For shareholders of Apple (AAPL), this September is shaping up to be a pretty big month. The company has just started a widespread iPhone buyback plan ahead its announcement of a new model on September 10. Also at some point this month, CEO Tim Cook will be having dinner with activist investor Carl Icahn. I imagine that Mr. Icahn's main argument will be that Apple should buy back fewer iPhones and more shares. Based on his recent antics, I imagine we'll find out how the dinner went on Twitter the very next day. I suspect Mr. Icahn will be pushing for a larger buyback plan, but I contend that the most value-creating plan would be an unorthodox buyback plan that I will outline here. I hope he argues for it.
First, we do need to recognize that Apple has committed to a reasonable share repurchase of $60 billion by the end of 2015. Apple is a massive company, so that buyback is less sizable than it appears as it will amount to roughly 4% of shares annually. This is certainly nothing to sneeze at, but for a company with $140 billion in cash against $17 billion in debt, it is far from groundbreaking. Mr. Icahn is right to argue that the firm can lever up its capital structure, which is horribly inefficient. With $123 billion in equity against $17 billion in debt, gross debt only accounts for 12% of its capital structure. With $123 billion in net cash, its equity value is 100% cash. That is not the hallmark of a capital efficient firm; it is one with severely excessive liquidity.
Apple is a consumer products company, and as such, near-term fortunes can swing wildly based upon the popularity of new products. If the next iPhone were to suck, the company's operating performance would deviate significantly. As such, it is wise to have an equity-heavy capital structure. Volatile income is not good to have when there are significant fixed interest payments. Still, I would argue that a 12% gross debt-to-capitalization ratio is far too conservative. I think a more reasonable, yet conservative, capital structure would be to have a 25% gross debt to cap. Under this scenario, Apple should have $45 billion in debt outstanding.
I think Icahn should push Apple to issue another $28 billion in debt. With this new debt, Apple could pull forward its share buyback plan, promising to buy back $60 billion stock in by the end of 2014 rather than 2015 with a commitment to launch a new plan in 2016, size to be determined by operating performance. Under this scenario, Apple would have a more reasonable capital structure and would be providing more lift to the stock by purchasing more shares every day.
However, even under this plan, Apple would still have a net cash position of nearly $100 billion, which is why I suggest Apple take a page from Warren Buffett by adopting a second, unconventional buyback. In 2011, shares of Berkshire Hathaway (BRK.B) had been languishing, trading around book value while other stocks were roaring. On September 26, Berkshire made the stunning announcement of an open-ended stock buyback so long as the company maintained $20 billion in cash. Buffett would buy as many shares as he could so long as the stock was trading no more than 10% over book value, which was roughly $75. Before the announcement, BRK.B was trading at $66. By October 21, less than one month later, the stock was above BRK.B's limit.
The market understand that Buffett could essentially match every sell order given his $40 billion in cash. By saying he would buy shares below a certain price, he put a floor in the stock at that price. No short seller was going to take on Buffett because he had infinitely more resources. By promising to buy as many shares as possible, he barely needed to purchase any. With Apple's massive cash hoard, I recommend they do the same thing.
Icahn should urge Apple to work with major banks to set up a multi-year credit line of $100 billion-equal to its net cash position. (Under Section 956 of the IRS code, the company could put up to 66.7% of its massive overseas cash hoard up to mostly secure the line without taking an immediate tax hit. The company would then pledge 2/3 of future overseas profits to fully secure the line within 18 months. While there would still be a tax hit to bring the money back if needed under a liquidity crunch, this cash along with new cash flow would be enough to pay back virtually the whole loan.) Apple should then announce it will draw on this credit line to buy every share it can whenever the stock is trading below 15 times earnings, or approximately $600. This plan allows the firm to use the majority of its overseas taxes as potential ammunition for a stock buyback, though based on the Berkshire experience, I doubt Apple will have to draw much if any of this credit line.
With $100 billion in additional buying power, no one could fight Apple, and it could quickly and easily put a floor in the stock at $600 without buying many shares at all. Between the $60 billion in cash it will have set aside to buy shares by the end of 2015 at any price and the $100 billion earmarked whenever its stock is below $600, it would have buying power of $160 billion, enough to buyback one-third of the company. Under this scenario, I imagine the market would respond in a similar fashion to how it reacted to Berkshire. No one will fight a $160 billion buy order, and the stock will within a month jump above $600 to stay. The company can then use its $60 billion commitment to cut the float and increase its EPS while barely having to use its $100 billion price-sensitive commitment. The threat alone will be good enough to put a floor in the stock and that floor is 25% higher than where it currently trades.
Mr. Icahn is right to argue for a more aggressive capital structure at Apple. The company should issue another $28 billion in debt to right-size its debt to cap ratio and use the proceeds to pull forward the end-date of its buyback plan. Further, it should follow Buffett's example and commit to an open-ended price-sensitive plan. Essentially, the bigger the commitment the less the money spent because no one will fight a buy order of $100 billion. By enacting this plan, Apple will provide the most appreciation to shareholders while spending the least amount of money. Mr. Icahn and all investors should urge Tim Cook to do just that.