August 16, 2016 - 1:10pm EST by
2016 2017
Price: 109.35 EPS 8.24 8.97
Shares Out. (in M): 5,500 P/E 12.84 12.72
Market Cap (in $M): 594,000 P/FCF 9.66 8.64
Net Debt (in $M): -146,000 EBIT 60,050 61,467
TEV (in $M): 448,000 TEV/EBIT 7.46 7.29

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  • Technology
  • winner


Investment Thesis Summary
Skepticism of Apple remains high on Wall Street despite compelling evidence that the company has i) navigated an
especially difficult phone transition due to extended average phone lives and reduction of carrier subsidies, ii) developed
a meaningful service revenue stream, and, iii) offered substantive new products that are very early in their lifecycle.
Moreover, the company’s ecosystem continues to gain market share across all computing platforms. Apple remains one
of the best managed companies in the world with probably the cleanest financials of any major company, yet the stock
is valued as a passé hardware company at 9x EV/FCF. Once Wall Street regains confidence in Apple’s product roadmap,
appreciates that the ecosystem continues to garner share and is quite defensible, and realizes earnings will grow to the
$12 per share range in a few years, the stock will quickly revalue to a more reasonable multiple and trade at $150+ per
share. Downside is protected by a reasonable but growing dividend, currently a 2.1% yield, and a significant share
repurchase program that has effected an annualized 5.0% decline in share count over the last 3 1/4 years.
Company Description
Most readers would likely assert that there is little need to provide a detailed company description as part of this
report. As the largest market capitalization company in the world with ubiquitous products that most people have
experienced, Apple needs little introduction. Moreover, from Wall Street’s perspective, the company is simply a mobile
phone provider. Mobile phones are by definition hardware commodities that are replaced ultimately by new innovative
products. Thus, by this line of thinking, it is perfectly rationale to conclude that Apple should trade for a significant
discount to other major leading companies. We believe Apple’s enduring value lies in its superior ecosystem and the
reinforcing and sticky nature of its broad product and services offerings. The Company’s Background from its 10-K
highlights these points. In the next two sections, we provide Apple’s Business Strategy as described in the 10-K, and,
although we do not think it does the company’s vision and positioning justice, it does highlight the contrast between the
conventional “phone hardware manufacturer” view of the company and management’s own view of the Company’s
From the 10-K:
"Company Background
The Company designs, manufactures and markets mobile communication and media devices, personal computers and
portable digital music players, and sells a variety of related software, services, accessories, networking solutions and
third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, iPod, Apple
Watch, Apple TV, a portfolio of consumer and professional software applications, iOS, OS X and watchOS operating
systems, iCloud, Apple Pay and a variety of accessory, service and support offerings. In September 2015, the
Company announced a new Apple TV, tvOS™ operating system and Apple TV App Store, which are expected to be
available by the end of October 2015. The Company sells and delivers digital content and applications through the
iTunes Store, App Store, Mac App Store, iBooks Store™ and Apple Music™ (collectively “Internet Services”). The
Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through
third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a
variety of third-party Apple compatible products, including application software and various accessories through its
 online and retail stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and
government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of
September. The Company is a California corporation established in 1977.
Business Strategy
The Company is committed to bringing the best user experience to its customers through its innovative hardware,
software and services. The Company’s business strategy leverages its unique ability to design and develop its own
operating systems, hardware, application software and services to provide its customers products and solutions with
innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to
expand its platform for the discovery and delivery of digital content and applications through its Internet Services, which
allows customers to discover and download digital content, iOS, Mac and Apple Watch applications, and books through
either a Mac or Windows-based computer or through iPhone, iPad and iPod touch devices (“iOS devices”) and Apple
Watch. The Company also supports a community for the development of third-party software and hardware products
and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience
with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its
ability to attract and retain customers. Therefore, the Company’s strategy also includes building and expanding its own
retail and online stores and its third-party distribution network to effectively reach more customers and provide them
with a high-quality sales and post-sales support experience. The Company believes ongoing investment in research and
development (“R&D”), marketing and advertising is critical to the development and sale of innovative products and
technologies. "
Investment Analysis
Investors have concluded that Apple’s stock and business have peaked. A review of the company’s financials in the next
table supports this thesis. September Fiscal Year numbers highlight that all financial metrics peaked in Apple’s Fiscal
September 2015 year. Yet, in all fairness to the company, all metrics have meaningfully improved since 2012.
