- Apple's cash pile is a key issue for the company.
- Foreign cash balance growing with no apparent repatriation in site.
- Debt cheaper than repatriation, but interest costs rising.
- The buyback-dividend-cash flow savings argument doesn't always apply.
- Repatriation at low tax rates could completely change the situation.
During my time contributing to Seeking Alpha, there is no name that I have covered more than Apple (NASDAQ:AAPL). When it comes to Apple, the company's products obviously are the most important item, but Apple's financial results are scrutinized quite often. One of the biggest issues I'm constantly asked about is the company's cash position. Apple's large cash balance has enabled the company to restart its dividend program and buy back tens of billions of dollars worth of stock. Over the last year, the cash issue has got more interesting, and in my opinion, has become perhaps the most important issue with Apple currently. Today, I'll take a much needed look at Apple's cash pile, and detail why I believe this issue is so important for shareholders.
Apple's cash pile and foreign held balances:
When it comes to Apple and other companies, we refer to a company's "cash pile" instead of just plain cash. This cash pile often includes both short and long-term investments. Most of these investments are in highly rated securities, and you can see the breakdown of Apple's holdings on page 9 of the latest 10-Q filing.
Over time, Apple's cash pile has grown tremendously. In the table below, I've detailed the breakdown of Apple's cash and investments going back to fiscal Q4 of 2009. I've also broken down the domestic portion of this pile, so you can see how Apple's foreign holdings have really increased in recent years. Dollar values are in millions.
*Domestic number is approximate as Apple rounds foreign balance to nearest $0.1 billion.
The numbers above were at the end of the March ending quarter, and we'll get the latest numbers in a couple of weeks. We know that Apple did take out more debt in the quarter, which I'll get to later on. Apple used a couple of billion dollars on the dividend, and perhaps even more on the buyback.
Apple's domestic cash pile has decreased steadily over the past five quarters, to its lowest point in about four years. This is one reason why I believe the latest dividend raise was a disappointment. Apple still generates a few billion each quarter in domestic cash flow, but the dividend runs almost $3 billion a quarter currently. If Apple buys back even a few billion dollars worth of shares in the quarter, the domestic cash value can decrease quickly. With Apple boosting the buyback recently, about $44 billion is expected to be bought back over seven quarters ending at the end of calendar 2015.
How this compares to peers:
Holding a large portion of the cash pile outside the US is not exactly an Apple-specific issue. In the table below, I've detailed how other large cap US tech peers also do this. Microsoft (NASDAQ:MSFT) and Cisco Systems (NASDAQ:CSCO) have an even higher percentage of foreign funds than Apple. Intel (NASDAQ:INTC) and Google (GOOG, GOOGL) don't have as high a percentage, but still have around half or more being foreign held. In the next section I'll detail what these companies are doing when their US cash balances get too low.
*For Apple, this includes long-term investments. All other names only include cash and short-term investments in their cash piles. Google's cash pile includes $160 million of cash and equivalents classified as assets held for sale.
**Intel has $11.0 billion held by foreign subsidiaries. However, about $1.9 billion of that was available for use in the U.S. without incurring additional U.S. income taxes in excess of the amounts already accrued in its financial statements. Please see Intel's 10-Q filing for more details.
Debt may be "cheap," but it is getting more expensive:
With the domestic portion of Apple's cash balance decreasing, Apple has gone to the debt markets to raise funds for the buyback/dividend instead of expensive repatriation. In one of my past Apple articles, I detailed how debt is getting more expensive for Apple, even though historically, interest rates are quite low. Here's the table from that article.
Apple took out $14 billion in fixed rate debt last year, with a weighted average interest cost of about 2.10%. Some floating rate debt was also issued. This year, Apple took out $10 billion in fixed rate debt, but the weighted average interest cost was up to 2.74%. Both of those numbers do not include any tax savings. As Apple takes out more debt, the balance sheet gets weaker, technically, so rates go up. Apple took out half as much 5-year debt this year but paid more than twice the rate as it paid last year.
With Apple expected to buy back $44 billion or so of stock between calendar Q2 of 2014 and the end of 2015, it is possible that Apple will need more debt to finish off the buyback. The company will produce a decent amount of cash flow, but I don't know if it will be enough domestically to cover the dividend and the buyback. I could see Apple taking out more debt in 2015, or perhaps earlier if rates start to creep up and management gets a bit nervous. Like many others, I do not think that we will see any repatriation before the end of 2015. Once we get into 2016, Apple starts to face debt maturities. In the chart below, I've detailed how much comes due each year. The numbers below include both fixed and floating rate debt.
A couple of billion here and there does not seem like much, but it does add up. Currently, Apple is on the hook for $14 billion of debt between 2016 and 2019. If rates do go up like many expect them to, Apple could be forced to refinance at significantly higher rates. If Apple runs the domestic cash balance at a low level, paying back the debt may not be 100% possible. The key takeaway here is that Apple investors probably should not expect the buyback to remain at such a high level after 2015. More on this later.
Apple is not the only name that is taking out debt. Microsoft took out a bit of debt in December 2013, and more since then, as seen on page 21 of its most recent 10-Q. Microsoft has $900 million of debt due in 2042, which has a stated interest rate of 3.500%. When Microsoft took out debt in December 2013 that comes due in 2043, the stated interest rate on just $500 million was 4.875%. In March 2014, Cisco took out $8 billion to help with its dividend and buyback, as seen in its latest 10-Q filing, page 24. These tech companies with constrained US cash balances are having to take out more debt, and at that usually means higher interest rates.
