apple inc. (aapl) – buy - · pdf filefebruary 25, 2013 charlie wolf •...

February 25, 2013 Charlie Wolf • [email protected] • 212-705-0447

Digital Lifestyle

Apple Inc. (AAPL) – Buy AAPL: In our semi-annual exercise, we’re reducing our Apple price target from $750 to $710 Cross currents in the second half of 2012 translated into a cut to our price target, to $710 vs. $750 previously. • The second half of 2012 was characterized by a number of cross

currents that both increased and decreased the value of the components in our Apple valuation model.

• On the positive side, the growth in excess cash over the past six months added $18.70 or 15.1% to Apple’s valuation.

• A newly minted line item—iTunes, software and services—contributed $83.48 or 11.7% to Apple’s valuation chiefly because of the outsized gross margins Apple earns on its software.

• On the down side, the value of the iPad fell $11.83 or 10.8% to $98.11 chiefly because of the introduction of the iPad mini, which has a much lower gross margin that the full-sized iPad.

• The value of the iPhone fell $14.56 or 4.5% to $308.64 because of our assumption that the iPhone’s worldwide share would stabilize at 20% rather than 22% as before.

• The largest decline occurred in the Mac, whose value fell from $100.50 to $57.42, a 42.9% decline, in belated recognition that neither Mac nor Windows sales would continue to rise at past rates because of the onslaught of the iPad and other tablets.

• We continue with 2013 and 2014 earnings estimates of $45.70 and $52.50, respectively, and a Buy rating on the stock.

• The lingering risk in the Apple story is that the company may no longer innovate at the same pace and with the same disruption that characterized the era when Steve Jobs was at the helm. With respect to our valuation model, any deterioration in the iPhone’s market share or gross margin would have an outsized impact on our price target.

Price Target Change

Price (02/15/13) $460.1612-Month Price Target $710.0052-Week range $702.10-439.88Shares Out. (MM) 947.2Market cap (MM) $435,871.4Avg. daily volume (000) 21,522.7Financial DataTotal Debt/Cap. 0.0%Price/LTM Rev. 2.6xTangible BVPS $129.73Net Cash Per Share $144.75

Market Data

Apple Computer, Inc. designs, manufactures, and markets personal computers and portable music players as well as peripherals, software, and services. The company’s products include the Macintosh line of personal computers, the iPod music player, and the iTunes music store.

Apple Inc. Price 02/15/13

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Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb

Volume (000)

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Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb

FY FY FY09/29/12 A 09/29/13 E 09/29/14 E

Old New Old NewRev. (MM) $156,508.0 $185,192.0 $185,192.0 $211,078.5 $211,078.5Growth 44.6% 18.3% 18.3% 14.0% 14.0%Op. Mar. 35.3% 30.6% 30.7%EPS: 1Q 13.87 13.81 13.81A 14.52 14.52EPS: 2Q 12.30 10.18 10.18 12.99 12.99EPS: 3Q 9.32 10.61 10.61 12.53 12.53EPS: 4Q 8.67 11.10 11.10 12.16 12.16

EPS: Year 44.14 45.70 45.70 52.20 52.20Growth 59.5% 3.5% 3.5% 14.2% 14.2%

P/E Ratio 12.0x 10.1x 10.1x 8.8x 8.8x

Source: Company data, Needham estimates. Note: Pro forma earnings estimates displayedabove do not include one-time items or any stock compensation expenses.

Disclosures applicable to this security: A, B, G.Disclosure explanation on the inside back cover of this report.

2 An Investment Analysis by Needham & Company, LLC

1. Summary Our Apple valuation model assigns a value to each of the company’s businesses—the iPhone, iPad, iPod, Mac, the iTunes Store, software and services and accessories. The unique feature of our model is that the growth in Mac sales is driven solely by the halo effects emanating from the iPhone and iPad. As shown in Figure 1, we’re reducing our price target from $750 to $710.

Figure 1

Apple remains a relatively small player in three very large markets—the personal computer, smartphone and tablet markets. With the buildout of the iPhone’s distribution network to 250 international carriers and the growing possibility that the iPhone could launch on China Telecom’s network before the year is out, the iPhone could gain some share in the smartphone market. Apple’s strategy of extending the iPhone’s lineup by selling older models at progressively lower price points could possibly enable the device to invade the high end of pre-paid markets. While the iPhone’s share in mature, post-paid markets has enabled the device to be the market leader, demand for smartphones is rapidly shifting to emerging, prepaid markets. In recognition of this, there has been an increasingly clamorous debate whether Apple should introduce a less expensive, large-screen iPhone targeting emerging prepaid markets. While it’s never say never, such a move on Apple’s part would be very uncharacteristic because the company has been the leader, not a follower, in the smartphone market. The iPad is arguably the most exciting product in Apple’s portfolio, in our opinion. We disagree with pundits who have predicted the iPad will rapidly lose share to Android tablets. There are over 225,000 applications written for the iPad, 10 times the number written for Android. Unlike a smartphone, which is multidimensional, a tablet is a blank slate in the absence of applications. Its value lies in the consumption and the creation of content. From a distribution perspective, then, the tablet is not naturally aligned with the carrier distribution network, which has played a crucial role in the ascendency of Android smartphones. Our view, then, especially in light of its dramatic invasion of the business market, is that the trajectory of the iPad’s market share will more closely resemble the trajectory of the iPod’s share rather than the iPhone’s. However, since most market research firms do not distinguish between content creation and consumption tablets, the iPad’s market share has succumbed to a plethora of entry-level consumption tablets such as Amazon’s Kindle Fire. But as a market research firm recently reported, the iPad accounted for 81% of tablet web traffic, followed in a distant second by the kindle Fire with less than 8%.1 We suspect that iPad’s dominance reflects its lock on the business market. 1 Kevin Bostic, “Kindle Fire & Android gains, but Apple’s iPad holds commending 81% tablet share”, Apple Insider, February 5, 2013.

