One of the most controversial debate topics in the investment community is what Apple (AAPL) should do with its cash. Should it pay a dividend, or should it shy away from redistributing its cash? And what about a stock split, or buying back shares? Surely after a move into triple digits, a stock split will make it easier for small investors to buy. Apple can certainly afford to buy back stock, given that it holds so much cash. After much thought, we have come to the conclusion that dividend, stock splits, and buybacks should be avoided, and we outline our arguments below. But first, a quick overview of Apple is in order.
As of the close of trading on March 13, 2012, Apple made another record high, closing at $568.10. Contributors to that particular increase include the general market rally, as well as Jefferies' decision to raise its price target on Apple to $699 from $599. Jefferies also noted that it has seen early evidence of the Apple TV (or iTV), and expects production to reach commercial levels in May or June. As of the close of trading on March 13, Apple has risen an astounding 40%, dramatically outperforming both the S&P 500 (SPY) and the NASDAQ (ONEQ).
As dramatic as Apple's rally has been, especially given its status as the world's largest company by market capitalization, this article is not meant to provide an analysis of where Apple will go from here, and if it is a buy or not. Our intent is to outline the reasons why a dividend and / or buyback is not the best course for Apple to take with its capital at this time. But before we argue against these 2 factors, we must first outline Apple's capital position, as well as arguments for a dividend and / or buyback.
An Apple Dividend: Some Background
It is important to note that Apple used to pay a dividend. The last dividend was paid out on December 15, 1995. Apple was forced to halt dividend payments as the company bled billions. When Steve Jobs returned in 1997, Apple was approaching bankruptcy and Jobs was focused on rescuing the company. Even though Apple would go on to have the biggest corporate turnaround in American history, under Steve Jobs, Apple treated its finances largely as an afterthought.
Though it may seem heretical to say that a public company doesn't care about its finances, Apple proves that this may not be a bad thing. At Apple, there is one person who manages money: CFO Peter Oppenheimer. Everyone else-- from Steve Jobs on down-- was focused on building great products, not obsessing over each penny Apple spends. Rightly, they knew that if Apple builds great products-- whatever the cost-- the profits would come pouring in the door.
As CEO, Steve Jobs essentially shut down any discussion of capital allocation before it began. His experiences in 1997, with Apple approaching bankruptcy, placed him into that mindset. Under his watch, Apple would keep every penny it earned, investing in the business and occasionally acquiring a company here and there. To him, Apple shareholders were, at best, a necessary evil he had to deal with as a CEO of a major public company (but that mentality is just one of the many traits that made Steve Jobs the most iconic CEO of our time).
But, with the untimely passing of Steve Jobs, Tim Cook took the reins of Apple. Perhaps due to his MBA (from Duke), or due to his temperament, discussion of Apple's cash-- long dormant under the reign of Steve Jobs-- began to resurface. More and more time on Apple's conference calls began to be devoted to Apple's cash, and Apple's plans for it. So far, all that Tim Cook has really said is that he and the board are "thinking very deeply" about what to do with Apple's cash. However, he did say that Apple has "more cash than it needs." With statements like that, the calls for a dividend have grown louder and louder.
Arguments for a Dividend
As Apple's hoard of cash & investments swelled to over $97 billion, investors and investment banks have come to see this figure as excessive. Apple's profits have become so large that even with the billions Apple spends on its retail stores, its supply chains, and research, it still adds billions to its balance sheet every quarter. In the most recent quarter, Apple posted operating cash flow of $17.554 billion. As such, it is natural that investors begin calling for some of that cash to be paid out as dividends.
More Institutional Investors
Another piece of the dividend argument is that it will attract dividend-oriented investors who only buy dividend-paying stocks. With all of the publicity surrounding Apple, it would seem that there are few, if any, investors left that do not own it. However, research from JPMorgan shows that this is far from the case.
JPMorgan notes that 77% of Apple shares are held institutionally, which is below the average for both the technology sector and the S&P 500 as a whole. 40% of mutual funds indexed to the Russell 1000 do not have Apple as a top 10 holding, even though Apple is the largest component of that index. JPMorgan believes that if Apple initiates a dividend, funds that tilt toward dividend-paying stocks will be forced to invest, thus creating a "scarcity issue." For the record, JPMorgan has a $625 price target on Apple.
