Why Apple Should Use Debt to Finance a Larger Buyback
Apple (AAPL) has received much attention due to its precipitous fall in stock price. The facts are as many have written about- Apple is trading at around 7x its trailing P/E ratio ex-cash, compared to roughly double that in the broad market. The company with the one of the most valuable brands in the world is trading at a 50% discount on an earnings basis? Obviously, Apple faces unique risks to its earnings due to declining margins and increased competition, but including catalysts is a 50% discount merited?
Regardless, the stock has gotten hammered as of late, and Samsung is in effect getting free press coverage from everyone covering Apple’s decline. Normally I would view stock price movements and future earnings potential to be somewhat independent, but in this case there may be some correlation Apple Executives should consider. If it is Apple’s goal to draw new consumers into their ecosystem, the most recent three month stock decline and press coverage have not been catalysts for this proposition. It is hard to argue that consumers would in no way be affected by the coverage. This is the perfect opportunity for Apple to show consumers and investors that it believes in its future, and that people are severely underestimating the enterprise.
What of Apple’s $137 Billion Cash-Like Balance?
Many articles I have read are berating Apple for inefficiently using its massive cash balance. They would like to see a dividend boost or a massive share-buyback program. Before I did some research on the nature of the $137 billion cash balance, I at first agreed. However, Apple very publicly laid out its plans for its cash balance in March of 2012:
According to Apple’s recent 10Q, of their $137 billion in cash-like assets, $94 billion is in foreign accounts. This means Apple would need to pay between 30-35% (probably around 33%) to repatriate the balance and return to shareholders. Put simply, as Apple clearly voiced in their conference call on cash last March, they do not want to pay the taxes on this balance. As a shareholder, I have no problem with this. I don’t want them to pay taxes on that balance either. Now some may assert this idea is somewhat immoral. Given the laws surrounding taxes that are currently in place, Apple must use the laws to their advantage otherwise they would not be acting in the best interest of their shareholders. Apple is by no means the only company that has money stranded abroad. Some estimate $1.5 trillion is sitting in foreign accounts. I am not an expert on the subject, but it seems like the longer companies like Apple hold out, the more leverage they will gain by continually increasing their cash balances to either change tax laws or enact a tax holiday. If Apple brought its money back today and tax laws were changed in a few years, Apple may have missed out on an opportunity to save money for its shareholders.
As Apple claimed on its conference call, they enacted the dividend and buyback policy based on the US cash balance and future US earnings. Apple also told us that they would like to have a safety net of US cash in order to take advantage of opportunities as they present themselves. The $45 billion Apple plans on returning to shareholders over the next three years allows Apple to pay out its US earnings and to have a considerable US cash balance, around $30-45 billion.
Taken together, Apple does not wish to repatriate foreign earnings and has utilized its US earnings. This means Apple’s next likely action to return money to shareholders is through the issuance of inexpensive debt.
Increase or A One-Time Dividend?
To decide whether this is a good option for shareholders, you must take a step back. Obviously, a shareholder purchases Apple not for the return on cash, but for the return Apple generates as a company. However, if a company is reluctant to return cash to shareholders, why not roll with what the casino gives you? Most portfolios out there will have some allocation to short-term, ‘safe’, assets. When you purchase $10,000 of Apple, you are really purchasing about $7,500 of Apple and $2,500 (net of taxes) of short-term assets. Now, I am not exactly trained on the policy of compounding IRS tax deferred bills, but if Apple is earning 1% on their tax-deferred cash balance, they are in effect deferring taxes for you. So, why not allocate your portfolio according to what your investments truly are and use the tax advantage.
Another common argument for dividends goes something like this: it attracts a new group of shareholders because of a higher yield, which will subsequently increase the price of the stock. If there is a higher demand for the stock because a new group of investors become buyers the stock price may go up. However, it is important to note that the supply/demand for a stock does not implicitly affect the true value of the stock based on its earnings. This potential higher stock price is a one-time action, and future shareholders will not benefit from this one-time action.
However, dividends may help reduce the volatility of Apple stock, as investors will proportionately receive more of their return through dividends as opposed to capital appreciation. Dividends in effect offer the investor more incentive to get paid to wait as opposed to cash out once the stock has seen a significant appreciation in value. Increased dividends would lower the overall stock appreciation, thus lowering the volatility on the upward and downward paths.
Currently, Apple is trading at around 7x earnings ex-cash. I believe a share buyback would be the best long-term option for Apple shareholders, which is the investor base Apple should currently be considering. A buyback would allow shareholders to benefit from the low valuation on Apple stock. If the Board of Directors believes that Apple will at least maintain earnings, it would be a mistake for them not to buyback shares at these levels. From a cash flow perspective, buybacks allow a company to either increase its dividends or lower their overall dividend obligation due to lower shares outstanding.
Most arguments against buybacks center around the idea that in the past, managers have not bought back their shares at opportune times. It is hard to argue this is not an opportune time for share buybacks given the low price to earnings ratio.
So…Debt Financed Buybacks?
Apple would not be new to this concept. Microsoft, Oracle and Cisco have issued large amounts of debt despite their large offshore cash balances. All have been buying back stock with some of these proceeds. A lot of people point to Microsoft’s buyback program claiming that the stock price hasn’t moved. Well, we are only seeing the stock price outcome as the result of this decision to buy-back shares. What would Microsoft be trading at if they had not bought back billions in stock? Also, Microsoft is not Apple and to compare the potential outcome of an Apple buyback with another company’s past buyback is not a fair comparison.
At record low interest rate levels, Apple could issue debt and theoretically save cash by buying back shares. Let’s assume Apple raises $25 billion in 10yr debt, and $25 billion in 30yr debt. Comparing yields seen on its peers’ debt of similar duration, Apple could pay about 2.75% on its 10 yr debt and 4.25% on its 30 yr debt. Apple’s average interest rate would be 3.5% (These are large assumptions, but I believe them to be a factually supported and a good first guess). Given the tax savings on its interest payments, the debt would have an after tax costs of 2.28%. Apple’s dividend yield is currently around 2.3%. Issuing debt and buying back shares would actually save cash and lower outstanding shares. Debt would allow Apple to keep its balances abroad and continue to gain leverage to negotiate with the government. All Apple has to do is stomach the idea of issuing debt. On a side note, isn’t it interesting that the US government’s policy aimed at lowering interesting rates allows companies to finance their offshore cash balances cheaply, thereby further reducing the incentive to bring money back to the United States.
Obviously, it takes some time to issue $50 billion in debt. If Apple raises debt acknowledging its purpose is to buy back shares the stock price may change. There will be a new $50 billion buyer, shorts may cover, there may be less sellers, and Apple will not be able to take advantage of the depressed prices. I believe over the next few months, Apple should use its US safety cushion to buy back shares, and once they have accumulated their desired shares, issue debt to restore their US cash balance. It is also important to note that they have over $8 billion left on their initial buyback policy from last March that has already been approved. I am not sure if Apple must publicly acknowledge an additional buyback policy before action is taken. Please comment below if you know the answer to that question.
So Why Now?
When Apple initiated its $45 billion 3-year program in March 2012, the stock price was trading around $600. It is at a historic low since initiating their dividend, now hovering around $450. Since March of 2012, earnings have dramatically increased and Apple has significantly more cash. Apple’s stock is much cheaper (again on an earnings basis) than a year ago. I hope the CEO and CFO of Apple view their stock cheap at these levels and understand how accretive a buyback could be for shareholders given their visions for Apple coming to fruition.