Is Icahn's Case for Apple at $1,250 Flawed?

Carl Icahn thinks Apple (NASDAQ: AAPL  ) stock could soar to $1,250 in the next three years, giving investors who own Apple at $525 a 33.5% annualized return. He laid out the scenario in his open letter to Apple CEO Tim Cook, made public this morning. As he has previously suggested, it would take a $150 billion buyback. This prompts two questions:

  1. Is the proposed buyback realistic?
  2. If the buyback were executed, could shares really appreciate to $1,250 in three years?

Let's dig in.

The buyback
Icahn suggests the buyback should be executed at $525 per share, approximately where Apple shares traded at market open this morning. Is it realistic to expect Apple to be able to repurchase $150 billion in shares at $525? Probably not.

Here's why. The buyback, Icahn suggests, should be in the form of a tender offer. In a tender offer, Apple would offer to purchase investors' shares at a given price. Typically, however, tender offers must tender a price at a premium to the market price in order to incentivize shareholders to sell. That being said, how would Apple get $150 billion worth of shares at $525 per share if the stock is currently trading slightly above that price? For instance, If a current shareholder is already holding shares at $525, why would he or she decide to sell at $525 just because Apple makes a tender offer that would offer zero upside? Even more, how would Apple find enough investors to get a whopping $150 billion worth of shares? With Apple trading at or above $525, it wouldn't.

In a conversation I had this morning with Fool contributor Adam Levine-Weinberg, who follows Apple's story closely, he suggested $525 may be far too low:

Short of reporting a terrible December quarter forecast, there's no way Apple could get shareholders to tender $150 billion worth of stock for $525. It would probably have to offer $600-$650 to get that much interest, at which point the economics are not quite so favorable.

In other words, Icahn should have struck hard back in June when Apple was still at $400.

Would a tender offer at $600 to $650 per share be good use of Apple's cash? Maybe, but that's certainly far more difficult to argue than a tender offer at $525.

Sure, Icahn did say that he believes the tender offer would still be compelling at $550 or $575 per share in an interview with MoneyBeat on CNBC this afternoon. But even this sounds wishful. A tender offer at $575 would give investors about an 8% return at today's price, hardly meaningful for current investors who obviously feel comfortable holding at $530. Even more, Apple reports fourth-quarter earnings and first quarter guidance on Oct. 28; if Apple beats analyst estimates, shares could easily jump to $575, once again increasing the amount Apple would have to tender in order to incentivize shareholders to sell.

Apple to $1,250?
The shares are irrationally undervalued, Icahn argues. In the letter to Cook, he calls Apple his "most compelling investment" and says its undervalued state is a "short-term anomaly." He illustrates his reasoning by comparing shares to the S&P 500.

The S&P 500 trades at roughly 14x forward earnings. After backing off net cash, Apple trades at just 9x (not factoring into account that the company has a significantly lower cash tax rate than the rate Wall Street analysts use). This discount (cash adjusted) becomes even more compelling given our confidence that Apple will grow earnings per share at a rate well in excess of the S&P 500 for the foreseeable future. 

With a position valued at about $2.5 billion, Icahn has put his money where his mouth is. In fact, he has recently increased his position from approximately 3.9 million shares to approximately 4.7 million shares (22% increase). Is Icahn right about Apple shares?

He's not generally a tech guy, however, so his confidence in Apple stock should be taken with a grain of salt. And the underlying premise for shares reaching $1,250 in three years is based on the unrealistic assumption that Apple could actually execute the proposed tender offer at $525 for $150 billion. The math goes like this:

... if the company decided to borrow the full $150 billion at a 3% interest rate to commence a tender at $525 per share, the result would be an immediate 33% boost to earnings per share, translating into a 33% increase in the value of the shares, which significantly assumes no multiple expansion. Longer term (in three years) if you execute this buyback as proposed, we expect the share price to appreciate to $1,250, assuming the market rewards EBIT growth of 7.5% per year with a more normal market multiple of 11x EBIT.

Sounds great. But unfortunately the tender offer is downright unrealistic unless a significant sell-off occurs. Even Warren Buffett recently suggested Apple's board should ignore Icahn's request.

