Last Friday, it was reported that technology giant Apple (AAPL) had bought back $14 billion in stock during the two week period since earnings. Apple saw the fall in its shares after the quarterly report, believing that share were a bit undervalued. Just as I stated in my earnings wrap up, the fall was an opportunity.
Apple took advantage of that opportunity to make a large purchase of shares, $12 billion via an accelerated program and $2 billion on the open market. This purchase will have tremendous short-term impacts on Apple's earnings, cash flow, and a few other items. But as you can probably expect, within hours, the critics were out in full force. Today, I'll break down the latest complaints from the non-believer group, and explain why this is good news for Apple.
Complaint 1 - This is pure financial engineering, Apple is just trying to prop up earnings per share:
$14 billion in shares equates to around 27-28 million shares, depending on what the average price was. Apple ended fiscal Q1 with about 892.45 million shares outstanding, so this program will reduce the outstanding share count by about 3%. It was a couple of weeks into the quarter when this program started, so you may not see the full impact on the diluted share count, which is used to determine EPS. There will be a fairly sizable boost to earnings in the quarter and fiscal year.
So here's why this complaint isn't valid. Would you prefer the alternative? If Apple didn't buy back shares, there would be a number of complaints about EPS growth, or the lack thereof. The following table shows Apple's estimates for the current and next quarters and fiscal years. The first half of the table is where estimates stood going into the fiscal Q1 report. The second half of the table shows where estimates stood as of Friday morning when we got the buyback report.
In last year's fiscal Q2, Apple had EPS of $10.09, meaning the estimate as of Friday morning called for just 6 cents of growth. Could you imagine what the bear camp and all of these negative nellies would have done if Apple reported a year-over-year decline in EPS? The same people complaining about Apple propping up EPS are the same ones complaining that they are too low. Again, you can't have it both ways.
Also, ask Intel (INTC) investors about not buying back stock. The chip giant massively slowed down its buyback during 2013, buying back less than 50% of what it did in the previous year. What happened to Intel's earnings? Well, although the buyback provided some help, Intel missed earnings estimates in three of the four reported quarters. Had Intel bought back even the same amount of stock as the previous year, it's safe to say that at least one or two of those misses, if not all three, could have been avoided. Intel is a great example of a company spending too much on R&D with no positive outcomes yet. Too much R&D may be one reason why capital returns have suffered greatly, with no dividend raise in more than a year and the falling buyback. Reality has set in for Intel, with shares losing about $3 since the recent high. Go ask some Intel investors about the prospects of a large buyback.
Complaint 2 - Money would have been better spent on R&D:
This complaint seems a little more viable than the one above, as investors are concerned about stalling revenue growth in the quarter. But as I detailed in my earnings wrap-up, a lot of Chinese iPhone sales were pushed forward, and Apple usually is conservative with its guidance. In the end, I'd be surprised if the company actually reported a year-over-year revenue decline. It can happen, but right now, I don't think it will.
Also, it's not like Apple is ignoring R&D. In my latest Apple article, I showed how Apple spent nearly $4.8 billion on R&D in calendar 2013. That was up more than 83% from what the company spent in calendar 2011. Also, management has confirmed that the company is investing heavily in R&D. Let's take a look at a piece of the fiscal Q1 conference call.
Katy Huberty (Morgan Stanley): And Peter, you're guiding OpEx flattish sequentially, despite the big revenue downtick. Are there any one-time items in SG&A and R&D in the March quarter? Or is the run rate reflective of investments for future opportunities?
Peter Oppenheimer (Apple CFO): It's definitely the latter, and let me have Luca take you through some details.
Luca Maestri (Apple VP and Corporate Controller: Yes, at the midpoint of the range of our guidance, we are expecting a minor decrease of $50 million. This is largely due to the lower variable expenses that we're going to have, in line with the seasonal sequential decline in revenue. But one thing that Peter already mentioned in his remarks is that we continue to invest very heavily in R&D. We make investments in areas that are visible to all of you today, but also in areas that are not visible, which we're very excited about. And for the things that are not visible to you, obviously were impacting ahead of the revenue that these products and services will generate in the future. So there is nothing that is one-off in nature in our guidance.
Apple isn't just talking the talk here. The following chart shows the quarterly expense for R&D, taken from the income statement. This is by fiscal quarter, and remember, Apple's fiscal year ends in September. The most recent quarter, which ended in December 2013, was fiscal Q1 of 2014 for Apple.