An Investment Analysis by Needham & Company, LLC 3

II. Setting the table The direction and magnitude of revisions in our valuation model reflect in part differences between the values in our August 2012 valuation exercise and actual shipments and revenues in calendar 2012. As shown in Figure 2, our forecast of Mac sales and iPhone sales were virtually in line with actual August shipments. Only the iPad fell below our forecast while iTunes and accessories were two new categories that Apple first reported at the end of its first fiscal quarter.

Figure 2

Source: Company data, Needham estimates.

III. Valuing the iPad—the value is lower following the iPad mini’s stunning invasion of the mid-tablet market. In his seminal book, The Diffusion of Innovations, Everett Rodgers explored the ways in which innovations spread through a social system.2 The subject had its start with the invention of hybrid corn at Iowa State University in the 1920s. Hybrid corn not only increased yields by 20% but also proved to be more resistant to drought, a recurring problem in the Midwest. The key driver of adoption was the signs hybrid corn companies placed by the fields along highways to visually demonstrate the superiority of their strains. Nonetheless, it still took two decades before all the farmers in Iowa switched to hybrid seeds. The speed at which a new technology is adopted depends on a number of factors, most importantly its perceived value relative to its cost. Businesses, for example, adopted personal computers quite quickly during the 1980s because of their obvious productivity enhancements in typing (word processing), data manipulation (spreadsheets) and communications (email). In contrast, households adopted personal computers far more slowly because the perceived benefits were less apparent. It was not until the emergence of the Internet in the late 1990s, accompanied by web browsing and email, that adoption in the home market took off. Today, the home market is far larger than the business market. The classic pattern of adoption traces out an S-curve. Early adopters are the first to embrace an innovation or new technology. During the initial phase of diffusion, growth occurs slowly. But it accelerates once the innovation enters the mainstream. Growth eventually slows after the technology moves into the late adopter community.

2 Everett Rodgers, The Diffusion of Innovations (fourth edition), The Free Press, New York, 1995


We’ve introduced the diffusion of innovations construct because it provides a framework for estimating the ultimate size of a market and, in turn, in calibrating shorter run forecasts. The key metric in this regard is the anchor; that is, an estimate of the ultimate size of a market. In the case of the iPod, for example, the number of households that owned personal computers anchored the ultimate size of this market because initially the iPod could only access content through a personal computer. Estimating the ultimate size of the tablet market is virtually impossible at this young age of the device. The iPad is essentially a specialized, as opposed to a general-purpose, computer. As such, its value depends importantly not only on the content that can be accessed, but also on the software applications that have been written for it. Applications turn a tablet into a far more versatile device, effectively customizing it for each owner. So it’s not possible to anchor the size of the tablet market with any precision. However, what’s noteworthy within the context of an S-curve adoption pattern is that, since its introduction in April 2010, the iPad’s growth has been far faster than other popular Apple products. In a recent note, Horace Dediu traced the growth of iPad sales relative to iPhone sales.3 He found that the iPad is outselling the iPhone by a factor of three at the same number of quarters after launch.4 The event that has driven the increase in the iPad’s value has been its dramatic invasion of the business market. In contrast with the consumer market, it’s far easier to assign a dollar value to the iPad in the business and other non-consumer markets. To illustrate, the savings in eliminating paper flight plans in airline cockpits can be easily estimated as can the increased productivity of doctors who use iPads on their patient visits. What this suggests is that the iPad could play as large a role in the business and other non-consumer markets, such as healthcare and education, as it does in the consumer market. Indeed, some research firms have estimated that the business and other non-consumer markets could now account for half of iPad sales. And the dramatic growth may just be starting. As Peter Burrows noted in an article in Bloomberg, large companies’ focus in 2011 was on testing the device, and these pilot programs are now beginning to turn into mass purchases. As Mr. Dediu noted, “Nothing touches the speed of adoption of the iPad”.5 What’s typically skipped over but is a crucial component in the iPad’s success in the business market, in our view, are the tools Apple has integrated into its iOS 6 operating system that make it more enterprise-friendly. For example, Apple has built-in support for Microsoft’s Distributed file system, Active Directory, Windows Server and Exchange. iOS enterprise management solutions offer a consistent set of provisioning options, controls and restrictions. We posit that iPads, in short, represent the most manageable and secure mobile platform, arguably equal to the BlackBerry Enterprise Server. In sharp contrast, Android tablets seem to have been a non-starter in the enterprise by comparison because the operating system is fragmented into multiple versions, which greatly diminishes developers’ interest in writing business applications and in our opinion virtually destroys the ability of IT managers to manage them. Which raises an important but virtually impossible to answer question: When is a media tablet a media tablet? Market research firms do not distinguish between the iPads invading businesses and entry-level tablets like the Kindle Fire that are used almost exclusively as consumption devices. Nor did market research firms attempt to group desktops or notebooks into separate categories. But we see a dramatic difference between the functionality of a Kindle Fire and the iPad. And the Kindle Fire is unlikely to ever penetrate the business market in meaningful volumes.

