Icahn's $203 Apple share price target built on rosy assumptions and guesses

Carl Icahn bought Apple (AAPL) shares last year and hit a home run, with the stock up over 50% since. But his call for the shares to double from the current price of $101.90 relies, in part, on optimistic assumptions, guesses and a couple of tax accounting strategies the company is unlikely to heed.

Will Apple be able to sell 20 million smartwatches next year? Turn around lagging iPad sales while increasing the average selling price? Come out with a television set retailing for $1,500 to generate over $50 billion in sales over the next three years? Or shave its tax rate by one-quarter?

Maybe – but maybe not.

“We continue to think that the market misunderstands and dramatically undervalues Apple,” Icahn wrote in a letter to Apple CEO Tim Cook, which he also released publicly on Thursday. “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,” he added.

Related: Icahn -- Apple stock worth $200, Cook should ramp up buyback

As he has in the past, Icahn also called on Cook to increase the company’s stock buyback program, while promising not to sell back any of his firm’s 53 million share holdings. In April Apple increased its stock buyback plan to $90 billion from $60 billion after pressure from Icahn.

But Icahn isn’t relying on buybacks to support his $203 a target price. Instead, it’s his conviction that Apple can reignite growth and increase revenue and profits at rates not seen for the past few years.

Apple’s sales increased 10% for the year ended September 30, 2013 and are on track to increase about 6% in fiscal 2014, according to Wall Street. Icahn says sales could increase 25% next year, double the Wall Street consensus of 12%, according to FactSet.

And net earnings per share, which declined 11% in 2013 and look to increase 12% this year, should increase 44% next year according to Icahn, triple the Wall Street forecast of a 15% gain.

With growth like that – and comparable increases for fiscal 2016 and 2017 – Icahn says Apple shares should trade at 19 times his $9.61 EPS estimate for next year. Add in $21 in cash and you hit Icahn’s $203 target.

The detailed analysis provided in Icahn’s 5,247-word letter makes some sense. Apple’s newest iPhones are proving extremely popular and should grab some market share from large screen phones that run Google’s (GOOGL) Android software. Icahn projects iPhone revenue will increase 30% next year, 7% in 2016 and 10% in 2017.

“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,” Icahn writes.

The $130 billion is higher than the $114 billion Wall Street expects on average, but less than the guesses from some of the more optimistic analysts.

And there are some reasons to have faith in Icahn’s rosy scenario. Not only did Wall Street frequently understimate iPhone growth prior to 2013, but Icahn and his son, Brett, have a strong record picking tech stocks, including mega-winner Netflix (NFLX).

When it comes to iPads, however, Icahn is less convincing. Sales of the Apple tablet declined the past two years but Icahn sees a 13% jump in 2015 thanks to possible revenue from a still-rumored 12.9” model and the recent partnership with IBM driving more corporate sales.

But Icahn never mentions that the iPhone 6 Plus, with its 5.5-inch screen, is widely expected to cut into sales of the iPad mini. Part of the boost in iPhone sales comes from this highly predictable cannibalization. The shift is likely good for Apple’s bottom line -– the 6 Plus carries a higher price and profit than the Mini -– but it’s still likely to be a big drag on iPad sales. And it’s a complete guess to project sales of a vaporware iPad that may or may not be released soon.

Similarly, Icahn’s Apple watch sales estimates are simply guesses without much data. Apple isn’t going to start selling the watches until sometime next year, and has only released the price of the $349 entry-level model. Icahn says Apple can sell 20 million next year, 45 million in 2016 and 72.5 million in 2017, tracing the growth path of the iPad in its first few years, at an average price of $450.

But Apple has only explained a fraction of the watch’s features and said little about battery life, a key concern for consumers. Relying on watch sales for $9 billion, $20.25 billion and $32.625 billion of revenue over the next three years, respectively, seems like guesswork more than analysis at this stage.

And then there’s the great hope of Apple investors everywhere –- an Apple-branded television set. Sure, Tim Cook has said repeatedly that Apple is focused on the TV market, but it’s still far from clear that Apple will market its own sets. Cook could be talking about enhancements to Apple’s $99 set top box or bolstering its video offerings to compete with cable.

But Icahn thinks there will be a $1,500 TV set. “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,” he writes. And his model includes over $50 billion of sales in fiscal 2016 and 2017 from TV sets. Taken together with projected watch sales, Icahn is modeling almost one-quarter of Apple's total revenue coming from these two unknowns in 2017.

Icahn notes that his $203 target is based on his forecast of next year’s earnings, which don’t include his TV prediction. But he justifies his 19 times earnings multiple by referencing projected growth rates for both of those years, including TV set revenue and profits.

Even if Apple never offers a TV, “the impact is not significant enough for us to question using a P/E multiple of 19x,” is Icahn’s non-defense defense of that more realistic scenario.

Finally, Icahn uses a couple of tax accounting maneuvers to close in on the $203 target. Apple reliably cites a tax rate around 26% in its income statements – the rate averaged 25.7% over the past five years – but Icahn says Apple should use a lower rate of 20%. Icahn says Apple, unlike tech companies such as Google, do not accrue taxes to cover unremitted international earnings so they can cite a 20% rate.

But Apple’s own securities filings claim the company is not withholding taxes on such non-U.S. earnings.
“The Company’s effective tax rates for all periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S.,” Apple says in its most recent 10-K, dated October 30, 2013.

Tax games also place a role in the way Icahn values Apple’s cash hoard as well. Analysts and investors typically shave the value of cash held overseas by the 35% U.S. rate companies would have to pay to bring the money back home. Apple held $137 billion overseas, leading to a $48 billion haircut.

But Icahn asserts that the tax on repatriation will “ultimately be 6%,” even though Congress has made zero progress in pushing such a plan. After subtracting $31 billion for debt, he values the remaining cash at $125 billion, or $21 a share. With the 35% rate, cash would be closer to $81 billion, assuming almost all the buyback was done with domestic cash, or about $7 less per share than Icahn assumes.

Icahn is one of the savviest investors on the planet, with an enviable track record. And he could be right about Apple again. But there are plenty of reasons to be careful given the analysis he’s put forward.