What can we take away from Icahn's proposal?
It's difficult to say whether or not anything could come of this letter. At this point, the biggest takeaway for investors from Icahn's proposal is an interesting angle for Apple as an undervalued stock. The theoretical possibility of the buyback and the fact that Apple's balance sheet is in such a position that the company could feasibly execute such a large tender offer provides a convincing case for Apple stock around $525.

But would a buyback truly be enough to get Apple stock into gear?
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Read/Post Comments (15) | Recommend This Article (18)

Comments from our Foolish Readers

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  • Report this Comment On October 24, 2013, at 4:26 PM, MaxTheTerrible wrote:

    You might be missing the point of Icahn's letter. The cynic in me feels that this is a classic example of pump & dump. Now, AAPL is certainly not a penny stock, though more often than not it behaves like one, rising and falling on however insignificant "news". All Icahn is trying to do is generate enough interest from speculators to get the price up he must be well aware of unrealistic his "proposal" is. Once the price is up, he can sell his entire stake on excuse that AAPL didn't share his "vision" for the future of the company.

  • Report this Comment On October 24, 2013, at 6:02 PM, thecinimod wrote:

    Technical note: 2.9m -> 4.7m is a 62% increase, not a 22% increase.

  • Report this Comment On October 24, 2013, at 6:08 PM, GaryDMN wrote:

    Cook is no fool. With interest rates at near zero, borrowing to buy shares back at the current price, makes sense, just based on recovering the dividends that would be paid on the shares they buy back. The math is simple and Apple's cash flow can easily handle the the increased debt load. Last quarter, I think they bought back $16 billion worth of stock, I'm curious to see how much they spent on the buyback program this quarter, when they announce the results next week.

  • Report this Comment On October 24, 2013, at 6:25 PM, kf6spf wrote:

    I can see Icahn's point, but to spend ALL of AAPLs cash hoard to buy back shares seems ... wrong.

    Spending $1.3 billion per week ($260 million per day) buying your own shares on the market is a pretty impressive buyback program as is. Buying 10 times that is ridiculous. ANd I think Icahn knows it. Like the commenter above says, it looks a lot like a pump-and-dump scheme - just played out with BILLIONs instead of millions.

  • Report this Comment On October 24, 2013, at 6:28 PM, corpgov wrote:

    The most important part of the letter wasn't the hypothetical numbers, it was the following:

    "Apple’s Board of Directors does not currently include an individual with a track record as an investment professional. In my opinion, any further delay in executing the buyback we hereby propose will reflect this lack of expertise on the board."

    There's the opening salvo for a possible contest. Apple does have its problem, which I'll write more about in the future but here's a recent post with a brief mention of Apple's attempt to keep my proxy access measure off the ballot. See http://corpgov.net/2013/10/dissident-directors-and-proxy-acc...

  • Report this Comment On October 24, 2013, at 7:02 PM, Shiroto wrote:

    The essence of Mr. Icahn's argument is that the stock price could reach $1250 if the number of outstanding shares were reduced by about a third through a $150 billion buy back. Price appreciation would be due not merely to the reduction in the number of outstanding shares, but a belief that such purchases would promise a higher rate of return than that cash currently returns. The stock could be bought back on the open market, as Apple's current buy back is operating. The price at which such buy back could occur is anybody's guess -- it could be higher than it is now, it could be lower, it could be the same. It is true that the announcement of such a buy back would tend to increase the price of the stock, but there are obviously a number of factors influencing Apple's stock price -- look at where the stock was only three months ago. I believe that one advantage of a buy back would be to permit "use" of the cash without incurring a repatriation tax -- although I'm not sure if this is true. Buy backs also avoid the "double taxation" that arises with dividends. As an optimistic Apple investor I tend to think it makes sense for Apple to step up its investment in itself through a buy back program -- at least as compared to its "investment" in short term cash positions. I think Apple could prudently increase its current buy back program substantially above it's current level and should do so. At the same time, though, I value Apple's cautious approach to its cash reserves, and prefer they maintain a substantial reserve for the inevitable ups and downs of the electronics industry. Rather than a "pump and dump," I think Mr. Icahn's position serves to drive home the market's substantial undervaluing of Apple's stock -- i.e., there won't be any "dumping" at all, just a smart long term investment with some nice built in gains.