Year      Revenue           Gross Profit      Operating Income      Net Income              EPS
2012      $156.5B            68.7B                        55.2B                       41.7B                      $6.30
2013        170.9               64.3                           49.0                         37.0                         5.66
2014        182.8               70.5                           52.5                         39.5                         6.40
2015        233.7               93.6                           71.2                         53.5                         9.28
2016*      219.7               84.0                           59.9                         45.7                         8.24
2017**     224.3               87.3                           61.9                         47.1                         8.99
*Includes street estimates for Q4 2016
** street estimates for entire FY 2017
(Note: As stated earlier, Apple’s financials are very clean. Unlike most companies, Apple’s historical EPS has represented
a conservative proxy for actual cash generated.)
In the world of technology investing, failing to grow, especially on the revenue and gross profit lines, is tantamount to a
death sentence. EPS, a meaningless metric for many technology investors, has held up better than other lines because
share count has declined approximately 18% from 2012 through 2016. Historically, Apple releases a completely
revamped iPhone product in even calendar years (Sep 2010 - iPhone 4, Sep 2012 - iPhone 5, Sep 2014 - iPhone 6, and
Sep 2016 - iPhone 7). In odd years, the company releases only enhanced versions (2011 - iPhone 4S, 2013 - iPhone 5S,
2015 - iPhone 6S). Interesting, surrounding the launch of even-year product redesigns the last two cycles, the stock
price peaked some 100% above prior odd-year cycle lows. However, the iPhone 6 saw a more extended, stock price peak
period that didn’t occur until February 2015 as a result of the late launch and success of the iPhone 6/6+ in Asia.
Expectations that the stock price could move meaningfully to new highs during the upcoming September launch of the iPhone 7 are nonexistent because the supply chain has indicated only modest upgrades for the iPhone 7 and many
observers believe Apple will offer a major redesign in a 10th anniversary product that will launch in September 2017, breaking with
historical cadence. Nevertheless, Apple’s stock has bounced over 20% off the recent cycle low.  A 100% move off the
recent cycle low would represent a $180 stock price.
A review of calendar quarterly numbers highlights the peak business thesis even more profoundly. Importantly, the
tables below also suggest that compares are about to take a pretty compelling positive turn, especially in the March and
June 2017 calendar quarters. The street still believes that the December 2016 quarter will show a modest decline.
Period                 Revenue         Gross Profit      Operating Income     Net Income        EPS
Q2 2014, Mar      45.6                17.9                          13.6                         10.2                 1.68
Q2 2015               58.0               23.6                            18.3                         13.6                 2.35
Q2 2016               50.6               19.9                            14.0                         10.6                 1.91
Q2 2017*             54.5               21.3                             14.9                         11.4                 2.16
Period                 Revenue         Gross Profit      Operating Income      Net Income        EPS
Q3 2014, June     37.4                14.7                           10.3                          7.7                  1.28
Q3 2015               49.6                19.7                            14.1                        10.7                 1.85
Q3 2016               42.3                16.1                            10.1                          7.8                  1.42
Q3 2017*             47.0                 18.1                           11.6                          9.0                  1.73
Period                 Revenue         Gross Profit      Operating Income       Net Income       EPS
Q4 2014, Sep       42.1              16.0                            11.2                         8.5                   1.42
Q4 2015                51.5              20.5                             14.6                        11.1                  1.96
Q4 2016*              46.7              17.7                             11.6                         8.9                   1.64
Q4 2017*              50.2              19.3                             12.8                         9.8                   1.90
Period                 Revenue         Gross Profit      Operating Income       Net Income        EPS
Q1 2015, Dec 14    74.6              29.7                            24.2                        18.0                 3.06
Q1 2016                  75.9              30.4                             24.2                        18.4                 3.28
Q1 2017*                 73.5              28.7                            22.5                        16.7                 3.12
Q1 2018*                 78.3              30.9                            24.5                        18.1                 3.51
Secular vs. Cyclical Mobile Phone Market
It is easy to conclude that Apple’s mobile phone sales have secularly peaked as the iPad appears to have done, yet the
product redesign cadence begs the question, is the current slowdown product cycle driven? Since Apple continues to
add new users and the average upgrade period continues to extend (currently almost three years), mathematically a
strong case could be made that the next product refresh could see a record number of Apple mobile phone sales. In
light of the growth in services and other products, a return to just prior even-year cycle sales would clearly drive
earnings to record levels. Finally, a convergence of new technology and the 10th anniversary of the iPhone may even
provide the opportunity for a super phone cycle. Many supply chain companies have been reporting that a large North
American OEM (of course Apple ) has initiated orders for significant numbers of OLED (Organic Light Emitting Diode)
displays, yet these orders cannot deliver product in time for the 2016 iPhone 7 launch. Most observers believe OLED
provides the opportunity for Apple to radically change the performance and form factor of the iPhone. If this occurred
in a 10th anniversary version, mobile phones could catapult to a record 250 million plus units.