When it comes to arguing for a dividend, the issue of foreign vs. domestic cash has no real relevance in our opinion. Apple generates so much cash that it should be able to fund a good dividend yield using only its domestic cash. According to Credit Suisse, Apple will have $62 billion in "excess" cash held in the United States by 2015, which would be more than enough to invest in the business and pay for a dividend.
The "Low Leverage Discount"
With the exception of Google (GOOG), Apple is the only major tech company to have zero debt. Microsoft (MSFT), HP (HPQ), Cisco (CSCO), and Oracle (ORCL) are just some tech titans that have billions in cash, but billions in debt as well. NYU finance professor Aswath Damodaran points out that America's tax laws are tilted in favor of debt, and this could be problematic for Apple.
If you have nearly $100 billion in cash and investments, what is the point of ever raising debt at record low rates? Should Apple choose to tap the debt markets, it would surely earn an AAA rating, given its current leverage ratio of about negative 20%. With Apple's cost of capital estimated to be around 9.5% right now, it would drop to 9% should Apple utilize debt to finance a dividend. Sanford Bernstein agrees, and says that a $50 billion debt raise, which would be the largest issuance ever, could be an "attractive" way to finance a dividend, given the low-rate environment. Should Apple use 100% of onshore cash flow, its payout ratio would be 30%, below the 36% ratio of companies such as Verizon (VZ) and AT&T (T). Debt could be a prudent way to amplify a dividend payout.
Arguments Against a Dividend
With all of these factors at play, how can we be arguing against a dividend? Our arguments against a dividend, and then against a stock split and buyback, are below.
According to the theory of dividend irrelevance, created by Franco Modigliani and Merton Miller, a corporation's capital structure is largely irrelevant. Given that they won the 1985 and 1990 Nobel Prizes in Economics, their work should be given some weight. And while the theory is not perfect (is any economic theory?), given the inefficiencies in the market, it does raise interesting issues. As Silicon Alley Insider noted, Apple investors can create their own dividends by selling the stock. That is a key tenet of the dividend irrelevance theory, that investors can create their own cash flows by selling shares of their holdings.
For all of the clamor over Apple issuing a dividend, we have not heard of any investors selling their Apple shares due to a lack of a dividend. As Steve Jobs so aptly stated during the Antennagate press conference, "you invest in the company we are..." If there are Apple shareholders genuinely upset over the company's lack of a dividend, then they are free to sell their holdings." Apple is not a company to invest in based on the potential for a dividend. There are a myriad of other stocks, as well as other asset classes, to invest in for exposure to dividends.
Apple Does Not Bend to Shareholders
Part of what has allowed Apple to generate such impressive returns for its shareholders is that it ignores them. Apple is seen by most as a technology company, when in fact it is a retailer. Thus, Apple's focus is with its customers, where it should be. The best retailers in the world, such as Whole Foods (WFM), Costco (COST), and Nordstrom (JWN), are those that obsess over their customers. Apple has always been a company that is obsessed with the experience that its customers have.
Too many companies frame everything they do as being in the best interests of the shareholders. Financials are especially guilty of this. They under-invest in customer service, arguing that it increases profits. And yet, with the possible exception of American Express (AXP), financials are widely derided as having terrible customer service, all in their pursuit of running the company in the interests of shareholders. But not Apple. Apple runs its business to serve its customers, not its shareholders. Like any good retailer, Apple knows that if it takes care of its customers and provides them with great products, the profits will materialize, and shareholders will be taken care of.
Rightly or wrongly, Steve Jobs largely ignored shareholders in his management of Apple. Under Steve Jobs, there was no talk of a dividend because that was not what Steve Jobs would do. With his passing, many investors have begun to worry that Apple will lose the corporate culture it had under Steve Jobs, which is one of the reasons it has been such a success story. And therein lies a logical fallacy. Investors cannot clamor for a dividend and clamor for Apple to retain the "Jobsian" way of doing things. Steve Jobs would have never initiated a dividend, and if his way of running Apple was the best way, Tim Cook should keep to it as best he can, and pay no dividends.
But It's Our Cash!
