Apple Should Reduce Outstanding Shares: Here Is Why The Opposition Is Wrong

| About: Apple Inc. (AAPL)

It seems that a large portion of the Apple (NASDAQ:AAPL) investors disagree with the proposal that Apple collects debt and returns the received cash to the shareholders. I received several comments on this previous article. I argued that Apple should collect $75 billion in debt and return this to the shareholders through a combination of a capital payment and a reverse stock split (hereafter: proposed transaction). According to the comments on this article, I find that there are a couple of misunderstandings regarding the proposed transaction. In addition to my previous article, I would like to elaborate why Apple should execute the proposed transaction in the first place and resolve some of the misunderstandings regarding the proposed transaction.

Management and Strategy

One of the misunderstandings regarding the proposed transaction is the assumption that I have no faith in the company, its management nor its strategy going forward. I do have faith in Apple's business model, current management and its strategy. The proposed transaction is purely a tool for Apple to increase value for the shareholders apart from the potential growth opportunities and without putting the business at risk. Carl Icahn already pointed this out in his letter to Tim Cook (see quote below).

We want to be very clear that we could not be more supportive of you, the existing management team, the culture at Apple and the innovative spirit it engenders. The criticism we have as shareholders has nothing to do with your management leadership or operational strategy. Our criticism relates to one thing only: the size and timeframe of Apple's buyback program. It is obvious to us that it should be much bigger and immediate.

Further, the proposed transaction does deliver strategic value for Apple's shareholders. The company has an attractive P/E ratio from a historical perspective (see graph below). The shares currently trade at 13.12 times earnings per share. Apple is not growing as fast as it did a couple of years ago, so a P/E ratio of 20 or higher is not realistic. However, analysts expects that Apple will grow revenue by 7.70% in 2014 and 6.50% in 2015 (source: Yahoo! Finance). When I take Apple's growth scenario into account, a P/E ratio between 15 and 17.50 seems reasonable to me.

AAPL PE Ratio (NYSE:<a href='http://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) Chart
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AAPL PE Ratio (TTM) data by YCharts

If Apple's management really believes the stock trades at a discount, they should embrace the idea of reducing the amount of shares outstanding immediately. This moment provides a unique opportunity to reduce the amount of shares outstanding for a relatively low price. The announcement to reduce the number of shares outstanding also implies that Apple's management has faith in the company's future and that the management believes that the shares trade at a discount. This could support Apple's share price, when the markets adopts Apple's management point of view regarding its valuation.

Financial position

Another argument against the proposed transaction is that it would jeopardize Apple's healthy financial position. An increase in the leverage of its balance sheet makes Apple (theoretically) vulnerable for a temporary slowdown in demand for its products. This argument does not make sense to me, because it implies that Apple is going to deliver poor quality products and the demand for its products will decrease. Apple has a proven track record when it comes to introducing great high-end products and there is no sign of a decrease in demand for its flagship products. For example: Apple's latest introduction of the iPhone 5s is a success (see this article).

Apple will have a healthy balance sheet after the proposed transaction. The total equity amounts $124 billion on September 28, 2013, according to the company's fourth quarter earnings report. As a result of the proposed transaction, the total amount of equity will decrease to $49 billion. Apple's total balance sheet amounts $207 billion as of September 28, 2013. Considering Apple will earn around $40 billion and will return $30 billion in dividends and buybacks in 2014, the total equity will be around $60 billion on September 30, 2014. So, the solvency ratio will be above 25% by the end of 2014.

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In my opinion, increasing the leverage of the company is a sign of trust in Apple's management and its strategy, rather than a threat to its financial position. Worries regarding the possibility that Apple will miss out revenue from a whole product launch are just not realistic any more. Apple is an incredible strong premium brand and the customers are more loyal to Apple compared to customers of Android devices and other competitors (see graph above). In the unlikely scenario that Apple will miss out on a new product launch, the company has still $147 billion (86% of last year's total annual revenue!) in cash reserves as a safety cushion.

R&D and M&A

The last argument against the proposed transaction refers to Apple's Research & Development and Mergers & Acquisition expenses. Commenters stated that Apple should invest in R&D and M&A, rather than reducing the number of stocks outstanding. In my opinion, Apple has more than enough cash in hand and/or free annual cash flow to keep spending money on R&D and M&A. To support my opinion I disclosed Apple's Cash generated by operating activities for the twelve months ended September 28, 2013 (see table below).

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Apple generated $54 billion in cash from operating activities (including the deduction of $4.5 billion R&D expenses) in 2013. Considering that Apple pays $11 billion in dividends and buys back $19 billion of its own shares, the company has a free annual cash flow of $24 billion. As a result of the proposed transaction, interest- and loan repayments will reduce the free annual cash flow by approximately $6.5 billion ($1.5 billion net interest charges and $5 billion loan repayments). The remaining free cash flow amounts $17.5 billion. This is enough to cover Apple's annual spending on M&A. For example: Apple spend $9.5 billion on M&A in 2013. If Apple raises R&D and M&A expenses by 50% compared to 2013, the company adds $1 billion to its $147 billion cash pile.

Conclusion

Considering all of the above, I am convinced that Apple should reduce the number of shares outstanding through the combination of a capital repayment and a reverse stock split, because:

  • Arguments that such a transaction puts Apple's financial health at risk do not match arguments that I do not have confidence in Apple's management and/or strategy.
  • Apple is a strong premium brand, it has extremely loyal customers and a proven track record in delivering quality products. In my opinion, worries regarding the possibility that Apple will miss out on revenue from a whole product launch are not realistic.
  • Apple's financial position remains strong, with $147 billion cash in hand and a solvency ratio above 25% by the end of 2014.
  • There is more than enough free annual cash flow to cover for Apple's annual spending on R&D and M&A. Even if Apple raises R&D and M&A expenses by 50% compared to 2013, the company adds $1 billion to its $147 billion cash pile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.