Apple: It's All About Capital Allocation

About: Apple Inc. (AAPL)
by: Jonathan Weber

Sources of capital explained.

Apple should increase leverage in order to lower cost of capital.

Share repurchases do not only boost earnings per share and thus per share value, but save the company money, too.

Issuing debt in other currencies to finance buybacks provides a free hedge against unwelcome currency movements.

Much has been said and written about Apple's (NASDAQ:AAPL) growth potential from numerous fields, the outlook for iPhone and Mac sales for the coming quarters and the technical details about every one of Apple's products. In this article I want to take a look at something else: Apple's sources of cash and cash uses.

Let's first take a look at the sources a company can access to get new capital: Debt and equity. The cost of debt is pretty clear when we look at the interest rates the company has to pay on its debt, which depend on several factors, among them the financial strength of said company and the duration of the notes (i.e. borrowing for a couple of months is less expensive than borrowing for a couple of decades). When we look at the capital cost of a company we have to adjust the company's interest expenses for the taxes that the company saves - since interest expenses are a pre tax cost, we have to multiply the interest rate with the factor (1-tax rate/100) to get to the after tax cost of the company's debt.

The other source of capital is through equity - a company can get capital by issuing new shares. The cost of equity can be calculated in different ways, e.g. through the concept of the company's earnings yield, which is the inverse of the company's PE ratio. A company trading at 18 times earnings has net income of $5.56 for every $100 in market capitalization - we can say that the company trades at an earnings yield of 5.56 percent. Another approach to a company's cost of equity is the Capital Asset Pricing Model, which uses the following formula:

The cost of equity depends on the return an investor can expect from risk-free alternatives (e.g. US treasuries), the so called equity risk premium (the additional return the stock market is generating) and the beta of the shares of said company (which measures the volatility).

Both of these approaches to equity costs are not cash costs though (unlike the costs of debt). When we want to look at the cash costs of the equity portion of the company's capital we have to look at the dividends the company is paying to its owners. Unlike interest expenses we do not have to adjust dividends because dividends are paid with after-tax dollars (unlike interest expenses, which are paid with pre-tax dollars).

We can look at Apple's numbers here:

Total debt $63 billion
Weighted interest rate 2.5 percent
After-tax interest rate 1.8 percent
Market capitalization $521 billion
PE ratio 10.3
Earnings yield 9.7 percent
Equity cost according to CAPM 8.5 percent
Dividend yield 2.2 percent

Apple is primarily financed through equity, with the company's market cap roughly eight times as high as the company's long-term debt. Apple's equity cost is 9.7 percent according to the concept of the earnings yield, and 8.5 percent according to the CAPM. We can use the average of these two to get to a cost of equity of 9.1 percent. This is five times as much as the company's after-tax cost of debt, and even the cash cost of Apple's equity (the dividend yield) is higher than the company's after-tax interest rate.

If Apple needs new capital (e.g. to fund future projects like its car), the company should thus look to access said new capital by issuing debt, since the company's cost of equity is a lot higher than the company's cost of debt.

Fortunately, the company does not require any new capital at this point, since the company's operating cash flows are high enough to cover all of the company's capital expenditures - with the remaining free cash flows coming in at an annual run rate of $63 billion. This gets us to another question: Since the company generates more capital than it needs, the company can pay back capital: Either by paying back debt (when the notes mature, or by buying back its notes before they mature), or by buying back its common stock. The decision is pretty easy here since Apple's cost of equity is so much higher than the company's cost of debt the company should not try to reduce its debt, but rather buy back as many shares as possible.

This leads us to another question - would it be beneficial to increase the amount of debt in order to buy back shares with the proceeds? The answer (at least in this case) is yes: By increasing leverage and using debt proceeds to reduce the share count Apple can lower its capital cost and save cash.