Part of the argument for an Apple dividend has been centered around the belief that it is the only way for Apple shareholders to get access to the cash sitting on Apple's balance sheet. In various articles discussing an Apple dividend, we have seen comments arguing for a dividend because that money belongs to the shareholders, not management and the board of directors. We would like to remind investors that dividend or no dividend, every single penny of Apple's nearly $100 billion in cash and equivalents is already in their pockets.
Let us, for a moment, picture a company-- we will call it Company X. Company X has $100 in cash on the balance sheet, no debt, 100 shares outstanding, and exactly 100 shareholders. Each shareholder holds one share. Too many investors see stocks as pieces of paper, or nowadays, as numbers in their brokerage accounts. Investors have forgotten that shares represent real pieces of a company. When you own a share of Apple, you own a proportional share of all its assets and liabilities.
Let us then return to Company X. Each shareholder, via their one share of the company, no matter what the price is, has a proportional ownership of the company's cash. Therefore, each investor has a claim to $1 of Company X's cash. Bowing to pressure, Company X announces a dividend, and distributes $20 to its shareholders, leaving $80 on the balance sheet. Now, shareholders of Company X have 20 cents in their pockets, and they each have a claim on 80 cents of Company X's cash. At the end of the day, they still claim ownership of $1 in cash. The only difference is where that cash is located. While it may be true that cash in the pockets of shareholders is more accessible to shareholders, we would like to remind shareholders that they can always sell their shares of Apple for cash.
It could be argued that it is better for shareholders of Apple to have the cash in their own pockets. But we see flaws in that argument, for several reasons.
- Re-investing those dividends is a zero-sum game: If investors receive $10 billion (for example) from Apple in dividends, and choose to re-invest every single penny back into Apple stock, it is a zero-sum game. Apple's balance sheet is drained of $10 billion in cash, and all else being equal, the only thing that changes is Apple's stock price. It is true that this re-investing of dividends could increase Apple's share price, but with $10 billion less on the balance sheet, Apple is now more expensive on a price-to-book basis, thus diluting, if not eliminating, the effects of the increase in Apple's share price.
- Apple is not an ideal "income stock": While it is true that Apple has proven itself relatively resilient to economic shock, that is not a guarantee. Apple is in a fiercely competitive industry where it has to work tirelessly each and every day to maintain a lead against its rivals. The smartphone industry is not a risk-free industry. If you are an investor who utilizes dividends as an income stream, Apple is not the stock you should own in the first place. There are plenty of other high-yielding stocks that offer dividends and a much higher measure of economic resilience, such as utilities, tobacco companies, and food companies.
Investors must not forget that dividends are a matter of capital allocation, and not the end goal of a public company. Public companies exist to generate profits for their shareholders, and in theory, it should not matter where those profits reside, on a company's balance sheet, or in the bank accounts of shareholders. If you are an investor who relies on dividend income, Apple is not the kind of company that should be present in the dividend-paying portion of your portfolio.
Apple's Cash is a Drag on Returns
It is true that Apple's cash earns a relatively low rate of return for Apple. As NYU professor Aswath Damodaran points out, Apple's cash holdings currently return under 1% for the company, given that the cash is held in treasuries, money market funds, and other conservative instruments. But we do not think that anyone will argue that Apple's profits are hampered by its cash balance. Apple's cash is a byproduct of its success, and a measure of just how successful the company really is. Apple invests billions in its business, and yet it manages to increase its cash and investment holdings by billions each quarter.
Apple's cash hoard is set to pass $100 billion this quarter. Applying a 1% rate of return means that Apple earns $1 billion in annual profits simply from the cash & investments it holds on the balance sheet. If that cash balance is reduced, Apple's interest income will decline. Therefore, if Apple chooses to pay dividends, its profits will actually be lower than they otherwise would be, because there is less to earn interest on.
Investors may argue that they can do better than Apple with that cash if Apple is paying a dividend. But unless they can do better than Apple in managing and investing that cash, we think that it is an irrelevant point. Doing better than the 1% rate of return will almost certainly require more risk than what Apple does with its cash and investments. We do not think it is Apple's job to pay out cash (that shareholders already own anyways), so that its investors can invest elsewhere.
Corporate Cash Management
We turn now to the issue of the "cash discount." Investors often discount the valuations of large companies who hold mountains of cash because of worries over what management will do with that cash. With a company like Microsoft (MSFT), that makes perfect sense. Microsoft has plowed billions of cash into research and acquisitions over the last decade, and yet it has little in the way of groundbreaking innovation to show for it. The company has spent billions on dividends and buybacks, and yet the shares are virtually flat over the last decade, advancing just over 2%, versus the nearly 20% rise of the S&P 500.
