AAPL Apple Inc. $189.

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We are initiating coverage on AAPL with an Outperform Rating and $230 price target (33x our FY10E EPS of $6.93). AAPL has experienced a terrific run up in 2009, increasing 122% (vs. the S&P at +17%) and remains one of the most widely followed and volatile stocks on the street. Momentum remains strong due to the continued success of the iPhone and methodical execution within its core Mac and iPod businesses. Investors have rewarded AAPL for much of this past success, as is evidenced by its recent close at its 52-week high. However, despite the significant move in the shares, we believe further upside exists as we expect AAPL to continue to gain share and expand its market with the iPhone, while continuing to execute within its core Mac and iPod businesses. By our calculation, Apple stands to add ~$0.15-$0.20 to 10 EPS estimates for every incremental share point the iPhone gains in the worldwide smartphone market beyond our current estimates. We believe AAPL stands to gain further iPhone share over the next two years as 1) supply improves in the near-term, 2) the addressable market increases significantly due to expanding availability and carriers, 3) carriers make significant investments in their networks to address meaningful capacity constraints, and 4) enterprise adoption increases at a modest pace. Two-year Stock Performance AAPL vs. the S&P 500

Source: BigCharts.com

Recent Stock Performance After a sluggish start to the year, AAPLs stock has had a terrific run in 2009. Following speculation and the eventual announcement surrounding Steve Jobs health, AAPLs stock entered a roughly three-month holding pattern to start the year before beginning a near continuous seven-month upward trend in midMarch. Strong results and increasing expectations fueled by robust iPhone shipments, its growing ecosystem, and better than expected margins have driven AAPLs stock up 122% year-to-date versus the S&P at +17%.

iPhone momentum is strong and getting stronger. AAPL released its first iPhone in June 2007 and momentum continues to increase with each ensuing launch. As seen in the chart below, AAPL iPhone shipments have tracked significantly higher over the past four quarters following the release of the iPhone 3G and App Store during July 2008 and iPhone 3G S in June 2009. AAPL shipped over 5 million iPhones in the FQ309 alone and currently has an installed base over 25 million.

Quarterly iPhone Shipments (Fiscal Year)

8,000 7,000 6,000
iPhone 3G release, App Store launch iPhone 3G S release

(in 000s)

5,000 4,000 3,000 2,000 1,000 0 Q1'08 Q2'08 Q3'08 Q4'08 Q1'09 Q2'09 Q3'09

Source: Company reports

The iPhone continues to do well for a variety of reasons, including its sleek design, ease of use, and a rapidly increasing selection of applications. The App Store, which has only been up and running for about 15 months, now has over 85,000 apps available and recently surpassed two billion downloads (9/28/09). Importantly, many of these apps are unique to the iPhone and are helping differentiate AAPL from competitors. The number of apps available and downloaded is even more astounding when compared to the size of other notable app stores, such as GOOGs Android platform with ~5,000 apps available and RIMM and NOK at roughly 1-2K apps each. The charts on the following page display how increased iPhone availability, features, and apps have helped AAPL increase its share in the worldwide smartphone market to 13%, up from just 3% in 2008. While some of this increase is due to the timing of iPhone releases (3G S was in CQ2 vs. 3G in CQ3), the sizeable share gains made by AAPL over the course of the last 12 months are undeniable.

Worldwide Smartphone Share Comparison CQ209 vs. CQ208

WW Smartphone Share Q2'09
Others 14% Fujitsu 3% HTC 6% Nokia 45%
Fujitsu 3% HTC 4% Apple 3%

WW Smartphone Share Q2'08

Others 25%

Nokia 48%

Apple 13%

Research in Motion 19%

Research in Motion 17%

Source: Gartner

Even with the staggering success AAPL has enjoyed with its iPhone to date, we believe AAPL is well positioned to take further share in the growing smartphone market in the foreseeable future for the following reasons: A) Improving Supply - We believe it is important to note that AAPL reported significant supply constraints during its FQ309 quarterly call. Supply constraints have been fueled by both the success of the new iPhone 3G S and increased demand due to the new $99 entry-level price point for the iPhone 3G. At the time of its Q3 call, AAPL reported that the iPhone 3G S was only shipping in 18 of the 80+ countries where the iPhone is available. However, AAPL did note that it expected to fill most of this demand by the end of CQ4, and despite what appears to be continued shortages throughout FQ4, we anticipate AAPL will report significant iPhone shipments in both FQ4 and FQ110 in order to attempt to fill much of this demand and stock its sales channels. B) Increasing Addressable Market - AAPL has materially expanded its addressable market for the iPhone over the past 18 months, increasing the number of countries offering the iPhone from six in March 2008 to 80 by year-end 2008, with a significant portion of those launches coming in the last quarter of the year. AAPL currently has just over 85 countries now offering the iPhone and only last month began selling the iPhone in China which has ~687 million wireless subscribers, more than twice the population of the U.S. We believe this expansion, as well as increasing the number of carriers available to sell the iPhone within these markets, is significant and will play an increasing role in future earnings growth as AAPL begins to tinker with the model on a country by country basis to best optimize each individual market. C) Increasing investment in the network by carrier partners should lead to significantly improved service and overall experience with the iPhone We believe that most iPhone customers have a strong affinity and few complaints about the actual iPhone hardware and software itself, as evidenced by the iPhones first place finish in the 2008 JD Power Business Customers Smartphone satisfaction survey. However, we do believe a meaningful number of customers are unhappy with the typical day-to-day service received due largely to network capacity constraints at the carrier level. Many of these complaints include dropped calls, spotty or no service, delayed text and voice messages, and slow download speeds.

