Over the past year, Apple (NASDAQ:AAPL) CEO Tim Cook has shown himself to be more shareholder-friendly than the late Steve Jobs. Cook convinced Apple's board that they should introduce a regular dividend and approve a share repurchase. Both of these decisions were announced in March, and the dividend and repurchase programs began over the summer. However, investors have not been particularly impressed by the extent to which Apple is returning cash to shareholders. Many were upset that Apple opted not to issue a special dividend before the end of CY 2012. Additionally, the share repurchase has been slow thus far; Apple entered into a $2 billion accelerated share repurchase agreement this summer, but has not yet disclosed any other share repurchase activity.
The result has been that Apple's cash and investments balance has continued to increase by billions of dollars each quarter, reaching $121 billion at the end of FY12. However, Apple's stock price has slid by nearly 30% since hitting all-time highs in mid-September, and now sits at levels not seen since February. Whereas Apple's existing repurchase plan is designed to offset potential dilution from employee stock options/purchases, I believe that the company should authorize a much larger buyback (at least $50 billion, but preferably $100 billion) that would potentially shrink the share count significantly. There would be several benefits to this course of action.
Three Reasons for a Big Buyback
First, the lack of a significant buyback at Apple is viewed by many investors as a potential confirmation of bears' worries. Fund manager Mark Mulholland recently said to CNBC, "If the company is not buying back at this level, I think it's absurd and suggests that something is seriously wrong with the company." The timidity about repurchasing shares makes investors wonder if management expects severe earnings disappointments going forward. While most analysts agree that Apple is undervalued, Apple's management has not been behaving as if this is the case.
Second, if Apple shows the disposition to repurchase more shares when the stock sells off, it might decrease the stock's volatility, making it a more attractive investment. Apple would not necessarily need to exercise the full buyback to have this effect. The CNBC article cited earlier quoted technical analysts who called the stock "broken" and suggested that it could continue to underperform in the near term regardless of fundamentals (e.g. earnings). Part of the problem is that many institutional investors are hesitant to buy shares now when the stock is in a downtrend, even though they think Apple is significantly undervalued. With Apple as a potential "buyer of last resort", I believe that institutional investors would be less worried about a downtrend of indefinite length. Value investors would be more likely to swoop in and buy the dips, stabilizing the stock.
Third, if Apple were to execute a significant share repurchase, it would allow the share price to grow faster than the company's market capitalization. As George Kesarios recently wrote here on Seeking Alpha, a variety of mega-cap stocks have seen severe multiple compression as their market caps apparently became "too big". Apple is seeing this kind of multiple compression at present (although on the flip side, it was able to support a much higher market cap just four months ago). Major institutional investors could be unable or unwilling to hold more than a certain percentage of their assets in one stock, which would provide a structural explanation for Apple's undervaluation. By repurchasing shares, Apple could grow EPS (offsetting multiple compression), while also allowing the share price to rise faster than the market cap.
Potential Negatives to a Large Repurchase
There are two main counter-arguments to this recommendation that Apple super-size its repurchase authorization. The first is that Apple shares may actually be overvalued (e.g. if competitive threats are about to hurt earnings). Corporations have historically been bad at judging their future prospects for the purpose of share buybacks. A particularly egregious example is Hewlett-Packard (NYSE:HPQ), which has executed massive buybacks in recent years. In just two years (FY10 and FY11), the company spent over $21 billion buying back stock at an average price of roughly $42/share. Even after HP's recent share price gains, HP has still destroyed $12.5 billion of shareholder value through these repurchases (equivalent to more than a third of the company's current market cap). Numerous other tech companies such as Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Cisco (NASDAQ:CSCO) have overpaid for their stock over the past decade (according to their current valuations). If Apple's management has reason to believe that earnings have peaked, then the company should indeed refrain from repurchases. However, I think Apple still has a few years of earnings growth ahead of it, in which case a repurchase would be very beneficial at current prices. Some repurchases do create value for shareholders.
The second argument against a big repurchase is that Apple should be investing for growth. This is similar to the argument that tech companies do not or should not return cash to shareholders, because that signals that they do not know what to invest in or have lost their competitive advantages. However, people who apply these arguments to Apple miss a critical point. These arguments only make logical sense on the assumption that capital is scarce (which is usually true). However, Apple does not face a situation of capital scarcity in any meaningful sense. Apple could spend $100 billion buying back shares over the next two years while also raising its dividend, executing several acquisitions in the billion dollar range, and doubling R&D spending. After doing all that, the company would still exit 2014 with roughly $100 billion of cash and investments.
Since Apple does not confront a scarcity of capital, the fact that the company continues to avoid a large buyback will likely weigh on the stock. While I think that Apple's highly conservative capital allocation policy is just a reflection of a highly conservative mentality at the management and board levels, investors will continue to punish the stock through multiple contraction and high volatility until/unless the company creates a larger repurchase authorization. At the current valuation, I think earnings growth should push shares higher this year, but expect the TTM multiple to be constrained to a 10X-15X range despite projected earnings growth and rising cash balances. Apple's board ought to put a much larger repurchase authorization on the table, but I think this is unlikely to occur in FY13. For the time being, investors will have to content themselves with a modest dividend increase during the year.