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This article serves to analyze Apple's (NASDAQ:AAPL) stock buyback program and shed light on the controversial topic.

Due to a series of disappointments, Apple's stock plummeted from $705 down to $385, which prompted the most aggressive capital returns program by any company in history. Now, here's where it gets interesting, and a bit confusing simultaneously. Rather than using its tremendous cash, accounts receivable (which will eventually be converted into cash), short-term, and long-term investments pile of $155.46 billion, Apple has chosen to issue debt to buy back its stock. It chose to do so because, in short, the cost of debt is cheaper than its cost of equity. For other reasons, much of Apple's assets are overseas and the cost of repatriating those assets is too steep. In this article, I will discuss and analyze the stock buyback program Apple has implemented.

Abstract

Apple's share buyback program through the use of debt has been controversial, but I believe it's worthwhile for the company to engage in. Ultimately, the buyback program destroys $12.19 billion in value from interest, while adding back $26.5 billion in value from retained dividends. The buybacks will push the share price to $647.78 even assuming unchanging growth prospects.

Approach 1: Cost of Debt vs. Cost of Equity

Cost of Debt

In May, 2013, Apple issued $17 billion in debt to finance its stock buyback program.

(click to enlarge)

The maturities of the notes range from 3-30 years, which allowed Apple to borrow at effective rates ranging from 0.51%-3.91%. Using the 35% marginal tax rate for U.S. corporations, the after-tax cost of debt actually ranges from 0.3315%-2.542%. Ultimately, Apple's weighted after-tax interest rate is only 1.26%. This seems low, but it's given the fact that 50% of Apple's debt issuance matures within 5 years, allowing Apple to benefit tremendously from the low short-term rates.

Cost of Equity

In calculating Apple's cost of equity, I will be utilizing the Capital Asset Pricing Model, which was introduced by William Sharpe, John Lintner, and Jan Mossin. The creators were awarded the Nobel Memorial Prize in Economics for this tremendous contribution to the financial world.

The model base its theory on a well diversified portfolio and stipulates that any particular stock's cost of equity is dependent on its level of exposure to market movements. To anyone who follows the stock market, it's quickly apparent that stocks tend to move together, or correlate each other. This asset pricing model extrapolates that a stock's level of risk depends how heavily it correlates the market. Essentially, if a stock moves twice the magnitude of the market (in an upwards, or downwards direction), then the investor should be compensated for that increased volatility.

Overall, though, investment risk isn't solely dependent on market risk (otherwise known as systematic risk). There's also tremendous business (idiosyncratic) risk associated to investing in a company. Apple, for example, is exposed to competition from Samsung (OTC:SSNLF), Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), BlackBerry (NASDAQ:BBRY), and Nokia (NYSE:NOK), which have been eating into its profits; however, in a well diversified portfolio, an investor would also own Google, for example, which has done well during the past years. Overall, the ups and downs of a particular stock would be nullified by ups and downs in other stocks. Theoretically, idiosyncratic risk would be eliminated in a well diversified portfolio, leaving only systematic risk, or market risk, to worry about. That's where the Capital Asset Pricing Model comes into play. The formula is as follows:

  1. E(R) is the expected return, or the cost of equity.
  2. Rf is the risk free rate
  3. β represents Beta
  4. E(Rm) represents the expected return of the market

The cost of equity essentially represents the risk an investor takes on when investing in an asset, which has to be at a premium to a risk-free investment, like investing in U.S. treasuries. It's arguable that U.S. treasuries aren't risk-free anymore, like they've historically been, but for the sake of this model, we will assume they are still the most risk-free benchmark.

Now, to simply explain what Beta is. In essence, Beta calculates a stock's magnitude of correlation with the stock market. So, if a stock's Beta is 1.0 and the stock market moves up/down 10%, then the stock's expected upward/downward movement is also 10%. If a stock's Beta is 2.0 and the stock market moves up/down 10%, then the stock's expected upward/downward movement will be 20%. Beta helps quantify the level of volatility a stock has with respect to the stock market, which helps quantify the expected return for a stock dependent on its market risk.

