billion of assets under management as of September 30, 2014. We believe this performance speaks for itself with respect to our expertise. At today’s price, Apple is one of the best investments we have ever seen from a risk reward perspective, and the size of our position is a testament to this. This investment represents the largest position in our investment history, reflecting the strength of the convictions we have expressed in this letter. While we recognize and applaud the company’s previously increased share repurchase authorization, we ask you to consider our advice once again (to the benefit of all shareholders) and consider accelerating share repurchases again via a tender offer. Our valuation analysis tells us that Apple should trade at $203 per share today, and we believe the disconnect between that price and today’s price reflects an undervaluation anomaly that will soon disappear. Mutual funds today face fierce competition with index funds that simply match the S&P500 index (in which Apple has a weight of 3.4%). Surprisingly, many mutual funds are underweight Apple, meaning that Apple represents less than 3.4% of their overall portfolio. This also means they are more likely to underperform the index if Apple outperforms, which is obviously an eventuality that should concern them. With more and more funds flowing from mutual funds to index funds (because mutual funds have consistently failed to outperform) the last thing they will want to see is their underperformance exacerbated by remaining underweight Apple as it continues to outperform. As the strength of the earnings growth we forecast materializes, and these funds scramble to correct this mistake, only to find themselves competing in the market to do so, a de facto short squeeze may occur, and we can only hope that the company has repurchased all the shares it can before that happens.
Carl C. Icahn
REMAINING KEY ASSUMPTIONS
Gross Margins – higher average selling prices, scale, higher margin new services such as Apple Pay, and our expectation that new product platforms (Apple Watch, TV) will have margins consistent with the overall company, together support gross margins rising from 38.5% in FY 2014 to 40% in FY 2015, and remain at 40% for both FY 2016 and FY 2017.
Research & Development “R&D” – we expect continued heavy investment in R&D, rising 17.5%, 15%, and 13% over the next three years to $9.2 billion in FY 2017 (up from $1.8 billion spent in FY 2010) as Apple continues to innovate aggressively.
Selling, General, & Administrative “SG&A” – we expect continued investment in SG&A, as it rises by 6.5%, 6%, and 5% over the next three fiscal years.
Interest Income – with regards to interest income, since we value the net cash separately from the business, we assume no interest income from the $133 billion of net cash in our earnings forecast.
Effective Tax Rate – importantly for the company’s income tax rate, we consider 20% a more appropriate tax rate for the purposes of forecasting real earnings, not the 26% effective tax rate Apple uses in their income statement. Most companies in the S&P 500 state that they plan to permanently reinvest its international earnings and therefore do not have to accrue for an income tax on unremitted earnings and thus show a lower tax rate. Google is a good example of this, as its effective tax rate is 20%. Apple, unlike Google and most companies in the S&P 500 has chosen to accrue income taxes on some of its unremitted international earnings and accordingly has an effective tax rate of 26%. Therefore, when assessing the multiple of earnings at which Apple should trade, we believe it is appropriate to use a 20% tax rate for Apple in order to make such comparisons Apples to Apples, no pun intended.
Share Repurchases – we assume Apple continues to repurchase $25 billion of stock per year for our forecast and not the more aggressive pace we hope this Board will undertake
Cash Flow – for simplicity purposes, we assume net income equals cash flow other than dividends and share repurchases.
Valuation – with regards to valuation of the company at $203 per share, this includes valuing the business $192 per share (at 19x our FY 2015 earnings estimate of $9.61 per share) plus net cash per share of $21 ($133 billion of net cash less the tax effect on international cash for repatriation, which we estimate to ultimately be 6%, and for simplicity purposes, apply to all cash on balance sheet rather than just the international cash).