3 Horace Dediu, “International Tablet of Mystery”, asymco.com, August 20,2012 5 Peter Burrows, “Apple Infiltrates $3.8 Trillion Market With iPad”, bloomberg.com, February 2, 2012.


We think tablets running the forthcoming Windows 8 operating system could pose a more serious challenge to the iPad because of Windows dominance of the business market. In developing Windows 8, Microsoft created a unified code base across desktops, tablets and smartphones. The company’s motive was to enable the vast army of desktop developers to more easily port their applications to tablets and smartphones. Whether this strategy will succeed is an open question. Desktop developers will literally have to start over to design successful applications for tablets and smartphones. Microsoft has not stopped there. Earlier this summer the company unveiled the Surface, a tablet that has a physical keyboard, unlike the iPad, and can run Windows applications as well.6 The Surface should begin to answer the question of whether there’s a meaningful market for a converged device that functions as both a tablet and a notebook. Initial reviews of the Surface RT and Surface Pro have been mixed, characterizing the device as neither “fish nor fowl” and awkward to use in a touch screen mode. Notwithstanding its limitations, the Surface could prove popular in the business market because of its ability to run popular Windows applications. But at over $1,000 with its keyboard cover, it’s more expensive than a MacBook Air and way more expensive and heavier than comparable tablets. The Surface could prove to be popular in the business market. But we question whether it will slow the iPad’s invasion of this market, because the business applications written for the iPad are dramatically different than traditional productivity applications. We have decreased our forecast of the share of the tablet market the iPad should capture because recent shipment data indicated that the iPad’s share of the tablet market actually declined in December despite a stellar quarter. We’ve also reduced the average selling price and gross margin of an iPad following the introduction of the iPad mini in the fall. As a result, our estimate of the value of the iPad falls to $98 from $110 in our August 2012 valuation exercise.

Figure 3


6 Many iPad owners have circumvented this problem by attaching light weight physical keyboards to their iPads from peripheral manufacturers, most notably Logitech.


Figure 4


IV. With the introduction of iPhone 5 and the continuation of the second and third generation iPhones at lower prices, the IPhone managed to hold onto an estimated 22% worldwide share in December. Contrary to our previous expectations, the iPhone continues to capture a significant share of the U.S. market. The iPhone 5 still accounts for the majority of activations on both the AT&T and Verizon networks. And several research firms indicated that iPhone captured over a 50% share of the U.S. market in December. Contrary to the recommendations of many industry observers, Apple has not created separate versions of the iPhone at different price points to exploit differences in the price elasticity of demand among consumers. In our view, Apple rightfully believes that a cheaper version of the iPhone that omitted important features would not sell that well and could degrade the brand equity of the device. Rather, Apple has pursued a time dependent versioning strategy, continuing to sell older generation iPhones at progressively lower prices. Indeed, demand for the iPhone 4 was so strong in December at a postpaid price of $0 that demand easily exceeded supply. Apple is launching an assault on the Chinese smartphone market. China Telecom and China Unicom have both introduced experimental post-paid plans that make the iPhone more affordable to Chinese consumers. We believe it is only a matter of time before China Mobile, the largest carrier in the world with over 600 million subscribers, begins to sell the iPhone. China Mobile is


experiencing increasing pressure from the two other Chinese network operators in the 3G segment of the market where its lead is far more modest. Its network relies on a proprietary radio technology that has proven to be much less popular than the 3G offerings of China Unicom and China Telecom. In any event, China Mobile is building out a LTE network that’s compatible with the worldwide standard. If the iPhone doesn’t land on China Mobile’s network this year, we believe it should by 2014. The call for a less expensive iPhone has reached new high levels. The most vociferous cheerleader is Henry Blodget, who noticed that two or three people at the front of the plane he was on were watching videos on their Galaxy phones. (We did not find out if the same phenomenon was repeated in the main cabin class.) But Tim Cook replied at the Goldman Conference, “The only thing we’ll never do is make a crappy product. That’s the only religion we have.” And a large-screen phone could well fall into that category. The iPhone’s challenge going forward as we see it is captured in the following Figure 5. Smartphones have captured a major portion of the feature phone upgrades in developed markets. But the dramatic growth in the worldwide smartphone market is occurring in emerging markets, especially China.

