Icahn’s Ten Key Points About Apple

Investor extraordinaire Carl Icahn sees Apple Pay as one of several factors that is going to propel the Apple and its new iPhones. In a letter to Apple CEO Tim Cook on Thursday (Oct. 9), Icahn offered a variety of observations and insights into what is doing and what it should be doing. These are our top ten favorite parts.

1)      Apple Pay

“As our model highlights, much like the success of iPhone and iPad before it, we expect the successful launch of new premium product platforms (the announced Apple Watch in FY 2015 and the rumored TV in FY 2016) along with new services (in particular Apple Pay). These new launches will further distance Apple’s ecosystem from its peers and accelerate revenue and earnings growth in excess of the status quo.”

Icahn is arguing that these shiny new features will only prompt existing iPhone users to upgrade, but will give fresh powerful reasons for current users of Android, Blackberry and other platforms to consider Apple-izing.

“As the home represents one compelling category for Apple, payments represents another. Apple Pay will launch in October 2014, and while we expect limited financial impact in FY 2015 as retailers upgrade their infrastructure to incorporate the requisite near-field communications technology (NFC), we expect a more meaningful contribution in FY 2016 that accelerates into FY 2017 and the following years. We estimate that, based upon Apple Pay’s rumored fee of 15 bps of all spend on credit and debit cards (U.S. card spend was $4.2 trillion in 2012) and merchant deployment of NFC reaching 80+ percent in 2017, Apple in the U.S. could generate revenues (also equivalent to gross margins, as the variable costs are de minimis) of $2.5 billion in FY 2017 if it reaches 30 percent market share of all spend on U.S. credit and debit cards. The potential in the U.S. and internationally over a longer term is much larger. Apple, dominant in the premium market, has customers who spend more on average than its peers, and it is therefore unusually well positioned to succeed with Apple Pay where others could not.”

Icahn’s 80+ percent NFC merchant deployment figure for 2017 is unattributed, but it might be from a 2012 report from Swedish research firm Berg Insight that predicted that the NFC penetration of North American merchants in 2017 would be 86 percent. But a lot has changed NFC-wise since 2012.

2)      Impact on Competitor Google

Icahn makes his case that Google’s Android is going to have a difficult time competing against Apple’s new phones.

“It is truly a watershed moment, with Apple poised to take marketshare from Google (Android) in the premium device market as iPhone 6 becomes Apple’s flagship device among a growing collection of products and services that work together to form an increasingly dominant mobile ecosystem. We believe this advantaged position over Google, the company’s only real competitor, justifies our forecasts for revenue and EPS (earnings per share) growth of 25 percent and 44 percent respectively for FY (fiscal year) 2015. ”

“Analogizing Apple to a modern day Secretariat, as this race continues, the further the distance grows between Apple and Google (and Google’s hardware partners) in the premium device category. Its leading ecosystem of products and services, added to peerless hardware design and quality, differentiates Apple from a simple hardware company. And, with its users consistently upgrading to the newest version of iOS (92 percent of iOS devices, iPhones and iPads, on iOS 7 prior to the launch of iOS 8), Apple is able to offer its users the most up to date software and service experience, while Android can’t because it’s hindered by relatively high fragmentation among its operating system versions. App developers appreciate the difference, which is why they often choose to make an App for iOS prior to (or instead of) Android.”

3)      iPhone Marketshare

The uber investor has come up with arguably the dullest analogy of the excitement of owning a new iPhone.

“Given historically high retention rates, we assume existing iPhone users will continue to act like an annuity, choosing to stay with the iPhone each time they upgrade.”

Maybe a new ad campaign for Apple? “Buy the new iPhone. It’s as exciting as an insurance annuity.”

Icahn continued his predictions for the iPhone’s new marketshare. “Since the iPhone 6 is the most significant improvement to the iPhone since its introduction, we expect users of competitive products to see the iPhone 6/6+ as an exciting opportunity to choose a superior product. Now that iPhone offers a larger screen size, its price competitiveness in the premium phone market is clear, as a premium Android phone such as the Galaxy S5 and Note 4 sells at a similar price point to the iPhone 6 and 6+ respectively. The choice between them is analogous to the choice between a Volkswagen over a Mercedes at the same price, and unlike a Mercedes, the $649 cost of an iPhone 6 is affordable for the mass market, equating to just $20 per month over a two year period (including a $170 estimated resale value of the phone at the end of two years, excluding financing and taxes). We see the iPhone remaining unaffected by the “junk”, as you called it, sold at lower price points, but we also see it dominating the entire class of premium Android smartphones, such as Samsung’s Galaxy phones.”

4)      Repurchasing Apple Shares

From Wall Street’s perspective, the most interesting Icahn comments involved share repurchasing.

