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Market Dynamics


CONTENTS                                                 25th Sep’ 2005




              Note: For textual analysis, see Appendix


                          KEY DRIVERS
CONTENTS                                                                      25th Sep’ 2005
              1) PC:
               45% of revenues
               Captures incremental revenue

              2) iPod/Shuffle:
               33% of revenues
               Gross margin of 20%; higher than competitors
                                   Composition of Revenue

                                                            Mac (total)
                                                            Music/I- Tunes
CONCLUSION                                   45%
                                                            Mac Peripherals
                    MARKET DYNAMICS
CONTENTS                                                             25th Sep’ 2005

              1) PC, Software and Peripherals:
               Short product cycles
               Frequent reduction of PC prices
               Market Leaders: Dell (16.8%), and Hewlett Packard(15.2%)

ANALYSIS      2) MP3 and Music Products:
               iPod is the market leader
               Global MP3 market is expected to double by 2010
               Notable competitors: Creative Technology, iriver, Sony,
                      SWOT ANALYSIS
CONTENTS                                                             25th Sep’ 2005

BACKGROUND     Strengths                       Weakness
              -Product Innovator              -Cannibalization of products
              -Strong Financial Position      -Overdependence on US
              -Brand Value                    sales
DYNAMICS      -Diversified Portfolio          -Claims from Lawsuits
                                              -Lack of R&D
               Opportunities                   Threats
VALUATION     -Digital Media Convergence      -Stiff competition
              -Expanding retail operations    -Sensitivity of the industry to
CONCLUSION    -Diversifying outside the U.S   macroeconomic factors
              -iPod/ Music downloads          -Lack of scale
                                  SWOT ANALYSIS
CONTENTS                                                                                25th Sep’ 2005

BACKGROUND                                                REVENUES

KEY DRIVERS                     14,000

                   MILLIONS $
MARKET                           4,000
DYNAMICS                         2,000
                                            2001     2002          2003   2004   2005

                                                          NET INCOME

VALUATION                   1600
              Millions $

CONCLUSION                   800
                            -200         2001      2002          2003     2004   2005
                    SWOT ANALYSIS
CONTENTS                                                           25th Sep’ 2005

                                REINVESTMENT RATE
KEY DRIVERS   40.00%
MARKET        10.00%
DYNAMICS       0.00%
              -10.00%   2001   2002          2003    2004   2005

                                      NON-CASH ROE

VALUATION     40.00%
CONCLUSION    10.00%

                        2001   2002          2003    2004   2005
CONTENTS                                        25th Sep’ 2005


              Year 2005 – 2010 is period of:
                      ‘High Growth’
              Year 2011 – 2015 is period of:
SWOT                   ‘Transition’

              Year 2016 onwards is period of:
                    ‘Stable Growth’
CONTENTS                                                   25th Sep’ 2005

              Estimates for Extraordinary Growth:

              Reinvestment Rate:         28.91%
              Growth rate:               9.82%
              Cost of equity:            9.79%
VALUATION     Non-Cash ROE:              33.96%
              PV of Cash Flows:          $ 4.802 billion
                      TRANSITION PERIOD
CONTENTS                                                  25th Sep’ 2005

              Estimates for Transition Period:

              Reinvestment Rate:        28.91% - 25.00%
              Growth rate:              9.82% - 4.00 %
              Cost of equity:           9.79% - 7.14%
VALUATION     Non-Cash ROE:             33.96% - 16.00%
              PV of Cash Flows:         $ 4.838 billion
                       STABLE GROWTH
CONTENTS                                                25th Sep’ 2005

              Estimates for Stable Growth Period:

              Reinvestment Rate:         25.00%
              Growth rate:               4.00 %
              Cost of equity:            7.14%
VALUATION     Non-Cash ROE:             16.00%
              Terminal Value (2015): $ 75.091 billion
              PV of Cash Flows:          $ 37.676 billion
                       VALUATION MODEL
CONTENTS                                                     25th Sep’ 2005

              PV of Cash Flows: $ (4.802 + 4.838 + 37.676) billion
              Market Value of Cash: $ 3.491 billion
DYNAMICS      Value of Equity: $ (47.318 + 3.491) billion

