The Lucrative Shareholder Returns In An Apple 30% Owned By AAA Bondholders

Feb.29.12 | About: Apple Inc. (AAPL)

Achieving a more optimal capital structure is a tried and tested method for juicing up a company's return on equity (ROE). By nature, secured bonds are a cheaper form of capital for a company as the return demanded by a AAA bondholder will always be less than that demanded by a shareholder, and interest payments have the added benefit of coming out before tax.

So why doesn't Apple (NASDAQ: AAPL) have any long term debt if it could boost total takeaway for all stakeholders and increase equity returns? The likely answer is Steve Jobs' distaste for financial engineering, which likely stems from the potential for management teams to get distracted with changes to the company's ownership structure when they should be focusing on running the company.

But with the acknowledgment from CEO Tim Cook that Apple's cash balance has become "more than we need to run a company" and his openness with regard to establishing a dividend, it appears Apple might finally be open to tweaking its capital structure. And the boon to shareholders could be quite immense.

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A dividend offers the potential of opening up Apple to a large number of institutional investors such as mutual funds and dividend ETFs that will suddenly need to add Apple to their portfolios. If the weighting of their Apple holdings is to be based at all upon market capitalization relative to the other portfolio companies they will need to buy a good deal of the company which should further increase the stock price.

Establishing a dividend also offers an opportunity for Apple to begin moving some of the $30.2B in cash and short-term investments it has out of the company (as of 12/31/11). Trimming down cash levels in an all equity company offers the opportunity to increase return on equity by removing assets generating returns significantly below Apple's other assets.

If Apple were to do a bond offering for 30% of their market cap ($146B) and buy back the same amount of stock, the company could further increase shareholder returns. After turning 30% of the company over, assuming coupon payments of 3% annually, average analyst estimates for the end of the year earnings per share (EPS) of $42.72 would instead be $56.07 (using the 25% Apple typically pays in taxes and taking out interest). At a $522 stock price, this would generate a ROE of 10.7% rather than the original 8.2%. The company thus could generate a 2.5% dividend yield and still have the original 8.2% ROE going back in to the company.

The major concern with taking a tech company that relies on being at the forefront of innovation to maintain market share and bringing bond holders to the table who are more concerned with the outlook for free cash flow is that a bond holder might be overly concerned with the company's cash prospects and not the growth of the business and making necessary investments for long term returns.

Now if the term on the bonds is long enough and Apple could get the right type of bond holders, there would be alignment in terms of investment time frame. With enough cash on the books to fully cover interest for quite some time and strong earnings to boot, bondholders would not likely feel the need to intervene in the management of Apple.

With 10 year Treasuries yielding 1.98%, issuing in AAA bonds would be an extremely cheap source of funding for Apple. According to NYU Stern's synthetic bond rating equivalents based on interest rate coverage ratios (EBIT / interest payment), a company needs to have above an 8.5 interest coverage ratio to get a AAA rating. A Triple-A company will default 0.65% of the time, so adding this to the 10-year Treasury rate (I'm using that as the risk free rate) we would expect Apple's bonds to yield around 2.63% for 10-year notes if they were rated AAA.

With an implied average analyst estimate EBIT of $48,549M (649.4M shares outstanding after stock buyback, $56.07 adjusted EPS and 25% tax rate), if we were to conservatively suggest a 3% bond yield on $146B worth of debt, that would generate $4,380M in interest, resulting in an interest rate coverage ratio of 11x. This is well above the 8.5x threshold, meaning that achieving a AAA rating for Apple would likely not be an issue.

To a value investor interested in dividend income, this change would be a dream come true, especially for those bullish on Apple's prospects to at least market perform in its product fields. Having 30% of the company owned by long-term issuance AAA bondholders would not likely require a different company management style either.

Disclosure: I am long AAPL.