- Obviously, Carl Icahn knows what he's talking about. At this point, I'm nitpicking on some of his outward growth assumptions.
- Unlike Carl, I think the Apple iPhone and Apple Watch will take up a higher percentage of the overall sales mix, which will move gross margins even higher.
- An increase in gross margins will have a more drastic impact on EPS, therefore, his model could be off by a significant amount.
- While his 2015 price target could prove unrealistic, his 2016 price target could be attainable, as the stock is pretty cheap and will take a while to reach 18x earnings.
- I continue to maintain my FY 2015 Apple EPS and CY 2015 Apple stock price target ($10.22 and $194 respectively).
Carl Icahn released the next installment of his Apple (NASDAQ:AAPL) letter to Tim Cook recently, and while I don’t necessarily agree with everything Carl Icahn publishes in his letter, I agree with a lot of what he has to say.
Carl Icahn is pretty conservative on his Apple EPS estimate, as there’s still some room for Apple’s EPS figure to improve when taking into consideration gross margin expansion due to a sales mix shift to higher margin categories. This is driven by iPhone shipments, as shipment may continue to grow at a better than expected rate for FY 2015 & FY 2016. Preliminary data from UBS indicates that there could be room for some smartphone acceleration, which is partially attributable to foreign demand, and the lack of supply in the earlier stages of launch for the current generation iPhone.
Remember, Apple slowly rolled out the launch of the iPhone 6 and 6 Plus in varying markets. And in Q1 FY 2015, there wasn’t sufficient supply for those wanting to buy the iPhone. Also, in any given quarter, two-year phone contracts are going to expire, which gives Apple the ability to gain market share against lower-tier brands that have yet to establish a fully functioning device ecosystem. Also, the price point of a high-end iPhone is low enough to attract users from low to mid end devices. As it currently stands, anyone caught using lower-end devices is thought to be underprivileged, so keeping up with the Jonses does require the purchase of a premium smartphone device, especially in the millennial generation, which is a bulging demographic in the United States.
The additional earnings and revenue from the iPhone could materially alter FY 2015 and FY 2016 expectations on a consensus basis over the next 18 months. Therefore, Carl Icahn’s EPS figure for FY 2015 and FY 2016 could be conservative. And while I think there’s a rational reason for why his team of analysts and managers are attempting to remain practical, supply chain reports from UBS and JP Morgan indicate that back-half surprises could be in store.
EPS will surprise as the iPhone carries higher gross margins than the consolidated gross margin figure. Icahn anticipates consolidated gross margins to stay steady at 40% over the foreseeable three years. I disagree with that; gross margin should trend higher at a run rate of 100 to 200 basis points over the next three years. Hence, my EPS estimate for FY 2015 is $10.22, which is higher than Icahn’s EPS estimate of $9.60.
According to prior court documents, the Apple iPhone has a 49% to 58% gross margin. Since 2012, the gross margin on the iPhone has increased, due to bigger memory & screen configurations. When taking into consideration the fact that gross margins could improve by 100 to 200 basis points prior to the end of the current fiscal year, Apple can easily hop over its own gross margin outlook, and the expectations set by sell-side analysts.
The Apple Watch isn’t going to be a huge contributor to EPS, but as the product scales production, and various costs are spread over a wider base of units, I believe that OpEx leverage will continue to materialize between the Apple Watch and Apple iPhone over the next three-years. Therefore, reported and expected profit margins should trend higher, as sell-side and buy-side analysts will begin to chase the stock with higher price targets. Analysts and fund managers will move numbers around in their CAPM and non-CAPM models, I assure you.
The P/E multiple of Apple stock continues to trend higher, in-line with my comments on earnings multiple expansion. The stock is getting more expensive on other value-metrics too, which is why it’s redundant for me to waste my time pulling up EV/EBITDA, P/S, and P/FCF metrics. The stock will continue to attract flows of capital, as both institutional and retail investors will increase portfolio weightings, due to comparative opportunity cost, and changes in indices weightings.
