Apple Computers, Inc. (AAPL)Comprehensive Business AnalysisCody SchoenigMatt SundbergCasey PazokiDaisy TorresHudson Marshall1

Table of ContentsExecutive Summary . 03Business & Industry Analysis . 07Industry Analysis . 07Five Forces Model 07Key Success Factors . 14Competitive Strategy Analysis .17Accounting Analysis 18Accounting Analysis Steps .18Manipulation Diagnostics . . 24Ratio Analysis & Forecast Financials 34Financial Ratio Analysis 35Cross Sectional Analysis . 38Financial Statement Forecasting Methodology 55Valuation Analysis 61Method of Comparables . 61Discounted Free Cash Flow 64Abnormal Earnings Growth 65Residual Income .65Long Run Residual Income 66Credit Risk Analysis 66Appendix (A-J) . . 68Sources . 782

Executive SummaryApple Computers, Inc.Investment Recommendation:SellDate of Valuation: 4/01/05OvervaluedAAPL – NASDAQ52 week price rangeRevenue (2004)Market Capitalization 40.89 12.75 - 45.4433.54 B30.45 BShares Outstanding817.17MDividend Yield3-month Avg. Daily Trading VolumePercent Institutional Ownership0%31,109,50075.19%Book Value Per Share (mrq)ROE (2004)ROA (2004)Est. 5 year EPS Growth Rate 7.1610.37%6.63%1.79%Cost of Capital EstimatesKe Estimated5-Year Beta3-Year Beta2-Year BetaPublished BetaKdWACC(bt)Altman’s Z - ScoreEPS ForecastFYE 9/31EPS2004(A) 2005(E) 2006(E) 2007(E).37.55.811.14Valuation Ratio ComparisonTrailing P/EForward P/EM/BForward PEGRatio Based ValuationsP/E TrailingP/E ForwardM/BDividend YieldPEG ForwardFord Epic 6.68%5.39%8.78%Intrinsic ValuationsDiscounted DividendsFree Cash FlowsResidual IncomeAbnormal Earning GrowthLong Run Residual Income Perp.2.63%5.26%3.303Act.65.9532.2033.241.79 15.61 20.67 37.16N/A 20.24 16.22N/A 28.95 23.22 23.40 20.84Avg.25.1816.295.441.20

Recommendation – Overvalued SecurityAfter a comprehensive evaluation of Apple Computers, Inc., our findingssuggest that the firm is overvalued and we recommend selling the stock. Eventhough, Apple’s sales in 2004 grew 33% and are estimated by analysts to grow25% in 2005, the company has experienced this growth from the iPod, and it isyet to be seen whether or not they will be able to maintain this success. Also,Apple only has a 2% market share in the personal computer market, and it iscrucial that they increase this percentage if they wish to be considered a moreserious player in the personal computer market.The computer industry is very diverse, dynamic, capital intensive, andhighly competitive. Products offered range from mp3 players to peripherals andpersonal computers. The high level of competition has forced firms to adopt acost leadership stance, and has drastically reduced profits. The maincompetitors in the industry are Apple, Dell, Hewlett-Packard, and Gateway, all ofwhich, excluding Apple and Dell have struggled to turn a profit.Industry Demand DriversThe drivers for new growth in the industry historically has been achievedthrough the introduction of innovative products and/or efficiently and costeffectively producing existing products. Apple and Dell have each capitalized onone of these methods and are currently experiencing the highest levels ofsuccess within the industry. Other demand drivers typically have encompassedincreased speed, memory, usability, and stylish designs.Growth in the personal computer market is expected to decrease in 2005due to the lack of new product introductions, resulting from the highly developedmarket. However, the portable music sector has experienced tremendousgrowth and is forecasted to continue this trend in the near future.4

