If Apple (AAPL) is as brilliant at engineering its capital structure as it is at designing society-changing products, the company would not only use all of its on-shore cash for buybacks, but it would raise significant debt (we'd suggest $50 billion) and engage in the largest share buyback in history.
While we do not anticipate this is what the company will do, we believe emphatically, that this is what Apple would do if it was trying to optimize both its capital structure and shareholder value. At under 9x EPS-ex cash, even with its 24% rise year-to-date, the stock is ridiculously cheap, and a buyback is both highly accretive and the single best thing management can do to benefit its shareholders.
While we have not read a single analyst or media source that makes a similar suggestion for an Apple debt offering, clearly our perspective is endorsed by many major technology companies. For example, despite huge cash hoards, and enormous cash generation, Cisco (CSCO), Intel (INTC), and Microsoft (MSFT), each accessed the credit markets in 2011, raising $4 billion, $5 billion and $2.5 billion, respectively. Cisco and Microsoft now have $17 billion and $12 billion in total debt, in addition to their cash hoards. Each is engaged in ongoing share buybacks and is following the basic precept of optimizing capital structure and utilizing low-cost debt to buy back high-return equity.
Buyback is clearly better than a dividend
The debate continues to rage regarding how Apple should allocate its near-$40 billion in on-shore cash. We firmly believe a buyback is the correct decision versus a dividend - in fact, in our view, the decision isn't even close. Assuming one believes street earnings estimates are accurate, or conservative, as we do, then every share that the company repurchases is accretive to earnings. Not to mention, current tax policy is advantageous to capital gains versus dividends.
While some argue that there are other benefits to a dividend, such as increasing the investor base, resulting in greater demand and a higher share price, we fail to see that as a convincing argument. We recognize a likely near-term bump (as is probable with a buyback), but there is little research that suggests long-term multiple expansion, from such a move. We also note that while a new class of investors would increase demand for shares - a buyback would lower supply of shares, and with the same number of investors "competing" for shares, the stock would also rise.
Apple should engage in a record debt offering
In addition to using its on-shore cash, Apple's board should recommend that Apple take appropriate debt on its balance sheet to make an even larger repurchase. We would suggest that Apple issue up to $50 billion in debt, which the company could easily finance from onshore free cash flow. This would represent the largest investment grade debt offering in history -- Roche raised almost $40 billion for its acquisition of Genentech. Investment grade bond yields are currently close to all time lows in the 3.5% range, and $50 billion even at 4%-5% would be covered by Apple's US cash flow around 8x. While this would be an enormous debt deal, we have little doubt that investors would have a tremendous appetite for the debt of the "sovereign nation of Apple." Isn't Apple a better credit than most countries?
With total U.S. cash of $90 billion, Apple could initiate a buyback, or even pursue a self-tender. The benefits of a such a buyback, even if completed at an average price of $600, would be a reduction in share-count of over 15% resulting in an increase in EPS of 13% (and obviously would be far more accretive if accomplished at lower prices). In addition it would create value, albeit modest, from the tax-deductability of interest. While we do not believe in excessive financial engineering, Apple's capital structure simply is not optimized.
A historically unique opportunity
We've bounced this idea off several colleagues who suggest that fast growth, cash-rich companies don't issue debt for buybacks - it's only when growth slows that they raise debt. We believe that is getting the causality wrong. Historically, fast growth companies did not raise debt for share repurchases because 1) debt came with high interest rates (at least relative to today's almost free money), and 2) high growth companies typically carried high P/Es. Fast growth companies did not raise debt for buybacks because it was a bad financial management decision.
For example, a company trading at a P/E of 40, that bought back 10% of its shares via 8% debt, would lower its EPS by about 12%, while the same company at a P/E of 8 buying back shares with 5% debt would increase EPS by almost 10%.
Typically P/Es don't contract until growth slows (like Cisco, Intel, and Microsoft). However Apple has a unique opportunity, with a compressed P/E, despite hyper-growth, in a period of historically low interest rates. If there was ever an attractive time for Apple to raise debt and repurchases shares hand-over-fist, it is now.
A return of capital makes sense
Finally, to those who argue that Apple should do something other than return cash to shareholders via buybacks or dividends, we strongly disagree. Apple's cash is truly excess cash. If there were a dollar more that Apple could spend in a value-add manner on r&d or marketing or supply-chain management, no doubt Apple would spend that capital. The argument that some make regarding Apple spending more on innovative products or making large acquisitions, is absurd. Apple's is a closed ecosystem and large acquisitions are not part of its core strategy, as it currently is for Google (GOOG), for example. While a "bite-sized" purchase of a company like flash memory developer Anobit for $500 million might make sense in a move downstream, we would be shocked if Apple made a large purchase, on the level of Google's acquisition of Motorola Mobility - it does not fit within its system. With its 46% ROE, Apple simply mints cash, while its excess cash creates no value. The highest and best use of this excess capital is share buybacks, and if the stock becomes fully valued, then it should be distributed in dividends.
This opinion is not just our own:
"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases."
Berkshire Hathaway 1984 Annual Report
Disclosure: I am long AAPL.
Additional disclosure: We conduct thorough research on our ideas, but our views are our own. Please do your own research.