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AAPL Buy Recommendation

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By TheAngryFerret
February 15, 2001

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Hey AAPL Fools.

Following is the first draft of a report I have written on why I believe that AAPL is an excellent long-term investment opportunity. Keep in mind that this is a first draft, and sometime refers to charts and models that I obviously can't post here. I did one of these for a stock called PCLE as well, and that is on the PCLE board.

Let me repeat that this is a first draft. A final draft with the charts and such should be available shortly at my website. I would appreciate any comments or criticisms that you have.


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APPLE COMPUTER (AAPL)
Buy Recommendation
Date: 2/13/01

RECOMMENDATION: BUY
Price Target: $33
Current Price (2/13/2001): $19 1/8


� INVESTMENT THESIS
The past few months have not been easy for Apple investors. After several negative pre-announcements and earnings shortfalls, Apple shares have fallen from a 52-week high of over $75 down to less than $15. Given the problems faced by Apple, the price decline was partly justified, however, the shares have been oversold. With many exciting products in the pipeline including OS X, high returns on capital, and an improving market for personal computers, there is tremendous value in this stock.

� COMPANY BACKGROUND
From Apple 10K: "Apple Computer, Inc. designs, manufactures and markets personal computers and related personal computing and communicating solutions for sale primarily to education, creative, consumer, and business customers. Substantially all of the Company's net sales to date have been derived from the sale of its Apple Macintosh line of personal computers and related software and peripherals. Apple Macintosh personal computers are characterized by their intuitive ease of use, innovative industrial designs and applications base, and built-in networking, graphics, and multimedia capabilities. The Company offers a range of personal computing products, including personal computers, related peripherals, software, and networking and connectivity products. "

� BACKGROUND: FROM $75 TO $15
To understand why the stock currently trades where it does and the risks facing Apple, it is useful to understand how it got here. Several times over the past few quarters, Apple has pre-announced earnings shortfalls due to various management miscues and a weak industry environment for personal computers.

Many of Apple's missteps as of late involve misjudging the market's appeal for its products. Apple's biggest release last year was the G4 Cube. Despite aggressive marketing and exceptional product design, the Cube met very weak sales, primarily overly optimistic projections of consumer demand. Several other product lines had poor sales for lacking consumer demanded functions, such as CD-R drives. As would be expected from the disappointing product sales, inventory levels became very high, and several rebate programs were initiated creating pressure on margins. Furthermore, Apple has been plagued by delays in the release of its new operating system, OS X, a product that when released will help push the upgrade cycle.

Not only has Apple been negatively impacted by company specific factors, but it has been impacted along with other computer manufacturers due to trends in the industry. Demand for computers has been down, as consumers have slowed their spending due to fears of a recession. Not only has this affected the results of Apple, but of its comparable companies as well.

Clearly these are substantial problems, and Apple must successfully turn itself around in the coming quarters for it to generate value for its shareholders. Fortunately, there are several positive catalysts both in the near term and long term that will positively benefit Apple's weak stock price, including promising products in the pipeline, the visionary leadership of Steve Jobs, Apple's excellent financial condition, and its competitive advantages.

� THE PRODUCT PIPELINE
As was demonstrated by Apple at its annual MacWorld Expo in early January, Apple has many exciting products in the pipeline that will push demand and help its top line growth. Many of these products come out of Apple's unique outlook for the future of computing.

At a recent analyst conference, Apple CEO Steve Jobs explained that the PC industry isn't dying, rather is going through a significant evolution. According to Jobs, PCs have gone through two main stages and are moving into a third. The first stage was from 1980 to the early nineties where PCs were being rapidly adopted and used primarily as productivity enhancing tools. From then to now, the PC has been for harnessing the power of the Internet, and using the PC as a communication/information gathering tool.

Now, Jobs believes we are moving into the third stage of computing with the PC as the digital hub, where the computer is the centerpiece of all the ubiquitous digital devices: Mp3 players, cell phones, PDAs, etc. The personal computer won't be eliminated due to its enhanced power, graphical capabilities, and storage space. According to Jobs, Apple, through its superior product capabilities, is well positioned to take advantage of this market shift. The new product pipeline backs up this conjecture. This strategy is seen in both hardware and software.

Stemming from this strategy is the idea of the killer application, an application so fantastic and innovative that it will compel consumers to purchase the hardware and the software. This strategy has been effective in the past with products such as iMovie, and represents a compelling differentiating factor between Apple and other computer hardware manufacturers.