“Given the persistently excessive liquidity of $133 billion net cash on Apple’s balance sheet, we ask you to present to the rest of the Board our request for the company to make a tender offer, which would meaningfully accelerate and increase the magnitude of share repurchases. We thank you for being receptive to us the last time we requested an increase in share repurchases, and we thank you in advance now for any influence you may choose to have communicating to the rest of the Board the degree to which a tender offer would have a positive impact on an EPS basis for all shareholders. To preemptively diffuse any cynical criticism that you may encounter with respect to our request, which might claim that we are requesting a tender offer with the intention of tendering our own shares, we hereby commit not to tender any of our shares if the company consummates any form of a tender offer at any price. We commit to this because we believe Apple remains dramatically undervalued. And we think you and the Board agree.

“If you did not, you would not continue to repurchase shares under the existing authorization. You have said before that the company likes to be “opportunistic” when repurchasing shares and we appreciate that. With this letter we simply hope to express to you that now is a very opportunistic time to do so. We think a tender offer is simply a good method of conducting a large repurchase in an expedited timeframe, but the exact method and the exact size is not the key issue for us. We are simply asking you to help us convince the board to repurchase a lot more, and sooner. We feel compelled to do so because we forecast such impressive earnings growth over the next few years, and therefore we believe Apple is dramatically undervalued in today’s market, and the more shares repurchased now, the more each remaining shareholder will benefit from that earnings growth.”

5)      Apple’s Ecosystem

Icahn’s argument here is that Apple is not creating an extensive ecosystem, but is laying a foundation where consumers who buy two or three of them have a strong incentive to buy more.

“In addition to iPhone 6 market share gains, we assume that earnings growth will be driven by successful innovations and launches of other products and platforms. To properly forecast future earnings for the purposes of valuation, we assume further innovation on existing product lines and services (such as the larger screen iPhone 6 and 6+), but also assume that launches of new product platforms and new services will happen, predict what they might be, and estimate and include the potential earnings from such innovation and launches into forecasted future-year earnings. As our model highlights, much like the success of iPhone and iPad before it, we expect the successful launch of new premium product platforms (the announced Apple Watch in FY 2015 and the rumored TV in FY 2016) along with new services (in particular Apple Pay). These new launches will further distance Apple’s ecosystem from its peers and accelerate revenue and earnings growth in excess of the status quo. For the next three fiscal years, we forecast robust earnings growth of 44 percent, 30 percent, and 30 percent respectively, driven by strong revenue growth of 25 percent, 21 percent, and 21 percent respectively. We detail below how we arrive at these forecasts.”

6)      iPad/Mac

And music, which used to be the heart and soul of Apple hardware, is still musical to Icahn.

“Contributing 17 percent to net sales, iPad has experienced tremendous growth since its introduction in 2010. After a disappointing FY 2014, we believe the iPad will reaccelerate growth next year, especially if Apple, as rumored, offers a larger screen 12.9” iPad in FY 2015 and improves the offering of its 7.9” iPad Mini and its 9.7” iPad Air. We believe there is still a large growth opportunity for iPad. With the recently announced partnership with IBM, we believe iPad will increase its penetration of enterprise.

For next fiscal year, the new iPad innovation and IBM partnership should drive iPad revenue growth of 13 percent, due to volume growth of 8 percent (innovation, larger iPad, IBM partnership) and pricing growth of 4 percent (mix shift to the rumored higher priced iPad). In each of the following years, FY 2016 and FY 2017, we expect revenue growth of 13 percent on relatively flat average selling prices as the ecosystem and IBM partnership continue to drive sales. Contributing 13 percent to net sales, Mac in contrast to the overall PC market, has grown market share to maintain its volume and sales. We expect Mac to continue this steady performance going forward and hold net sales flat over the next three years. While we are not yet prepared to make near term adjustments to raise our forecasts for the next three years, we do believe Apple may be able to innovate even further across the iPad/Mac platforms. Some see a larger iPad as a necessity if Apple is going to transform iOS into a hybrid desktop/tablet operating system by adding a keyboard/mouse centric user interface to iOS, while at the same time maintaining its touch-friendly user interface. With a near 13” model, Apple would have a screen size lineup that overlaps their Macbook Air line, a promising path into the $63 billion sub $1,000 laptop market in which Apple barely participates today, according to Rod Hall at JP Morgan.”

7)      iTunes, iPod

” These three segments, contributing 10 percent, 3 percent and 1 percent to net sales respectively, fill out the remaining portion of Apple’s current net sales mix. iTunes, Software and Services are not only important to Apple’s ecosystem in terms of driving sales of its products, but also in terms of its own long term revenue growth. This represents one of Apple’s faster growing segments and one we expect to not only continue its double digit top line growth but also to disproportionately benefit gross margins as higher margin services (such as 100 percent margin App Store sales revenues) compose a greater portion of the sales. As for Accessories and iPod, we expect the impact of the acquisition of Beats and accessory growth moving forward to more than offset the continued decline of iPod, which is already relatively immaterial to net sales.”

