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Why Apple Should Increase Its Buyback in Seven Pages by Carl Icahn

January 23, 2014 | About:
Holly LaFon

Holly LaFon

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Dear Fellow Apple Shareholders,

Over the course of my long career as an investor and as Chairman of Icahn Enterprises, our best performing investments result from opportunities that we like to call "no brainers." Recent examples of such "no brainers" have been our investments in Netflix, Hain Celestial, Chesapeake, Forest Labs and Herbalife, just to name a few. In our opinion, a great example of a "no brainer" in today's market is Apple (AAPL). The S&P 500's price to earnings multiple is 71% higher than Apple's, and if Apple were simply valued at the same multiple, its share price would be $840, which is 52% higher than its current price.1 This is a dramatic valuation disconnect that simply makes no sense to us, and it seems that the company agrees with us on this point. Tim Cook himself has expressed on more than one occasion that Apple is undervalued, and as the company states, it already has in place "the largest share repurchase authorization in history." We believe, however, that this share repurchase authorization can and should be even larger, and effectuating that for the benefit of all of the company's shareholders is the sole intention of our proposal. The company has recommended voting against our proposal for various reasons. It seems to us that the basis of its argument against our proposal is that the company believes, because of the "dynamic competitive landscape" and because its "rapid pace of innovation require[s] unprecedented investment, flexibility and access to resources", it does not currently have enough excess liquidity to increase the size of its repurchase program. Assuming this indeed is the basis for the company's argument, we find its position overly conservative (almost to the point of being irrational), when we consider that the company had $130 billion of net cash as of September 28, 2013 and that consensus earnings are expected to be almost $40 billion next year. Given this massive net cash position and robust earnings generation, Apple is perhaps the most overcapitalized company in corporate history, from our perspective. Regardless of what liquidity it may require with respect to "unprecedented investment, flexibility and access to resources" for innovation moving forward, we believe the unprecedented degree to which the company is currently overcapitalized would overcompensate for any such investments (including possible investments in strategic M&A, to which the company does not refer). Said another way, we believe that the combination of the company's unprecedentedly enormous net cash balance, robust annual earnings, and tremendous borrowing capacity provide more than enough excess liquidity to afford both the use of cash for any necessary ongoing business-related investments in addition to the cash used for the increased share repurchases proposed.

It is our belief that it is the responsibility of the Board, on behalf of the company's shareholders, to take advantage of such a large and unmistakable opportunity. Indeed, we believe that by choosing not to increase the size of the repurchase program, the directors are actually performing a great disservice to the owners, especially smaller shareholders who may not be in a position to buy more stock themselves. Meanwhile, we are in a position to continue buying shares in the market at today's price, so perhaps we should thank the Board for not being more aggressive, and thus allowing us to accumulate an even larger investment position at a price that reflects the aforementioned valuation disconnect. In fact, over the past two weeks we purchased $1 billion more in Apple shares, $500 million of which we purchased today, bringing our total ownership position in Apple to a current value of approximately $3.6 billion.

Given the degree to which Apple appears undervalued to us, we almost feel that it's a waste of time to debate the point. As we believe it to be the preeminent and most innovative consumer products company in the world, with the greatest brand, hardware, software, and services in the world, Apple has had tremendous growth to date, and we fail to see why this growth would not continue moving forward. The industry (smartphones and tablets) is expected to grow volume at a 15% compounded annual growth rate from 2013 through 2017 according to IDC. We believe Apple should continue to benefit from this secular growth, as last year, 85% of Apple's revenues came from smartphones, tablets, and related software, services, and accessories. The naysayers question whether Apple will be able to participate in this growth without sacrificing pricing and gross margins, especially with competition from Google, Samsung, Microsoft, Amazon and Chinese manufacturers. Our response to them is that the answer is already evident to us from the continuing loyalty of Apple's growing customer base. The highly successful evolutionary (not revolutionary) introductions of the iPhone 5s and 5c and Ipad Air and Mini, prove to us that Apple could, for the most part, maintain pricing and gross margin as we believe consumers are willing to pay a reasonable premium for the world's best smartphones and tablets. The rumored future introduction of product line extensions with larger screens for both the iPhone and iPad would further support this view.2 In fact, a recent study from NDC shows that the iPhone accounted for 42% of smartphone users in the United States at the end of 2013, up a staggering 20% from the prior year. Despite its great scale and narrow focus, Apple has an operating margin of just 28.5%. We believe its customers' willingness to pay a premium price for the world's greatest products should enable Apple to participate in the expected volume growth of these categories while at the same time largely maintaining its average selling prices and gross margins. And, as software and services improve and become even more important to consumers in the future, we expect customer loyalty to strengthen further.

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