Transition to a More Sustainable Business model
The prevailing wisdom regarding Apple is that the company lives and dies by the iPhone. Dollar sales of iPhones as a
percentage of total sales increased from 55.7% in fiscal 2014 to 66.3% in fiscal 2015, so this appears supported by the
data.But the 2015 percentage should represent the high-water mark, as services and other products will grow at a
much faster rate than iPhones going forward.  In fact, if one thinks about the value of the iPhone franchise as a
percentage of market cap, which is how an equity purchaser should do it, the iPhone impact is significantly muted,
which in my view argues for a much higher PE multiple.
I expect Apple to generate $223 Billion in revenue in FY 2017. The composition of this number is as follows:
iPhone: $140 B
iPad: 20 B
Mac: 20 B
Services: 28 B
Other: 15 B
I don’t believe it is a stretch at all to value the revenue of services and other products (which would include future
products) at 2x the multiple of the mature hardware revenue of the three main products. The company has stated that
Services has higher than corporate average margins, and most observers believe services should grow 15-20% annually
for the next several years. Other Products revenue will grow meaningfully as well, given the significant increase in R&D
spending the last several years and the impending ramp of Apple Watch (more on that later). With these conservative
assumptions, iPhone already represents just 45% of the company’s market value, iPad and Mac 6.5% each, Services 18%,
Other 10%, and cash 14%.
This admittedly somewhat convoluted exercise highlights that Apple’s value is not driven as much as perceived by the
iPhone. In fact, the iPhone’s success stems from the value of Apple’s ecosystem, not the other way around. This
includes the premier apps and software development platform, superior design and hardware manufacturing, better
retail distribution and customer service, and more tightly integrated usage among different devices, in addition to the
most robust and secure architecture and operating system. It is the broad-based benefits of this system that keep
customers so loyal.
The large, billion-unit installed base that builds on this ecosystem will drive remarkable amounts of revenue and
opportunity going forward. Pokemon Go highlights this.  Apple receives 30% of software and content purchases made
within an App on an Apple device.  Some analysts expect Apple to receive $3 billion in revenue from Pokemon Go alone
in the next 18 months.  In 2015, the App Store generated around $6 billion for Apple on some $20 billion in gross
revenues.  This gross number is up from an estimated $10 billion in 2013 and $15 billion in 2014.  As a standalone
company, Wall Street would value this business at well over $100 billion.  I would much rather own this revenue stream
than the capital intensive Amazon Web Services or Netflix.  Moreover, Google is believed to happily pay Apple
approximately $1 billion per year to be the default search option on Apple devices.  In addition, Google pays a
percentage of search revenue that could represent at least another $1 billion per year.  Finally, Apple reported that Non-
GAAP installed base related purchases grew 29% y/y to $10.3 billion in the June quarter.  This accelerating growth rate is
up from 27% in Q2, 24% in Q1, and 23% for all of FY’15.  These revenue streams are already included in the estimated
$28 billion of services revenue for 2017, yet they highlight the likely durability and growth prospects of Apple’s Services
Of course, these opportunities vanish if users switch away from Apple hardware, but the use cases for Apple’s
ecosystem only appear to be getting more compelling.  The optimal authentication of a user has allowed Apple to
negotiate receiving a reported .15% of every transaction completed with Apple Pay.  The convenient double-click use of
Apple Pay on Apple Watch ushers in a much easier way of executing a transaction.  Apple CarPlay is hailed by many car
OEMs as an important differentiating feature.  We think it is just a matter of time that this hardware/software/trusted
partner ecosystem brings about the ability to use your phone/watch/or future Apple devices for keys, payments, remote
controls, among countless other features.
That brings us to the much-disparaged Watch, which is held up as a monument to Apple’s perceived inability to innovate. This is a
product that sold an estimated 12-13 million units and generated an estimated $6 billion in revenue in its first year.
More importantly, user satisfaction levels remain higher than any Apple product, despite the Watch not being
waterproof and lacking GPS and LTE cellular phone capabilities.  We believe this is because the Watch, in addition to be
comfortable and stylish, offers many conveniences and useful applications. This product will likely ultimately become an
individual’s health sensor, remote control and access device, payments vehicle, in addition to providing a convenient
way to monitor messages, calendar events, stock quotes, among countless other activities. The second generation
Watch is almost certain to add $15 billion to $20 billion in FY 2017, approaching numbers generated by the iPad and Mac.
Another underappreciated expansion of the Apple ecosystem is into the enterprise and businesses.  Just as PCs replaced
dumb terminals in most retail establishments, the iPad is clearly displacing PCs in this function.  Furthermore, Macs
continue to gain share in personal and business computing.  These trends highlight enduring value of Apple’s superior
ecosystem and the reinforcing and sticky nature of its broad product and services offerings.
