to talking to the analyst at J.P. Morgan, I was planning to talk to one of my past Babson strategy professors who
studied Apple in our class. Our meeting was unfortunately moved to next week so we can’t fully report the findings of this
discussion yet. Professor Sims did mention so far that he views their move with the Apple watch as “one of their riskiest
ventures in years”.
[A meeting is scheduled for Wednesday March 11th
with Professor Sims]
9. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Apple Stock Price Performance
Over the last year, Apple consistently beat earnings estimates allowing the stock to rise from the mid $70 range in March 2014
to its current $130 range. The latest earnings surprise was over 17% positive which allowed to stock to increase around 20%
immediately after the earnings announcement. The graph below illustrates this story and one of the precautions it carries is
that the stock is trading near it’s one year high and any miss in earnings could have major repercussions.
Sources: Bloomberg
Valuation Analysis
Based on our DCF and Compco valuations, we determined the fair price per share to be $153.62. We weighted the whole DCF
valuations and Compco evenly at a 50% split.
Valuation Summary
Price Per Share Weight
DCF $175.02 50%
CompCo $132.22 50%
Target Price $153.62
Driver: Valuation upside despite recent share price increase
10. BABSON
COLLEGEFUND
10
(NASDAQ: AAPL)
Comparable Company Analysis
The comparable companies that we used for Apple are a mix of major consumer electronics companies such as Microsoft and
HP as well as more targeted smartphone companies such as Nokia and HTC.
Source: Thomson One, Bloomberg, Company Filings
11. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Discounted Cash Flow Model
Growth assumptions in our revenue model are on the next page. The revenue drivers for this model are also highlighted in
detail in the following pages. We utilized a 10 year DCF model with a terminal growth rate of 0.5% which represents an
implied terminal EV/EBITDA value of 8.2x.
Apple DCF Model Estimates
Forecast Period BCF Extrapolation
($ in millions ) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Total Revenue $182,759 $225,489 $237,582 $252,444 $265,066 $278,319 $289,452 $298,135 $304,098 $307,139 $310,210
% Growth 6.9% 23.4% 5.4% 6.3% 5.0% 5.0% 4.0% 3.0% 2.0% 1.0% 1.0%
EBIT $53,447 $69,460 $76,004 $84,108 $88,797 $93,237 $96,966 $99,875 $101,873 $102,892 $103,921
EBIT Margin 29.2% 30.8% 32.0% 33.3% 33.5% 33.5% 33.5% 33.5% 33.5% 33.5% 33.5%
-Taxes $13,973 $18,078 $19,761 $21,868 $14,208 $24,242 $25,211 $25,968 $26,487 $26,752 $27,019
Tax Adjusted EBIT $39,474 $51,382 $56,243 $62,240 $74,590 $68,995 $71,755 $73,908 $75,386 $76,140 $76,901
+Depr. & Amort. $7,946 $10,510 $11,323 $12,002 $12,602 $13,232 $13,761 $14,174 $14,458 $14,602 $14,748
+Stock based comp $2,863 $3,238 $3,200 $3,400 $3,570 $3,749 $3,899 $4,016 $4,096 $4,137 $4,178
+Change in Net Work. Cap. ($2,805) ($2,255) ($2,376) ($2,524) ($2,651) ($2,783) ($2,895) ($2,981) ($3,041) ($3,071) ($3,102)
+Capital Expenditures ($9,571) ($11,964) ($13,160) ($14,476) ($14,682) ($15,416) ($16,033) ($16,514) ($16,844) ($17,013) ($17,183)
Free Cash Flow $37,907 $50,911 $55,230 $60,642 $73,429 $67,777 $70,488 $72,602 $74,054 $74,795 $75,543
Perpetuity Growth Model Growth RateTerminal Year Implied Terminal EV/EBITDA
Terminal Value 0.5% 2024 8.2x
Cost of Capital Sources
Beta 1.02 Bloomberg (2 year adjusted)
Risk-free Rate 2.01% Bloomberg
Risk Premium 6.50% BCF
Weight of Debt 5.20% Bloomberg
Cost of Equity 8.64%
Cost of Debt 1.51% Bloomberg (see screenshot in sources tab for details)
Weight of Equity 94.80% Bloomberg
WACC 8.3%
DCF Model Sources
Enterprise Value 877,742$
Cash and Equivalents 177,955.0$ Bloomberg
Minority Interest -$ Bloomberg 0.903955
Total Debt 36,403.0$ Bloomberg
Fair Equity Value 1,019,294$
Shares Outstanding 5,824.0 Bloomberg
Fair Stock Value 175.02$
Fiscal Year End: 28 Sep 2014
Terminal Value
977,193.1$
16. BABSON
COLLEGEFUND
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(NASDAQ: AAPL)
Important Disclosures
Babson College Fund
The Babson College Fund (BCF) is an academic program in which selected students manage a portion of the Babson College
endowment. The program seeks to provide a rich educational experience through the development of investment research skills and
the acquisition of equity analysis and portfolio management experience. Please visit http://cutler.babson.edu for more information.
Analyst Contact Information
Sanjay Zimmermann | szimmermann2@babson.edu
Joseph Winn | jwinn1@babson.edu
Gaurav Makkar | gmakkar1@babson.edu
Definition of Ratings
BUY: Expected to outperform the IYW producing above average returns.
HOLD: Expected to perform in line with the IYW producing average returns.
SELL: Expected to underperform the IYW producing below average returns.
References
Thomson One
Capital IQ
Finviz
Published Analyst Reports
Bloomberg
Apple Investor Presentations
Apple Company filings
Yahoo! Finance
Investor Relations Calls
IBIS World
Value line