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Dell LBO Looms Large Over Icahn's Apple Activism

Stocks in this article: AAPL DELL

Updated from 7:00 a.m. ET to reflect opening Apple share price

NEW YORK ( TheStreet) -- It's hard not to see Carl Icahn's two recent activist plays as closely related.

In August, Icahn took to Twitter to make the case for an expanded share buyback at Apple (AAPL) just weeks after he had hit a wall in pressing for a leveraged recapitalization of struggling PC-maker Dell (DELL) to trump the firm's eventual $24.9 billion leveraged buyout.

Comparing Icahn's advice to Apple CEO Tim Cook with his complaints against Michael Dell, who now will own a majority interest in Dell, contextualizes issues that loom large over cash rich firms across Corporate America such as Microsoft (MFST), IBM (IBM), Hewlett-Packard (HPQ), Wal-Mart (WMT) and Pfizer (PFE).

How aggressively should mature corporations facing the uncertainty of new competitive threats pursue share buybacks or other returns of capital to investors?

In the case of Dell, five year's worth of share buybacks far above the firm's eventual takeover price proved to be a huge waste of money for investors. At the same time, Dell's over $13 billion in idle cash helped Michael Dell and private equity Silver Lake Partners finance the biggest leveraged buyout since 2007, in what Icahn deemed a "great giveaway."

Icahn proposed that Dell instead pay a special dividend with its unused cash and focus on growing the cloud software and IT assets the company had bought in a multi-year acquisition binge. It was certainly a risky strategy that included billions of dollars in financing with strings-attached. Ultimately, Icahn lost for a variety of factors, some unrelated to the merit of activist proposals.

Now after concluding his battle for Dell with a profit, Icahn believes Apple should significantly up its share buyback program, even after the iPhone maker instituted a $100 billion program to return of cash to investors by the end of 2015, some of it funded through a $17 billion debt offering that was the largest in U.S. corporate history at the time.

According to Icahn, Apple shares are significantly undervalued given their price-to-earnings (PE) multiple of about eight times the company's consensus forward earnings estimate. That multiple is significantly below the overall PE ratio of the S&P 500, according to Bloomberg data. If the company can buy its shares at a deep discount to the prevailing market multiple, Icahn believes investors will be enriched over the long run.

But Icahn's recommendation for Apple faces the same risks that he pointed out at Dell.

Michael Dell ramped up Dell's share buyback in the wake of the Great Recession, only to see a swiftly declining PC-market pressure the firm's earnings and push its share price below $10. In retrospect, Dell's buyback plan was a disaster. And yet, Dell's offshore cash stockpile made it an easier target for LBO buyers at the start of 2013. What a quagmire.

Icahn wants Apple to increase its share buyback to $150 billion, an amount that is nearly three times the firm's current authorization and is equal to the cash and cash equivalents currently sitting on its balance sheet. All of Apple's R&D, capital expenditure, interest expense and operational costs can be financed by Apple's about $40 billion in annual free cash flow, according to Icahn's logic. In fact, new data from Moody's indicates Apple's cash stockpile continues to grow even as it embarks on $11 billion in annual dividend payments and far larger buybacks.

If Apple's sales and cash flow continue to grow as the company pushes into China and users continue to upgrade to new iterations of the iPhone and iPad, the share buybacks Icahn is advocating could position it for even more impressive earnings growth in coming years. If, however, factors such as declining average selling prices on mobile devices continue to depress Apple's profits, as they have at certain times in 2013, share buybacks could eventually appear misguided.

In an extreme scenario, today's incremental debt to finance share buybacks and a smaller cash cushion could wind up restricting Apple from investing in emerging technological opportunities. Hewlett-Packard and Dell all but gave up on fast-growing consumer tablet and smartphone markets as a result of their financial challenges.

At a dinner on Monday, Icahn told CNBC he and CEO Tim Cook spoke about the increased buyback and they will meet again in a few weeks. Icahn was optimistic his financial recommendations would carry the day, however, he also said he won't go away quietly if management continues to idle Apple's cash.

Could Icahn eventually pull a similar move at Apple as he did with Dell, in unveiling some form of tender offer or leveraged recapitalization?

The activist has already invested $2 billion in Apple and will be a buyer of shares if they fall, according to his Tuesday CNBC interview. In theory, Icahn could significantly increase his investment in Apple.

With the financial terms of Dell's LBO in mind, there isn't much stopping Icahn from offering up an even more aggressive proposal for Apple. All one would need is an unthinkable amount of debt financing to match Apple's awesome earnings power and the support of shareholders.

Such a proposal would clearly be taken as an absurdity, but the numbers do add up.

If one were to leverage Apple to six times the company's forecast $58 billion in 2014 earnings before interest, taxes, depreciation and amortization (EBITDA), the same multiple used in Dell's takeover, financing could fund most of a deal given the company's current enterprise value of about $315 billion.

Ring up a few shareholders to roll in their stakes into a deal, as Icahn did with Dell, or find a private equity consortium to throw in some equity, and presto a deal is in the works!

While an Apple LBO is clearly speculation at its most extreme, such a hypothetical coupled with the firm's possible resistance to additional buybacks highlights challenges that many of America's most widely held corporations face. Apple is simply the best example.

The top 50 cash generating non-financial corporations in the U.S. hold, in total, nearly $1 trillion in unused cash on their balance sheets, according to data released by Moody's on Sept. 30. The tech sector, alone, accounts for over half of Corporate America's cash stockpile and that ratio is growing.

Apple should beware of financing too large a buyback or dividend.

It was only last quarter that Apple's earnings fell for the first time in a decade amid a soft cycle of new products. Meanwhile, firms such as Dell, IBM, Microsoft, Cisco and Hewlett-Packard have all seen mixed results from their share buyback and dividend policies. Nevertheless, widespread dissatisfaction with Dell's takeover clearly shows that shareholders want corporations to eventually make use of their cash.

Icahn has stated he wants to use his pulpit to hold corporations accountable for their performance to shareholders. When Apple was riding the wave of its early iterations of the iPhone, investors were willing to overlook the company's unwillingness to pay a dividend or return cash to shareholders. However, right now, Icahn's views are in-line with complaints voiced by other investors.

How big of a point does Carl Icahn want to make?

Some bankers have said Dell's takeover will go down as one of the most challenging deals since the LBO hit Wall Street three decades ago. Icahn is now rumbling for change and has management's ear at what was was the biggest company in U.S. history only a year ago. In contrast to Icahn's competing offer for Dell, there is no quick way out of Apple if the company resists his recommendations.

Icahn clearly isn't slowing down after a bruising battle over Dell's fate. He may be doubling down in targeting Apple.

Apple shares opened slightly lower in early Wednesday trading at 487.38. Shares gained nearly 3% on Tuesday as Icahn took to airwaves to discuss his correspondence with Tim Cook.

-- Written by Antoine Gara in New York

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