SWOT          No of shares Outstanding: 839.77 million

              Value of Equity Per Share as per valuation:
VALUATION     = Value of Equity/No. of shares Outstanding
              = 50809/839.77
                         VALUATION MODEL
CONTENTS                                                             25th Sep’ 2005

              PV of Cash Flows:                              $ 47.318 billion

              Market value of cash and other holdings        $ 3.491 billion
              Value of equity                                $ 50.809 billion
              No. of shares outstanding                      839.773 million

              Value of equity per share                          $60.50


                   Share trading on S&P500 as of Sep 2005 at: $ 53.61
CONTENTS                                                     25th Sep’ 2005

BACKGROUND    Apple Computers was thus undervalued as of 25th
                            September, 2005

                   There is an upside potential of: 12.85%
                                We suggest:

    Apple Computer Inc. was a forerunner in PCs, revolutionizing the computer hardware
    and software industry. Incorporated in 1977, it designs, manufactures, and markets
    PCs, portable digital music players (MP3 players), software, storage, and related
    accessories. The Macintosh (commonly known as the “Mac”) was introduced in 1984
    and it revolutionized PCs with its Graphical User Interface (GUI). In the 90’s, Apple’s
    sales suffered at the hands of Microsoft’s Operating System - Windows. Combined
    with low-cost hardware and an improving software suite, an increasing number of
    potential customers turned to the "Wintel" standard instead. In 1998, Apple launched
    a new all-in-one Macintosh: the iMac, a new design that eliminated most of Apple’s
    standard connections. The iMac proved to be a phenomenal success, with 800,000
    units sold in 1998.
•   In 2001, Apple introduced the Mac OS X Operating System and later that year it
    launched its best selling portable digital audio player - iPod. Apple has subsequently
    launched the iPod mini, nano and shuffle. As of September 2005, the MP3 line-up
    consisted of fifth generation iPod, with video playback capabilities, the iPod nano and
    the iPod shuffle. The software used to upload pictures, music and Videos to the iPod
    is called iTunes. Apple remains dominant in the MP3 market and as analysts we
    believe that it will continue its dominance based on its ability to introduce innovative
    products, its strong brand image and the iTunes software. The Apple Intel transition
    which was announced on June 7th 2005 is expected to be completed by the end of
    2007 and will play a major role in determining the future market share and growth
    profile of Apple’s PC business.
Key Drivers
•   PCs: Apple’s four main PC products include: PowerMac, PowerBook, iMac and iBook.
    Apple charges a premium for its PC products compared to traditional PC vendors.
    Apple’s PCs differentiate themselves by virtue of their sleek design and software
    capabilities, creating an incremental margin versus plain-vanilla box manufacturers.
    Having its own Operating System (OS) allows Apple to capture the revenue and
    margin that Microsoft captures in a traditional PC sale. Consequently, we expect
    Apple’s PC business to generate sustainable higher margins and returns versus
    traditional PC vendors, all else being equal.
•   iPod/ shuffle/nano: Since the introduction of the 5GB iPod in October 2001, it has
    grown from constituting 2% of Apple’s revenue in FY02, to more than 30% currently.
    It has led to a strong increase in revenues and earnings, and currently forms an
    important part of Apple’s overall strategy. As compared to PC’s, iPods have lower
    gross margin of about 20%[1]. However, these margins are above those of
    competitors’ due to the iPod’s strong brand, its firmware/ software, iTunes and its
•   Software: Apple sells software on a stand-alone basis, which accounts for 8% of its
    revenues. Apple sells its software on its PCs; a significant portion of the premium PC
    margin could be attributed to their software.
•   Mac Peripherals and other: Apple sells various computer hardware peripherals,
    including iSight™ digital video cameras and a range of high quality flat panel TFT
    active-matrix digital color displays. It also sells a variety of third-party Macintosh
    compatible hardware products directly to end users. Peripherals comprise roughly 8%
    of Apple’s revenue.
Market Dynamics
•   Personal Computers, Software and Peripherals: The PC market is dominated
    by players such as Dell and HP with 18.2% and 15.7% of market share
    respectively (as of 2004). This market is characterized by rapid technological
    advances in hardware and software and cut-throat price competition. Further, as
