Apple's Repatriation And Share Buyback Could Trump All

| About: Apple Inc. (AAPL)

Summary

If enacted, President-elect Trump's proposed tax policies could lead to a massive repatriation of offshore cash for Apple.

Cash repatriation and share buyback could reduce outstanding shares by 20%.

Apple shares should trade at +$130 shortly thereafter.

As we digested the news of Donald Trump's surprising victory, our focus quickly shifted to the impact his policies could have on our portfolio. Apple (NASDAQ:AAPL), one of our long-term holdings, will no doubt be affected by President-elect Trump's stance on corporate taxation, immigration and global trade. Let's focus today on corporate taxation, given that his campaign has already provided some high-level details of what it wants to achieve. The other issues we'll leave for another day once additional information is released.

While details of the President-elect's tax policies are still being crafted, we do know that they propose to reduce corporate taxes from 35% to 15%. His proposals also call for a 10% deemed repatriation tax. This is fairly close to House Republican proposals, which include decreasing corporate taxes from 35% to 20% and full taxation of all previously deferred income over a period of time at a high-single digit tax rate. The chance for major tax reform next year is high given the Republican controlled Congress.

If the President-elect's plan were to be enacted we'll very likely see Apple repatriate a substantial amount of its offshore cash. In fact even before the election, Tim Cook, Apple's CEO, was primed to do so, having stated in an interview on Irish radio.

"We provisioned several billion dollars for the U.S. for payment as soon as we repatriate it, and right now I would forecast that repatriation to occur next year,"

While he did not provide an amount, a reduced 10% repatriation tax would be a significant incentive to repatriate the bulk of Apple's offshore cash. Let's explore the impact this would have on the stock.

Apple's Offshore Mattress

As of September 30, 2016, Apple has a total of $237.6B in cash, cash equivalents and marketable securities. For simplicity, we'll call cash, cash equivalents and marketable securities "cash".

Over 90% of this cash is held overseas, in an Irish mattress (okay technically a non-resident Irish mattress), and domestic cash totals only $21.6B

September 30, 2016

US

OUS

Total

Cash, cash equivalents, marketable securities (both ST/LT)

$21,585

$216,000

$237,585

% of Total

9.1%

90.9%

100%

Click to enlarge

For our exercise, let's assume that Apple's foreign subsidiaries retain $20B of the $216B of cash as a working capital cushion to fund non-US spend. This is largely conjecture, but we're trying to estimate the impact of a repatriation plan, so this could be adjusted up or down. We're using $20B because Apple has $21B of domestic cash, and given sales are split OUS (60%) / US (40%) we're assuming that a roughly equivalent amount of offshore cash should suffice.

This would mean Apple could repatriate $196B of the $216B. Applying a 10% repatriation tax would mean reducing the actual cash received to $176.4B

Foreign

Domestic

Total Domestic

Cash

$216.0B

$21.6B

Amount retained in foreign subsidiaries

$20.0B

Net (pre-repatriation tax)

$196.0B

Repatriation tax (10%)*

$19.6B

Net cash

$176.4B

$21.6B

$198.0B

Click to enlarge

*Note that we haven't reduced the repatriation tax for any foreign tax credits ("FTC") that would be brought back to offset the US tax for two reasons. First, the change in corporate tax rates will force the company to true-up its deferred tax assets ("DTA"), and the value of the FTC will decline. Second, given that DTAs are valued at $4.1B as of September 30, 2016 and DTAs include FTCs and many other tax assets), the amount of FTCs are likely "small" relative to the amount repatriated, and when coupled with the reduction in corporate tax rate, the actual FTC impact may be negligible for purposes of our calculation.

What could Apple do with the cash?

Flushed with $176.4B of additional US cash, we don't think Apple will increase its dividend or pay out a one-time dividend; the former would unnecessarily constrain future cash management and the latter is tax inefficient.

Moreover, we think Apple will refrain from repaying its $79B of debt, particularly given the low rates and long-maturity. Apple's corporate debt is also held by the US entity, Apple Inc., which means the interest expense is shielding US income from taxation. Although a reduction of the US federal corporate rate from 35% to 15% decreases this benefit, there are still state taxes to factor in, and overall the deduction, albeit reduced, is still beneficial.