Quantifying the Cost of Equity

Assumptions will have to be made when building the model. We'll look at historical and current data to do so. For the sake of conservatism, we'll assume a 30-year holding period.

Taking the 30-year holding period into account, I needed to define our market risk premium, which is a function of the expected market return and current 30-year risk free rate. To emphasize why I chose the 30-year risk free rate, it's because I wanted to match our holding period with my duration. Furthermore, I'll be utilizing the 30-year arithmetic return of the Russell 3000, which has historically been 11.40%. Also, the Russell 3000 resembles the market the closest, assuming its 3000 stock portfolio more definitively correlates the market than the other indices. The current yield on a 30-year treasury sits at 3.86% as of August 20, 2013.

Using the current 30-year risk free rate of 3.86%, as represented by the 30-year U.S. Treasury yield, Beta of 0.98, and expected market return of 11.40%, as represented by the Russell 3000's 30-year arithmetic average, we can derive a cost of equity of 11.25%.

So, how does this cost of equity really play into the whole Apple valuation thing? Well, the 11.25% is the rate used to discount Apple's future cash flows, which is used to calculate Apple's present value. So, for example, let us assume that Apple will generate $50 billion in free cash flow in the next year. The present value of that free cash flow will be ($50 billion)/(1.1125), which comes to $44.94 billion. If Apple generates (for example) $75 billion in 10 years, then the present value becomes ($75 billion)/((1.1125)^10) which comes to $25.83 billion.

The key takeaway here is that the cost of equity is used to discount Apple's future cash flows to present values, which tremendously influences the stock's fair value. Essentially, in the long run, an investor who owns shares of Apple is expected to generate 11.25% returns annually.

Recap

So now we know that Apple's after-tax weighted cost of debt sits at only 1.26%, whereas its stock's cost of equity sits at 11.25%. The fact that Apple has access to such cheap debt allows it to finance buying back its stock at deep discounts to its stock's cost of equity. This made it viable for Apple to initiate such a tremendous stock buyback program to create stock price appreciation for its shareholders.

Approach 2: Marginal Cost vs. Marginal Return

The economic concepts of marginal costs and marginal returns support Apple's buyback program as a way to retain shareholder value. Now, to explain these concepts:

Taken from Investopedia, the Marginal Cost of Production is: "The change in total cost that comes from making or producing one additional item". The Marginal Return is the change in total return of producing one additional item. So, let's explain this further.

Scenario 1

If a company wants to create 1 widget, it costs them $3 to make that 1 widget. It can then resell that 1 widget for $10, making a $7 profit on that widget.

If the company wants to create 1,000,000 widgets, it costs them $1 to make each widget because factors like economies of scale come into play. It can then sell those widgets for $10 each, making a $9 profit per widget.

In this scenario, the company is experiencing increased marginal returns from building and selling more widgets, as the profit increases from $7 per widget to $9 per widget.

Scenario 2

If a company wants to create 1 widget, it costs them $3 to make that 1 widget. It can then resell that 1 widget for $10, making a $7 profit on that widget.

If the company wants to create 1,000,000 widgets, it costs them $3 to make each widget. It can then sell those widgets for $10 each, making a $7 profit per widget.

The marginal return on creating the additional widgets is fixed at a constant $7 return per widget.

Scenario 3 (the most important one)

If a company wants to create 1 widget, it costs them $3 to make that 1 widget. It can then resell that 1 widget for $10, making a $7 profit on that widget.

If the company wants to create 1,000,000 widgets, it costs them $5 to make each widget. It can then sell those widgets for $10 each, making a $5 profit per widget.

Here's where it gets interesting, and very important. In the third scenario, the company is experiencing declines of marginal returns, which means that for each additional widget they create, they're making less profit per widget.

In this scenario, the company made its maximum profit per widget when creating only 1 widget, but as they ramped up production, the profit per widget declined. Now, let's create a table to help illustrate this situation, which plays into Apple's buyback program (I promise).