    the personal computer industry and its customers place more reliance on the
    internet, an increasing number of simpler and less expensive internet devices such
    as PDAs may compete with Apple PCs for market share. However, one can
    foresee that Apple’s growth in PC sales will outstrip that of the overall market due
    to the following reasons: (1) halo effect of Apple’s successful iPod[1] (refer to
    appendix ), (2) stability and security of the OS X software platform, (3) industry-
    leading customer service and retail stores and (4) Intel’s cost/performance
•   iPod and related content: Apple is the dominant player in the MP3 market with
    close to 70% of market share in the US and 50% worldwide. Singapore-based
    Creative, iriver (owned by Korean-based ReignCom) are important competitors in
    the MP3 market. In addition, many of the flash makers have introduced MP3
    players, including Samsung, SanDisk, and Sony. However, Apple currently enjoys
    a competitive advantage by integrating an entire solution, including the hardware
    (iPod), software (iTunes), and distribution of third-party digital content (iTunes
    Music Store). The iPod Video offers exciting growth opportunities in the years
    ahead and puts Apple in the position of developing a home media/computing
    platform that integrates the home office and living room.
SWOT Analysis for Apple Computers
    – Product Innovator: Since its turnaround in the early 1990’s, Apple has invested
      heavily in product innovation and product development; the company streamlined
      its portfolio under the premise of “all in one solutions” and realized the potential
      of digital convergence more aggressively than the rival competition. Product
      innovation also helped Apple to establish a highly loyal customer base.
    – Strong financial position: As a result of the soaring revenues from iPod sales
      in 2005, Apple benefits from a strong financial position with net income
      exceeding 1.3 bn and substantial cash reserves of over $8 billion. The company
      is well positioned for further growth by acquisitions and product development.
    – Increasing Brand Value: Nurturing the Apple brand was a key in the company’s
      overall strategy. Apple has successfully grown their products with a focus on
      form and function and as being the alternative of choice to the Windows PC
    – Diversified portfolio: While the traditional PC market still contributes to almost
      half of Apple’s revenues, the companies’ other segments – most notably the
      music business comprising of iPod and iTunes sales – has grown to become a
      substantial contributor and growth factor.
   –   Lack of substantial R&D: Despite Apple’s strong cash position, and the fact
       that the company’s investment in R&D has substantially grown over the
       previous years - exceeding half a billion in 2005 for the first time – these
       investments are not substantial when compared to other rival competitors;
       Microsoft and Intel alone spent 18 times as much as Apple on R&D in their
       fiscal year 2004/05, thus making it difficult for Apple to maintain the role as
       innovator in product design and technology over the coming years.
   –   Cannibalization of products: The PC industry is characterized by fast
       technology and product lifecycles, and Apple is no exception to this. The
       company has seen some cannibalization of products in recent times, as sales
       of some of its newly released products have had dramatic effect on sales of
       established products.
   –   Supply of raw materials: Apple’s resistance to outsourcing and outside
       suppliers – which has only changed in 2005 with the decision to transition to
       Intel processors - means that the company is susceptible to a supply risk for
       key components.
   –   Unsettled Lawsuits: As of 2005, Apple is faced with unsettled lawsuits;
       Claims could have adverse effect on the company’s financial condition.
   –   Reliance on US sales: The United States represents Apple’s largest
       geographic marketplace. Approximately 50% of net sales were achieved from
       sales in the US. This focus on the US market makes the company more
       vulnerable to adverse local market conditions that may affect the revenues.
•   Digital Media Convergence: Apple’s business strategy with a focus on
    digital convergence helped to position the company to profit from cross-
    product sales and lock-in effects.
•   Expand retail operations/International Growth: Since the 2001 launch
    of Apple’s retail initiative to widen brand awareness and lowering
    switching costs for apple products, the company has successfully
    expanded its distribution network in the USA and Europe. In the USA
    alone, Apple is now operating 65 Apple concept stores. Expanding this
    retail concept overseas should allow the company to profit from
    international coverage.