Learning Organizations with a high investment in R&D and operating efficiencieswill be best positioned to create/capitalize on growth in the industry.Apple is well positionedAs stated previously, Apple and Dell have most effectively utilized thecompetitive strategies that allow firms in this industry to remain profitable.Apple is well known for its differentiated and innovative products, and loyalcustomer base. This coupled with the “halo” effect from iPod sales is projectedto increase overall market share and better position Apple to take away marketshare from its competitors. Also, Apple devotes the highest percentage of itssales to R&D which better positions itself to enjoy first mover advantage with theintroduction of new products.Margin ExpansionApple has the highest gross profit margin amongst its competitors due toits higher prices, and is solely responsible for allowing Apple to stay afloat in thepersonal computer market with a meager 2% market share. However, Apple’sspare no expense philosophy in producing high quality differentiated goodsdrastically reduces its ability to translate a larger portion of gross profit into netprofit. Apple has the highest operating expense ratio and the lowest net profitmargin amongst its competitors. If Apple is able to cut down on operatingexpenses and utilize some of the benchmark strategies employed by Dell, theywill be able to translate more of their revenues into earnings per share.Healthy FinancialsApple shows favorable numbers in terms of liquidity/operating efficiencyanalysis. The company is both able to meet short-term obligations and hassteadily been recovering its receivables. Inventory turnover was lower in 2004than in previous years; however, it is our opinion that this is a result of Apple5

intentionally increasing its inventory levels precluding the release of newproducts. Profitability analysis revealed overall good profitability on sales, butthey lack the ability to convert satisfactory levels of gross profit into net income.Apple demonstrates a healthy capital structure and is able to take on largeamounts of cheap debt.ValuationBased on valuation models, Apple’s stock is currently overvalued. Ourmost accurate models indicate that the firm’s intrinsic value is in the range of 20- 24. It is our belief that even though the firm is headed in a positivedirection, and has very healthy financials, much of their market price iscomposed expectations instead of actual performance. Earnings in 2004 were .37 per share ( .74 per share before the 2 for 1 stock split). Estimatedearnings in 2005 are .55 per share. We believe that investors should placeApple on a watch list, and that it may become a more attractive stock in thefuture.Other Positive FactorsApple effectively paid off all its debt in 2004 and is completely equityfinanced, and is the only firm within their sector that has been able toaccomplish this. Furthermore, the stock recently split and many analysts haveissued buy and strong buy recommendations while also upgrading to outperformthe market.RisksThe dynamic nature of the computer industry is reason enough to assumea high level of risk. Also, the state of the economy plays a huge factor in Apple’sperformance; given a dip in the economy, Apple would suffer greatly.6

Industry AnalysisThe computer industry includes a wide variety of products, from mp3players and printers to personal computers and powerful servers. Companieshave trouble operating within the computer industry, namely due to the dynamicnature of technology. Moore’s law, formulated by Gordon Moore in 1965, statesthat the numbers of transistors per square inch on integrated circuits will doubleevery 18 months, and prices will be reduced. This means even the largest firmsmust stay on their toes, as the industry is constantly changing and redefining itsparameters.Apple Computer Inc. has recently made headlines by breaking into theportable music market with its introduction of the Apple iPod and iTunessoftware. Apple also carries a long line of computer products including personalcomputers, computer accessories, servers, networking solutions, and softwarepackages. Currently capturing a market share of 65% among the portable musicmarket, and holding a profitable 2% of the personal computer market, Apple hasconsistently kept its name in the industry.1,12 Apple has stayed afloat in theindustry by keeping an eye for aesthetics and creativity, coupled with userfriendly and innovative products.Five Forces ModelCompetitive Force 1: Rivalry among Existing FirmsThe two main areas within the computer hardware industry in which applecompetes are the personal computer and portable music markets. The personalcomputer market is fairly well developed and growth in this market will bemoderate. According to the Credit Suisse First Boston, it is estimated thatpersonal computer growth in 2005 will be approximately 8%, which is 3% lowerthan 2004.7 There is a high degree of concentration in this market which iscontrolled by a few very large competitors who have a great deal of capitalinvested in the firms, namely, Dell, HP Compaq, Gateway, and Apple. Personal7

