Icahn's Letter To Apple Leaves Out Some Key Points

Carl Icahn tweeted on Thursday, January 23, announcing that he had bought another $500 million of Apple Apple's stock that day ($1 billon over the past week) bringing his total to $3.6 billion and published a seven page letter to shareholders on why the company's buyback should be markedly increased and executed faster. (Note that my family and I own Apple shares and have sold put options which is a bullish strategy).

Agree that the shares are undervalued and the company should buyback shares quickly

I agree that the shares are undervalued (I own them and my target price is $630) and would like to see them repurchased as quickly as possible. It also makes sense to borrow money at this time as it should only get more expensive as the Fed tapers further.

Icahn does point out the company's positives such as the ecosystem it has developed and potential for wearables, TVs and a payment platform. Overall I believe few would disagree that the company should be buying back stock and doing it quickly. The question is how much to buyback and when.

$50 billion buyback in 2014 would drive Apple to borrow at least $20 billion and risk a credit downgrade

From a note I wrote last week Apple spent $10.6 billion for dividends in fiscal 2013 while it generated about $13.5 billion in U.S. cash, up from $11.4 billion in fiscal 2012.

Icahn wrote "Given that the company has $130 billion of net cash and $40 billion of expected annual earnings, and the fact that it is hard to find a better time in history to borrow money, a $50 billion share repurchase over the course of fiscal year 2014 seems more than reasonable to us. Apple could either continue to carry this debt, repay it from its domestic earnings over time, or repatriate cash from abroad upon the passage of corporate tax reform."

To accomplish this the company would have to spend all of its U.S. cash of $35 billion, about $5 billion of cash that it should generate after paying the dividend and borrow $10 billion. This would leave Apple with no U.S. cash. Since Apple wouldn't put itself in that position it would have to take on more debt but could run into a potential rating downgrade if it takes on more than $10 billion in debt per a Moody's report in December.

From a financial perspective Apple could take on more debt, have its credit downgraded and pay what would probably be a slightly higher interest rate. However, I don't think management will do that or want to do it planning for a lower tax rate on overseas cash becoming eventually enacted by Congress. Mathematically it pencils out but that isn't the way to run a business.

Only U.S. cash can be used for dividends and share buybacks

In fiscal 2013 Apple spent $22.9 billion on share buybacks and $10.6 billion for dividends ($33.5 billion in total). Apple took on $17 billion in debt and used $16.5 billion of U.S. cash to make up the difference. Since the company's U.S. based cash decreased by about $3 billion for the year it generated about $13.5 billion in U.S. cash vs. about $11.4 billion in fiscal 2012.

Through calendar 2015 Apple will need over $20 billion to pay dividends and has over $37 billion remaining in its buyback program for $57 billion in total. Assuming that U.S. cash generation increases to $15 billion per year ($30 billion in total for two years) it will need to use about $27 billion of its remaining $35.5 billion that it had as of September 2013 or take on more debt.

Icahn is being very optimistic on how much money Apple can generate from the TV market

In Icahn's letter he wrote "With 238 million TVs sold globally in 2012, it would not surprise us if Apple could sell 25 million new Apple ultra high definition televisions at $1,600 per unit, especially when considering both its track record of introducing best in class products and its market share in smartphones and tablets. At a gross margin of 37.7%, which would be consistent with that of the overall company, such a debut would add $40 billion of revenues and $15 billion to operating income annually."

These assumptions are optimistic to me. With a 60 inch Sharp Sharp HDTV selling for $1,300, Vizio's at $800 and Samsung's 55 inch at $1,000 on Best Buy Best Buy's website I believe it will be difficult for Apple to capture 10% of the global TV market at a $1,600 price point.

Next the TV market is extremely competitive with brutal price competition. Based on how the current TV manufacturers are faring Icahn's assumption that Apple can obtain the company's average 37.7% gross margins is aggressive.