Figure 5


The conundrum is that Samsung running on the Android operating system has surged to a leadership market share position, selling an estimated 63 million smartphones in December, far more than the 48 million iPhones sold. However, there are doubters that a cheaper iPhone with a five-inch screen is the way to go. As Tim Cook noted at the Goldman conference, Apple leads. It does not follow. And building a supersize phone would be to follow, although in our view the iPad mini has proven that Apple can follow and still lead. Arguably the most vocal critic of a supersize phone is Daniel Eran Digler. We quote from his article at length. Virtually every pundit disagrees with him. But we think he needs to be heard.


“A rumor originating on Chinese blogs of an oversized “iPhone Math” has been given new legitimacy in renderings that depict it as a midway between iPhone 5 and iPad mini. But where’s the evidence? “The first strike against “iPhone Plus” is that it feeds upon two sources of strength: fan fiction renderings of what Apple “‘should” do (which are almost 100% incorrect in every way and the notion that Apple needs to follow the rest of the industry, particularly segments that are performing far worse than Apple itself. Apple has, time after time, expressively not followed the trajectory of competitors, seemingly even more so in cases where observers were expressing confidence that there was no possible way Apple could not bend its path to line up behind the rest of the industry. “As the rest of the industry was gearing up for mass production of netbooks, observers insisted that Apple too needed to get on this bandwagon. Instead, Apple delivered the iPad, which has many of the characteristics of a netbook, but taken to a whole new level, rethinking everything about what a mobile computer device should be. “Apple rarely follows the herd without incorporating big, fundamental shifts in its direction and approach. You might call this “following the herd as a predator”. At the same time, it doesn’t just do the opposite of its competition (like Samsung and its sudden affection for the stylus Apple rejected); beating the rest of the market requires applying the right mix of art and science to discover what the true needs are and how to solve them in creative ways. “Developing a successful product has more to do with “boring” things like able to source components and build reliable software (that is so sophisticated that it appears simple) than it has to do with Imagineering “cool looking” futuristic stuff. That’s why people are always so unimpressed when Apple delivers one of its blockbuster products that will go on to change the world. The tech media and their pundit friends are always instead hoping for an impossibly unworkable and complex mystery to contemplate, not a straightforward, obvious and simple answer to a broad problem. “But geeky tech people are usually wrong about the market. Just look at the string of disasters Google has foisted upon the world. Imagine how well Apple would be doing if it had released a string of failures every year. Essentially, the more an idea has the seal of approval from geek Technorati, the less likely it is to be a viable product for the mass market. “People today similarly view super sized screens as an unquestionable trend in smartphones. And like netbooks in 2008, pundits are insistent that Apple has to deliver one. “There are a couple of problems with this idea. The first is that despite some sales, there’s no evidence that super big smartphones are selling in volumes that can support profitability, or that there is a significant specific demand for big screens (more about this later). We know that Samsung sells more of these big screen smartphones, but Samsung’s profitability is (much) less than half of that of Apple, largely because it sells lots of low-end cheap phones. Samsung has bet on big screens to drive its phone portfolio into premium territory (or at least induce sales of more expensive models). But Samsung has also bet on the stylus and OLED technology. There is really no evidence consumers really want any of these things. So just as Android, styli and OLED screens aren’t really driving phone demand (certainly not in the way that iOS or features like Siri clearly are in every market and on every carrier), there’s no real evidence that oversized screens are driving demand or in


demand by the public. Samsung’s second most popular phone in the U.S. isn’t a Note, it’s the Galaxy IIS, which has a smaller 4.3-inch screen. “If the market really wants bigger phones, why doesn’t it want Samsung’s biggest phones? There does not seem to be any direct correlation between huge screen size and overall demand. There is, however, a correlation between phone size and both first generation LTE chipsets and large batteries. “I’m not saying there aren’t any people who want a phone with a big, even huge oversized screen. But the market does not seem to be revealing real unit-moving demand for smartphones with big screens. Oversized smartphones take the idea of easy to read mobile devices and exaggerate them into big, heavy and expensive devices that threaten their own mobility. Samsung has spent billions of dollars telling people that they need a big screen. But Samsung’s’ product mix isn’t tilting towards its “phablet” line. It’s trending toward devices more like the iPhone. “It would be unprecedented for Apple to offer a new iPhone with nothing else but a bigger screen. What’s the upside to creating a slightly larger iPhone 5; attracting buyers who want a slightly bigger screen? In order to really entice anyone with screen size, you’d need a substantially bigger screen. To offer the same differentiation that iPad mini does for the full sized iPad, you need a stupidly big iPhone. “There may actually be a significant audience that would like to have an iPad mini and a phone, but can’t afford duplication. Such a “SuperiPhone” would be significantly differentiated from an iPhone in that it could run full size iPad apps and games. That’s something today’s Android ”phablets” don’t really offer, because there aren’t really any tablet Android apps of significant value”7.