•   Shift towards legal music downloads: Much like the iPod has given
    Apple a competitive advantage in portable MP3 devices, the introduction
    of iTunes has helped transform music downloading from illegal p2p
    networking to a viable and legitimate business – strengthening Apple’s
    position in a growing market with cross-market potential for its existing
    product range; In 2005, the number of registered users to legal
    subscription services increased from 1.5 million to 2.8million globally in
    2005; 420 million single tracks were (legally) downloaded in 2005 globally
    – more than doubling the number of 2004 (156m).
•    Industry environment: Today’s PC industry is highly competitive in nature, with
     barriers of entry significantly having fallen in recent past as a result of outsourcing
     efforts to third-party suppliers. Apple competes directly with powerful players such
     as Microsoft, IBM, AMD and the open source community; Also, much of its unique
     selling points are not based on technology advancements, but on successful
     branding activities.
•    Transition Risks: Apple’s still ongoing shift to Intel-based Processors bears
     significant transition risk to the company, including the potential for customers to
     defer purchases of its existing line of PowerPC-based PCs.
•    Volatile Earnings/Sensitivity to macroeconomic environment: Earnings in the
     PC and electronic media industry are historically volatile to external
     macroeconomic developments as well as the success of a single outperforming
     product. The iPod turned out to be a cash-cow for the company; but, in sight of
     growing competition and unknown market potential, Apple needs to focus on
     synergy effects between its traditional PC business and its newer businesses
     segments to avoid overdependence on a single product.
•    Lack of Scale: Apple's lack of scale relative to the traditional PC/Windows
     platform generally forces the company to charge a premium for its PC products;
     Moreover, Apple’s stand-alone system architecture and customer’s lack of
     familiarity over available peripheral applications and software creates high
     switching costs, which in turn force the company to invest heavily in marketing
Valuation Assumptions:
    We predict that Apple, currently in Extraordinary growth as of September 2005, will continue in
    this period of High Growth till 2010, followed by a transitory period of 5 years and finally go into
    stable growth mode from 2016 onwards. The above statement is backed by reasons for expansion
    previously stated above, as well as by the following assumptions:
•   Assumptions for High Growth: Larger iPod expanded product portfolio, an Intel launch in 2006,
    the launch of iPod Video as well as talks of launch of iPhone in 2006 and expansion in digital
    content via iTunes could help expand market share and thus high growth is predicted.
•   Assumptions for transitory period :Increases in R&D and marketing expenditure followed by
    increasing leverage in fixed cost retail stores could bring down revenues in the long run. As of
    now, the spending on R&D is far lesser than its competitors and if Apple continues to spend less
    on R&D, competition will soon eat into its market share. On the other hand, if to counter this,
    Apple starts heavily investing in R&D, then it could end up spending far more than it should and
    that would also affect its revenues in the long run. Thus, it is important to strike a balance. Apple’s
    USP is not technological advancements but strong branding and Apple invests heavily in
    marketing of its products as most of its sales are attributed to first time users. This results in it
    spending a humongous amount in advertising and this in the long run, will inevitably affect its
    profit generating capability.
•   Competition in the form of, Dell’s DJ Ditty, launched in Sep, 2005; Sony’s newly revamped
    walkman; Microsoft’s product in the making which will combine games, music and video in one
    handheld device, pose threats to the iPod and other Apple products. With lesser barriers to entry,
    more players will enter the market who will attempt to clone the iPod. The technology behind it is
    not difficult to emulate and Apple being a company far more successful with branding and image
    maintenance than technological advancements, could face potential problems. Additionally, the
    French regulation on making iTunes available to all players could affect the iPod’s monopoly and
    in turn, its revenues. Most of the competitions products will become available from 2008 onwards,
    and presuming it will take a while for these to catch up with consumers, a period of transition for 5
    years followed by stable growth is predicted.
•   Using the Discounted Cash Flow Valuation Approach, Apple Computer Inc. was
    selected for valuation as it was seen that the company, as of September 2005, is still