computers are quickly becoming a commodities market due to virtually identicalproducts produced by the leading competitors. This has placed an increasedemphasis on competitive pricing, which has drastically reduced profit. This isforcing companies to be cost leaders to maintain a reasonable profit margin.Apple’s bread and butter has always been achieved through productdifferentiation, and “in a market where everyone except Dell has struggled tomake money, Apple has long been highly profitable with only a 2% marketshare.”12 In 2005, Dell and Apple are speculated to have the most potential toincrease market share in the PC market due to lack of new product introductionsby other firms and the anticipation of Microsoft Longhorn in 2006.7 If Apple isable to increase its market share by a few percentage points, its profits andability to spend on marketing, and research and development (R&D) could allowthem to become a much more serious player. Switching costs for the customerhave been the main deterrent in Apple’s quest to attain a more sizeable marketshare, due to their higher prices and perceived incompatibility with othersoftware.8Recently, a fairly new and less developed market within the parameters ofthe computer hardware industry has emerged through portable music, whichwas a substantial portion of Apple’ revenue in 2005.5 This market provides agreat deal of opportunity and high growth potential for firms. Currently, Appledominates the portable music industry music market with an estimated 90% forhard disk based players, and 65% of the total portable music market.9Thisadvantage allows them to set and enforce the rules of competition. Apple hascapitalized on its product differentiation, and is charging two to three times themarket price of conventional mp3 players for its iPod (A price that consumers aremore willing to pay). Competitors are struggling to offer up a product that is atechnological/innovative equivalent to the iPod, and until they can produce onethat surpasses it, they will not be able to dethrone the portable musicjuggernaut. Apple is in no danger of losing market share in the short term andhas continued to pour money into its R&D to support its long-term strategy.8

Since the release of the iPod, Apple has released the iPod Mini and the iPodShuffle which has tightened its grip on all areas of the portable music market.Switching costs for the consumer are low allowing customers to flow fromproduct to product based on price, but Apple will continue to rely on brandidentification, differentiation, and innovation to maintain a firm grip on marketshare.In both the personal computer and portable music markets, componentcosts are large part of the total hardware costs, but through Apple’s productdifferentiation and higher pricing they are able to counteract the price wars thatusually ensue under such conditions. Finally, there are little to no exit barriers ineither market, which could be advantageous in ousting some of Apple’scompetition in the future.Competitive Force 2: Threat of New EntrantsWithin the personal computer market there are a few well-establishedcompanies that consume most of the market share. These companies are: Dell,HP Compaq, and Gateway. There are large economies of scale in the personalcomputer market and this limits new entrants. A company would need to haveaccess to an enormous amount of capital in order to effectively compete with thefew well-established market leaders.The large economies of scale make itnearly impossible for new start-up companies to gain any type of significantmarket share. In the personal computer market there are basically two mainoperating systems offered on personal computers: Microsoft’s Windows andApple’s Mac OS X. A new company would have to create competitive softwarethat is one step ahead of the rapidly changing technological advancementswithin the computer software market. Another barrier that new entrants wouldhave to face are legal barriers; mainly in the form of patents. The main marketleaders have numerous patents on computer designs as well as technology,which make it extremely difficult for new entrants to enter the market without9

large amounts of start up capital to create new and innovative advancements intechnology.Apple is the most dominant company in the portable music market. Theportable music market is relatively new, and as a result there are a fairly largeamount of competitors. The main competitors in the MP3 sector are: Apple, Rio,Nike, Sony, Creative, Napster, and Dell. There is more of a threat of newentrants in the MP3/Portable Music market than there is in the personalcomputer market. While portable music hardware still requires significant capitalinvestment to develop and produce the hardware units, the portable musicwebsites (i.e. Napster, iTunes) have relatively small startup costs. This leavesApple susceptible to new entrants who could possible steal away a portion of itsiTunes market share.Apple is enjoying the first mover advantage in the hardware side of themarket with their iPod.While numerous portable music players have beenreleased within the last 5 years, Apple was the first to combine style, usability,and large capacity into a single unit, and because of this they are enjoying thefirst mover advantage with the introduction of the iPod. Even though the iPod ismost expensive portable music player on the market, it is highly sought after bycustomers because of the ground breaking technologies it employs. Customersare pleased with the quality of Apple products thus far and they continue to lookto Apple for future innovations (iPod mini, Shuffler, and accessories). Althoughthis creates an obstacle for new entrants, it is possible for them to establishthemselves within the market. Due to the potentially high growth rate of thismarket, it is still profitable for companies to invest the capital involved inbreaking into the market. It will be essential for companies entering the portablemusic market to innovate beyond the standard set by Apple. Even though themain market leaders already have many patents protecting their technologies,new entrants can develop pioneering technologies due to the relatively youngnature of the market.10

