How Apple Let Its Shareholders Down

May. 6.13 | About: Apple Inc. (AAPL)

As an Apple (NASDAQ:AAPL) shareholder, I'm happy to hear about the recent plans to return $100B to shareholders over the next few years. Part of this strategy includes the recent issuance of $17B in debt to help finance dividends and buybacks. While I've cheered these developments along with the market and most other AAPL investors, I've been having lingering doubts that AAPL has done right by long-term shareholders.

The problem has to do with cash management. AAPL is issuing debt largely to avoid having to repatriate and therefore pay taxes on its foreign held cash, which totaled $102.3B as of the end of last quarter. That's a whopping $108.99 per share stashed away in tax havens alongside $45.17 per share held domestically. Yet while this debt deal is an improvement on the status quo ante, it is not a free lunch. There was a clear trade-off made by AAPL management over the last few years: lower taxes in exchange for delays in returning capital to shareholders. As I will argue below, those delays have been costly, and shareholders would have been better off if they had just taken the tax hit upfront, received their payouts and moved on.

Mission Creep

Here's the evolution of AAPL's cash holdings over the last five years:

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Way back in September 2007, the first time the company broke down its cash holdings into foreign and domestic baskets, total cash was $15.4B. $6.5B of that was foreign held. At that point, foreign cash was less than half of the total, and the fancy accounting footwork to reduce taxes probably made a lot of sense. Why not get a little boost if you're building a cash stockpile anyways, especially when foreign cash is a supplement to the main rainy day fund?

Yet once this clever practice became institutionalized, it evolved a logic of its own. Rather than being a neat trick to tweak the balance sheet a bit, the foreign cash stash became an end in itself, sucking up capital and dwarfing the funds allocated to R&D, domestic reserves or working capital. Management was essentially saying that it could think of no better place for AAPL's free cash flow than a bank account in Ireland.

But like most AAPL investors, I believe the company is a much better investment than some low-yield offshore bank account. I am sure management agrees, but that is the problem with letting tax considerations dominate capital allocation policy. A short-term accounting tactic somehow transformed into a long-term investment strategy by default, not conscious deliberation.

And once the foreign cash pile reached a certain size, it raised a whole host of additional problems. After nearly going bankrupt in the 1990s, AAPL's culture had become financially conservative to the extreme. So while Steve Jobs was in power, debt was not an option. I'm not a company insider, but I suspect that this aversion to leverage continued into Tim Cook's tenure and that the recent debt issue was undertaken only after a long period of internal debate. The only other option would have been to repatriate the cash. But what executive wants to explain to shareholders and analysts why they paid the government an "extra" $10B+? The financial media would have had a field day, comparing Uncle Sam's windfall to the total corporate taxes paid by all companies, etc. It would be a PR nightmare. So with no good options or clear capital allocation strategy, management did nothing and just let the cash build up until the stock crashed and the screams of shareholders reached a fever pitch.

Act like Exxon

AAPL should have acted differently all along, using Exxon Mobil (NYSE:XOM) as its model. After making necessary capital expenditures and maintaining a reasonably sized cash cushion, XOM forwards almost all additional profits to shareholders. Much of this capital return is accomplished through a steady and growing dividend, supplemented by a more variable buyback program depending on current performance.

When I presented this sort of idea before here, I was surprised by the negative feedback in the comments section. Many comments questioned my sanity or hinted at my perverse love for the IRS. While my politics put me to the left of center, debates about tax policy distract from the main issue of maximizing value given the policies we already have. And with the polices we have, AAPL shareholders would have been better off paying taxes and pocketing the difference.

If Only Apple Had Done This

Here's how I came to this conclusion: I modeled an alternate-universe AAPL less obsessed with tax avoidance and more interested in optimal capital allocation. This Alt-AAPL kept the $6.5B in foreign cash reported in September 2007 and let its domestic cash pile grow in the same way as real world AAPL did. The only difference is that all foreign cash above that $6.5B ceiling was immediately repatriated with a 35% corporate tax and used to purchase stock at the midpoint price for the quarter it was earned. Here's what that quarterly flow would have looked like after taxes:

Click to enlarge Although there is some variance, in most quarters, AAPL would have been able to reduce its float by about 0.8%-1.4%:

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This is a big deal for investors, because dilution of shareholders has been a significant drag on performance over time:

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Because AAPL management has been so hesitant to return foreign cash to shareholders, there has been no counterbalance to the significant dilution caused by its compensation policies. Compared to September 2007, every share entitles investors to 7% less of AAPL's net income pie. Alt-AAPL investors would have experienced the opposite, with a float of 754 million rather than 939 million, a 25% reduction.

Assuming that the stock price and the business fundamentals of AAPL and Alt-AAPL are identical and the only difference is how foreign cash was handled, here's how the two companies would stack up today:

Alternative Apple

Real Apple

Cash Per Share Domestic

$56.21

$45.17

Cash Per Share Offshore

$8.62

$108.99

Total Cash Per Share

$64.83

$154.16

Price ($447) minus total cash

$382.17

$292.84

Trailing EPS

$52.60

$41.89

Trailing P/E

8.5

10.7

Trailing P/E minus total cash

7.3

7.0

Dividends Per Share, Trailing

$3.30

$2.65

Dividends Per Share, Declared

$3.80

$3.05

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Because Alt-AAPL investors can claim larger portions of the balance sheet, earnings and dividend streams, they get an $11.04 per share boost in domestic cash, $10.71 more in trailing earnings, and a $0.75 quarterly dividend increase. In exchange, they have given up $100.37 per share in foreign cash.

Who is better off, AAPL investors or Alt-AAPL investors? The domestic cash should be worth about face value because it is post-tax. The market is currently giving AAPL a trailing P/E ex-cash multiple of 7, so we'll say the additional earnings claim is worth $10.71*7 = $74.97. A DCF analysis for the increased dividend using a 10% discount rate and a 3% perpetual growth rate yields a value of $55.91. Taken together, the increased earnings, cash and dividend are worth an estimated $141.92. This is much more than the face value of the foreign cash, which I would hesitate to value at face given the tax issue and its limited accessibility. If I follow many analysts and discount the value by 35%, foreign cash is worth $65.24 per share. This is a no-brainer.

Better Late Than Never

In its decision to avoid taxes rather than return cash to shareholders, AAPL management made and is continuing to make an historic mistake. While taxes should be an important part of capital allocation decisions, they should not overshadow other important considerations. AAPL's recent debt issuance tries to square the circle by essentially using the foreign cash as collateral as it ramps up its capital return program. Yet the underlying problem has not been solved and management does not seem to be in a hurry to address the issue.

Returning $100B over the next three years sounds massive, but is still pretty miserable considering that the business is generating $40B+ in annual free cash flow. At that rate, the cash pile will be even bigger at the end of 2015 than today despite the increased dividend and buybacks. And while the $17B debt issuance broke records, it represents only about two quarters worth of foreign cash growth. At the current foreign cash growth rate, AAPL would have to issue an additional $17B in debt every quarter for the next two and a half years to get all the foreign cash around the taxman. While there is a high level of interest in AAPL debt right now, how might the market feel about its bonds with the company in debt to the tune of $200B+ 2016? Or how about $500B+ in 2020? Furthermore, where will AAPL stock be in three years? As a long-term investor, I believe that the stock will do quite well in the future, and I would much rather have a reduced float or increased dividend now rather than wait for AAPL's slow, rickety, and uncertain bond market ATM scheme to play out over the next decade or two.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.