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Dear Tim,

First of all, I wanted to wish you best of luck as you head into 2012, your first full year at the helm of an amazing technology company. Apple (AAPL) is the rare company that captures both the hearts of consumers who love your iGadgets as well as investors who have made tremendous returns on AAPL equity. As both a converting Apple loyalist on the consumer side, and a stock investor, I wanted to say thanks.

The purpose of this letter, since I didn’t think you would actually read it if I mailed or emailed it to you, was to discuss Apple’s capital structure. I know, kind of heavy for the holidays. I have blogged about your stock a couple of times in the past year, and my view hasn’t changed that the stock is no doubt inexpensive, both relative to its current and future growth rates, as well as to its dominant and growing market share in your line up of phones, tablets and computers. Quick math suggests that, excluding your cash, AAPL equity is trading at under 11x next year’s earnings. Quite a bargain.

But I wanted you to take away one key item from this letter. And it is this: as Apple continues to build its mountain of cash, you should realize that you are no longer just managing a technology company, but also you are becoming an asset & money manager. The reason I point this out is, you can continue to grow the company and its market share and profits, but if you mess up the asset management side of the business (i.e. your cash hoard), then you can destroy billions, even tens of billions of hard earned capital.

It is no doubt the single biggest risk that I see in your equity.

First, look at your balance sheet. You have almost $82BB of cash, and other assets totaling less than $35BB, Many of which are intangibles and goodwill by the way. You generated over 70% Returns on Equity last year on your operating businesses, including the intangibles. Stellar. However, most of your balance sheet, the cash, generated less than 1% ROE! Why manage a company whereby 70% of the balance sheet generates near zero return, and 30% generates ALL your return?

The key to your success down the road, in my humble opinion, will be as much about managing the balance sheet, your capital allocation decisions (i.e. your cash), as it is developing and selling new tech gadgets for consumers.

The Apple business is extraordinary, and I am convinced that you have top notch engineers and programmers and employees to run the operating side of the business. Apple employs some 60,000 people. But how many people do you have managing the biggest asset on the balance sheet? I am guessing less than 1%. And are they top quality? That is, are they people who have run billions of dollars, and know how to invest it wisely, for the benefit of shareholders? Or at least can make some expert recommendations on how to manage your capital structure?

I ask the question because clearly you don’t need to keep adding to your piles of cash. It’s nice to have a cash cushion, a la Berkshire Hathaway (BRK.A) with a pristine balance sheet, with cash ready to deploy when opportunity arises. But it’s another thing altogether to have so much cash, that you don’t know what to do with it. Would you run the firm differently if you had $10BB of cash instead of $82BB? Probably not. But might you spend the cash differently? Probably so.

I am not just arguing the case for avoiding expensive acquisitions. I’ll get to that in a minute. First I think you should consider ways to manage cash to open the stock up to a new investor base. Namely, dividend investors. Why? Because any growth manager worth his salt in the world is already long or has been long AAPL stock. Organic revenue growth however cannot continue forever, the law of large numbers suggests that your growth rate will slow. Of this there is no question. In fact, these growth investors are already leaking out your shares in the anticipation of this. That explains the P/E contraction in your stock.

Dividend Idea

Just to put some numbers around a dividend, suppose you declared a $5 per share quarterly dividend, or $20 per year. Sounds high, I know, especially since you reported EPS of around $7 a share last quarter. But that only equates to $18BB a year. That would also equate to a dividend yield north of 5%, which I can guarantee would attract tremendous amounts of capital. Your stock would easily rise by 20% to 25%, reaching a 4% yield level (similar to Intel’s yield for example).

To understand why this level of dividend is actually quite low, let’s look out 5 years and see how that level of payout impacts your capital structure. To be very conservative, I assumed EPS grew by 20% next year, to around $33 in earnings per share, and only 5% thereafter. Even doing this, shows that you will still have more than twice as much cash on the balance sheet in five years as you have today – after paying this “huge” dividend!

2011

2012

2013

2014

2015

2016

EPS

$27.67

$33.20

$34.86

$36.61

$38.44

$40.36

FCF/Share

$27.67

$33.20

$34.86

$36.61

$38.44

$40.36

Dividend

$20.00

$21.00

$22.05

$23.15

$24.31

Cash Per Share

$87.04

$100.24

$114.11

$128.67

$143.95

$160.00

I am not looking for ways to suggest how to create a short term gain in AAPL stock. I honestly believe that a move like this would attract legions of dividend investors, who tend to be more long term in nature. Growth investors, who will still be attracted to the growing dominance and growth rates in earnings, should stick with AAPL as long as there is growth and return to be had.

Share Buy Back Idea

Clearly it seems that even this large a dividend would only slow the accumulation of cash. It is still getting far bigger than you need. The fact that it doubles still over the next 5 years brings me another idea on how to wisely invest your cash: share buybacks. Note that I said invest. Because for shareholders, it’s no different using cash to buy your own stock, as it is to buy other stocks, or other companies. If you buy back stock, and that stock is generating 70% ROEs, and you pay less than 14x for that stock, then I’d say that is a bargain.

In the buyback category, I recommend you become a follower of Warren Buffett. I have read all of his letters, as well as pretty much anything written about him. To give one Buffett example, look at his investment in the Washington Post, ticker WPO.

In 1973, Buffett began purchasing a stake in WPO stock. The firm generated tons of cash at the time, and the markets mostly ignored its cash holdings, as well as its ability to continue growing its cash balances. Over the next 11 years, Buffett, as board member and friend of control owner Katharine Graham, eschewed risky acquisitions, and encouraged stock buybacks. Given the cheapness of its equity and its high returns on capital, it was a smart move. In the next decade the Washington Post bought back almost 40% of its stock, and Buffett turned a $10mm investment into a $200mm investment.