As a result, we believe there is a sizeable lag between many of the features and capabilities available on todays iPhones when measured against network capacity, with this lag being further exacerbated by the release of the feature-rich iPhone 3G S, which includes the addition of bandwidth-heavy video and MMS capabilities. This disparity was recently confirmed in a survey of over 1000 customers by CFI group which shows the iPhone has a sizeable lead when it comes to smartphone customer satisfaction, yet AT&T finished last when it came to service provider customer satisfaction. iPhone Customer Satisfaction vs. AT&T Customer Satisfaction

Source: CFI Group

As the economy improves, we expect carriers to place increased focus on investing in the network, resulting in a decrease in the sizeable gap between features and service. For example, AT&T has said that the majority of the ~$18 billion it will spend this year on its networks will be diverted into upgrades and expansions to meet the surging demands on its 3G network. To accomplish this the company intends to erect an additional 2,100 cell towers to fill out patchy coverage, upgrade existing cell sites by adding fiber optic connectivity to deliver data faster and add other technology to provide stronger cell signals. Ultimately, we believe increasing investments such as those being made by AT&T will help to minimize what we believe is a meaningful stigma associated with the iPhone and its service. D) Deeper Enterprise Penetration - While AAPL has gained significant share quickly with consumers and small businesses, AAPL has seen only limited traction in the enterprise segment due to security concerns and challenges with deployment. However, we believe there are signs in the market that AAPL is beginning to turn the corner in this segment. For example, during its July conference call, AAPL reported that ~20% of Fortune 100 companies placed iPhone orders of 10,000 units or more, with some governmental agencies ordering up to 25,000 units. With the release of the iPhone 3G S, AAPL made a number of improvements from a security standpoint as they seek to alleviate some of the concerns. Noteworthy improvements include adding on-device encryption for data and remote data wipe features. With the release of iPhone 3G S, AAPL also updated its iPhone Configuration Utility and released a detailed enterprise deployment guide for the iPhone OS that explains how to configure, activate and deploy phones within the enterprise. Additionally, AAPL also details how to distribute apps that are developed internally by enterprises.

While most of these updates and upgrades should help AAPL on the margin, we believe the adoption of enterprise specific apps could be a key differentiator for AAPL over the next 12-24 months. Solid execution on the Mac (35% of revenues) and iPod (15% of revenues) fronts are necessary to warrant valuation.
A) Macs - While much of the focus and attention concerning AAPL is on the success of the iPhone, Mac

sales continue to increase despite their premium price point and the sluggish economy. For example, AAPL reported that in FQ309 it sold ~2.6 million Macs, setting a FQ3 record, as Mac unit sales increased by Macs - more than 100,000 over the prior year. That number is especially impressive when compared to a 3% decline in the overall PC market seen during that same time period, according to industry sources. During CY09, AAPL has been able to drive increased demand due to a refreshed product line and lower entry-level price points. U.S. P.C. Share CQ209

Other 19%

Dell 25%

Toshiba 7%

Apple 9% HP 26%

Acer 14%

Source: Gartner

Near-term challenge/opportunity - We believe the primary near-term challenge/opportunity for AAPLs Mac business is the upcoming release of MSFTs Windows 7. Windows 7 will be released on October 22 and includes many significant improvements over MSFTs widely criticized Windows Vista release in early 2007. While we do not believe AAPL is at much, if any, risk of consumers switching from Macs to Windows PC because of this OS release, AAPL has been able to take meaningful share due to the poor adoption of Vista and any improvements to the Windows OS should make these share gains incrementally more challenging going forward. While we do believe there is some risk related to the Windows 7 release, we believe AAPL has already taken necessary steps to minimize this risk. In preparation for the Windows 7 release, AAPL surprised some in the industry by releasing its own OS update, Snow Leopard, nearly two full months ahead of the Windows 7 release and included MSFT Exchange support as well. However, what was most surprising about AAPLs Snow Leopard announcement was its noticeably lower price point at $29 to upgrade (vs. $129 for the previous release). As a result, we believe that by being proactive with its Snow Leopard release and pricing,

