We were very encouraged by Apple's (AAPL) shareholder meeting, and hopeful that the company will do the right thing and announce a buyback in the near-term. If you're Tim Cook, with a 1 MILLION SHARE stock grant, you have every reason to research the best use of excess cash, and that currently is a buyback.
Our key takeaways from the meeting are:
1. Confirmation that Apple's cash is indeed excess cash.
2. Management does not plan to break from strategy by acquiring content or other companies not core to the Apple ecosystem.
3. The Board is doing real research on the best use of Apple's excess cash.
Confirmation that Apple's cash is indeed excess cash.
Apple CEO Tim Cook reiterated that Apple has more than enough cash to operate its business. This means that those who continue to suggest that Apple needs its cash to be innovative, or to have better supply chain management are way off the mark - Apple is spending every dollar that it can effectively spend on r&d, marketing, store openings, supply chain management, etc., and it still has this excess cash. Spending more would be flushing cash down the toilet. So at virtually 0% interest, Apple is piling on cash that is basically useless. Interestingly, Mark Hulbert just wrote a terrific article that cites several studies that indicate the superior performance of companies that return excess cash to shareholders.
Management does not plan to break from strategy by acquiring content or other companies not core to the Apple ecosystem.
As we've previously argued, Apple has a closed ecosystem, buying large ancillary businesses simply does not fit in. Hulbert discusses this as well, indicating that acquisitions often are followed by underperformance. Certainly hubris might inspire acquisitions, but why should Apple buy disparate businesses, pay a premium, and deal with integration risk when it can buy back the very cheap stock of a wonderfully performing company - itself.
The Board is doing real research on the best use of Apple's excess cash.
We were thrilled when we heard Tim Cook's answer to the question on a stock split. He said that research suggests that after a stock splits there is a short-term pop and then the stock resets, so in the long-term it does nothing. We are quite familiar with the academic research, so Cook's spot-on answer gives us confidence that he and his Board are doing real research regarding financial decisions. Of course, a split has nothing to do with addressing the excess capital issue, but clearly Cook is consulting the experts.
All of this gives us confidence that Apple will do a buyback - preferably a large buyback, coupled with a large debt offering.
As we wrote previously on Apple, we believe that with Apple shares as cheap as they are - still less than 9x EPS net of cash - Apple should do a massive repurchase with excess on-shore cash, and lever up for an even larger buyback. We also pointed out that Cisco (CSCO), Intel (INTC), and Microsoft (MSFT) all took advantage of ultra low-interest debt in 2011, despite huge cash hoards.
While some of you may ask why a cash rich company would "taint" its pristine balance sheet with debt, we'd suggest that there is no inherent taint with debt, as it lowers a company's WACC and can optimize its capital structure. This is unequivocal in any finance academic textbook, and if you still disagree, we'd suggest contacting any of the finance faculty at the University of Chicago, Wharton, Harvard, or Columbia (or speak with any friends who attended those institutions). Those faculty supplement their income by regularly consulting with Boards - and Cook, with 1 million shares of Apple, has every reason to consult the experts.
We are not against dividends, just not at this multiple
Our strong preference for a buyback is because Apple shares are absurdly cheap, and a buyback represents the current highest and best use of capital. If Apple shares were trading at 50x earnings, we'd staunchly be in the dividend camp. We strongly disagree with those who are staunchly opposed to an Apple dividend, like fellow Seeking Alpha contributor Rocco Pendola. He writes:
Endpoint - If you want dividends, you should have been building positions, over time, in dividend-paying blue chip stocks. AAPL is not a dividend-paying blue chip stock. It is an innovative hyper-growth machine in perpetual start-up mode that needs to stay that way or die.
I honestly think Apple executives view the situation in that regard. Why in the world should we pay a dividend? It's not in our culture.
Since CEO Tim Cook said Apple is using all the capital it needs in order to innovate, we're not sure how issuing a dividend would limit Apple's ability to remain in "perpetual start-up mode" or how it would change Apple's "culture" - incidentally, Apple's culture included a dividend through the mid 90s.
We're not exactly sure how Apple differs from Cisco, IBM, Intel, Microsoft, or Texas Instruments (TXN) - ALL dividend payers - except that Apple has more excess capital than all of those companies combined. An "innovative" company should constantly be reassessing and challenging its assumptions, including regarding financial management and capital structure.
Walking through the math
Some of you have asked us why we prefer a buyback to a dividend. Apple is in a low interest rate environment with a low P/E, which creates massive earnings accretion. If it were in a high interest rate environment with a high P/E, a buyback would be dilutive to earnings - and we would argue for a dividend.
We walk through a hypothetical example below:
Company A with 1 million fully diluted shares outstanding, $2.5 million net income, no debt, no cash, trading at $100 per share - 40 P/E, in 8% interest rate environment. The EPS is $2.50 per share ($2.5 million net income and 1 million shares out). Company A raises $10 million in debt at 8% (5% after tax) which it uses in entirety to repurchase 10% of shares outstanding. After repurchase, there are 900,000 shares outstanding and $2 million of net income ($2.5 million net income minus $500k of after-tax interest on debt). Now EPS is $2.22, almost 12% less than prior to the buyback.
Company B with 1 million fully diluted shares outstanding, $2.5 million net income, no debt, no cash, trading at $20 per share - 8 P/E, in 5% interest rate environment. The EPS is $2.50 per share ($2.5 million net income and 1 million shares out). Company B raises $2 million in debt at 5% (3% after tax) which it uses in entirety to repurchase 10% of shares outstanding. After repurchase, there are 900,000 shares outstanding and $2.44 million of net income ($2.5 million net income minus $60k of after-tax interest on debt). Now EPS is $2.71, almost 10% more than prior to the buyback.
Apple currently looks very much like Company A - an incredible opportunity for Cook and his Board to create enormous shareholder value.
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.
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