Apple Upgraded To Outperform

We are upgrading Apple Inc. (AAPL) to Outperform from Neutral, as we believe Apple shares have further room for expansion. Apple has experienced tremendous growth, driven by the success of its iPhones and increased Mac shipments.

We expect the iPhone-driven momentum to continue, as the company’s product generates the highest customer satisfaction in the industry. In our opinion, this is the key to long-term growth and continued appreciation of the stock, given the large addressable market.

The investment case for Apple is based on its earnings momentum and accelerated revenue growth. The company has undergone a total turnaround from a loss of 7 cents per share in fiscal year 2001 to a profit of $6.29 per share in fiscal year 2009.

The company reported strong 2009 results, with increased revenue (up 12.5% year over year) and earnings (up 17.4% year over year) despite the recession. The results beat the Zacks Consensus Estimate and the company’s own guidance.

The company’s lattest quarterly results were particularly impressive, driven by strong sales in the quarter, representing the second highest revenue growth in the company’s history.

Meanwhile, strong revenue growth has driven margins and resulted in significantly higher earnings. In fact, operating margin has increased to 21.0% in 2009 from 19.3% in 2008. The company is currently benefiting from a positive mix shift to the higher-margin iPhones/iPod business from its traditional MP3 players, as a result of which gross margin grew to 36.0% in 2009 from 34.3% in 2008.

We believe the company will continue to post solid results due to the resurgence of its Mac portable systems, including MacBook Air, Mac Pro and the new Snow Leopard. The company revamped its line of iMac desktops and MacBook laptop computers, as well as increased sales of iPods, including the new iPod Shuffle, iPhone 3G, iPhone OS 3.0 (beta release), iTunes Movie Rentals and the successful launch of the iPhone 3G S.

Apple has a strong balance sheet with zero debt and $34.0 billion cash, short-term investments and long-term mark etable securities as of September 2009 versus $31.1 billion as of June 2009. Cash flow from operations increased to $10.2 billion in fiscal 2009 from $9.6 billion in fiscal 2008 and $5.5 billion in fiscal 2007. We view this as a positive step in the current credit-constrained market, where adequate cash resources are vital for sustenance.

With a market cap of over $170 billion, Apple is poised to benefit from the growth in the smart phone mark et. According to iSuppli, the smart phone mark et will increase from 184.2 million units in 2009 to 235.6 million units in 2010 to 334.1 million units in 2011. The company increased its mark et share from 2.1% to 13.7% year over year in the second quarter of 2009.

While Apple has solid growth potential, its rivals Nokia (NOK), Research In Motion (RIMM) and Palm (PALM) are still struggling to recover from the recession’s impact on consumer spending.

Year to date, Apple’s share price has more than doubled.  Apple’s valuation premium is justified, given the company’s various positive attributes and track record in earnings growth, and leaves room for further upside from the current levels.

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