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Icahn Was Half Right About Apple's Risk in China

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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One doesn't have to take Carl Icahn's decision to dump his big stake in Apple as an omen. The veteran activist investor has certainly been wrong about stocks before. His motives for the move, however, deserve careful examination.

Icahn held 45.8 million shares in Apple by the end of 2015, about 0.83 percent of the total shares outstanding, worth $4.8 billion at the time. It was the second-biggest holding in his portfolio after Icahn Enterprises LP, his diversified conglomerate. Now, according to Icahn himself, he's out of the stock he has repeatedly called undervalued. 

QuickTake Apple

In October, 2014, when Apple shares traded at about $100, he wrote the company's chief executive Tim Cook that his analysis showed it should trade at $203. In May, 2015, with the market price at $130, he said a share should be worth $240. These prices, of course, have never materialized: At the end of the first quarter of 2016, when Icahn liquidated the position, the stock traded at less than $110. It has dropped to $95 since, so Icahn has made a sizable profit.

Icahn would have held on to his Apple stake, had he still believed in his previous valuations. The reason he doesn't anymore, he says, is that he's worried about the company's exposure to China because of the unpredictable nature of the Chinese political system:

In China, for instance, they will come in and make it very difficult for Apple to sell there. They could theoretically, you know… They’re basically in some senses I would say, perhaps benevolent but a benevolent dictatorship. I don’t know if benevolent is the right word.

Icahn has been right about that. This month, after he'd sold his shares, the Chinese authorities shut down Apple's iBooks and iTunes Movies stores, just six months after allowing them to launch, for the usual censorship-related reasons that prevent Google and Facebook from operating in China. Yet these moves have not been particularly damaging to the Cupertino, California company's business. The services segment, of which iBooks and iTunes Movies are part, generate just 11.8 percent of Apple's revenue. The Chinese business, new within the segment, can hardly affect the valuation in any meaningful way. 

Besides, China was only mentioned once in the 2014 letter to Cook -- Icahn wrote that he expected the company to take a significant share of the smartphone market there as the country rolled out 4G technology -- and not mentioned at all in the 2015 letter. Obviously, Icahn didn't attach too much significance to it just as Cook bet big on Chinese expansion and won spectacularly. The drive helped make last year's iPhone 6 upgrade cycle the most lucrative in Apple's history.

In 2014 and 2015, China was also a dictatorship, but Icahn didn't appear to be worried about that then.  Now, he says, "China is sort of looking at Apple and saying 'Well can you do this? Should we let you do that? Should we let you do this?'" 

What is it that he knows and the rest of us don't?

My guess is nothing. Icahn is still involved in other companies that are active in China: He has, for example, a big holding in PayPal, which is probably more politically exposed than Apple because the Chinese authorities are keenly interested in controlling the cross-border movement of capital. Icahn is probably acting on a gut feeling that he wouldn't be the only one to get looking at this chart:

Throughout most of 2012, 2013 and 2014, Apple's greater China business grew just about as fast as its total revenue. Then, in 2015, growth in China exploded. By the time Icahn sold his stake -- in Apple's second quarter of fiscal 2016 -- the two lines had converged again, and in the last full quarter, the Chinese business performed worse than the company as a whole. The Chinese miracle that led to Apple's brilliant 2015 results had fizzled. The trend in a geographical segment that, in the three months through March, provided 24.7 percent of the company's revenue bodes ill for Apple's market cap. Icahn must have realized that the 2015 explosion was short-lived, and sold before others realized there was some downside to Apple's infatuation with China but, in the foreseeable future, no upside.

The reasons for this have nothing to do with politics. Chinese consumers, who used to view the iPhone as a status symbol, are increasingly willing to look at local brands, whose devices are just as well-made and often more technologically daring. This is an increasingly well-reported trend that Cook is refusing to acknowledge but investors such as Icahn cannot afford to ignore. Selling an overpriced device in a highly competitive market where everyone knows the iPhone, too, is made in China, mostly from local components, just decorated with a big U.S. brand, is a difficult proposition. The Chinese government doesn't need to step in to hurt Apple's sales.

Icahn, of course, has made losing bets before. In 2008, Yahoo, then involved in a battle with him, even put out a presentation on his failures for other investors, hoping they wouldn't follow his judgment. I wouldn't ignore his gut feeling in this particular case though, especially since the market  is showing that with Apple, he has so far avoided significant losses by getting out when he did.

(Corrects second paragraph to indicate that Carl Icahn's Apple holdings were as of the end of 2015, not 2005.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net