Widget Production

Cost Per Widget

Revenue Per Widget

Profit Per Widget

0-500,000

$3

$10

$7

500,001-1,000,000

$5

$10

$5

$1,000,001-9,999,999

$9

$10

$1

$10,000,000-$15,000,000

$9.75

$10

$0.25

$15,000,001+

$12

$10

($2)

This table helps illustrate the law of diminishing returns. As production ramps up, the profit of producing each additional widget declines. Ultimately, once the company produces its 15 millionth widget, it will stop producing widgets because producing each additional widget comes at a loss.

Now, how does this all play in with Apple's stock buyback program? Apple is issuing debt to buy back and retire its stock which pays a nice dividend of $12.20/year, or at a 2.4% yield. Back in May, Apple issued $17 billion in debt at a weighted average after-tax rate of 1.26% and bought its stock which was then yielding 2.4% (back when its dividend was $10.6/year). Applying the current dividend to the historical price for consistency, the stock was yielding 2.8%. So, essentially, Apple issued debt at 1.26% to buy back its stock that was yielding 2.8%, netting them a 1.54% spread which is now retained by the company.

Lately, Carl Icahn has been pushing Apple to issue debt at 3% to buy back and retire shares. Applying Apple's U.S. marginal tax rate of 35%, the effective cost of that debt will only be 1.95%, as Apple's stock is still yielding 2.4% in the market. At this point, though, Apple's net interest spread will be 0.45%, which still makes it worthwhile to buy back and retire its shares. Apple can keep buying back its shares until the net interest spread is 0%, which makes it profitable to continue the buyback until the stock's dividend yield reaches 1.95%, or when the stock price is $625. As Carl Icahn stated, "Buy the company here and even without earnings growth, we think it ought to be worth $625." Interesting, I know.

Food For Thought

Apple's current $60 billion share buyback program still has room to expand, as some analysts claim, and as investors like Carl Icahn are pushing for. Amit Daryanani (from RBC) believes Apple can issue another $55 billion in debt to finance the share buyback program. In total, that would indicate a $115 billion share buyback program. As of now, Apple bought back and retired $17 billion worth of shares through its debt issuance, implying that it can buy back an additional $98 billion in shares assuming such a program expansion would be initiated.

Assuming an average cost of $563.04 (the midpoint of the current stock price and the target $625 price), Apple would be able to retire an additional 174.06 million shares. As per Apple's most recent earnings report, there are currently 908.42 million shares outstanding. The additional buybacks would reduce the total shares outstanding to 734.36 million shares. Assuming a constant market cap, this would push the share prices to $628.37.

Now, remember where we calculated the marginal cost and marginal returns of share acquisition and concluded that it would be beneficial to repurchase shares up to $625? Well, we just calculated that it would take about $115 billion in debt to do so. Interesting, I know.

The analyst at RBC didn't use my approach in calculating the additional $55 billion buyback, instead, he looked at average Debt/EBITDA levels for large-cap companies, which is where he calculated that Apple could increase its debt by $55 billion.

However, the market cap won't stay the same. The interest expense will lead to a degree of value destruction. In my calculations (which I will get into next), the interest expense on $115 billion in debt will destroy a total of $12.19 billion in present value for the company, which would bring its current market cap to $449.26 billion. Even accounting for this adjustment, the share prices will reach $611.77 even with no additional earnings growth. From what it seems, analysts haven't been accounting for the impact of the interest payments on Apple's share price.

Methodology

In calculating the value destroyed by Apple issuing new debt, I had to make certain assumptions.

First, I looked at Apple's previous $17 billion debt issuance to see the spreads Apple was paying on top of U.S. Treasury Rates. From this information, I was able to calculate the new costs of debt Apple would incur if they issued the remaining $98 billion in debt.