Let me illustrate what buying back shares in addition to the dividends could do for Apple’s earnings. Below I assume you decided to buy stock at no more than 14x earnings. Here I present a $10BB annual buyback of shares, capped at that 14x earnings level. I further assumed (as above) that net income only grows 5% a year after 2012.

2011

2012

2013

2014

2015

2016

Net Income (BB)

$26

$31

$32

$34

$35

$37

Shares (mm)

937

937

919

901

885

870

EPS

$27

$33

$35

$37

$40

$43

Buy back

$10

$10

$10

$10

$10

Buyback Price per Share at 14x

$544

$581

$620

$662

$708

Shares retired

18

17

16

15

14

Shares outstanding year end

937

919

901

885

870

856

Cash at year end (BB)

$82

$83

$86

$90

$95

$101

Cash per share

$87

$91

$96

$102

$109

$118

You would still have a huge load of cash after 5 years, roughly $101BB in this example. Even after paying dividends of $20BB per year, and after buying back $10BB of stock per year. And as a bonus, in a world of lower 5% net income growth, you could still grow EPS by 8% a year.

As a side note, even if you can only use 1/3 of your cash (that is the cash domestically held) for both dividends and buybacks, my numbers suggest that that would not be an issue. Apple would never see a negative domestic cash balance (i.e. you wouldn’t need to borrow) even if all dividends and buybacks in this example had to come from US domiciled cash holdings.

Acquisitions

That brings me to my last point, acquisitions. First of all, the fact that Apple has made zero large acquisitions in its past is admirable. The history of large tech deals is not encouraging, to say the least. I’d like Apple to keep its current policy in place, truth be told. I don’t want your firm to merge with Disney (DIS) for example. I can buy that stock separately myself. And really, to my point above, making acquisitions at smart prices is an entirely different skill set. Even Warren Buffett consigns himself to allocating capital. He takes almost no role in managing the day to day details of his portfolio companies. He sticks with asset management, and avoids company management. He knows what his talents are and sticks to them.

Below I have outlined a few of the more notable tech deals in the past decade. I felt it was worth reiterating that good, well intentions tech companies, with lots of cash, have destroyed tremendous amounts of shareholder value, by thinking they could be good asset managers.

1. Time Warner (TWX) buying AOL in 1999. A classic case of chasing returns at the height of the tech bubble. They dramatically overpaid for AOL so as not to “miss the boat.” Time Warner gave away 55% of their equity to AOL shareholders. Needless to say, this one might go down as the worst deal in history. Management turned a $200 stock into a $30 stock in less than 2 years.

2. Sprint (S) buying Nextel in 2007. Nextel’s iDEN network seemed like it was the means for Sprint to reach a new customer, the high paying “walkie talkie” customer. Integration was impossible, Sprint wound up operating two separate cell phone networks, which is strategically beyond idiotic considering that it is economies of scale that drive margin in this business. Sprint turned a $25 stock into a $3 stock. Truly an operational flop that they should have seen coming.

3. Microsoft (MSFT) paying $8.5BB for Skype. Skype generates maybe $300mm of cash flow. Is that worth it? Is 28x CF a good multiple? Or a deal that generates 3.5% returns on cash? Don’t be fooled into overspending on an acquisition, just to “use” internationally domiciled cash. That is simply beyond silly. You are overpaying for it either way. I would rather see a firm pay a 35% repatriation tax and distribute that capital to shareholders.

4. While on the subject of Microsoft, do you remember their purchase of aQuantive in 2007 for $6BB. What did that do for them? Microsoft has continually traded between a $20 and $30 range for the past decade. They do pay a smart dividend, but then continue to waste money on high priced deals that rarely if ever work out for them. The good internal ROE business seems to be drowned by the bad asset management side.

5. Hewlett Packard (HPQ) buying Compaq computer in 2005. Turns out the computer business is cut throat and low margin. Most computer gadgets end up becoming commodities. This fall, HPQ almost dumped their PC division, tossed out their idiot CEO, then backtracked, and finally decided to keep it. The distraction away from R&D has surely cost Hewlett Packard.

Sure there are successful tech deals all the time. I do admire IBM and Oracle (ORCL) for layering in deals that seem to work for them year after year. But more often than not, large acquisitions in particular end up being terrible investments.

With your cash heap (ok I am running out of adjectives for cash: mountain, pile, heap, load), I am sure investment bankers are salivating at the prospect of advising you to make certain, carefully thought out strategic acquisitions. Big ones, too. Yes?

I suspect you have checked out deals to buy the following: Netflix (NFLX), Disney, Sony (SNE), Facebook, Adobe (ADBE), EA (ERTS). I would suggest that many of these would be simply acquisitions of ego. It sounds so cool that you could orchestrate buying Netflix for example. Just by ordering a few of your minions to make it happen! That is the power that is in your hands. I caution you to view your role, as a money or asset manager or whatever you want to call it, the way I did when I ran money on the institutional side. You are a fiduciary of other people’s capital.

As a fiduciary, nothing is more important than wealth preservation. Please invest Apple’s capital wisely to generate solid returns for shareholders. The power to build wealth for yourself and others is invigorating. But it comes with the ability to destroy other people’s wealth too. Don’t listen to investment bankers who get paid fees to “advise” you. Find your own people to trust. Hire people with track records managing money, experienced institutional investor types that really know how to invest. Overpay them too, because a slew of smart guys may cost you a few million a year to manage your cash, but that is far more valuable than not having them and potentially blowing $20 billion on a bad acquisition.

Regards,

Thomas Lott

Source: An Open Letter To Tim Cook, CEO Of Apple Incorporated