Other than one small tick down in late fiscal 2013, R&D expense has been rising for years. In three years, it is up more than 131%, and I expect it to continue increasing. I've already stated that I believe something new will come in 2014, and I'm not just talking about bigger iPhones or iPads.
But there are two other sides to this argument. First, just spending on R&D doesn't guarantee you success. Intel spent an extra $1.8 billion on R&D in 2012 and the company's revenues declined in 2013. In 2013, Intel spent another $450 million or so on top of the 2012 amount and the company is forecasting flat revenues for 2014. R&D spending isn't always about spending the most money. It also has to be spent effectively.
Additionally, go back to the argument above about EPS. Apple spent $1.33 billion on R&D in fiscal Q1. If Apple had spent another $100 million, would anyone have really noticed a difference? Would it matter in terms of products right now? Probably not. What would have been the result? Well, keeping all else equal, Apple's EPS would have been about 8 cents lower, or $14.42 instead of $14.50. The same people complaining about EPS growth and lower net income are the same ones complaining about more R&D. If Apple spends more on R&D, net income and EPS will be lower, and again, it's no guarantee of future products and their potential success.
Complaint 3 - Apple is giving in to Carl Icahn:
The jury is still out on this one. Carl Icahn has been arguing for a much larger buyback, and there will be a vote at the upcoming annual meeting. With Apple's domestic cash pile under $35 billion at the end of fiscal Q1, and likely a lot lower after the recent purchases, Apple will probably have to borrow more debt or repatriate funds if it does go with Icahn's proposal. The debt route is the more viable one at the moment.
At the moment, Apple has not given into Carl Icahn. Apple has remained committed to a $60 billion buyback that is scheduled to end in calendar 2015. With about $32 billion left at the end of fiscal Q1, there's about $18 billion left now. It is possible that Apple finishes the current buyback in late 2014 or early 2015. At that point, Apple could announce an extension/increase to the current plan, or a new buyback altogether.
But the key part here is that Icahn was arguing for an extra $50 billion in repurchases by September. Even if Apple ups the buyback this year, it may take another couple of years for the company to complete the buyback. Is that necessarily giving in to Icahn? I really don't think so. Also, Icahn's position is very small, 1% or less in Apple shares. Icahn's words might have a tremendous amount of power, but he doesn't hold a lot of stock. There are mutual funds and ETFs that hold more than Icahn, so they have more power.
Complaint 4 - What about a special dividend?
You could make the argument that this complaint is not specific to what Apple did these past few weeks. This complaint could go more towards the overall argument of dividends versus buybacks. However, there are some that will ask why instead of just buying back $12 billion in one shot, Apple just didn't pay out like $12 or $13 to shareholders in a special dividend.
The problem here is that investors just want money, and they will take the money and run. A special dividend is a short-term rush for investors. Apple pays out $12, and that money goes off in a million different places. Some investors will reinvest it into Apple shares, some will invest in other names, and other investors might pocket the cash. Going this route, investors also have to pay taxes on the dividends. Buybacks don't have that issue upfront.
But for Apple, the buyback is better for the company, and most likely shareholders, in the long run. Apple can not only boost earnings per share, but can also help to support shares when they are falling, like the company did recently. Additionally, Apple can save money on dividend payments.
Why this buyback matters:
Many seem to lose sight of the long-term aspects of Apple's buyback. The following chart shows what Apple's outstanding share count could look like at the end of Q2.
*Q2 value assumes share count down by 25 million due to buyback partially offset by some dilutive securities.
Depending on how much stock Apple bought back prior to earnings (if any), and how much the company might buy back by the end of March, my outstanding share count reduction of 25 million might prove to be conservative. We'll see. If we use that 25 million figure, Apple will have reduced its outstanding share count by about 7.7% in the past year. That's a tremendous amount and should not be overlooked. You won't find that at Microsoft (MSFT), Cisco Systems (CSCO), or even Intel. Of course, if you are investing in Google (GOOG), you are actually being further diluted every single quarter. But in this market, that gets you to new all-time highs. I can't wait to see what happens to Google shares if Google starts buying back stock. Right now, Apple is being criticized for buying back stock, while others are being rewarded for not buying it back or not buying enough to help results.
But reducing the share count by 25 million does more than just improve earnings. It also improves Apple's cash flow in a sense. Apple doesn't have to pay dividends on those 25 million shares anymore. Even if we assume no raise this year, that's a cash flow savings of over $305 million in the next twelve months. If Apple gets down the share count by 30 million in the quarter and the next dividend raise is quite significant, the buyback this quarter could save the company over $400 million in the next twelve months on dividends. That money helps future dividends and buybacks, and I'm sure some of it would get funneled to R&D as well.