With a company like Microsoft, it is in fact prudent to worry what will be done with that cash. But investors in Apple should have more faith than that. When Steve Jobs was CEO, he and the current management team proved that they could manage Apple's cash in a prudent way. If the "Jobsian" mindset has been sufficiently ingrained into Apple's executives, then there should be no worries about what Apple will do with its cash. If you are someone who worries about what Apple will do without Steve Jobs, the dividend and Apple's cash policy should be the least of your worries.
Technology Dividends in Practice
By its very nature, the technology sector is not one that is meant for dividends. This is a growth sector, and although there certainly are companies that pay dividends, such as Microsoft and Intel (INTC), we do not see this sector as an income generator. Dividends are, at best, a bonus. By and large, people do not invest in technology companies for their dividends, but rather for their growth. As Silicon Alley Insider noted, companies such as Microsoft, Oracle, and Cisco have seen little effect on their stock prices from dividend initiations, or increases.
Furthermore, while JPMorgan believes that a dividend will draw in income investors, it is very possible that a dividend will scare away growth investors. In most sectors, a dividend is a sign of confidence in the future. But not in technology-- in this sector, a dividend is generally seen as a sign that the company is no longer growing rapidly. Whether or not that is true is irrelevant-- it is a matter of perception. Investors may assume that if Apple is paying a dividend, it has run out of ways to invest its cash, even if Apple is investing every penny it can into its business. If Apple decides to initiate a dividend, new investors could quite possibly be offset by a decrease in growth-oriented investors.
Our final argument against a dividend has to do with taxes. Currently, dividends and capital gains are taxed at the same rate. But, in 2013, that is set to change. The tax rate on dividends will revert to the ordinary rate for high-income earners, which could mean an increase of up to 41% in the taxes levied on dividends. The politics of such a move aside, a tax increase on dividends dents their appeal.
This presents a conundrum for Apple investors: it is impossible to refuse a dividend payment. And if Apple shareholders begin seeing dividend payments, they will be forced to pay taxes on them regularly, as opposed to capital gains taxes on a sale of Apple stock, which are due only when a shareholder sells their stock. Such a tax bill occurs only on a shareholder's timetable, not regularly as with a dividend. This tax policy makes dividends a good deal less attractive for high-income earners, and it places investors in the awkward position of having to decide between keeping their Apple shares, and being taxed on the dividends, or selling them-- thus leaving them unable to profit from the rise in Apple stock, which we think will continue. A one-time dividend, however, could solve this particular issue.
Stock Splits: Investor Psychology Defined
We turn now to stock splits, which we see as one of the best ways to prove the power that psychology plays in investing. From a fundamental perspective, a stock split does nothing. A $500 stock with $50 in EPS becomes a $50 stock with $5 in EPS after a 10-for-1 split. The arguments that we have seen for an Apple stock split are mostly rooted in the argument that a lower share price will allow for more retail investors to buy the stock, thus driving the share price higher. For the record, Apple has split its stock three times: in 1987, 2000, and 2005. Stock splits are often seen as a sign of management's confidence in a company's future, but we do not think that Apple suffers from a confidence problem.
Tim Cook addressed the issue of a stock split at Apple's most recent shareholder meeting, and he argued that essentially, a stock split does nothing in the long run. While a split could make Apple accessible to a larger pool of investors, and make it more likely that it will be included in the Dow Jones Industrial Average (DIA), a stock split does have its costs, notes NYU finance professor Aswath Damodaran. Specifically, it increases the bid-ask spread as a percentage of the stock price, and results in higher frictional costs for investors. Furthermore, research from the Yale School of Management shows that in general, "sophisticated" investors-- such as institutions-- sell stocks after they split, while "retail" investors tend to buy in, diluting the effects of an expended investor base.
