Toni Sacconaghi, an analyst with a questionable track record at Bernstein Research, wrote an open letter to Apple (NASDAQ:AAPL) urging the board of directors to return some of its growing cash hoard to its shareholders in the form of a dividend Thursday morning. Just as I began to believe Wall Street analysts couldn't get any more idiotic, Sacconaghi sends this highly misguided open letter to the board of directors at Apple.
Here's why Apple should at least hold off on paying a dividend for a few more years. Apple is currently trading at an elevated market capitalization that rivals the likes of Exxon Mobil (NYSE:XOM), and all indications point to Apple far surpassing Exxon to become the largest company in the United States in terms of market capitalization sometime in 2011. For the market to have full confidence in Apple's market cap, Apple will have to show that though its net income isn't anywhere close to surpassing Exxon's in the immediate future, its extraordinary cash position justifies a very large portion of its market cap.
Wednesday, I published an article at Fortune explaining why Apple will probably trade at a $375 billion market cap in early 2012 compared to Exxon Mobil's $315 billion market cap. Now Exxon Mobil reports between $25 and $40 billion in net income yearly depending on the price of oil. Apple, on the other hand, is expected to report about $18-19 billion in net income in 2011. Yet, what drives the difference between Apple and Exxon is Apple's extraordinary cash position. At the end of 2011, Apple will grow its cash from $45 billion to $70 billion or at a rate of about 40% on an annual basis.
Exxon Mobil, on the other hand, reinvests a lot of its cash back into the business, making its book value far more important in the analysis. Exxon Mobil's book value stands at nearly $137.6 billion versus Apple's expected book value of about $73 billion at the end of 2011.
So how will Apple justify a market capitalization that far exceeds Exxon Mobil when Exxon not only reports a higher net income than Apple, but holds a significantly higher book value? Here's how. Apple's growth rate in cash and net income far exceed that of Exxon's, justifying a higher valuation based on future growth. By the end of 2012, Apple will likely exceed a $100 billion in cash and record net income that rivals Exxon Mobil. By closing in on Exxon Mobil's level of net income and book value, Apple's market capitalization will be a lot easier for Wall Street to swallow.
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Yet, if Apple starts to return a lot of that cash back to its shareholders, Apple's stock price will benefit in the short term from an elated sugar rush at the expense of Wall Street likely misconstruing the strength of Apple's balance sheet. Having large amounts of cash on the balance sheet has always been key in demonstrating that a company deserves an elevated market capitalization because it's always easy to point to that cash as a basis for justification.
Furthermore, shareholders will derive a larger benefit from headlines that read "Apple exceeds $100 billion in cash" than headlines that read "Apple returns a few dollars to its shareholders." Once the fact that Apple surpasses $100 billion in cash spreads across the financial industry, no one will question whether Apple should hold the #1 market cap. This is very much an issue of perception. For while Apple can accomplish the same result from a valuation perspective whether it does or doesn't offer a dividend, perception of valuation is far more powerful than what that valuation itself indicates.
The more astute investor understands all too well Wall Street's general ineptitude at valuation. Almost no one disagrees that the market entirely failed in giving Apple an appropriate valuation under the relatively (un)complicated iPhone subscription accounting regime. I fear that if Apple prematurely offers a dividend, Apple will see the same result as Wall Street grapples with the difficulty of understanding cash flow.
Here's probably the most important piece of advice that I've ever given to anyone in finance. Whenever being faced with two different ways to valuate a company, Wall Street will always choose the easiest of the two despite the more difficult method's accuracy and fairness in valuation. Apple paying a dividend will force the majority of Wall Street into analyzing cash flow to justify market capitalization - something that requires more than total laziness on the part of the average large investor.
Instead, what Apple should do is either offer a share buy-back program to reduce its market cap, or hold off on offering a dividend until it surpasses $100 billion in cash. This much is obvious.
Disclosure: At the time of this writing, the author holds September $46.00 puts on the QQQQ.