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Summary

  • With shares undervalued, buybacks are a better option.
  • Dividends are less flexible during economic downturns.
  • Yes, buybacks do increase the share price.

The Cash Conundrum

Apple (NASDAQ:AAPL) by way of its success has accumulated a massive pile of cash (and cash equivalents for you nitpickers) which is largely held overseas. To bring this money abroad the company must either pay a hefty 35% in taxes or hope for a tax holiday. As it seems, Apple has decided to buckle down and wait. With more cash than is feasibly expendable on R&D or acquisitions, the company has elected (as is appropriate) to pay this money to loyal shareholders via dividends and share repurchases.

On April 23, 2013, Apple increased its annual dividend by 15% from $2.65 to $3.05 per share. That day, Apple shares closed at $406. Since then, the company has paid out nearly $8.4 billion in cash to shareholders. In the interim, share prices have risen by over 25% as the company continues to support the price by buying back its own stock. The company has also been actively repurchasing shares which in turn causes the share price to rise.

For Inexperienced Investors: Think of a company as a large pizza cut into eight slices, your share is one of those slices before a share repurchase. Now think of a large pizza cut into only six slices, your share is one of those (larger) slices after the repurchase. Theoretically, share repurchases boost the share price by reducing the float.

Cash Disposal Options

When companies have the severe problem of excess cash, the two most popular ways solving this issue are by distributing the money as dividends or by repurchasing company stock. One less popular way employed by companies such as Facebook (NASDAQ:FB) is to burn through by overpaying for tech startups.

The most fundamental question an investor should ask himself (or herself) before making an investment is whether his cost of capital is higher than or lower than his anticipated return on that investment. If the return is greater than his cost of capital then he should invest, if not he is better off making origami cranes out of that money (or choosing a better investment).

Back in April, 2013, Apple issued debt to finance its capital return program. At that point interest rates were at historic lows and the yield on Apple shares was higher than the yield on the issued bonds. The bonds carried the additional advantage of tax-deductible interest to sweeten the deal for Apple. At that point it was an absolute "no-brainer" to issue debt and buy back shares as the cost of capital was lower than the return. At this point in time, the yield on new debt would likely be higher than the yield on Apple shares so it's not as obvious as to which route management should take.

The Case Against a Dividend Increase

There are two reasons why I hope that Apple does not raise the dividend this quarter as it has in the past. Firstly, I own shares in Apple because I believe that shares are undervalued. If you are investing under the same premise as me, the best method of capital return is via share repurchases where equity return is greater than the dividend. Secondly, while management can allocate repurchases at will, cutting a dividend is an enormous vote of no-confidence. For a tech company such as Apple, a protracted economic downturn may erode cash flows and I would not fancy the slaughter to ensue should the dividend be cut.

At the end of the day, the greatest vote of confidence a company can convey is an investment in itself. The board of directors of Apple has historically acted in the interest of investors and should continue to do so by keeping the dividend stable and buying back shares at breakneck speed.

Source: Apple: The Case Against A Dividend Increase

Additional disclosure: I am net long Apple in a position consisting of shares, long options and short options.