Finally, Apple should be aware of the threat of a counter culture ofcustomers which shy away from Apple’s products due to their dominance in themarket.This phenomenon is best represented by the counter culture thatdeveloped with Microsoft that led some customers to Linux. A counter culture ofthis sort has not yet asserted itself into the portable music market, and is of noimmediate threat.Competitive Force 3: Threat of Substitute ProductsOn the personal computing side of Apple’s market are a number ofproducts from various competitors. Each of these competitors has a wide rangeof computing systems designed for various types of users. Dell is marketing itsDimension line of computers for desktop users and its Inspiron line for laptopusers. Both the Dimension and Inspiron lines differ in features and power toprovide varying selections for customers with diverse needs.2 The same can besaid of Hewlett-Packard’s Pavilion/Presario desktop and laptop PCs, as well asGateway’s 3200/5200/7200 series desktop computers and M210/M320/M520series laptops.3,4 It would immediately seem that Apple has a wide array ofsubstitutes in the market, but the proprietary nature of Apple’s products setsitself apart from its competitors.While HP, Dell, and Gateway each use theMicrosoft Windows operating system and an Intel/AMD based CPU, Apple’scomputers use their own in-house OSX operating system and an IBM derivedPower processor CPU. This separates the computers in how they function, whichinevitably means the software packages and overall functionality differs greatly.While Dell, HP, or Gateway could out perform Apple in both speed and in price,Apple has set itself apart from these other computer manufacturers by keepingitself unique in the market and gathering around itself a loyal group of users.Regardless of this, Apple will have to continue to stay innovative and priceconscious as new and existing computer owners begin to make the decision ofwhether their new computer is a PC or a Macintosh.11

Within the portable music market, Apple’s hard-drive based MP3 playerhas many possible substitutes within the market. Some examples include theJetAudio iAudio U2, Creative Nomad, iRiver iFP-790, and Rio Forge. These MP3players are similar to the iPod, but are flash-memory based, meaning theytypically hold less mp3s but consequently cost less. This doesn’t seem to bemaking a substantial impact on Apple’s iPod sales as buyers are getting moremp3 capacity per dollar using the iPod and do not have to worry aboutupgrading their players with additional memory cards in the future. Apple hasresponded to the flash-memory based market with its recent introduction of iPodShuffle. However, the iPod Shuffle is a new product and it has yet to be seen ifit can capture market share away from the flash-memory units already on themarket. Finally, portable CD players and radios are still on the market, thoughthey pose a very small threat to the iPod as they lack the ability of storing yourmusic in digital mp3 files.Competitive Force 4: Bargaining Power of BuyersApple focuses on differentiating its products in both the personalcomputer market and the portable music product. Both the Macintosh line ofproducts and the iPod have a signature style and innovative features that setthem apart from their competitors. This makes buyers less price sensitive whenit comes to buying the iPod and Macintosh, as it is very difficult to find a productthat has the same features or stylish look. If customers want to avoid Microsoftsoftware and Intel/AMD based PCs, the only alternative would be to purchase aMacintosh computer, creating a niche market out of Apple and in turn makingbuyers less sensitive to price.Additionally, buyers of the iPod and Macintosh computers have lowrelative bargaining power considering they would have to buy in very largevolumes. There is no “Wal-Mart” of electronic stores, so there is no way forindividual resellers such as Best Buy, Circuit City, or CompUSA (to name a few)to bully Apple into lower prices. Apple also has 98 national and 4 international12