8)      Apple Watch

“Over the next three years, we expect the Apple Watch to have a significant impact on Apple’s growth. Apple’s first new product category since the iPad in 2010, and the company’s first foray into wearables, the Apple Watch will launch early next calendar year. It appears to us that Jony Ive and his team have yet again executed at a level that will bring to market a product that revolutionizes the entire category from both a hardware and software perspective, especially given that Apple has developed an entirely new operating system for this device, and catered to the notion that such a device needs to be far more fashionable and personal than other products currently available in this category. As an accessory to the iPhone (model 5 or thereafter), we believe we have included in our forecast sales for the Apple Watch that imply a reasonable attach rate to the iPhone, with unit sales volume resembling that of the iPad in scale, and ramping at a similar incline, selling 20 million units in FY 2015, 45 million units in FY 2016, 72.5 million units in 2017. Although the sales mix between collections, the attach rate of bands to each watch, and the related prices remain unknown, we expect the average selling price to exceed the entry level price of $350, forecasting an average selling price of $450 per unit, including the extra band.”

9)      UltraHD TV

“While Apple has not announced plans for a TV set and may never do so, we believe we have good enough reason to expect the introduction of an UltraHD TV set in FY 2016. We think television represents a large opportunity for Apple, one that reaches far beyond “the hobby” that Apple TV currently represents. You recently stated, “TV is an area of great interest for Apple” and we agree that it should be. As we highlighted in our previous letter, we believe UltraHD’s (ultra-high-definition television) superior picture quality in comparison to regular HD will drive a major TV replacement cycle as the price gap between them narrows. It should also be noted that Reed Hastings, CEO of Netflix, has referenced UltraHD as a major catalyst for Netflix going forward, and while this is true for Netflix, we believe it is also true for Apple. Against the backdrop of this replacement cycle, FY 2016 represents an opportune time to introduce an UltraHD TV set. Therefore, included in our forecasts, we expect Apple to sell 12 million 55” and 65” TV sets in FY 2016 and 25 million in FY 2017 at an average selling price of $1,500 at gross margins consistent with the overall company. While we think adding a TV set to the Apple ecosystem would be meaningful from a financial perspective, we understand that you may choose not to do so, as you have wisely stated that “the toughest choices for Apple are what not to work on.” But, even if Apple chooses not to offer a TV set, our earnings estimates would only be revised for FY 2016 and FY 2017, and the impact is not significant enough for us to question using a P/E multiple of 19x our FY 2015 EPS for Apple today, especially since, even without a TV set, our forecast shows EPS growth of 19 percent in FY 2016 and 23 percent in FY 2017. While the UltraHD replacement cycle alone offers a compelling revenue opportunity, the opportunity is not limited to the sales of an UltraHD TV. Televisions are a centerpiece to the modern living room and thereby a promising gateway into the home for Apple’s growing ecosystem. Apple could sell UltraHD movies and shows through iTunes over the internet to the UltraHD TV since cable companies will likely be slow to upgrade their expensive linear infrastructure, as one example of an incremental opportunity. Another is the user interface of television, which you humorously (but accurately, in our opinion) described as being “stuck in the 1970s.””

10)   HomeKit/HealthKit

” But like so many of Apple’s opportunities, an UltraHD TV is just one possible point of entry to a much broader overall opportunity, as the living room is just one room in the home and Apple’s growing ecosystem makes the entire home an approachable venue. For example, Apple’s recently released HomeKit, a framework in iOS 8 for communicating with and controlling connected accessories in a user’s home from the iPhone and Apple Watch. The point here is, when considering the overall ecosystem, the iPhone and the Apple Watch become control devices for both the television in the living room, as well as the lights in the living room and throughout the entire house, and the lock for the front door, the thermostat, the alarm system, etc. You said publicly that you enjoy using your Apple Watch as a remote control for your TV, and we look forward to joining you. But we also assume you will soon enjoy using your Apple Watch to control many more devices in your home. The recently released HealthKit platform represents another similarly large opportunity, and while the details of the business model are still unclear, just as they are for the home category, the degree to which both could impact their respective venues is immense. At a minimum, these new efforts in Health and Home will strengthen the Apple ecosystem and drive product sales of the Apple Watch and iPhone. Though it is likely Apple will monetize HomeKit and HealthKit in some way going forward, we have not included any revenues from these emerging platforms in our forecast for the next three years.”