So what kind of numbers are we talking about? Samsung does not report its mobile phone shipments, leaving IDC and Gartner to guess at them. But there are some estimates. Mr. Dilger wrote, “Samsung sold more smartphones that Apple in the winter quarter, but the majority of Samsung’s smartphone sales were low end devices. Less than a third (an estimated 22 million of the 63 million total) of Smartphone sales were its high-end Galaxy S III or Galaxy Note II models. And it’s unclear how many of these were bought, not sold. As Tomy Ahonen has repeatedly pointed out, it’s the carrier staffs that make most of the smartphone choices; and they would rather sell a high-end phone with a decent margin than a low-end phone. But regardless, assuming Mr. Dilger’s estimate is close and recognizing that Apple might sell a lot more than 22 million large screen phones than Samsung, is it still a big enough opportunity to pursue? However, we find the argument ludicrous that Apple could introduce a $300 iPhone. The bill of materials and other costs would reduce the gross margin on such a phone to zero. Daniel Dilger may be the lone voice in the wilderness. And it may be a done deal that Apple will introduce a 5” or so iPhone +. But we respect Mr. Dilger for his contrary and insightful thoughts on the subject. Our guesstimate is that Apple could introduce such phone at $500 prepaid. But it would do a lot more damage to the Android ecosystem if it could reduce its price to $450 or possibly $400. At $400, Apple could still probably earn around a 40% gross margin on the device. In our iPhone valuation model, we’ve reduced the iPhone’s estimated market share from 22% to 20%, chiefly because of the significant fluctuations in the iPhone’s share from one quarter to the next. The iPhone’s worldwide market share typically approximates 20% on a worldwide basis. It was reportedly 22% in the December quarter. But the iPhone’s market share typically trails off by

7 Daniel Eran Dilger, “Whre’s the math supporting Apple’s rumored plus size iPhone?”, Roughly Drafted Magazine, February 2, 2013


the second quarter following the quarter of a launch. The open question discussed above is whether Apple will introduce a new iPhone to address emerging markets with larger screen phones. We believe we presented the contrary view in Mr. Dilger’s comments. Indeed, we believe it would be atypical for Apple to do so. But Apple may now be dancing to a different drummer. If Apple were to introduce a larger iPhone, we would adjust our August 2013 valuation forecast accordingly. Apple’s challenge is captured in the quarterly granularity of market shares across regions, as shown in Figure 6. In 2012, the iPhone captured about a 20% worldwide share. However, the iPhone’s share varied widely by quarter and region. The iPhone has been able to maintain a share north of 40% in the U.S. and a decent share in mature markets. But its share has deteriorated in Asia Pacific, especially China, where cheap Android devices have captured some if not most of the feature phone market. So Apple’s challenge is whether the company goes for market share through an oversized, less expensive smartphone or whether it’s content to maintain a 20% share at premium prices, which consumers appear prepared to pay.

Figure 6



Figure 7


Figure 8



Of course, our current projections would be very different if Apple were to introduce a larger, less expensive iPhone. In that event, the average selling price would most likely come down at a faster rate that we’ve forecast and the gross margin would likely come down as well. But at this point in our opinion it’s senseless to speculate if that event ever will happen. V. The value of the Mac deteriorates as the growing installed base of iPads and iPhones begins to cut into Mac as well as PC shipments. By definition, Windows users switching to the Mac have been the sole driver of the increase in Mac sales over the past several years, assuming that pretty much everyone owned a personal computer by 2005. As shown in Figure 9, since the beginning of 2005 when the iPod halo effect kicked in, the installed base of Windows switchers has grown to the point where it is now more than twice as large as the installed base of original Mac owners at the beginning of this period.

Figure 9


As is becoming increasingly evident in recent quarters, tablet sales are cutting into Mac and PC sales. Our Mac model cannot accommodate a declining PC shipment rate because it implicitly assumes constant PC shipments. However, we believe it’s possible to capture declining shipments by lengthening the average life of a PC upgrade. In our previous Mac model, we assumed that Windows owners upgraded their PCs every three years, translating into a 20% annual upgrade cycle. In our new model, we assume an average PC life of five years, which translates into a 14% annual upgrade rate. The other assumptions in our previous model continue to hold; that is, 15% of Windows owners who buy an iPad or iPhone switch to a Mac when they replace their old PC, courtesy of the twin halo effects emanating from the iPad and iPhone. Our forecast further assumes that when upgrading to a new PC four plus years later, 95% of the original Windows switchers purchase another Mac. Upgrade purchases among Windows switchers are a significant component in our forecast, accounting for 40% of the Macs purchased by switchers during our 10-year forecast period. The problem in using both the iPhone and iPad to forecast Mac sales is that many consumers own both devices. To address this problem, we first counted the entire installed base of iPhones


owned by Windows users in measuring the number of Windows users who switch to a Mac. But we could not use the entire installed base of iPad owners in our forecast of Mac sales because that would have led to double counting. Fortunately, a number of surveys have been conducted, which quantify the demographics of iPad buyers. Surprisingly, the overlap between iPad and iPhone owners appears to be less than what we might have guessed. One survey by the NPD group found that 62% of iPad buyers did not own an iPhone.8 A more recent survey by ComScore found that 73% of iPad buyers did not own an iPhone.9 And in a survey of 3,990 consumers, Forrester Research found that 83% of iPad buyers did not own an iPhone.10 In our Mac model, we assumed that 50% of iPad owners did not own an iPhone. Our Mac model is shown in Figure 10.

