Investors have been keenly interested in the prospect of Apple (AAPL) using its huge cash hoard to make acquisitions. Companies recently mentioned as acquisition targets include Hulu, Sony (SNE), and Barnes & Noble (BKS), amongst others.
Most commentary in the financial press has focused on the relative merits of AAPL making or refraining from making such acquisitions from a "strategic" point of view. For example, such issues as product synergies and corporate culture compatibility have been hotly debated. Another major reason cited for Apple's reticence to make acquisitions has been its stated desire to focus very narrowly and intensely on a few product areas and strive to be the best in every product category that it offer.
However, in the midst of the financial crisis of 2008 and 2009, Apple managers suggested that another thing might be influencing their decisions: Stinginess.
At the time of the global financial crisis, some AAPL managers complained publicly about the lofty valuations of Silicon Valley start-ups and expressed the hope that the global financial crisis would bring the valuations of those companies into a range that would make them attractive.
Such a mindset raises the specter of Apple potentially taking advantage of the present corrective environment to make some strategic acquisitions. Indeed, I believe that this prospect will prompt much speculation in coming weeks and months.
Why Not Use Cash To Take Advantage Of Bargain Prices?
Much M&A speculation overlooks an important financial impediment that Apple management may be sensitive to: AAPL's extremely low P/E. Given AAPL's extremely low valuation on a P/E basis (roughly 11x 2012 EPS), most acquisitions that they make would be dilutive to their earnings.
Some may reply that the problem of whether acquisitions are accretive is not an issue when the acquiring company is not using its stock as "currency" and is instead using cash. And surely, this is true to an extent. Virtually any level of actual or prospective earnings on the part of a target will be more accretive to AAPL's earnings than what AAPL is currently making on cash.
However, there is a sense in which cash acquisitions will be dilutive if Apple acquires firms with high P/Es, or perhaps high prospective P/Es: The acquisition would be dilutive relative to simply returning cash to shareholders via payment of dividends or share repurchases.
Making acquisitions may not be the best use of AAPL's cash. Indeed, it needs to be understood that AAPL does not need cash at all in order to make acquisitions. I will elaborate more on this later.
Paying a Dividend: A Strategic Deployment of Cash
I believe that there is an important strategic alternative that AAPL should evaluate - and may be evaluating - when it weighs the pros and cons of a prospective cash acquisition. Namely, AAPL should take into account the potentially explosive expansion of its current P/E multiple that might result if AAPL became a dividend paying stock.
A dividend would dramatically heighten the appeal of AAPL stock and greatly widen its potential shareholder base.
AAPL could become to consumer electronics what Procter & Gamble (PG) is to consumer staples or what PepsiCo. (PEP) is to food and beverages, with one big difference: AAPL offers much more growth; and it is a much more exciting brand.
If PG and PEP could recently trade at a 15X forward P/E, AAPL should quite logically be able to do just as well or better.
For example, let us assume that AAPL declared a $10 per share dividend. It could easily sustain such a dividend with its current free cash flow generation, without even having to tap into its cash hoard. This implies a dividend yield slightly north of 2.5%. Such a dividend would in no way impair AAPL's ability to invest aggressively in its business, either organically or through acquisitions. With this sort of dividend, it is quite likely that AAPLs P/E ratio could expand to 18 times forward earnings. That implies a stock price for AAPL of over $650.
AAPL might consider an even more aggressive alternative. AAPL could consider paying a very high dividend, say $20 per share, which would imply a current dividend yield of 5%. Assuming that AAPL invests aggressively in the interim - organically and via acquisitions - such a dividend would require drawing down the cash hoard over the course of several years. However, a reasonably conservative estimate of AAPL's free cash flow growth would enable it to comfortably pay a $20 per share dividend in 5 years - even allowing for a 7% per annum dividend growth rate in the interim.
In other words, AAPL can have its cake and eat it too, so to speak. They can invest aggressively and make all the acquisitions they want and simultaneously pay a handsome dividend. In this case, the strategy would be enabled merely by modestly drawing down the cash hoard for 5 years.
Paying a Massive Dividend and Raising Debt - The Optimal Alternative for AAPL
An even more aggressive alternative would involve AAPL taking advantage of historically low interest rates and the deductibility of interest expense in order to lower its weighted average cost of capital (WACC). In this scenario, AAPL would raise debt in the debt market at once-in-a-lifetime interest rates. For example, they might issue a 10-year note which would enable them to pay a large one-time special dividend of around $24 per share, plus annual dividend of $24 per share ($6 quarterly) starting immediately, or an implied dividend yield of 6%.
