It was only a few months ago that the financial press was discussing the possibility of Apple (AAPL) shares hitting $1,000 and becoming the first trillion-dollar market capitalization company. Since topping out just above $700, the shares have lost almost 25% of their value amid fears about slowing iPad and iMini sales. Increased competition to the iPhone from the Android Alliance led by Google (GOOG) and Samsung (GM:SSNLF) is also weighing on the shares. But while Apple is unlikely to grow earnings or its stock price at the rate of the last 3 years, fears of Apple's best days being behind its are likely an overreaction. In fact, Apple's decade-long dominance has given its a few secret weapons that can help drive the stock back to the old highs near $700 and maybe even the vaunted $1,000 share price few stocks have ever attained.
Let's acknowledge that Apple's price downside from current levels should be minimal. Unlike other technology stocks which suffered multi-year declines that often lasted a decade or more before making new highs, Apple stock is not suffering from nose-bleed valuations. In 2000, most of the technology sector sold at unreasonable P/E levels. Cisco Systems (CSCO) was at Apple's market-cap of today, but sold for 60x forward earnings. Dell Computer (DELL), which had gone up 30-fold in the previous three years, was selling at 40x forward earnings. And Intel (INTC) and Microsoft (MSFT), the "Wintel" monopoly of their day, each sold for 30-40x forward EPS.
Contrast those situations with Apple which sells at only 11x forward earnings, 8x if you strip out the cash on its balance sheet. Apple stock has gone up despite P/E compression in recent years because the "E" in the P/E ratio has gone up. Most of the cash from those earnings has gone straight to the balance sheet, providing a floor for the stock. A low P/E combined with cash balances equal to almost 25% of the market cap prevents the kind of stock price meltdown its technology peers encountered in the 2000s. With not much downside, Apple management can focus on what will work to generate upside.
Apple executives have never been very communicative with the investor community, but they probably feel like saying something like "look, our stock is cheap, if you won't do something about it, we will." But talk is also cheap, if Apple management really believes it deserves a higher multiple and the stock's future cash generating ability justifies it, then they need to show investors the money. Apple shares probably do deserve at least a market multiple closer to 14x forward earnings, since the S&P 500 in the aggregate has less cash behind each share and grows earnings closer to 6-7%, less than the Apple consensus. There are 3 strategies Apple management can pursue that would signal to the market that Apple management believes in its future cash generating abilities and that the shares should be revalued higher:
- A Dutch Auction: Apple can borrow at very low rates because of the ultra-low rate environment and the strength of the corporate bond market. Apple would probably garner a AA or AA- rating, a rarity for a new issuer which should ensure extra-strong demand for its debt. The old saying is "strike when the iron is hot" and right now the market is hot for highly-rated corporate debt. Apple can easily afford to take on $50 billion in debt; right now it has none so 100% of its cash balances are net to the firm. Many of its tech peers already have debt in addition to cash and do not generate as much free cash flow as Apple. Here are 2013 forecasted debt/EBITDA levels for Apple (assuming debt of $50 billion) as well as technology and consumer product peers.
Apple falls in the middle of the rankings even after the debt and is in better shape considering its much larger cash balances and its growing free cash flow, thanks to minimal CAPX requirements. Let's say that Apple floats $50 billion in 10-year debt at about 2.5%. The after-tax cost of the debt would be under 2% compared to buying in stock with an earnings yield of about 9% (12% if you exclude the cash). Apple can then retire about 10% of its shares. Fair value taking into account the reduced share count and constant earnings (less the added interest cost) would be about $585/share. The stock will eventually move beyond that once the reasons for the exchange - confidence in future earnings - become clearer. The threat of future Dutch Auctions would also buoy the shares as shorts would cover some positions since another buyback could take place in the future.
- Stock Buybacks: Similar to the Dutch Auction but more gradual and over time, Apple could float debt - or use current cash flows and cash on the balance sheet - to buy in stock. Apple has $140 per share of cash (January 2013 estimate) and is currently forecast to earn $50/share in FY 2013. Given Apple's minimal CAPX and R&D requirements, returning that cash via stock buybacks is an efficient use of capital. With over 30% of both the cash hoard and the annual cash flow based in the United States, Apple has access to plenty of cash to buy back 5-10% of its shares per year. Apple can worry about accessing the larger overseas cash at a later date when corporate tax reform or a repatriation holiday would minimize the tax bite on its overseas holdings. Right now, the cash is actually accelerating:
- A 6% Dividend: If we assume the same willingness to float debt, or access domestic and/or overseas cash, Apple could actually afford a 6% dividend without being financially reckless. At the current stock price, Apple needs to pay about $32/share in annual dividends compared to the $10.60 paid now, so just under $22/share extra is needed to get to a 6% dividend. Apple generates about $50 billion a year in free cash flow in addition to the balance sheet cash, about 30-35% of each amount being U.S.-centered. Apple can utilize $12/share from the domestic cash hoard of over $40 billion and even if earnings are flat, the combination of U.S.-only cash flow and U.S.-only cash reserves is enough to fund the dividend through 2015. If Apple floats the $50 billion in debt for dividends, then Apple has $90 billion in U.S. cash reserves, enough to handle a $32 dividend at least through 2017. After 2017, U.S. cash flows would need to be combined with repatriated overseas cash, with or without a tax holiday or corporate income tax reform. Apple can worry about that later.
All 3 of these options avoid touching overseas cash flows or cash balances, which will be growing and possibly accelerating. As Apple approaches 2015, it will have a much better focus on future iPhone, iPad, and other product market shares and growth trajectories. It will also have another 3 years of results - and cash - in the bank. While Apple's history and battles with past tech titans have no doubt impressed upon management the need to be conservative, the current plan could have a ridiculous 50% of today's stock price in cash within 3 years sitting on the balance sheet.
Apple is hurting its shareholders -- and the company (since retention of employees will be tied to future stock price appreciation and/or dividends) -- by being too conservative. Companies have been using the once-in-a-lifetime low rates to pay special dividends and/or increase regulars. Unless Apple is planning massive and sizeable M&A deals, there is simply no better use for its cash than retiring shares or paying an outsized dividend in the present. It will jump-start the stock, and in the case of a high dividend, attract new institutional and retail investors to the stock who may not see Apple as a growth stock (nobody can predict the future) but who can clearly see the preeminent technology stock of the day paying 6% to investors even if earnings and the P/E stay flat.
Apple has won the hearts and minds of a generation of consumer and technology buyers by not being afraid to be bold. It can similarly win the hearts and minds of retail and institutional investors by deploying its cash arsenal at a time when it will hurt the company least and help the stock the most.