Despite the recent rally, I believe Apple (AAPL) shares are still significantly undervalued for two simple reasons: 1) the company has both the ability and willingness to return significant capital back to shareholders and 2) the fundamentals of the business is not as bad as people think. In light of the recent development with Carl Icahn agitating Apple to increase share buybacks, this article will focus on the first reason - Apple's willingness and ability to return capital to shareholders.
Ever since Apple hit the $450s level last February (and every time it dips below $450) I have been buying. Soon after I took an initial long position, David Einhorn came out demanding Apple "iPrefs", or perpetual preferred shares. The stock rallied slightly on the news before continuing on its merry journey downwards. This gave me and other patient investors an opportunity to "average down", which is a good practice when four conditions are met:
- The company is undervalued;
- You took a small initial position, leaving you with cash to buy more;
- The fundamental reasons to buy remain the same;
- And the stock price is dropping.
After David Einhorn gave up on the iPerf idea, Carl Icahn took an estimated $1.5 billion long position in Apple. Icahn's disclosure and a good June quarter sent the stock rallying.
I am not surprised that value investors like David Einhorn and Carl Icahn are interested in Apple - the stock is obviously undervalued. And there is a catalyst that can further support share prices - a catalyst that both David Einhorn and Carl Icahn tried to speed up: returning capital to shareholders.
Significant Room to Lever Up
On 4/30, Apple sold the largest corporate-bond deal in history, a $17 billion offering at an incredibly low interest rate: Apple borrowed $5.5 billion for 10 years at an annual yield of 2.415%. It also issued three-year debt at 0.511%, five-year debt at 1.076% and 30-year debt at 3.883%. And Apple sold floating-rate bonds that mature in three and five years at rates of 0.05 and 0.25 percentage point over the three-month LIBOR (wow!). According to Deutsche Bank, there was $52 billion worth of orders for the deal, making it one of the most hotly desired bond deals Wall Street has ever seen. The irrationality of the bond market is a gold mine for companies like Apple!
What kind of damage did the largest corporate-bond offering in history do to Apple's balance sheet? It raised Apple's total debt to $16.958 billion, and debt-to-equity ratio to 0.137, up from 0.
Let's put this debt in perspective. Apple's 2013 June quarter free cash flow (simply calculated as operating cash flow less investments in PP&E and net acquisitions) is $37 billion, implying that Apple can pay back this debt in 5-6 weeks. (3Q13 10-Q)
In my view, AAPL will have no problem issuing another $44.7 billion in debt, bringing its debt-to-equity ratio to 0.5, or between IBM's 0.6 and ORCL's 0.4. (Apple can in theory issue up to ~$140 billion in debt by collateralizing its world-wide cash and investment positions, and backing it up with its cash flow - please correct me if I'm wrong on this assumption.) Realistically, however, I don't expect Apple to be this aggressive on issuing debt, even if Carl Icahn is nagging the company to buy back more shares. But issuing another $17 billion or so to buy back shares is both a realistic expectation for investors and a wise use of capital for Apple.
Addressing the Anti-Buyback, Anti-Apple Crowd
There is the Forbes article calling Icahn's suggestion to increase share buybacks "absolutely awful". The author, in my view, represents many Apple bears, so I will address his article here. You don't need to read his article since his key points are addressed below:
- The author wrote "While the math of retiring more stock will doubtless increase short-term earnings per share, as always, a buyback cannot increase actual earnings." This is simply wrong. Versus a no buyback scenario, all else equal, share buybacks increase earnings per share - forever. Share buybacks may not make sense for all companies. Companies that are ostensibly overvalued, those with stretched balance sheets, or those with rapidly deteriorating businesses should abstain from share buybacks and instead use the cash to shore up its business or return it directly to shareholders. However, none of those applies to Apple. Instead - with excess cash tied in foreign markets, tremendous operating cash flow, and access to incredibly favorable rates in the debt market - Apple is in a very unique position to enjoy the full benefits of share buybacks. Does the Forbes author suggest Apple spend the $60 billion on R&D instead?
- After giving the worst examples you can think of (MSFT, CSCO), the author wrote "Does Apple want to group itself with ancient companies and those in businesses that are perceived to be dying like retail?" This point is invalid in the face of countless examples and academic studies demonstrating that buying back shares is an effective way to increase shareholder value - International Business Machine (IBM) and Berkshire Hathaway (BRK.A) are just two examples that popped in my mind right away. The worst thing a company can do is pretend to be a start-up when it is not. I'll take the good-old cash cow over the pipe dream any day.
- The author wrote "[Increasing share buyback] would confirm the worst fears of those bearish on Apple long term: That the company is out of ideas and in permanent decline." Hoarding cash will do nothing to make Apple more innovative. I'm an investor. I'm in the game to make money. You keep the perception, I'll take the cash.
More Share Buybacks Will Create Shareholder Value
In 2012, Apple authorized a program to repurchase up to $10 billion of the Company's common stock beginning in 2013. In April 2013, Apple increased the share repurchase program to $60 billion, of which $18 billion had been utilized as of June 29, 2013. During the third quarter of 2013, the Company also repurchased 9.0 million shares of its common stock in the open market at an average price of $446.74 per share for a total of $4 billion. (3Q13 10-Q)
Clearly, Apple is willing and able to ramp up its share buyback program. If Tim Cook and Carl Icahn had a "nice conversation" about Apple being undervalued and the possibility of increasing share buybacks, then there is a good chance the buyback program will ramp up again.
Chris Whitmore at Deutsche Bank made some interesting calculations that parallel my own back-of-the-envelope calculations - since his are better, I'll use his. He made two important points:
- If Apple increased its share buyback plan by another $50 billion at an average price of $500, it would add about $4.25 in earnings per share for the company's FY 2014, or 10.5% increase in earnings just from buybacks.
- The additional $50 billion buyback could be self-funding, since Apple's interest expense on debt needed for the increase would only be about $1 billion, which would be offset by a reduction in dividend payments on the retired shares.
Bottom line: not only will additional buyback increase EPS, it will increase EPS for free.
I hope that I have demonstrated in this article that returning additional capital to shareholders in the form of buybacks makes sense to investors. Not only does buybacks support the stock price by directly increasing the demand for shares, but it will also drive EPS growth by reducing the number of outstanding shares. Moreover, Apple has the ability and willingness to ramp up its buyback program - and it's always good to have Carl Icahn on your side trying to make it happen.