Figure 10


Our forecast has the Mac capturing a 9.8% share of the worldwide PC market in 2022, the final year of our forecast, up from 4.8% in 2011. While this forecast is arguably aggressive, it’s instructive to note that Mac sales outgrew the PC market for 25 consecutive quarters with the Mac’s share more than doubling over this period. Indeed, if iMacs were not in short supply in December, we think the string of outperformance would probably have been extended

8 “Nearly 90% pf initial iPad Sales are Incremental and Not Cannibalizing the PC Market, According to NPD”, npd.com, October 1, 2010 9 “A look at iPad Users: Apple Still Trouncing Android”, blogs.wsj.com, April 19, 2011. 10 Sarah Epps, “U.S. Tablet Buyers are Multi-PC Consumers, Forrester, August 19, 2010


Figure 11


VI. Valuing iTunes, software and services Our iTunes, software and services valuation is a new category Apple recently introduced. Since the App Store’s launch in 2008, over 20 billion applications have been downloaded and Apple has paid over $7.0 billion to app developers. Apple recently announced that the iTunes media store passed the 25 billion-download market. Most market research firms are projecting robust growth in application sales. Canalys, for example, is forecasting that app store revenues will reach $37 billion by 2015.11 IDC is forecasting that app sales will reach $35 billion in 2014.12 And other research firms project Apple’s App Store should be able to maintain between a 60% and 75% share of this market for the foreseeable future. What’s instructive to note is that “other” revenues are becoming an increasing portion of Apple’s total valuation. Assigning a value to iTunes software and services is daunting. First, we don’t know the proportions represented by each component. And the components themselves have dramatically different margins. For example, the gross margin on iTunes is around 30% based on Apple’s original 2003 formula. The gross margin on services might be even lower. However, the gross margin on software, especially Apple-developed software, such as iLife or iWork, could be 80% or more. In our valuation, we assumed a 40% blended gross margin, which could be high but we think probably isn’t.

11 “App stores’ direct revenue to exceed $14 billion next year and reach close to $37 billion by 2015”, canalys.com June 29, 2011. 12 Leslie Horn, “IDC: Mobile App Revenue to Jump 60% by 2014”, pcmag.com, December 14, 2010


Figure 12


Figure 13



VII. Valuing accessories In our model, we forecast accessory sales from historical data. Sales of Apple TVs are beginning to contribute to the growth of peripheral sales. On its third quarter earnings call, Apple reported that it sold 1.3 million Apple TVs in the quarter, upping total fiscal 2012 sales to 4 million units. There has been intense speculation in the press that Apple will continue to enhance the device to position it for Apple’s invasion of the TV market. As shown in Figure 1, we estimate the contribution of accessories to Apple’s value was $16.50,

Figure 14


Figure 15



VII. Price Target History—the Law of Large Numbers Kicks in Figure 16 reports the changes in our price target over the past four years. What’s instructive to note is that the increase in our price target has not kept pace with the growth in Apple’s earnings. Over the four-year period, our price target has increased 227%. But Apple’s earnings have increased 685%.

Figure 16



Apple, Inc.Sales/Earnings Forecast($ in millions)

2012/1 2012/2 2012/3 2012/4 2012 2013/1 2013/2 2013/3 2013/4 2013 2014/1 2014/2 2014/3 2014/4 2014Sales Mac Desktops $1,936 $1,563 $1,287 $1,254 $6,040 $2,036 $1,597 $1,531 $1,564 $6,728 $2,128 $1,596 $1,596 $1,596 $6,916 Mac Notebooks 4,662 3,510 3,646 5,363 17,181 5,300 3,975 4,306 4,961 18,543 5,300 5,300 5,631 5,963 22,194 Total Macs $6,598 $5,073 $4,933 $6,617 $23,221 $7,336 $5,572 $5,837 $6,525 $25,270 $7,428 $6,896 $7,227 $7,559 $29,110

iPod $2,528 $1,207 $1,060 $820 $5,615 $2,143 $935 $845 $840 $4,763 $1,750 $1,006 $963 $875 $4,594 iPhone 24,417 22,690 16,245 17,125 80,477 30,660 24,059 22,400 22,400 99,519 31,250 28,125 26,563 25,000 110,938 iPad 9,153 6,590 9,171 7,510 32,424 10,674 8,600 10,750 10,750 40,774 12,500 12,500 12,500 14,938 52,438 Peripherals and other hard 766 643 663 706 2,778 0 0 0 0 0 0 0 0 0 0 Software 844 832 891 892 3,459 1,829 800 800 800 4,229 850 850 850 850 3,400 Music + iPhone apps 2,027 2,151 2,060 2,296 8,534 3,687 2,250 2,300 2,400 10,637 2,750 2,500 2,600 2,750 10,600 Total sales $46,333 $39,186 $35,023 $35,966 $156,508 $54,512 $42,216 $42,932 $43,715 $185,192 $56,528 $51,877 $50,702 $51,971 $211,079