A large-scale M&A transaction is also unlikely given Apple's history of bolt-on acquisitions and because any large-scale acquisition would compress Apple's industry leading margins. Consequently, we think Apple will likely fund a large share buyback.

How Much?

There really are no restrictions on the use of Apple's cash. The company's recent cash hoarding has simply been the byproduct of a US tax system that creates its own "reality distortion field", which incentivizes companies to defer offshore earnings.

It's important to note that none of Apple's debt has any financial covenants. Under its most recent prospectus supplement, Apple states

"The indenture for the notes does not . . . require us to maintain any financial ratios or specific levels of net worth, revenues, income, cash flow or liquidity and, accordingly, does not protect holders of the notes in the event we experience significant adverse changes in our financial condition;"

(See for example Prospectus Supplement dated April 30, 2013)

As such, the company is free to use its cash to benefit shareholders (albeit to the detriment of bondholders). The size of the share buyback will be driven more by financial conservatism than any financial restrictions, and Apple for all its vaunted cash generating prowess has historically been financially conservative.

This is due in large part to Steve Job's penchant for accumulating cash after the near-Apple bankruptcy in 1997; a time when Apple needed a bailout from its rival Microsoft to survive. Apple's secrecy also means a large cash balance creates certain competitive advantages. The cash provide financial flexibility, allowing the company to pre-fund R&D for multiple generations of future products, monopolize raw materials for large-scale projects (to delays rivals from manufacturing their own copycat products), fund experiments and acquisitions that may not work, and insure financial stability to buffer itself from the fickle consumer driven market.

Thus, we believe if Apple were to bring back $176.4B, it's likely to use only a portion of the cash to fund a share buyback. We think the company could retain $50B in the US and declare a buyback of $125B.

Why $125B?

This is the company's debt maturity profile for the next five years. Repatriating $176.4B and retaining $50B means the company would have sufficient cash to cover the debt maturing over the next five years (approx. $30B) without having to overly rely on current/future earnings.

Maturity

2017

2018

2019

2020

2021

+2022

Amount Due

$3.5B

$6.5B

$6.8B

$6.5B

$7.8B

$46.3B

Click to enlarge

Alternatively, having $50B on hand would represent a "coverage ratio" for the following expenses (i.e., assuming the company makes no profit for the years, how long would US cash last).

Metrics for US Cash

CapEx (2017)

OpEx (2016)

Dividends (2016)

Amount

$19.2B

$24.2B

$12.0B

Cash ($50B)

$50.0B

$50.0B

$50.0B

"Coverage Ratio"

2.6x

2.1x

4.2x

Click to enlarge

If the company retains $50B in the US, the size of the buyback could be approximately $125B and at today's $110 share price, the company can buyback and retire close to 20% of its outstanding shares (i.e., 1.1B shares repurchased from the 5.3B shares currently outstanding).

Size of Buyback

Share Price

O/S Shares

Share Buyback

Remaining Shares

$125.0B

$110

5.33B

1.14B

4.19B

Click to enlarge

Shortly after the share buyback is announced we believe the share price will trade 20% higher (i.e., from $110 to +$130/share).

There are some downsides, however, so let's address them:

Lost Interest Income

Apple is currently earning a blended interest rate of 1.73% on its cash, therefore interest income could decline by $2.1B (pre-tax). Given that Apple pays out $2.28/share in dividends, buying back 1.1B shares would essentially negate having to pay out $2.5B of dividends, offsetting the lost interest income and making the buyback cash flow neutral.

From an earnings standpoint, the decline in interest income translates to a reduction of EPS by approx. 40 cents ($2.1B pre-tax interest income (assuming a 20% tax rate = $1.6B / 4.2B shares), and at a 10x multiple a reduction of $4/share. We believe this slight decline in earnings will be mitigated by higher investor sentiment surrounding the stock, higher returns on capital and an overall improved capital allocation strategy.

Lastly, we have purposely avoided discussing the fact that Apple will continue to generate cash every year because we are only addressing a one-time event. Cash flow from operations (less capex) in 2016 totaled approximately $50B, which we think can and will continue. The proposed share buyback above should not affect Apple's preexisting plan to pay out dividends and fund future stock buybacks.

If and when tax reform is enacted, we think Apple will act quickly to begin a large-scale repatriation plan. None too soon as this has been a long time coming, and Apple's offshore cash, which the market has placed little value on, will soon be much appreciated.

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Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.