AAPL has effectively increased its brand awareness and affordability as consumers are set to face the decision of converting to Windows 7 or switching over to the Mac platform. B) iPods - The iPod line continues to do well and AAPL sold 10.2 million units during FQ309, down only modestly from 11 million in FQ308. While AAPL has experienced some anticipated cannibalization of its pocket-sized iPods (shuffle and nano), sales of the iPod touch, which leverages the iPhones OS, increased over 130% during the most recent quarter. AAPL remains the clear market leader in the digital music segment and controls over 70% share of digital music players in the U.S. U.S. Digital Music Player Share CQ209
Other 18% Microsoft 1% Sandisk 7%

Apple 74%

Source: Industry reports

Near-term outlook While AAPL remains the clear leader in digital music and iPod units remain strong, we believe the biggest near-term hurdle for AAPL will be continuing to offset cannibalization of iPods due to sales of the iPhone. For the first time, iPod unit sales declined year-over-year last quarter. In order to remain the market leader, AAPL must maintain its innovative designs and marketing approach for the iPod, while continuing to leverage the iPhone. We believe AAPL is addressing this and taking steps in the right direction. For example, in order to stimulate iPod sales in front of the always important Holiday shopping season, AAPL recently made significant improvements to iTunes for the first time in years and refreshed most of its iPod line, which now includes an iPod nano with built-in video capabilities and a FM-tuner. Perhaps more importantly, AAPL must continue to leverage the iPhones sleek design, easy-to-use software, and its ecosystem. AAPL has done a great job of this to date with the iPod touch, which sports the same look and feel as an iPhone while also utilizing the same OS. AAPL has sold over 20 million iPod touches to date and its users have access to the same 85,000+ apps in the App Store via broadband and wi-fi connections. Thanks to the significant number of apps available to iPod touch users - over 20,000 of which are games - AAPL has been to uniquely position the iPod touch as a handheld gaming console in competition with Nintendo and Sony. We believe this type of creative and adaptive marketing will be instrumental in the success of the iPod line going forward.

Valuation
Ticker Price Return YTD Market Cap (at close on 10/6) ($ in Billions) AAPL $190.01 123% $170.0 HPQ $47.01 30% $110.5 IBM $121.35 44% $159.5 DELL $15.51 51% $30.3 GOOG $498.74 62% $159.6 MSFT $25.11 29% $224.1 RIMM $66.43 64% $38.5 NOK (ADR) $14.42 -8% $54.0 MOT $8.49 92% $19.8 PALM $16.43 435% $2.7 AVERAGE (ex AAPL) 89% Ent Value ($ in Billions) $146.0 $115.0 $176.0 $21.8 $138.5 $198.0 $35.8 $56.0 $17.1 $3.2 P/E 32.5x 12.4x 12.8x 13.6x 28.3x 14.4x 18.2x 16.5x NM NM 16.6x FWD YR EV/ EV/FWD YR P/E EBITDA EBITDA 26.8x 19.3x 14.7x 11.0x 7.3x 6.3x 11.4x 8.3x 7.5x 12.2x 6.4x 5.4x 20.2x 15.9x 11.7x 13.2x 8.5x 8.2x 13.7x 10.9x 8.3x 13.9x NM NM 30.9x NM 9.6x 39.8x NM 16.9x 18.5x 9.8x P/S 4.8x 0.9x 1.6x 0.6x 7.1x 3.8x 2.8x 0.8x 0.7x 4.5x 2.5x P/FCF 16.1x 11.7x 10.0x 13.9x 22.6x 13.8x 35.3x 28.8x NM NM 19.5x

Source: Bloomberg

At first glance at the table above, AAPL trades at a premium to the peer group on nearly every multiple. However, because of accounting issues surrounding the timing of revenue recognition for the iPhone, income statement-based valuation multiples are overstated. While AAPL would still likely trade at modest premium to its peer group following any iPhone-related adjustments, we believe this lower premium would be warranted by AAPLs strong growth rates and continued solid execution. We also believe that P/FCF (which is not impacted by the revenue recognition issues) may ultimately be the most appropriate multiple to use when comparing AAPL to its peers. As exhibited in the table above, AAPL is currently priced at a discount to its peers on a P/FCF basis and with strong FCF growth expected, AAPL appears undervalued based on forward estimates. Bottom Line: Despite the significant move in the shares and its premium valuation, we believe further upside exists as we expect AAPL to continue to gain share and expand its market with the iPhone, while continuing to execute within its core Mac and iPod businesses. We believe AAPL stands to gain further iPhone share over the next two years as 1) supply improves in the near-term, 2) the addressable market increases significantly due to expanding availability and carriers, 3) carriers make significant investments in their networks to address meaningful capacity constraints, and 4) enterprise adoption increases at a modest pace. As a result, we are initiating coverage on AAPL with an Outperform Rating and $230 price target (33x our FY10E EPS of $6.93).