Next, I analyzed the structure by which Apple issued its debt. What I found came as follows:

Bracket

Maturity

Debt

Weight

1

3 Years

1,000,000,000.00

5.88%

2

5 Years

2,000,000,000.00

11.76%

3

3 Years

1,500,000,000.00

8.82%

4

5 Years

4,000,000,000.00

23.53%

5

10 Years

5,500,000,000.00

32.35%

6

30 Years

3,000,000,000.00

17.65%

Sum

17,000,000,000.00

100.00%

In short, Apple structured its maturities as follows:

  1. Expiring in 3 years: 14.71% of total debt issued
  2. Expiring in 5 years: 35.29% of total debt issued
  3. Expiring in 10 years: 32.35% of total debt issued
  4. Expiring in 30 years: 17.65% of total debt issued

From this, I was able to extrapolate the amount of debt Apple would issue according to its maturity:

Expiration

Debt

3 Year

14,411,764,705.88

5 Year

34,588,235,294.12

10 Year

31,705,882,352.94

30 Year

17,294,117,647.06

Sum

98,000,000,000.00

Now I had to calculate the interest rate Apple would be paying on its debt issuance which came as follows:

Treasury Maturity

Premium

Current Treasury Rates

Apple's Rate

After-Tax Rate

3 Year

0.20%

0.73%

0.93%

0.60%

5 Year

0.40%

1.60%

2.00%

1.30%

10 Year

0.75%

2.84%

3.59%

2.33%

30 Year

1%

3.86%

4.86%

3.16%

Finally, I had everything I needed: the structure of debt expirations and the after-tax interest rate Apple would be paying on the borrowed funds. With this information, I projected the interest payments Apple would be paying for the next 30 years on the additional $98 billion debt issued. I discounted these outflows with Apple's cost of equity and found the present value of them to be $10.855 billion. I also applied the same methodology and calculated the present value of Apple's previous $17 billion debt issuance, and came to $1.334 billion. The total value destroyed from Apple issuing $115 billion in debt came to $12.19 billion.

Value Retention

From our calculations, if Apple were to expand its stock buyback to $115 billion, it would be able to buy back and retire 174.06 million shares. These used to be shares which Apple would have been paying dividends to for the life of the company's existence, but now it has retained those dividends, which should create some value for the remaining shareholders.

As of now, Apple is paying $12.20 dividends/year per share outstanding; however, the dividend will not remain the same in the future years. In reality, dividends grow through time. So now that Apple has retired those 174.06 million shares, it can now retain all those dividends as well, which would have grown throughout time. So let's try valuing the amount of savings derived from retaining the dividends on those shares. A few assumptions will be made:

  1. We'll assume that Apple will not decrease its future dividends
  2. We'll assume that the dividends will grow at 3% per year
  3. We'll use the Dividend Discount Model to value the savings to Apple
  4. We'll use Apple's cost of equity of 11.25%

So, what is the Dividend Discount Model? Essentially, it's a model used to discount future cash flows (dividends) and derive its present value. Utilizing a base dividend/year of $12.20, cost of equity of 11.25%, and growth rate of 3%, we derive a value of $26.51 billion which is retained by the company. Assuming 734.36 million shares outstanding (after the buyback), this translates to an added value of $36.10 per share.

Ultimately, $12.19 billion in value was destroyed by the interest from the buyback program, while $26.5 billion in value was retained. This ultimately pushes the share price up to $647.78 after the buyback program, even if growth prospects have not changed.

Final Words

Apple's share buyback program through the use of debt has been controversial, but I believe it's worthwhile for the company to engage in. Ultimately, the buyback program destroys $12.19 billion in value from interest, while adding back $26.5 billion in value from retained dividends. The buybacks will push the share price to $647.78 even assuming unchanging growth prospects.

Apple is currently in a position in which its access to debt markets creates a strategic opportunity to finance stock buybacks, which will lead to share price appreciation, even without any additional growth prospects. Many have argued, to which I agree, that Apple's stock is undervalued and this buyback program will allow Apple's management to take advantage of this opportunity. Some argue that this is a form of "financial engineering" and artificially inflating the stock price, which just isn't true. In the end, the shares that are being bought back are being retired, which increases the value of each remaining share outstanding, leading to gains for current shareholders.

Source: Apple's Buyback Program: Value Destroying And Value Retaining