Finally, we have not begun to appreciate the advantages derived by such a robust, familiar, trusted ecosystem
and the products that could be spawned.  In the world of augmented and virtual reality, ubiquitous displays, machine 
learning, and advanced voice recognition, one is unlikely to predict the winning form factor.  Nevertheless, a
compelling case can be made that Apple has the winning ecosystem to deliver it.
Financials and Valuation
Apple’s last quarter (its June Q3 June FY 17 quarter) provided strong proof that Apple’s business remains defensible and
durable.  Despite reducing channel inventory by in excess of $1 billion and facing customers holding out for the new
version of the iPhone and Watch, the company earned $1.42 per share.  Thus a distressed, conservative forward
earnings projection still leaves one comfortably in the $8.00 per share range. In light of the positive contribution from
services revenue and upgrade dynamic detailed above, $9.00 per share of earnings for FY 2017 appears eminently
attainable. When factoring in Apple’s substantive balance sheet (over $26 per share of net cash or $15 per share,
assuming full tax on repatriation), Apple should trade for a more reasonable 12x earnings plus fully repatriated cash, or
$123, today.
Apple’s stock has demonstrated that, like most technology equities, it will trade based on the perception of forward
earnings. When trying to determine a target price for Apple one year out, an investor should determine earnings for
the company’s fiscal year September 2018. There are many comprehensive, sound models published by Wall Street
analysts. Most have Apple earning approximately $10 per share in FY 2018. In light of Apple’s recent
underperformance, these models are likely conservative.  We have made the case that the ecosystem and large
installed base will drive stronger than expected revenue.  The nice thing about an investment in Apple is that you do not
need to have upside surprises to drive the stock higher.  Most analysts’ models project modest iPhone growth off the
very weak 2016 numbers, declining iPad and Mac sales, slowing services growth rates, and very modest revenue from
new products.  Moreover, most project flattish gross margins and significant increases in operating expenses (especially
R&D).  Nevertheless, EPS reaches over $10 and FCF per share will be close to $12. The excess FCF reflects Apple’s conservative
accounting for taxes, stock-based compensation, and accruals.
Apple’s balance sheet, of course, is fortress-like, but one of the key questions in analyzing the stock is how much credit
for the net cash of $26 per share do we give the company? This question is more theoretical than practical, as it will never
be returned in a single transaction such as a special dividend, even if there was a repatriation tax-holiday.
However, I think Apple’s approach to this cash is clear. Over time, it will likely be worked down, but more importantly,
the balance sheet allows the company to utilize all FCF for shareholders in an optimal manner.  Recently, the company’s
board of directors made it clear that buybacks are the top priority followed by a modestly growing dividend. In
addition, the company remains in a position to complete strategic M&A. Our view is that Apple is correct not to pursue a
large, say over $15 billion, strategic acquisition.  Those arguing for such a transaction do not appreciate the strategic
nature of Apple’s position.
So what is the proper valuation for Apple?  Despite strongly believing that Apple’s services business is developing into
a franchise that is worth a meaningful part of the company’s enterprise value, we do not think a sum-of-the-parts
valuation is appropriate.  Clearly services require the hardware to maintain its dominance for the installed base to grow.
Also, existing and new products exploiting its ecosystem will drive improved margins and earnings, so it is not only about
services growth.  Apple is correct when it says it is uniquely positioned to leverage the combination of hardware, software,
and services to provide a superior customer experience. Some combination of hardware and services in conjunction with its
scale; brand; design, manufacturing, and marketing capabilities; customer service; distribution network; and balance sheet
should allow Apple to continue to grow earnings. When the market’s fear of declining earnings abates, the stock must
revalue to closer to a market multiple. We are gaining visibility into that scenario with the pending iPhone 7/10th
anniversary launches, expanding services offerings, and growing revenue from new products, especially the watch, and
continuing stock repurchases.
Apple clearly remains one of the best companies in the world. Its products are loved by a remarkably diverse
demographic. Its cash flow generation is unparalleled. The narrative that the company is a passé hardware company
with imminent risk of perpetual decline doesn’t stand up to reasonable analysis. This view is in the process of being
quickly debunked. As the company’s stock is institutionally under owned, the stock should quickly rerate to a 13-14
EV/FCF ratio ($150 range), especially when one considers the quality of the cash flows and alternative investment
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Better than expected product launches this fall and next year, steady growth in services and other products, clarity on the stickiness of the ecosystem and all that implies, combined with "earnings yield" value accretion to shareholders from buybacks and dividends will eventually force a revaluation of the shares.

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