    in the High Growth period. Five years financial data was easily available and that
    aided the analysis. Thus, historical Financial data from 2001-2005 was obtained and
    from hereon, the valuation was begun. The steps used are outlined below:
•   It was assumed (because of the reasons stated earlier), that the company would
    retain a high growth period of another 5 years and another 5 years of transition
    before going into the stable growth phase. Thus, from 2001-2010 was assumed a
    period of high growth followed by a period of transition till 2015 and finally stable
    growth from 2016 onwards.
•   R&D expenses were not considered. This was because it was affecting the
    calculation of FCFE.
•   Net Income was adjusted to include Extraordinary Charge – Pretax and Depreciation,
    Depletion & Amortization. On the other hand; Extraordinary Credit – Pretax, Non-
    Operating Interest Income, Other Income/Expense – Net, Extraordinary Items & Gain
    (Loss) Sale of Assets were excluded from it to find out the ‘Adjusted Net Income’.
    Shareholder’s equity for each year was found from the financial statements.
•   Cash and Equivalents were found and here, short term investments were ignored.
    This is because the formula in calculating the Non-cash Return on Equity required the
    deduction of ‘only cash’ from the equity. Equivalents being synonymous with cash
    were taken into account. Also, the fact that cash and equivalents were grouped
    together in the statements made it difficult to deduce just the cash portion.
•   Subsequently, The Non-Cash Return on Equity was calculated by dividing the
    adjusted Net Income by Equity less Cash and Equivalents.
Valuation (Continued)
•    From hereon, Non cash Current assets and Non Cash Current Liabilities were
     calculated to find the Non-Cash Working Capital. This was normalized over the
     last 5 years (by taking the average of Non-Cash working capital from 2001-2005
     over sales. From here, the percentage obtained was used to re-calculate the
     normalized Non-Cash Working Capital for the last 5 years). From this, the change
     in Non-Cash Working Capital for each year was calculated
•    Capital expenditure was normalized using the same method as above, by taking
     the percentage obtained from the ratio of capex to sales to recalculate the capex
     for each year. From this, depreciation was deducted to find the Net Capex.
•    Tax rate for each year was obtained from the Financial Statements and an
     average was used for the subsequent years while moving towards a marginal rate
     of 35%.
•    Subsequently, the reinvestment rate was found as a sum of Change in Normalized
     Non-Cash Working Capital and Net capex divided by Adjusted Net Income times
     (1-Tax rate).
•    Growth was calculated as a product of Non Cash ROE and Reinvestment Rate.
•    FCFE was calculated as Adjusted Net Income times (1 - Reinvestment Rate).
Valuation (Continued)
•   Till 2010, Non-Cash ROE was presumed to be the Non-Cash ROE obtained for 2005.
    This is because, 2005 was also a period of high growth. Thus, this was used as a
    starting point to forecast the Non-Cash ROE for the next 5 years. Subsequently, the
    Non-Cash ROE was brought down to 16% from 33.96% because in a period of stable
    growth, the market saturates and growth opportunities shrink in number.
•   The same reasoning was used to fix the Reinvestment rate till 2010. But
    subsequently, from 2011 till 2016, the Reinvestment was no longer fixed and its value
    became dependant on Growth divided by Non-Cash ROE.
•   As for Growth, it was derived as a product of Non-Cash ROE and Reinvestment rate
    till the end of the high growth period. Subsequently, growth was fixed from 2011
    onwards and finally fixed at 4% in stable growth period. This is because it is
    presumed that the economy would be growing at between 4.5%-5% and no company
    in a stable growth period can grow at a rate higher than the rate at which the
    economy is growing.
•   No changes were made in the formula to obtain FCFE and it was generated from
    Adjusted Net Income and Reinvestment rate. Subsequently, the FCFE was taken for
    each of the periods, their present values found and finally, the amount of cash and
    equivalents deducted to find the Non-Cash ROE earlier, was added back to obtain
    the Value of Equity. This was then divided by the number of shares outstanding as of
    September, 2005, to find out the value of equity per share. This revealed a figure of
•   As of September 2005, the shares of Apple were trading at $53.61 on the S&P 500.
    Thus, after comparing this with the figure obtained from the valuation process, we
    conclude that since there is an upside potential of 12.85%, Apple Computer Inc
    stocks are undervalued and a ‘strong buy’ recommendation is given.

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