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BACKGROUND CONTENTS 25th Sep’ 2005 BACKGROUND KEY DRIVERS MARKET DYNAMICS SWOT ANALYSIS Note: For textual analysis, see Appendix VALUATION CONCLUSION KEY DRIVERS CONTENTS 25th Sep’ 2005 1) PC: BACKGROUND 45% of revenues Captures incremental revenue KEY DRIVERS 2) iPod/Shuffle: MARKET DYNAMICS 33% of revenues Gross margin of 20%; higher than competitors SWOT ANALYSIS Composition of Revenue VALUATION 8% 8% Mac (total) Music/I- Tunes CONCLUSION 45% iPod Mac Peripherals 33% Software 6% MARKET DYNAMICS CONTENTS 25th Sep’ 2005 BACKGROUND 1) PC, Software and Peripherals: Short product cycles KEY DRIVERS Frequent reduction of PC prices Market Leaders: Dell (16.8%), and Hewlett Packard(15.2%) MARKET DYNAMICS SWOT ANALYSIS 2) MP3 and Music Products: iPod is the market leader Global MP3 market is expected to double by 2010 VALUATION Notable competitors: Creative Technology, iriver, Sony, Samsung CONCLUSION SWOT ANALYSIS CONTENTS 25th Sep’ 2005 BACKGROUND Strengths Weakness -Product Innovator -Cannibalization of products KEY DRIVERS -Strong Financial Position -Overdependence on US -Brand Value sales MARKET DYNAMICS -Diversified Portfolio -Claims from Lawsuits -Lack of R&D SWOT ANALYSIS 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 16,000 KEY DRIVERS 14,000 12,000 MILLIONS $ 10,000 8,000 6,000 MARKET 4,000 DYNAMICS 2,000 - 2001 2002 2003 2004 2005 SWOT ANALYSIS NET INCOME VALUATION 1600 1400 1200 1000 Millions $ CONCLUSION 800 600 400 200 0 -200 2001 2002 2003 2004 2005 SWOT ANALYSIS CONTENTS 25th Sep’ 2005 REINVESTMENT RATE BACKGROUND 60.00% 50.00% KEY DRIVERS 40.00% 30.00% 20.00% MARKET 10.00% DYNAMICS 0.00% -10.00% 2001 2002 2003 2004 2005 SWOT ANALYSIS NON-CASH ROE VALUATION 40.00% 30.00% 20.00% CONCLUSION 10.00% 0.00% 2001 2002 2003 2004 2005 -10.00% -20.00% VALUATION CONTENTS 25th Sep’ 2005 BACKGROUND Year 2005 – 2010 is period of: KEY DRIVERS ‘High Growth’ MARKET DYNAMICS Year 2011 – 2015 is period of: SWOT ‘Transition’ ANALYSIS Year 2016 onwards is period of: VALUATION ‘Stable Growth’ CONCLUSION EXTRAORDINARY GROWTH CONTENTS 25th Sep’ 2005 BACKGROUND Estimates for Extraordinary Growth: KEY DRIVERS MARKET DYNAMICS Reinvestment Rate: 28.91% Growth rate: 9.82% SWOT ANALYSIS Cost of equity: 9.79% VALUATION Non-Cash ROE: 33.96% PV of Cash Flows: $ 4.802 billion CONCLUSION TRANSITION PERIOD CONTENTS 25th Sep’ 2005 BACKGROUND Estimates for Transition Period: KEY DRIVERS MARKET DYNAMICS Reinvestment Rate: 28.91% - 25.00% Growth rate: 9.82% - 4.00 % SWOT ANALYSIS Cost of equity: 9.79% - 7.14% VALUATION Non-Cash ROE: 33.96% - 16.00% PV of Cash Flows: $ 4.838 billion CONCLUSION STABLE GROWTH CONTENTS 25th Sep’ 2005 BACKGROUND Estimates for Stable Growth Period: KEY DRIVERS MARKET DYNAMICS Reinvestment Rate: 25.00% Growth rate: 4.00 % SWOT ANALYSIS Cost of equity: 7.14% VALUATION Non-Cash ROE: 16.00% Terminal Value (2015): $ 75.091 billion CONCLUSION PV of Cash Flows: $ 37.676 billion VALUATION MODEL CONTENTS 25th Sep’ 2005 BACKGROUND PV of Cash Flows: $ (4.802 + 4.838 + 37.676) billion KEY DRIVERS Market Value of Cash: $ 3.491 billion MARKET DYNAMICS Value of Equity: $ (47.318 + 3.491) billion SWOT No of shares Outstanding: 839.77 million ANALYSIS Value of Equity Per Share as per valuation: VALUATION = Value of Equity/No. of shares Outstanding = 50809/839.77 CONCLUSION VALUATION MODEL CONTENTS 25th Sep’ 2005 BACKGROUND PV of Cash Flows: $ 47.318 billion KEY DRIVERS Market value of cash and other holdings $ 3.491 billion MARKET DYNAMICS Value of equity $ 50.809 billion SWOT ANALYSIS No. of shares outstanding 839.773 million VALUATION Value of equity per share $60.50 CONCLUSION Share trading on S&P500 as of Sep 2005 at: $ 53.61 CONCLUSION CONTENTS 25th Sep’ 2005 BACKGROUND Apple Computers was thus undervalued as of 25th September, 2005 KEY DRIVERS There is an upside potential of: 12.85% MARKET DYNAMICS We suggest: SWOT ANALYSIS BUY VALUATION CONCLUSION Appendix Background 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%. However, these margins are above those of competitors’ due to the iPod’s strong brand, its firmware/ software, iTunes and its design. • 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. •  http://www.macnn.com/articles/05/10/21/apples.gross.margin/ 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 (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 improvement. • 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. •  http://www.economist.com/agenda/displayStory.cfm?story_id=3555353 SWOT Analysis for Apple Computers Strengths: – 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 platform. – 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. Weaknesses: – 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. Opportunities: • 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). Threats: • 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 initiatives 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. Valuation • 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 $60.50. • 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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