retail stores, in addition to its own online store carrying the full line of appleproducts.6 The internet is also a huge selling point for iPod and Macintoshproducts via and (to name a few) with the popularity andbenefits (tax free) of at-home shopping.6 Businesses have some relativebargaining power when it comes to purchasing Macintosh computers in bulk foroffice use, but home users have literally no control over Apple when it comes totheir pricing. On a final note, once Apple sells to the end user it has essentiallysecured future sales of its hardware and software due to a lack of third partyoptions. This gives buyers even less relative bargaining power to shop for betterprices or alternatives for their software/hardware needs.Competitive Force 5: Bargaining Power of SuppliersApple uses a large variety of suppliers for manufacture of its computersand portable music players.In most cases, Apple is not limited to a singlesupplier for the various components used in the process of assembly for itsproducts. This leaves Apple’s suppliers with less bargaining power concerningprice in most cases.Apple uses both NVIDIA and ATI for video cards in itscomputers, so it has two choices concerning who to go to. This is the same forits motherboards (ASUSTeK and Ambit Microsystems), Display units (Samsung,Toshiba, International Display Technology), storage devices (Hitachi GlobalStorage Technologies, Western Digital, Seagate), and CD/DVD drives (Samsung,Hitachi Global, and LG. Phillips Co.).5 In most of the other parts in Apple’sMacintosh computers and iPod the situation is the same, giving Apple power toswitch suppliers if needed. The only real exception to this is its current positionwith IBM and its G series processors, as moving to a new processor would haveextremely high switching costs. A customized chip would have to be created toreplace the G series processor as PC and Macintosh computers have completelydifferent technologies concerning the CPU.13

Key Success FactorsCore StrengthsApple has numerous internal strengths that make it a successful andcompetitive company. For one, Apple has a powerful footing in the personalcomputer market by being “different” with its innovative style and ease of use.Its operating system is developed in house, leaving it free from the tangles ofthe dominant Microsoft operating systems. This gives apple a very large degreeof control over its product in the physical appearance, specifications, and overallusability. Apple does all this while keeping its Macintosh computers compatiblewith existing PC computers.Additionally, Apple fosters a research intensiveoffice environment and is constantly releasing products with the current trendsand styles as seen through its latest iPod and Mac mini. This makes Apple oneof the biggest innovators in the computer and portable music industries, beingfirst to bring new and creative ideas to the market.Core WeaknessesDue to their research intensive nature, Apple has high R&D costs, whichmeans that Apple is far less cost effective in a very saturated market. While theycurrently hold 90% of the portable music market, Apple is constantly relying oninnovation to keep it ahead, putting the company in a risky position if its R&Ddoes not come through.1 Moreover, Apple has a hard time selling the Maccomputer to many customers do to the perception that the Macintosh isincompatible with other PCs and software. In other words, customers get scaredof an operating system that looks different then windows and assume it doesn’twork the same. While this is not true, it hinders the ability of Apple to stealaway existing PC users to grow its market share.8 Finally, Apple has problemswith some customers due to the high prices of many of their products. Whilethis has not hindered their sales in the portable music market yet, it can betraced to problems within their computer market sales.14

Market OpportunitiesWithin the industries that Applecompetesopportunities for increased market share and growth.therearenumerousSince Apple is alreadyrecognized as one of the main leaders in the portable music market they havethe ability to further increase their company image and qualityimage reputation. This will allow Apple to maintain their alreadythe personal computer market Apple is expected to sustainsubstantial market share gains in 2005 because customers areawaiting the launch of Windows Longhorn for Microsoft.7 On theportable music side of things, it is speculated that if Apple were toiPod Shuffler Flash PlayerProvided by Apple.comwell established clientele as well as attract new customers. Withinrelease a flash-memory based mp3 player that its music businesswould be worth close to 5 billion by 2006.9 As a final point, many speculate thatApple’s entire line of Macintosh computers will gain market share due to the haloeffect of the iPod.11Market ThreatsThere are many potential threats that Apple faces everyday. The primarythreat that they face is the rapid advancement in technology. Since most peoplejudge the computer on the speed (GHz) of its CPU, Apple has had a hard timewith customers considering the Macintosh inferior incomputers have begun using 64bit technology asopposed to the PC which is still primarily using 32bittechnology.6 This has given Apple a slight edge to theirspeed problem. Therefore, Apple must make sure thatthey stay up-to-date and on the cutting edge ofadvancements and innovations.Image property of Napster.comspeed to the PC. Although, recently the new MacintoshOne slip in their R&Ddepartment and Apple could lose an enormous amount of their market share.One final note is the threat of Napster, Apple’s primary competitor to its iTunes15

music service. Napster has begun aggressively marketing its new service whichallows unlimited music downloads which are “rented” to the mp3 unit while thesubscription is active.This service, costing only 14.95 a month, is the firstserious challenge to iTunes 99 cent per song download business strategy.13,6Whether or not Napster will effectively unseat Apple is yet to be seen, but showsthe vulnerability of Apple’s portable music market share.16