To make the offer even more tantalizing to prospective shareholders, AAPL should simultaneously announce that it plans to pay out a special dividend of $24 at some undisclosed date during the next 5 years. Again, as in the example above, at the end of the 10-year period of paying high dividends and even a special dividend, AAPL should be able to comfortably pay the dividend with its internally generated cash flow, even allowing for strong growth of the dividend in the interim.
Imagine, a company with AAPL's growth profile, making a special distribution and then announcing the equivalent of a 6% annual dividend yield! And then imagine the speculative value of the pre-announced special dividend to be paid in the next five years.
Currently, companies paying a 6% dividend yield (and no special dividends) are fetching valuations of 18-20 times earnings. But the catch is that they typically offer less than 5% earnings growth. Such is the case with the REIT or MLP space, for example. By comparison, AAPL should be able to fetch P/E valuations of 25x or more. This would place the value of AAPL's stock at above $1,000 per share.
There is another important reason why the alternative of raising debt to enable a more aggressive dividend might enhance AAPL's P/E multiple. It would substantially improve the company's EVA, or economic value added. The concept here is that Apple would improve the spread that it is earning for shareholders between its cost of capital and its return on capital invested. Companies with higher EVAs sport higher P/E multiples. And a manner in which companies improve EVA is by enhancing the efficiency of their capital structure. Currently, AAPLs capital structure is quite inefficient. The massive cash hoard is just one aspect of this problem.
The other aspect of AAPL's capital inefficiency is that AAPL finances all of its operations with equity capital, which currently is enormously more expensive than debt capital. Indeed, at no time in history has the spread between the cost of equity and debt capital been so high. The spreads between earnings yields and bond yields are at historic highs. AAPL should be taking advantage of this historic anomaly on behalf of shareholders by acquiring cheap debt, returning expensive equity capital and lowering the company's overall cost of capital or WACC.
Thus, before using cash to make an acquisition, AAPL would be well advised to look at other strategic alternatives that are available to raise its stock price and create value for shareholders. Indeed, it makes more strategic sense to focus on using that cash to raise its stock price and P/E multiple first. This would enable AAPL to use its appreciated stock rather than cash to make acquisitions in an accretive fashion.
Is $1000 unrealistic? Not at all. What is unrealistic about a P/E of 25x for a company like AAPL? If anything, what we need to be asking is why AAPL stock is not at $1,000 already. One of the reasons may be that AAPL has an inefficient capital structure. AAPL's enormous cash hoard is just one aspect of this problem.
There many good reasons why AAPL should be careful in how it deploys its enormous cash hoard. And very high on the list of these reasons is that a very good strategic alternative exists for AAPL to deploy this cash: Institute a large annual dividend, payable on a quarterly basis.
In my view, before making an acquisition, AAPL managers should strongly consider the electric effect to its long-term share price that becoming a dividend payer could have..
In this same vein, AAPL should consider an aggressive complementary strategy of raising debt in order to enable an even higher dividend. Furthermore, this strategy would lower its WACC and improve its EVA, thereby raising its fair value P/E multiple.
This brings us to a final point: Does anybody think that AAPL really needs cash lying around paying 0% in order to make acquisitions? That is absurd. AAPL can raise all the cash it needs in debt markets. And that is exactly what it should do at this historic juncture of extremely low interest rates. If AAPL can borrow money for 10 years at an after-tax rate of 3.5%, it should lever itself up and buy anything and everything that makes long-term strategic sense. The availability of money per se should not be an issue for AAPL.
Indeed, AAPL managers should completely divorce in their minds the issue of their cash hoard from their acquisition strategy. The former literally has nothing to do with the latter. These two issues should be treated as entirely separate matters.
Apple can have its pie and eat it too, so to speak. Why? Because it has so many ways to acquire cash, either through internal generation or by resorting to debt markets, that before it is done eating one "cake" (i.e. cash), another is already on the plate, acquired at an even cheaper cost. The only limitations that AAPL should impose on itself in that regard is that any acquisition make long-term strategic sense and that it produce a return on capital that exceeds AAPL's WACC.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.