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Apple Has A Major Cash Problem

Sep. 08, 2015 10:34 AM ETApple Inc. (AAPL)MSFT, ORCL2 Comments
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Summary

  • Apple has a huge pile of cash, but limited options for how to spend it.
  • Most of this cash is stored in offshore accounts and cannot be used in the United States to buyback shares, pay dividends or make acquisitions.
  • This has left Apple stockholders wanting more, and the company has partially come through by issuing massive debt offerings to pay for share buybacks.
  • Apple cannot continue to offer debt and will need to bring its cash back state-side eventually.
  • A repatriation tax holiday could bail Apple out of a messy situation.

$200 Billion is a Problem?

Apple (AAPL) has a problem. The most valuable company in the world, with a market capitalization of $623 billion, has a cash dilemma. This dilemma is not quite evident when you hear Apple CEO Tim Cook state that in the third quarter the company's cash pile surpassed $200 billion for the first time. With that much unused cash, how could Apple possibly have a money problem? Before answering that question, I want to quickly put $200 billion into perspective.

That amount of money could buy Intel (INTC), Micron (MU) and Tesla (TSLA) and there would still be about $15 billion left over. Obviously not going to happen, but the example can help one understand just how much cash Apple has in its possession.

Here's the Issue

This section will provide background on the topic of corporations keeping their profits offshore because I think an understanding of the history and inner workings of the phenomenon is essential. This section is rather lengthy, but I found the information both interesting and highly relevant to Apple's current cash dilemma.

So where is the problem? The problem is that most of Apple's cash is held in offshore accounts. This money cannot be used for dividends, buybacks or acquisitions in the United States, which put management in a difficult position. Many shareholders, including Carl Icahn, were demanding that Apple use its immense cash hoard to return value to investors, but the company did not have the physical cash with which to authorize buybacks or a dividend.

This leads to the following question: If the problem was that Apple didn't have the cash on hand to give back to shareholders, why didn't the company just bring its overseas cash stateside?

Apple currently has $181 billion of its cash, or 89%, held in offshore accounts. If this were to be repatriated, or brought back to the U.S., Apple would lose out on approximately $63 billion or 35%. Microsoft (MSFT) is in the same boat as Apple and has $108 billion held in offshore accounts as of the third quarter. A review by Bloomberg in March of this year found that U.S. corporations have $2.1 trillion stored offshore.

As a side note, the repatriation rate is not exactly 35% but is rather calculated by subtracting the U.S. rate (35%) by the foreign tax rate a company incurred. To avoid double taxation, companies are given tax credits for the taxes paid to foreign governments. However, the effective rate is still substantial. For example, it is estimated that if Microsoft repatriated its cash, it would pay an approximate tax rate of 31.9%.

The reason these companies keep their foreign profits out of the country is because the U.S. tax code has a loophole. Corporations are taxed on foreign profits by the U.S. government to the tune of 35% (which is the standard corporate tax rate in the U.S.), but can defer paying taxes on this income until it is repatriated. This leads many companies to simply stockpile profits overseas because the tax rate in many countries is a fraction of the U.S. rate.

This leads to another, very relevant question: Why do companies keep all of this cash offshore if they will have to pay the 35% tax rate at some point in the future?

It is obvious off the bat that corporations don't actually use the cash for foreign investments because then the capital would not remain uninvested in offshore bank accounts. With this in mind, if this cash cannot be used for stock buybacks, dividends or U.S. acquisitions it doesn't make much sense to keep the cash offshore, even if bringing it back to the U.S. would result in a hefty tax. So keeping cash in foreign bank accounts doesn't make any sense . . . Unless there was a way to repatriate the cash without paying the 35% rate!

On October 22, 2004 President George W. Bush signed into law the American Jobs Creation Act of 2004, which, among other things, provided for what's called a repatriation tax holiday ("RTH") during which companies could repatriate cash held offshore at the miniscule rate of 5.25%. This law was meant to create jobs and invest in the U.S, which would in turn stimulate the economy. Under the law, $362 billion was brought back to U.S. Great idea right? The results were hazy.

Critics claim that an RTH initially generates increased government revenue, but eventually leads to revenue losses. In fact, Congress' Joint Committee on Taxation estimated in 2014 that a RTH would cost the government $95 billion over 10 years. Regardless of how an RTH affects the economy, if one were enacted it would undoubtedly be beneficial for U.S. corporations and especially Apple which has by far the largest offshore cash stockpile.

The RTH of 2004 is a primary example of kicking the can down the road. If anything, it gave corporations an additional incentive to keep its cash offshore. The U.S. government set a precedent in 2004 and corporations took the cue. Expecting another RTH, which has been proposed multiple times, companies can stockpile their cash in foreign countries, confident that repatriation will entail a lower tax rate in the future. This is how Apple got into its current dilemma.

I will come back to the legislative side of repatriation later on in the article. In the next section, I will detail how Apple has coped with its predicament.

Has Apple Sold Its Soul to the Devil?

