There has been a lot written about Apple's (AAPL) announcement earlier this week that it was increasing its dividend by 15% and adding a whopping $50B to its stock repurchase program to bring the total to an astounding $60B. A lot of commentators have chimed in disapprovingly that the move shows the company is losing its innovative product design ways and would have been better off spending the money on R&D to develop new products. A couple of points I would like to bring up for the detractors of this move. First, Apple increased its R&D spending 33% Y/Y in the quarter. Second, it still has over $90B left in the till even after these capital allocation decisions. This should be more than enough to fund any interesting new products or acquisitions should opportunities present themselves. Finally, innovation is a creative process. One does not necessarily get better results by throwing a lot of bodies on something that requires vision. As my late father was fond of saying: "You can assign nine women to produce a baby, it still is going to take nine months before you see the first results."
I understand the dissenters' concerns. I think they need to be patient, as from a product cycle point of view, Apple was always going to be a second half story for 2013. The company should have refreshes of the iPad and iPhone in the back half of the year. I also would not be surprised to see an iWatch or iTV launch in this time frame as well. I think Apple is showing a solid bit of "financial" innovation here, prodded by David Einhorn and other activist investors, of course. What these moves do is to put a floor under the stock until these products come to market in the second half of the year. This is something that Cramer has been pounding on the last few days on CNBC and Mad Money.
To understand how huge and supportive this record breaking stock repurchase program is, let's do some back of the envelope calculations. For simplification, let's assume the company begins this $60B stock buyback program on July 1st and it runs through the end of 2014 (Apple intends the buyback to be complete at end of 2015, but this makes the exercise a bit easier to demonstrate). Let's also state that the company will buy roughly equal amounts of stock each quarter, or some $10B every three months. We will also combine the buyback projections with very pessimistic assumptions around the company's prospects over the next 18 months or so. We will assume that revenue growth will only be six percent annually over that timeframe, less than half the current consensus estimates. Let's also say the company's margins will shrink 1% a quarter for the six quarters through to the end of 2014. If the stock stays in a narrow trading range over that time frame, each quarter, we are removing 2% to 3% of the float. These purchases more than offset the margin decline and, combined with the tepid sales growth, get you to higher earnings per share by end of 2014, even with much lower expectations than the current consensus forecasts. If Apple keeps its margins around the 36% it forecast for the next quarter and grows sales by just 10% a year, earnings should be approximately 25% to 30% a share higher in 18 months. In either scenario, Apple will also have rebuilt its cash hoard past the original $145B it had at the end of the recently completed quarter by year-end 2014. Looking at it this way, it is hard not to be optimistic about AAPL's prospects if you are a longer-term investor.
The other thing this record buyback will do is pave the way for other tech companies to either do the same or be pushed to make similar moves in the near future. By borrowing money at extremely low rates and buying back stock with some sort of dividend hike, tech companies like Cisco Systems (CSCO) and Microsoft (MSFT) accomplish three things: a) They reward their shareholders and also provide solid catalysts to drive up their stock prices, b) The companies avoid the taxes they would have to pay if they directly brought the cash home from overseas (The United States has the highest corporate tax rate in the G7), and they have ample cash flow to take on and retire the debt over time, and c) This strategy provides a much higher return on equity than just keeping the money overseas earning 1% to 2% on the idle cash.
It has been speculated that Apple will be able to raise some $50B over the next year or two for a rate below its roughly 3% dividend yield. Cisco and Microsoft have similarly rated balance sheets, so it is logical to assume they could do the same in this low interest rate environment with investors desperate for yield. Let's do another back of the envelope exercise. We will assume activists or management at these companies will drive a mimic of Apple's new capital allocation strategy. For the exercise, we will say that both companies will take roughly the same 40% of the net cash/short-term marketable balances on their books and allocate this to stock buybacks and dividend increases. For fun, let's say three quarters of those funds will go to stock repurchases and one quarter will be allocated to a special dividend. What would that look like?
Microsoft has roughly $70B in net cash on its books. That would mean $21B available for stock buybacks and $7B in dividend hikes. At the current stock price, this would remove 7% to 8% from its float and increase earnings per share by a similar amount. It would also allow the company to pay roughly an 85 cent a share special dividend (maybe Mr. Softie will be nice and pay an even buck a share). This is just one more reason I am positive on MSFT and have it in my portfolio.
Cisco Systems has the least cash of the three tech giants -- approximately a paltry $46B of net cash. Using the same ratios, this gives it a little over $15B for repurchases and $5B for a special dividend. This would remove just slightly under 5% from the float and raise earnings 5% a share at current prices. It would also allow the company to pay around a $1 a share special dividend. I already believe CSCO is undervalued, and this is just one more possible event that can unlock shareholder value.
Just food for thought.