Let's look at an example: If Apple chose to issue $50 billion in new debt at an average interest rate of 2.5 percent, the company's after-tax expenses would total $925 million (or 1.85 percent of the $50 billion). If the proceeds are used to repurchase shares at an average price of $95, the company could lower its share count by 526 million. This share count reduction would in turn mean that the company's total dividend payments would decline by $1094 million. Apple would save $1094 million and have new costs of $925 million, on a net basis this would mean that the company's expenses would decline by $169 million. The company's cash flows and net income (after dividend payments) would thus improve by the same amount of roughly $170 million. At the same time, the company's earnings per share would see a huge boost since the company's net income would get divided over a smaller number of shares - earnings per share would increase by roughly 10.5 percent.

We can say that such a move would be highly beneficial for the company: The company's total expenses (we include the dividend here) would decline, the company's cash flow situation would improve and investors would see a huge boost to EPS (and thus ultimately to the value of their shares).

Apple's management knows about this, and thus has repeatedly issued new debt in the last quarters, which has been used in order to fund the company's vast buybacks. Just today we got news about new debt papers being issued - the total amount will be $12 billion. If Apple uses all $12 billion in order to fund share repurchases, the company would save about $40 million in cash a year (due to dividend payments being lower, partially offset by higher interest expenses) and earnings per share would increase by two and a half percent - the effect would not be as big as in the example I used above, but recognizable still. Luca Maestri, Apple's CFO, has stated that the company would be "very active" in debt markets in 2016 we can thus assume that this will not be the only issuance of new debt this year. $50 billion, the amount I used in the above example, seems not unlikely when we spread this out over four separate issuance dates (one per quarter) at $12 billion (or slightly above) each.

Issuing new debt (in order to finance buybacks and other corporate activities) provides an additional advantage if the notes are issued in a currency other than the US dollar. Let's look at Apple's debt denominated in € as an example: Apple has repeatedly issued debt in €, e.g. in September 2015 and November 2014. Apart from being slightly cheaper than debt in dollars (e.g. Apple's low pre tax interest rate of just 2 percent for bonds maturing in 2027) issuing debt in other currencies provides a natural hedge against unwelcome currency movements.

When Apple sells bonds totaling €10 billion, the proceeds are converted to US dollars in order to use them to finance buybacks. This would mean $11.3 billion at the current rate, enough to buy back 119 million shares (which will lead to the known benefits of lower cash costs and higher EPS). When the bond matures the company can finance the repayment by converting dollars back to Euros and paying back the note.

There are three possibilities for the currency rates for Euros and dollars at the time the bond matures and has to be paid back:

- The rate is the same as at the time the bond has been issued. Nothing would happen in this case, but Apple still has saved money since the € debt has been cheaper than the debt.

- The Euro is more expensive than it is right now. In this case Apple would have to pay more than $11.3 billion to pay back its €10 billion notes, which would mean currency losses for Apple. On the other hand this would mean higher operating profits for the company since its income from the products (and services) Apple sells in Europe is higher when the Euro is more expensive.

- The Euro is less expensive than it is right now. In this case Apple would have to pay back less than $11.3 billion to pay back its €10 billion notes, which would mean currency gains for the company. This would (at least partially) offset the negative impact a declining Euro has on Apple's earnings (since Apple's operations in Europe are less profitable when the Euro is cheap relative to the dollar).

We can summarize that issuing notes in non-dollar currencies helps hedge against negative currency impacts, and thus helps stabilize earnings (in addition to the benefit of a very low interest rate for notes issued in other currencies than the dollar).


Apple has a rather high cost of equity and a very low cost of debt. It is thus a wise decision to increase the company's leverage in order to lower the cost of capital.

By issuing debt and using the proceeds to repurchase shares Apple can lower its cash expenses and increase earnings per share at the same time, and if said debt is issued in currencies other than the dollar the company gets a free hedge against the negative impact of a strong dollar at the same time.

I believe management's decision to increase debt levels this year is prudent and could be very profitable for shareholders. By improving the company's capital structure Apple can create additional shareholder value in times when organic growth is lower than in previous years.

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.