In the absence of cash in the U.S., Apple has utilized the debt market to finance its stock repurchases and dividend payments. In April 2015, Apple announced that it had authorized a cumulative $200 billion in share buybacks and dividends by March 2017. As of the third quarter, management had fulfilled $126 billion of this total, leaving $74 billion in additional capital return. Apple also has $22 billion in cash and $50 billion in outstanding debt. As the company continues to ramp up its debt offerings, interest expense will continue to eat into net income. This could be an unsustainable development.

Apple is not adding to its U.S. cash hoard fast enough to continue to keep up with shareholder demands after March 2017. After this point, the company will have an immense pile of debt that will continue to cut into net income, cash generation and any additional capital return programs. For the time being, Apple management has decided that paying the interest payments on their low-yield bonds is preferable to the repatriation tax, a decision with which I agree.

Apple's cash problem dates back to the Steve Jobs era. The man behind Apple's success was a staunch opponent of giving back to shareholders. This quote embodies his aversion to paying dividends or repurchasing shares:

We know if we need to acquire something - a piece of the puzzle to make something big and bold - we can write a check for it and not borrow a lot of money and put our whole company at risk . . . The cash in the bank gives us tremendous security and flexibility.

Regardless of my personal opinion on Jobs' rationale in this quote, I'm fairly certain the true reason Jobs didn't put Apple's cash to any particular use is because he just didn't know what to do with it.

After Jobs' death, Warren Buffett stated that he had received a call from Jobs who asked him what he should do with Apple's cash. Buffett encouraged a share repurchase program, which Jobs never initiated. I don't know if Jobs called expecting to hear some investing secret that only Buffett was privy to, but evidently Buffett's unsurprising advice did not sway Jobs. And if you don't take advice from the Oracle of Omaha, you won't take advice from anyone. For someone who didn't plan on using Apple's cash for dividends and buybacks, keeping it offshore probably didn't bother Jobs all that much. But when Tim Cook took over as CEO, the offshore cash was a problem indeed.

This chart depicts how Apple, Microsoft and Oracle (ORCL), three companies with foreign cash stockpiles, buyback programs and dividends, have decided to finance their capital return programs.

AAPL Total Long Term Debt (Quarterly) Chart

AAPL Total Long Term Debt (Quarterly) data by YCharts

Now the most valuable company in the world is also one of the most leveraged, and its shareholder base is hungry for dividends and buybacks. Apple has a long way to go before its long-term debt becomes a pressing issue, but interest payments will continue to be nuisance and $181 billion in cash (and growing) is sitting in foreign bank accounts gathering dust.

Reason to Be Hopeful

Luckily for Apple, and especially Apple shareholders, there is a ray of hope that the company could repatriate its cash sooner rather than later.

There is a bipartisan effort in Congress to enact a repatriation tax reform in order to 1) fund for the Highway Trust Fund, which pays for U.S. infrastructure and 2) remedy the growing foreign cash issues many multinational U.S. corporations are facing. Now, I mean bipartisan in the sense that both parties agree that something has to be done, but they are still split on how to actually solve the issue.

Sen. Rand Paul and Sen. Barbara Boxer proposed a plan that entails a repatriation tax holiday that is voluntary, has a duration of 5 years and puts the repatriation rate at 6.5%. President Obama has proposed a plan that entails a one-time mandatory tax of 14% on all foreign profits, and a 19% tax on foreign profits into the future.

Obviously there is big gap between these two plans, but I think both have merits. Whatever plan eventually is formulated to deal with this issue, I personally hope it sets a tax on foreign profits into the future so that companies don't again stockpile their cash overseas and deprive shareholders of capital returns and value-creating acquisitions.

So how does this political back-and-forth affect Apple? Repatriation tax reform has come and gone since 2004 without making much noise. But as the offshore cash piles of U.S. corporations continue to grow, Congress will be pressured into some sort of action, which will allow Apple and other U.S. corporations to repatriate cash at a low tax rate.

Whether Congress is pushed into action by the looming maturity dates on debt that corporations issued to pay for dividends and stock repurchases, or by the fast-approaching bankruptcy of the Highway Trust Fund, which is a vital resource, Apple will be the beneficiary. The company's growing debt should be of no concern to investors and once the cash pile arrives stateside, which I think will be sooner rather than later, investors can expect continued buybacks and perhaps a boost in dividend payouts. In another possible scenario, interest rates could rise and deter Apple from raising more debt. In this case, the share price will be negatively affected because of the ensuing halt in share buybacks. Cash is only a boon if you can actually use it, and investors will be very unhappy if Apple cannot continue its capital return programs into the future.

Conclusion

Apple has nearly 90% of its cash held outside of the U.S. and is issuing massive debt to pay for stock buybacks and dividends. Interest payments on this debt will cut into Apple's near-term profits, but tax reform on foreign profits should be resolved before the debt starts to apply to much pressure. If tax reform does not occur and issuing more debt is either not an option or too costly, Apple stock could sustain losses. I think investors would benefit by keeping a watchful eye on these developments to inform decisions about Apple in the future.

Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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