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By Brian Colello, CPA | 10-10-2014 09:00 AM

Icahn Overly Optimistic on Apple

Apple can still gain share in the high end of the smartphone market, but activist investor Carl Icahn’s projections and $1.2 trillion valuation for the firm are too rosy, says Morningstar’s Brian Colello.

Brian Colello: Carl Icahn issued an open letter to Tim Cook and Apple (AAPL) requesting greater stock buybacks. They think the stock is materially undervalued. They outlined a host of projections on what the stock is worth, and they think it's worth about $203 a share, which implies about a $1.2 trillion market cap. So, they see material upside from here.

We think the letter has overly optimistic projections for three main reasons. The first is that they are fairly dismissive of commodification. We think there is still a real risk that good enough products made by Android competitors will eat into Apple's market share and will always put pressure on the company in the long term. Apple is doing extremely well with its iPhone 6 launch. They will probably continue to gain share over Android in the long term. But if manufacturers issue products with 80% of the features for 50% of the price, which is what Xiaomi is doing in China, or products with 50% of the features at 10% of the price, which some of the low-end smartphone competitors are doing, we think that's a problem. We think that hundreds of millions of customers will gravitate toward those lower-end devices. So, regardless of Apple's strength on the high end, there is always going to be that low-end competition that weighs on them.

The second reason is that we think there's a bit of double-counting in these optimistic projections. Any single projection may happen in the long term. They are probably more bullish than what we think in terms of iPhone and iPad projections, but any one of [their projections] may occur, but we think it's unlikely that all of them will occur at once. If the iPhone sees tremendous growth, particularly on the higher-screen phones at high ASPs [average sales prices], we think that will cannibalize iPad sales, and particularly the iPad mini. Similarly, if enterprise iPad adoption occurs in great numbers, that will probably weigh on consumer iPad adoption. So, it's hard to see Apple firing on all of these cylinders at exactly the same time.

Our third concern, and this is debatable. It's more of a question than an answer. But what would happen to Apple as it approaches a $1 trillion market cap? Are there enough investors to continue buying the stock if it's already a substantial part of their portfolio? Are there enough investors out there to continue buying when it makes up an $800 billion to $900 billion market cap? Basically, regardless of P/E or cash flow or even what weighting it has in the index, is it possible that Apple could potentially be too big of an investment at a $1 trillion price target? Since we don't see Apple approaching $1 trillion anytime soon, that's not something we are concerned about and, quite frankly, we don't look at stocks that way here at Morningstar. But if you are going to be that bullish about the company and think that Apple is worth that sort of market cap, I think it's something that investors would need to get comfortable with.

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