Now the legendary investor/billionaire Carl Icahn has added his 2¢ (or $1.5 billion) to the dialogue and he agrees. Icahn broke the news of his purchase of a large block of Apple shares by posting on Twitter, "We currently have a large position in Apple. We believe the company to be extremely undervalued. Spoke to Tim Cook today. More to come." Just a few minutes later he said, "Had a nice conversation with Tim Cook today. Discussed my opinion that a larger buyback should be done now. We plan to speak again shortly." He said later that Apple shares may be worth $700, while they currently only trade around $500. Ostensibly, he would like a 40% appreciation in equity value over a paltry 2.7% cash dividend.
Buybacks, Dividends and Debt
Furthermore, Apple is currently paying 2.4% on the 10-year bonds which it issued to finance dividends and stock buybacks. Since Apple stock pays 2.7% in dividends, theoretically, Apple could issue debt and buy its own shares for a profit assuming the share price won't fall over the long term. Interest rates have risen since then, and Apple would have to pay a slightly higher yield now, but if buying back shares with debt is a good move, then using available cash is a no-brainer.
The basic dynamics of how a buyback works are as follows: A share of stock is essentially a claim to the residual equity in a corporation after all prior claims are paid off. When a company buys back its shares, there are then fewer shareholders with claims to the company's equity. While the cash on the balance sheet will go down, the shares should go up as the upstanding shares after the buyback have a larger claim on the residual equity left in the corporation. After a share repurchase, the anti-dilutive effect of the repurchase will cause the earnings per share to rise even if earnings are flat.
In spite of the above, buybacks are a double-edged sword. If a company buys back its shares when they are undervalued, and there is a subsequent ascent in the share price (resulting in a higher market cap than before the cash was spent), the company effectively returned capital to the shareholders while at the same time creating for shareholders. On the other hand, if the company buys back shares when they are overvalued and the share price subsequently declines, the company has essentially destroyed shareholder value in the repurchase.
Why Buybacks Often Fail
Unfortunately, as Warren Buffet has pointed out, companies have a horrible track record of destroying shareholder value when repurchasing their shares. The reason for this phenomenon is that when share prices are low, companies often increase dividends to buoy the share prices. When shares are on the rise, it is often due to success at the company, and the cash is used to offset dilution from stock option issuances. When the share prices are high management is typically not concerned with artificially supporting the share price. Buybacks have one more advantage over dividends which should not be overlooked. When an investor receives a cash dividend, she/he immediately pays out between 15% and 20% in capital gains taxes. If that money were to be reinvested into the corporation without passing over to the shareholder, the tax on gains is deferred until the sale of those shares.
The optimal capital return structure would be a flexible program in which management buys back shares up to a certain stock price, and past that spends the same amount on dividends. When shares are overvalued, a company should by no means buy back shares, and should distribute excess cash as dividends. Effective management should not hold onto more cash than a company will need or can effectively invest as shareholders can effectively put that money to use in other investments.
How Dividends Destroyed Apple Shareholder Value
Fundamentally, the case for greater share repurchases at Apple is quite easy to make. Since Apple's share price dropped under $500, the company has paid out over $7.8 billion in dividends. Hypothetically, to give a crude measurement of how much value management could have created by using this cash to repurchase shares, let's assume Apple would have been able to use the cash to purchase shares at the closing price of the pay-date. We'll assume that the fact that the shares would be driven up in the process of the buybacks would be largely offset by the lower dividends which Apple would pay out in future quarters. We also know that the share repurchase was executed through an accelerated program. In this instance, Apple would pay upfront (with a premium) and take immediate delivery on shares from a third party, which would essentially initiate a short position to cover on the open market.
Dividend (Million $'s)
Value Potentially Created (Million $'s)
Total Value Potentially Created (Destroyed)
What we learn from this is that dividends were not Apple's best option. Last time I wrote this I received a barrage of angry comments, but history has now proven my point. Now I know that it is tough for a company to decrease a dividend, so I would just hope not to see any increases until the shares are fairly valued. I still feel that Apple is undervalued and I hope for increased share repurchases.