Competitive Strategy AnalysisIn such a highly competitive industry where superior quality and brandimage are key success factors for a computer company, it is necessary forcomputer companies to become cost leaders or differentiate themselves byoffering a unique product. Apple has become known as a computer companythat has innovative and stylish computers and music players. By highly investingin research and development, providing a variety of products, and maintaining aunique brand image, Apple has been able to create a sustainable competitiveadvantage by differentiating its personal computers and portable digital musicplayers.By spending 489 million dollars on research and development alone, Applehas been able to develop innovative products that enable them to maintain aloyal customer base.5 Apple is known for its unique and user friendly productslike the new MAC mini, the all in one design of the eMAC and the iPod which allappeal to the “stylish consumer.”Introducing PC’s in various colors anddistinctive monitors have given Apple a unique image. For example, competitorshave tried to mimic the iPod but the iPod consistently beats out the competitionbecause of its efficiency and stylish design.Furthermore, the multi-colored apple logo has become an unmistakableicon. Apple has been able to build up its image in the past couple of years by itsinnovative products and popular designs. This has given Apple a comparableadvantage because the apple logo is now being associated with quality anduniqueness.17

Accounting AnalysisStep 1: Identifying Key Accounting PoliciesAs a leading competitor in the personal computer market and thedominant firm in the portable music market, Apple has maintained and gainedmarket share time and time again through its focus on creativity, innovation, ahigh investment in research and development (R&D) and brand image.Apple is very limited by GAAP in accurately portraying key successfactors through the use of different accounting policies. As stated previously,Apple invests heavily in R&D and brand image (advertising), 489 million and 206million in 2005, respectively. However, in accordance with GAAP, they are forcedto expense the costs as they are incurred, and are unable to capitalize them.Some latitude is given in capitalizing software R&D expenses pursuant to SFASNo. 86, which states that development costs of computer software to be sold,leased or otherwise marketed are subject to capitalization beginning when aproduct's technological feasibility has been established. However, in 2005,capitalization of software R&D amounted to less than one percent of R&Dexpenditures.Per Apple’s notes to consolidated financial statements, managementidentifies key accounting policies and estimates as those related to revenuerecognition, allowance for doubtful accounts, inventory valuations and purchasecommitments, valuation of long lived assets including acquired intangibles,warranty costs, and income taxes. These policies are deemed important becausethey are critical in the representation of the firm’s financial standing and thatthey require judgments and estimates regarding events that are uncertain.However, the stances taken on these issues reflect industry norms, and arestated very similarly by leading competitors in the respective markets.18

Step 2: Assessment of Accounting FlexibilityApple has very limited accounting flexibility in capturing its key successfactors concerning research and development, brand image, and marketing. Theonly flexibility in their key success factors involves a small portion of its R&Dcosts being capitalized. This leaves management with few accounting policies inwhich they can be flexible, which causes accounting data to be less informativeregarding the true economy of the firm.Flexible Accounting PoliciesAccounting PolicyDegree of FlexibilityResearch and Development*MinimalBrand Image (Advertising)*NoneInventory PoliciesModerateEstimation of Bad DebtModerate to HighAmortization of Goodwill andModerate to HighIntangibles*Key Success FactorApple currently uses a straight-line method over the estimated useful livesof assets concerning the depreciation of property, plant, and equipment, whichare 30 years for building, 2 to 5 years for equipment, and the shorter of leaseterms of 10 years for leasehold improvements. It is of importance to note thatApple, as of first quarter of fiscal 2002, adopted SFAS No. 142, which requiredthat ass

differentiation, and “in a market where everyone except Dell has struggled to make money, Apple has long been highly profitable with only a 2% market share.”12 In 2005, Dell and Apple are speculated to have the most potential to increase market share