  • Report this Comment On October 24, 2013, at 7:11 PM, dwilh51183 wrote:

    AAPL SHOULD BE TRADING AT THAT PRICE RIGHT NOW !!! ,BUT WALL STREET IS CROOKED. WILL SEE HOW MUCH AAPL GOES UP IN THE AFTER HOURS IF THEY BEAT ESTIMATES LIKE CHIPOTLE DID…BY 15% CMG WAS UP $75 A SHARE AND GOOG WAS UP $110 A SHARE AFTER A LITTLE BETTER THAN EXPECTED. AAPL IS EXPECTED TO SELL 28 MILLION IPHONE'S, SO IF THEY SELL 35 MILLION, 40 MILLION OR BETTER…AAPL SHOULD BE UP $144.00 A SHARE IN THE AFTER HOURS.AAPL SHOULD ALWAYS TRADE AT A PREMIUM TO ALL TECH STOCKS, NOT A HUGE DISCOUNT! WHY IS AMZN TRADING TO THE STRATOSPHERE WITH 3 OR 4 STRAIGHT QTRS OF LOSING MONEY, AND A P.E. OF 4000

  • Report this Comment On October 24, 2013, at 7:13 PM, TheRealRacc wrote:

    Trying to intentionally reign on AAPL lovers' parade, nobody seems to want to talk about competition in the tablet market which, yes, it exists whether you want to admit it or not. AAPL 1,250 in three years? Maybe. AAPL back down to 750 in 4 years. Yes sir. The boom and bust cycle will continue. Everyone should shut up already unless your entire portfolio is in AAPL. And if that's the case, I do feel sorry for you.

  • Report this Comment On October 24, 2013, at 7:14 PM, TheRealRacc wrote:

    And Apple is not a tech stock, it is consumer discretionary.

  • Report this Comment On October 24, 2013, at 7:16 PM, TMFDanielSparks wrote:

    @thecinimod,

    Thanks for catching that. 2.9 was actually a typo. Should have been 3.9. And both numbers are rounded. If you see Icahn's letter it was a 22% increase.

  • Report this Comment On October 24, 2013, at 8:26 PM, pfinger wrote:

    Before Apple spends all this money on stock manipulation, perhaps they could build out their company by:

    1) Creating a finger-print, iPhone based Apple credit card to compete with Visa, Mastercard and American Express.

    2) Make PC versions of Mavericks, Pages, Numbers and Keynote to replace Windows 8, Chrome and Office.

    3) Similarly, create a version of IOS 7 to take on Android.

    Apple makes the best hardware. Their hardware will always be best suited to their software (keeping its functional superiority). So why not try to flood universe with software that brings people to buy content in the Apple iTunes store.

    Use the money to build the company.

  • Report this Comment On October 24, 2013, at 10:53 PM, thevandman wrote:

    I wholeheartedly agree with pfinger.

  • Report this Comment On October 25, 2013, at 12:53 AM, PMTP wrote:

    So let's see... I sell my stock to the tender offer at $525. Once $150 B worth of stock is offered to the tender, the remaining stock is immediately worth 33% more than the $525 (or $700). So, I can have $525 today or do nothing and have $700 as soon enough people turn in their shares for no premium. This is so ridiculous its funny.

    Surely Icahn knows Tim Cook isn't that dumb. He must think we are.

    Does he really think his 0.5% stake in Apple is big enough to push anyone around?

    If he thinks Apple is his most undervalued holding, why doesn't he do something novel like hold it for a while. I realize that isn't as fun as pillaging a stock and running.

    I may be a Fool but I'm no dummy!

  • Report this Comment On October 26, 2013, at 3:32 AM, chris293 wrote:

    Big deal, more ways to dumb down millions of people by playing games or listening to music while the world burns. Right, Nero? I know we all need to relax sometimes, but we are going to be inserting chips in ourselves one of these days if we are not doing this already.

    r

  • Report this Comment On November 02, 2013, at 10:40 AM, KatBelew wrote:

    I do think Apple will go back up to $750 a share in 2014. Just wait and see.

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