Less: Cost of goods sold $25,630 $20,622 $20,029 $21,565 $87,846 $33,452 $25,697 $25,937 $25,926 $112,829 $33,862 $31,229 $30,719 $32,094 $127,904 Gross profits 20,703 18,564 14,994 14,401 68,662 21,060 16,519 16,995 17,790 72,363 22,666 20,649 19,984 19,877 83,174

Selling genl & adm 2,605 2,339 2,545 2,551 10,040 2,840 2,828 2,748 3,008 11,424 3,561 3,372 3,245 3,534 13,712 Research & development 758 841 876 906 3,381 1,010 1,055 1,073 1,049 4,188 1,018 1,141 1,217 1,299 4,675 Operating expenses $3,363 $3,180 $3,421 $3,457 $13,421 $3,850 $3,884 $3,821 $4,057 $15,612 $4,579 $4,513 $4,462 $4,833 $18,387

Operating income $17,340 $15,384 $11,573 $10,944 $55,241 $17,210 $12,635 $13,174 $13,733 $56,752 $18,087 $16,135 $15,522 $15,043 $64,787 Interest and other income 137 148 288 (51) 522 462 385 390 395 1,632 400 405 410 415 1,630 Pretax income $17,477 $15,532 $11,861 $10,893 $55,763 $17,672 $13,020 $13,564 $14,128 $58,384 $18,487 $16,540 $15,932 $15,458 $66,417 Taxes 4,413 3,910 3,037 2,670 14,030 4,594 3,385 3,527 3,673 15,179 4,807 4,300 4,142 4,019 17,268 Tax rate 25.3% 25.2% 25.6% 24.5% 25.2% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0% 26.0%Net GAAP income $13,064 $11,622 $8,824 $8,223 $41,733 $13,078 $9,635 $10,037 $10,455 $43,205 $13,680 $12,240 $11,789 $11,439 $49,149

GAAP earnings per share $13.87 $12.30 $9.32 $8.67 $44.14 $13.81 $10.18 $10.61 $11.10 $45.70 $14.52 $12.99 $12.53 $12.16 $52.20

Average shares 942 945 947 948 945 947 946 946 942 945 942 942 941 941 942

% change in revenues 73.3% 58.9% 22.6% 27.2% 44.6% 17.7% 7.7% 22.6% 21.5% 18.3% 3.7% 22.9% 18.1% 18.9% 14.0%% change in Mac shipments 24.2% 6.8% 1.8% 0.6% 8.9% -21.9% 4.6% 9.5% 0.0% 4.2% 37.9% 23.8% 23.9% 15.8% 15.2%% change in iPhone shipme 127.9% 88.0% 28.0% 57.6% 72.9% 29.1% 6.9% 34.5% 30.1% 24.2% 4.6% 20.0% 21.4% 14.3% 14.3%% change in iPad shipments 110.5% 151.3% 84.3% 26.2% 80.0% 48.1% 69.5% 46.7% 78.1% 62.9% 31.2% 50.0% 20.0% 45.0% 32.9%% change in iPod shipments -20.8% -14.9% -10.4% -19.3% -17.5% -17.7% -28.3% -25.9% -6.4% -19.9% -21.1% 4.5% 10.0% 0.0% -6.8%% change in EPS 115.6% 92.3% 19.6% 23.0% 59.5% -0.5% -17.2% 13.9% 28.0% 3.5% 5.2% 27.6% 18.1% 9.5% 14.2%

Percent of sales Gross margin 44.7% 47.4% 42.8% 40.0% 43.9% 38.6% 39.1% 39.6% 40.7% 39.1% 40.1% 39.8% 39.4% 38.2% 39.4% Selling, genl & adminstrati 5.6% 6.0% 7.3% 7.1% 6.4% 5.2% 6.7% 6.4% 6.9% 6.2% 6.3% 6.5% 6.4% 6.8% 6.5% Research & development 1.6% 2.1% 2.5% 2.5% 2.2% 1.9% 2.5% 2.5% 2.4% 2.3% 1.8% 2.2% 2.4% 2.5% 2.2% Operating expenses 7.3% 8.1% 9.8% 9.6% 8.6% 7.1% 9.2% 8.9% 9.3% 8.4% 8.1% 8.7% 8.8% 9.3% 8.7% Operating income 37.4% 39.3% 33.0% 30.4% 35.3% 31.6% 29.9% 30.7% 31.4% 30.6% 32.0% 31.1% 30.6% 28.9% 30.7% Pretax income 37.7% 39.6% 33.9% 30.3% 35.6% 32.4% 30.8% 31.6% 32.3% 31.5% 32.7% 31.9% 31.4% 29.7% 31.5% Net GAAP income 28.2% 29.7% 25.2% 22.9% 26.7% 24.0% 22.8% 23.4% 23.9% 23.3% 24.2% 23.6% 23.3% 22.0% 23.3%