Berkshire Hathaway (BRK.A, BRK.B) is a prime example of why Apple should not split its stock. Berkshire's Class A shares have never been split, and it is because Buffett does not want unsophisticated investors "playing around" with his company. This excerpt from the 1983 Annual Report is as true today as it it was then (the shares traded for $1,300 then):
"Could we really improve our shareholder group by trading some of our present clear-thinking members for impressionable new ones who, preferring paper to value, feel wealthier with nine $10 bills than with one $100 bill?... If the holders of a companies stock and/or the prospective buyers attracted to it are prone to make irrational or emotion-based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying and selling the stocks of other companies. But we think it is in both your [Berkshire Hathaway investors] interest and ours to minimize their occurrence in the market for Berkshire."
We see no reason to split Apple's stock-- a move that would likely lead to more volatility in the share price as it becomes easier for investors to trade in and out of the stock. Warren Buffett has never split the Class A shares due to his belief that he is running the company for the benefit of long-term holders (Berkshire has split its Class B shares, due to several tax issues related to the Burlington Northern acquisition). Apple should be run the same way. Thus, we see no benefit in splitting Apple's stock.
What about a buyback? Dividends and buybacks are the two tools companies have to return capital to shareholders. In theory, they are similar. Dividends are a redistribution of profits into the pockets of shareholders, whereas buybacks shrink the number of shares outstanding, thus allowing each investor to have "ownership" of a higher amount of profits via an increase in earnings per share.
Calls for Apple to buy back stock have grown right alongside calls for a dividend, yet we see problems with such an approach as well. Of Apple's almost $98 billion in cash, $64 billion is held offshore, leaving around $34 billion in the United States. Given that Apple cannot currently repatriate its offshore cash without incurring a 35% tax bill, which would mean spending $22.4 billion to repatriate all of the cash, it cannot be used in a buyback. That leaves Apple's domestic cash holdings. Even if Apple used every single penny of its domestic cash holdings to buy back stock at current prices, it would only be able to retire 6.42% of its outstanding shares (about 59.67 million shares).
Simply put, we do not think that is a large enough sum. Apple could always raise debt to buy back stock, but part of the reason that Apple is such an appealing investment is that it is free of debt, providing it with an unrivaled safety net. While Apple's domestic cash flow-- as we noted above-- could sustain a dividend, we do not think the same holds true for a buyback. We believe that to be truly effective, Apple's domestic cash and cash flow will not be enough.
Furthermore, stock buybacks are extremely difficult to execute properly, and few companies have proven themselves to be able to consistently time their buybacks effectively. Microsoft, for instance, has spent billions on buybacks, but has little to show for it. The key with buybacks is to buy stocks at a discount to fair value. As Warren Buffett put it, "when companies purchase their own stock [at a discount to fair value], they often find it easy to get $2 of present value for $1." While many would argue that Apple is still undervalued at these levels, we do not think that the numbers to support a buyback are there. Retiring $34 billion worth of shares, while certainly a sizable figure in nominal terms, is small when compared to Apple's market capitalization of nearly $530 billion. While a company with Apple's valuation and financial profile is a prime candidate for a buyback, the amounts needed to truly make it effective are beyond Apple's domestic cash reserves, in our opinion. That being said, if forced to choose between a dividend and a buyback, we would go with a buyback.
Apple is the most unique company in America. It has proven its critics wrong time and time again, and has delivered immense joy to its customers and immense profits to shareholders. We continue to believe in Apple, but caution investors against clamoring for a dividend or a buyback, for the reasons outlined above. Dividends are fraught with tax issues, matters of perception, and in the end, Apple is not the type of company to be paying a dividend. We would see an Apple dividend as merely a transfer of shareholder wealth from one source to another. And if investors truly believe that the "Jobsian" way to run Apple is the best way, there should be no talk of a dividend.
Investors who need dividend income should not be investing in Apple in the first place, as there are many companies in less competitive industries that have safe and growing dividends. A stock split accomplishes nothing in the long run, other than exposing Apple shares to more volatility and widening the bid-ask spread. We do not think that a buyback would be very effective given Apple's size, and it is very difficult for any company to effectively time a stock buyback. That being said, we will be holding Apple for the foreseeable future, dividend or no dividend, stock split or no stock split, and buyback or no buyback. The future potential of this company is still as great as ever.
Additional disclosure: We are long MSFT, T, VZ, INTC, CSCO, HPQ, and AXP via the SPDR Dow Jones Industrial Average ETF. We are long shares of GOOG via a mutual fund that assigns it a weighting of 2.75%.