Efficient market theorists would argue that all the available information is already priced into the stock. But not so, from my point of view, the world of CAPM is a mythical world created out of modeled risk behavior that may not be congruent with the actual behavior of market participants. Funds are under-invested in Apple, which indicates that there should be pent-up demand for Apple stock going into the back half of the year, which should lead to lower volume and accumulation of shares. The unwillingness to sell, and the overwhelming desire to own a piece of Apple’s pie will drive the stock price higher (no pun intended).
The inclusion to the Dow component, and the reduction in free-floating shares due to the expansion of the share buyback program also supports the $193.48 price target in my Apple stocs analysis. A $1 trillion market cap is a theoretical limit from the context of technical traders. Some could argue that anyone chasing the stock beyond $1 trillion will be disappointed. However, there’s technically no upper-limit to the value of a stock, as inflation can go on for ad infinitum, or until publicly traded markets no longer exist.
In this case, Apple’s growth rate is well ahead of inflation adjustments, so the problem could be a lack of currency in relation to Apple. However, with currency being a global market, I could imagine foreign investors just as aggressive as domestic investors. Therefore, Apple’s market cap shouldn’t be compared to just U.S. stocks, but to the global stock market float, which is $69 trillion, according to McKinsey Global Institute, Haver, BIS, Deutsche Bank estimates. Since Apple derives its revenue globally, it would be unfair to make the case that it’s big in relation to the U.S. stock market. Instead, the comparison should be made to global markets, and global market flows, because Apple has gotten to that “size.” In that case, $1 trillion is still a small pond in a large ocean of capital, as global financial assets total $294 trillion, according to the aforementioned source.
Therefore, I believe that it’s a fallacy to discount the value of the stock, simply because its market cap is the largest in the world. In economics, free lunch opportunities do exist, and at any given point, the free lunch opportunity may last for extended or shortened durations. Sometimes stocks are cheap, and while rational behavior should lead to a narrowing of the market value and intrinsic value, that reality doesn’t always materialize for a period of time. In this case, Apple is cheap, but will that reality continue to be the same? Of course not, the premium over earnings and various other metrics has trended higher over the trailing three-year period. Therefore, price equilibrium is starting to settle in, which indicates that the stock is still catching up to its implied value in comparison to the broader market. This will take time, which most growth-oriented investors have plenty of.
Apple is a multi-year growth story, but that doesn’t mean that it will release new product categories at the pace that Carl Icahn mentions in his letter. Perhaps a TV won’t come out for five to six years, and it’s not exactly clear whether televisions will retain its current market position in comparison to virtual reality, or actual reality headsets. The points of differentiation for the TV is driven by the quality of the display, but with PCs coming with comparable displays in smaller form factors, it may mean that the TV will become less of the all encompassing device form factor it once was. Therefore, the market could ultimately shrink for certain device categories, and Apple may avoid engaging in markets until it can create a uniquely differentiated solution. In the case of TVs, Apple will need to engineer something that’s unique, intuitive, and useful, that also integrates into its software ecosystem. Even with a never-ending supply of R&D resources, this will be difficult to accomplish. Therefore, TVs may not ever come into the picture. Or if they do, it may mean a 2020 launch.
Cars are also an interesting market, but it’s not clear whether Apple will create an automobile or a software ecosystem for automobiles. Clearly, Apple is both a hardware and software company. However, creating cars isn’t really in Apple’s genetics. It could be at some point, but right now, there’s a lot of speculation around project Titan. It could be scrapped, or Apple creates a flop. We don’t know the outcome of a product that has yet to be rated by critics. Not to mention, I have yet to come across reliable survey data that indicates that there’s demand for an Apple branded car, and with hardly any data on the car specifications it’s probably better to leave the Apple Car out of multi-decade growth projections.
As I have already mentioned, I agree with a lot of what Carl Icahn mentions in his shareholder letter. He probably should have modeled a higher gross margin figure, a higher growth rate for the iPhone, and should not have included the Apple TV into his forecast. Needless to say, the projected multiple seems realistic in light of continued earnings multiple expansion and his revenue estimate seems similar to my sales estimate. Maybe his price target is high for FY 2015, but by FY 2016 it will likely even out due to investors chasing the stock due to sustained growth in the iPhone, and easing of skepticism towards U.S. stocks following the Fed’s interest rate hike.
I continue to reiterate my high conviction buy rating, and $194 price target.