The main "killer app" deserving of investor focus is the next version of the Macintosh operating system, OS X. The new operating system is a dramatic retooling of previous versions of Apple's operating systems. Early reviews of the system seem very promising, and Apple is confident that most consumers will upgrade when OS X launches in late March. Apple is also hopeful that it will push the upgrade cycle for hardware when it comes preinstalled on all systems beginning this summer.

� SUPERB MANAGEMENT
As demonstrated above, Apple clearly benefits from the visionary leadership of Steve Jobs. Since Jobs reclaimed his CEO position in 1997, Apple has been revolutionized, which up until the last quarter was clearly reflected in the AAPL share price. Jobs is one of the true visionaries in the computer world, and it is difficult to envision him allowing Apple to fail to execute. Apple investors can gain confidence in the outlook of their company due to its superb leadership.

� COMPETITIVE STRENGTH
Apple also benefits from an arguably superior competitive position. Apple is able to focus on a niche market of non-Windows users, a group that seems to be getting bigger over time as Microsoft loses its monopoly on the market. Furthermore, if expectations are met for OS X, Apple is well positioned to take even further market share away from Microsoft.

Apple also enjoys a strong foothold in the design community, and in turn design-conscious consumers, who tend to replace their equipment more regularly. Apple hardware is attractive to these uses due to its relative performance to Wintel products. Consumers are functionally fixated on the Mhz gap between Apple G4 and Intel processors, although it is clearly a faulty comparison. In tests, Apple is proven to have the faster processor.

� RISKS
Clearly the past few months have not been good for computer hardware makers. Consumer demand is very low given the apprehension about the strength of the economy. However, we seem to be reaching a turning point, and the economy could start improving. Nevertheless, Apple shares could face continued downward pressure over the near term in computer demand does not improve along with the overall economy in the coming quarters.

Apple has suffered some serious problems with execution, and it remains to be seen if this situation will improve. The company has taken the initiative to replace several executives in its sales departments. So far, the results have been promising, but it remains to be seen how effective this will be. Especially crucial is the education market where Apple lost significant market share. If Apple does not turn around its position in the education market, there will be problems for the overall top line.

Finally, clearly a lot is riding on the release of OS X. If OS X lives up to expectations, the operating system will be a killer app that will drive sales of Apple hardware, and improve the supply of software available to Apple users. However, OS X has been delayed several times, and further delays create an additional risk.

The main risk for Apple is to convince customers to give up on their Wintel machines. For Apple to become successful, it must continue to go after new computer buyers and Window's users and show them that Apple is superior. This is a very formidable task, but nevertheless achievable.

� FINANCIAL STRENGTH AND COST OF CAPITAL
Not only does the Apple product pipeline and management create a situation of compelling value, so does Apple's financial strength. Apple is an extremely efficient company.

As mentioned above, Apple currently holds $12 per share in cash. Although it would be best for shareholders that this capital be invested in a higher return than treasuries, it creates interesting opportunities for growth, and ensures Apple should be able to withstand a few quarters of unprofitability. Such opportunities could mean acquisitions or a share buyback.

One such opportunity is the Apple Store. Apple is currently developing its first proprietary store, much like a Gateway country store in Silicon Valley. Operating its own stores brings on additional risks for Apple, but does help in some areas. An Apple store creates a more unique buying experience for consumers, making it more likely for them to come back next time they upgrade. The stores are beneficial as they carry a higher margin of product sales, as sales are direct and discounts offered to retailers are retained. However, there are additional overhead costs that offset these benefits.

Apple's large cash balance and working capital efficiency create a low cost of capital. This is confirmed by cost of capital estimates made by Stern, Stewart Consulting in their annual MVA survey. By achieving a low cost of capital, Apple is able to set the bar lower to create shareholder value, as it is the spread between the weighted average cost of capital and the cost of capital and how this spread is exploited that creates value.

� VALUATION
With its large cash balance of $12 per share, and book value of $13 per share, and given its financial strength, there is minimal downside in this stock. On an enterprise value multiple basis, Apple is an extremely compelling value opportunity with a very positive risk/reward ratio given the limited downside.

Based on an EVA valuation model (Appendix A), the shares appear undervalued. Using the EVA model based on financial statement projections over the next 10 years with a steady-state period following ad infinitum, a value of over $33 was estimated. This represents a potential upside of over 50% from current price levels.

APPENDIX A: EVA VALUATION

APPENDIX B: ASSUMPTIONS USED IN MODEL
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Congrats if you read this far.

The Angry Ferret
www.angryferret.net