Debt rates versus dividend yields:
There's always been a long time argument that using debt is worth it for buybacks when you can retire shares that have dividend yields higher than your after-tax debt cost. That makes perfect sense on short-term debt, because if you are paying 1% after tax and the dividend yield is 3%, you save a nice chunk of change over time.
However, with some of these recent debt issues, the argument has changed quite a bit. Then, add in the fact that Apple is getting close to its all-time high, and Microsoft and Intel are at multi-year highs. That means that dividend yields have dropped a bit, and you can see current yields in the chart below.
So the debt for buyback discussion does take a bit of a hit with yields coming back down. Sure, Apple's 1% interest rate debt looks good when used to buy back shares currently yielding 1.96%, but what about Apple's 4.45% yield debt? Not all debt works when dividend yields drop, and that's what we are seeing now.
This is why repatriation is so complex and important:
I don't want to turn this into a debate about the US tax code. However, because of the current system, Apple and many other large multinational firms are leaving cash parked overseas. Apple was over $132 billion in its foreign cash pile at the end of fiscal Q2 2014 (calendar Q1). Unless Apple makes a substantial foreign acquisition in the near future, that number is likely to pass $150 billion sometime this year and head towards $200 billion.
Apple's current tax rate is running around 26% on a quarterly basis, mostly thanks to lower taxed profits outside the US. This tax gap would have to be made up when Apple brings these profits home, and thus, you have the repatriation issue. Apple cannot use these foreign funds for the dividend or buyback.
Right now, it is a no-brainer for Apple to borrow against its foreign resources. Even if Apple has to pay up to 5% or so in interest, that's nothing compared to a potential 10%, 20%, or maybe 30% tax bill on repatriated funds. This is no small matter when you are talking about numbers well over $100 billion. Apple is not going to repatriate $10 billion if it has to take a $2 billion hit from taxes. The company will just go to the debt market and probably average around 3-4% interest, which is just a few hundred million dollars.
It is quite obvious that repatriation could change everything. In the best possible scenario, Apple could repatriate all of its foreign funds without having to pay any taxes. Although this is highly unlikely, just imagine what it would do for the stock. At the end of the latest quarter, Apple had spent a little more than half of its current $90 billion buyback. Apple's share count peaked above 940 million shares at the end of fiscal Q2 2013. At the end of fiscal Q2 this year, that share count was down to less than 862 million, with just half of the buyback being used. The second half of the buyback won't reduce the share count as quickly on a numerical share basis, just because Apple shares have risen so much. Those share counts were before the 7 for 1 split, so you can adjust accordingly.
Imagine if Apple could bring $130 billion back to the US without any taxes. Apple could pay off all of the debt it took out in recent years, as well as double the buyback. That would certainly make this stock a must own, if it isn't already. Apple essentially would have its own stimulus plan, and the share count would be reduced in an even more dramatic way. Unfortunately for now, Apple would have to pay a large tax bill if it wanted to repatriate funds. If the foreign balance gets large enough, Apple may eventually decide to bring some money home. Perhaps when the debt starts coming due in 2016 Apple might, so maybe some extra funds are brought back home to continue the buyback and further dividend payments.
2016 becomes the key pivot point:
I know we are only halfway through 2014 at the moment, but since most people think markets are forward looking, I do have to discuss how Apple's future could change in a big way. Once we get into 2016, debt will come due, and the current buyback is scheduled to end. By that point, Apple may have taken on even more debt to help with the buyback, unless the company really drains its US cash pile or starts to repatriate.
That's what makes 2016 so important for Apple, regardless of what happens with the company's product line. By then, I think the iPod will be mostly gone, and you'll see something new like the iWatch. Apple's decision on what to do with its cash will be closely scrutinized, and since there are many Apple bears out there, I'm sure the company will be criticized for whatever it does. I have stated in past articles that I expect the dividend raise in 2015 to probably be light as Apple funnels most of its cash resources to the buyback. A dividend raise that matches the share count reduction, kind of like what we saw in 2014, seems logical at this point.
I think that once we get into 2016, you could start to see Apple funnel more cash to the dividend. Investors do need to realize that Apple will not be a high yielder compared to its peers for at least a couple of years. If you are looking purely for income, Intel, Microsoft, and Cisco Systems are much better ideas. Once the share count gets down enough and the buyback slows down a bit though, the dividend could be the beneficiary.
As for the buyback, I do think it will continue in 2016 and beyond, albeit in a very different form unless Apple starts to repatriate in a major way. Without repatriation, I could see the buyback returning to its original form, which was just to negate the impact from executive options and other dilutive securities. Apple's original buyback amount was $10 billion, that was expected to be used over a roughly three-year period. Originally, the buyback was not intended to get the share count down, rather, just to make sure it didn't rise as fast or rise at all. Pressure from shareholders and a declining stock changed the situation, however, and Apple eventually decided to use the buyback to get the share count down. That plan has worked, but what happens in 2016 and beyond may be very different than what we see happening today.
Apple's cash pile is becoming an even more important item with each passing quarter. The company's foreign cash balance continues to skyrocket, with no repatriation in site, an issue most US tech companies are facing. Apple can borrow against these funds, but interest costs are rising for the company. The strong buyback will continue through the end of 2015, at a slight cost to the dividend. Once we get into 2016, Apple investors must prepare for a substantially lower buyback unless US tax law changes or Apple decides to start repatriating and paying Uncle Sam. Either of those scenarios would further cement the long thesis. At least for the indefinite future, Apple's strong capital return plan is a reason to own this stock. Shares hit a new 52-week high on Monday, which shows that optimism abounds when it comes to Apple.
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.