Also, this was a strong statement by Apple that it believes the stock is undervalued. Looking at the past couple of weeks, Apple basically bought more than two full trading days' worth of volume. It seems that Apple put a line in the sand, and that was around $500. I mentioned in my last Apple article that I expected Apple could potentially trade down to the 2.50% dividend yield level at $488 or the 200-day moving average, which was then at $485. I feel pretty confident in saying Apple would have hit one or both of those levels if not for the buyback. Also, don't forget that Apple shares hit a high of around $575 before earnings. The pullback allowed Apple to buy back a bit more shares, so this was truly an opportunity all-around, for both the company and investors.
Nobody else compares / low valuation:
For everyone complaining about Apple's buyback right now, I challenge you to find another top tier tech name that's doing more. The following table shows the diluted share count for the names I've mentioned in this article already against the year prior. Remember, these are the share counts used to determine EPS, not shares outstanding. These are as of the latest reported quarter for each, so Q1 to Q1 for Apple.
*Cisco numbers as of previous quarter. Cisco will report its quarterly earnings this week.
Cisco has a chance to change its number a bit this week, but I still wouldn't be surprised if the networking giant has a year-over-year rise for its diluted EPS. That being said, Apple is only one of two names to report a year-over-year decline! Microsoft has a small decline, but Intel and Google show more dilution. Apple just bought back a large amount of stock, so the fiscal Q2 percentage should be quite sizable as well. When it comes to buybacks, there is no other name that compares right now. I don't expect that to change anytime soon.
Now you would think that Apple is dead, according to many of the bears. Apple's guidance caused many estimates to come down, but yet, Apple's valuation has a bit as well with the fall in the stock. In the following table, I've compared these five names in terms of growth and valuation for their current fiscal years.
*EPS growth and P/E are non-GAAP.
Apple is still projected for revenue and earnings per share growth in the mid to upper single digits. You would have thought revenues were declining by 20% given the way Apple trades. Cisco is projected to show a decline in both revenues and earnings per share. But when you convert Cisco's P/E to GAAP, Cisco trades for slightly more than Apple does. Cisco has a higher dividend yield, but Apple has a much more powerful buyback. Intel has reported two straight years of revenue declines and plunging earnings. Intel has forecasted flat revenues in 2014, and earnings per share are expected to decline again. Yet, Intel trades at a P/E multiple nearly a full point higher than Apple. Does that make sense to you? Microsoft has an advantage on revenue growth, but not earnings per share growth. Microsoft trades at an even larger premium than Intel, and yes, I believe Microsoft is fairly valued. Then we have Google. Yes, Google gives you growth, but nothing else. No dividend, no buyback, just some growth and dilution per quarter. In fact, everyone said that Google's sale of Motorola's hardware ops would boost Google earnings per share this year. Yet, Google analysts have reduced EPS estimates by 45 cents since Google reported Q4, and Google missed by 25 cents in Q4. Do you hear any outrage over Google missing? No, everyone said that a sale would help earnings, but yet, analysts are cutting estimates, and Google still hasn't been downgraded by one analyst in about ten months. For that, Google trades near an all-time high and at a substantial premium.
Apple made a major announcement last week, which means that the critics have to come out and complain. Apple defended the fall in shares post-earnings by buying back $14 billion in stock. Critics say this is just Apple trying to prop up earnings per share. Yet, if Apple didn't buy this stock back, critics would complain that earnings per share were flat or declining. You can't have it both ways. Critics want Apple to spend more on R&D. Apple is doing that, and R&D spending does lower earnings per share that are so valuable. Additionally, R&D is no guarantee of future success for revenues or profits. Just ask Intel shareholders about the past couple of years. Finally, critics complain that Apple is giving in to Carl Icahn, who holds only about 1% of Apple shares. I would argue that the jury is out on Apple giving in so far. Apple is buying back stock under its $60 billion program, and the company has not announced a large increase to the program yet. Also, Icahn makes some good points, and look at the numbers I presented above. No other name is reducing its share count like Apple, and Apple trades at such a low valuation, despite providing more growth than many other names. Buybacks are also much more valuable to the company long term than just paying out a large special dividend.
In the end, Apple did what it had to do. The company defended its share price. There will always be Apple critics, and these critics or bears just aren't happy with anything. They want Apple to do one thing, but if Apple does it, the critics argue for something else. As I've continued to state, these people can't have it both ways. Apple should be applauded for what it did in recent weeks. This will benefit shareholders in both the short and long term.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.