Apple Inc.($ in MM, except per share data) Annual Quarterly

Fiscal Year Ending September 29 FY FY Ending Ending Ending Ending9/29/2011 9/29/2012 3/30/2012 6/29/2012 9/29/2012 12/30/2012

BALANCE SHEETASSETSCash & Short-term Investments 25,952.0 29,129.0 28,538.0 27,654.0 29,129.0 39,820.0Receivables 5,369.0 10,930.0 7,042.0 7,657.0 10,930.0 11,598.0Inventory 776.0 791.0 1,102.0 1,122.0 791.0 1,455.0Other Current Assets 10,877.0 14,220.0 11,777.0 13,201.0 14,220.0 16,580.0 Current Assets 44,988.0 57,653.0 50,712.0 51,943.0 57,653.0 72,348.0Property and Equipment 7,777.0 15,452.0 8,847.0 10,487.0 15,452.0 15,422.0Goodwill and Intangibles 4,432.0 4,224.0 4,745.0 5,461.0 5,359.0 4,462.0Long-term Marketable Securities 55,618.0 92,122.0 81,638.0 89,567.0 92,122.0 97,292.0Other Assets 3,556.0 5,478.0 4,992.0 5,438.0 5,478.0 5,183.0 Total Assets 116,371.0 176,064.0 150,934.0 162,896.0 176,064.0 196,088.0

LIABILITIES AND SHAREHOLDERS' EQUITYCurrent Liabilities 27,970.0 38,542.0 32,036.0 33,060.0 38,542.0 46,879.0Short-term Debt 0.0 0.0 0.0 0.0 0.0 0.0Long-term Debt 0.0 0.0 0.0 0.0 0.0 0.0Shareholders' Equity 76,615.0 118,210.0 102,498.0 111,746.0 118,210.0 127,346.0 Total Liabilities + Shareholders' Equity 116,371.0 176,064.0 150,934.0 162,896.0 176,064.0 196,088.0

INCOME STATEMENTRevenue 108,249.0 156,508.0 39,186.0 35,023.0 35,966.0 54,512.0Gross Profit 43,818.0 68,662.0 18,564.0 14,994.0 14,401.0 21,060.0Operating Income 33,790.0 55,241.0 15,384.0 11,573.0 10,944.0 17,210.0Pretax Income 34,205.0 55,763.0 15,532.0 11,861.0 10,893.0 17,672.0Net Income 25,922.0 41,733.0 11,622.0 8,824.0 8,223.0 13,078.0Shares Outstanding 936.6 945.4 944.9 947.1 948.2 947.2

CASH FLOW STATEMENTDepreciation and Amortization 0.0 0.0 0.0 0.0 0.0 0.0Cash Flow from Operations 0.0 0.0 0.0 0.0 0.0 0.0Capital Expenditures 0.0 0.0 0.0 0.0 0.0 0.0

CASH MANAGEMENT*DSOs 18.3 19.0 18.3 18.9 23.3 18.6Inventory Days 5.2 3.3 5.1 5.0 4.0 3.0Days Payable 75.8 74.4 77.4 75.9 80.5 62.8Cash Conversion Cycle (52.3) (52.1) (53.9) (52.0) (53.2) (41.1)

PROFITABILITYGross Margin 40.5% 43.9% 47.4% 42.8% 40.0% 38.6%Operating Margin 31.2% 35.3% 39.3% 33.0% 30.4% 31.6%Net Margin 23.9% 26.7% 29.7% 25.2% 22.9% 24.0%Return on Assets* 27.1% 28.5% 32.1% 22.5% 19.4% 28.1%Return on Equity* 41.7% 42.8% 48.3% 32.9% 28.6% 42.6%Total Debt/Capital 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

PER SHARE DATATangible Book Value 77.07 120.56 103.45 112.23 119.02 129.73Cash 87.09 128.25 116.60 123.77 127.88 144.75Net Cash 87.09 128.25 116.60 123.77 127.88 144.75EPS (Pro Forma) 27.68 44.14 12.30 9.32 8.67 13.81EPS (Pro Forma Including Option Expenses)EPS (GAAP) 27.68 44.14 12.30 9.32 8.67 13.81


ANALYST CERTIFICATION

I, Charlie Wolf, hereby certify that the views expressed in this research report accurately reflect my personal views aboutthe subject company (ies) and its (their) securities. I also certify that I have not been, am not, and will not be receivingdirect or indirect compensation in exchange for expressing the specific recommendation(s) in this report.

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Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Dec 12 Mar 13

Price, Rating, and Price Target History: Apple Inc. (AAPL/NASDAQ) as of 2-15-13

Source: Factset (Prices) / Needham (ratings and target price)

8/9/10 B : $375.0

2/7/11 B : $450.0

8/4/11 B : $540.0

2/8/12 B : $620.0

8/22/12 B : $750.0

Disclosures applicable to this security: A, B, G.


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