Apple's (NASDAQ:AAPL) enormous cash hoard has been growing at an epic rate and has now reached truly obscene levels - $246 billion, to be precise.
This is due to the explosive growth of the iPhone over the past decade, as well as former CEO Steve Jobs's almost pathological need to maintain a giant safety buffer so that the company would never again risk bankruptcy.
However, under Tim Cook's leadership, Apple has become the most shareholder-friendly company in human history, at least when it comes to returning capital to shareholders.
Still, despite over $200 billion in buybacks and dividends over the past five years, Apple's stunning river of free cash flow has continued to increase its cash on the balance sheet. This has stoked increasing speculation about the best way for the company to maximize long-term shareholder value.
Let's take a closer look at why this question is going to become increasingly relevant over time, and most importantly, what are the best and worst ways Apple can and should spend its lucre.
The Reason For The Largest Cash Hoard In History
To give you an idea of just how big the company's cash pile is, if it were the GDP of its own nation, then Apple's cash would be the 44th largest economy on earth, larger than that of Finland and Portugal.
Now, in fairness to Apple and Tim Cook, the reason that the company hasn't reduced the cash position more is because 93.5% of it is held overseas. That means it can't be used for capital returns, at least not without repatriating it (bringing it back home) and incurring a 35% tax rate. In other words, Apple is trying to avoid a $80.5 billion tax bill.
That explains why, in this era of record low interest rates, the company has been taking on an incredible amount of debt - $88 billion in total - in order to fund its incredible pace of buybacks (5.4% CAGR over the last five years).
And given that Apple's strong fundamentals and credit rating allow it to borrow at a weighted average interest rate of 1.9%, I can't blame the company for borrowing against its cash pile to reward investors with such value-boosting buybacks and an impressive (if short) dividend growth rate.
However, now that the Trump administration and the GOP-led Congress have promised America sweeping tax reform, including a 10% repatriation tax holiday, the day that so many investors have dreamed of is likely coming. Apple will probably soon be able to bring home $207 billion in post-tax cash to its domestic balance sheet, meaning the company will have over $223 billion to work with.
In fact, because Apple is generating free cash flow, or FCF, at a rate of $52.5 billion a year, by the time tax reform is passed and goes into effect (likely 12-18 months from now), its domestic, usable cash could stand at $230-250 billion.
Which means that what the company can, should, and will do with that money is potentially the most important factor that long-term dividend investors need to consider.
Apple's Options Are Many, But Most Ideas Are Ill-Advised
There are five things a company can do with its cash: reinvest in its own business (R&D), acquire other companies, pay down debt, buy back shares, or pay out dividends.
Let's take a look at Apple's options, in order of the worst to best ideas, for maximizing long-term total returns.
First, we have giant, and splashy, headline-grabbing acquisitions, such as buying Netflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA), or even Disney (NYSE:DIS). The problem with such a move is that decades of studies have shown that giant acquisitions are one of the worst uses of cash management can make.
In fact, a study by the National Bureau of Economic Research that looked at 12,023 acquisitions over 20 years found that 83% of the time, giant buyouts decrease shareholder value. Specifically, over the 20-year period studied, large companies lit $226 billion of shareholder money on fire pursuing this "empire-building" approach.
Now, it is true that some acquisitions can be spectacularly successful, such as Alphabet's (GOOG, GOOGL) purchase of YouTube for just $1.65 billion in 2006. Bank Of America (NYSE:BAC) estimated back in 2015 that YouTube was worth $70 billion, meaning that Alphabet's decision resulted in a 51.7% CAGR return for investors.
Then there's Disney's trifecta of studio purchases:
- Pixar for $7.4 billion in 2006
- Marvel Entertainment for $4 billion in 2009
- Lucasfilm for $4 billion in 2012
Undoubtedly, these purchases have proven to be some of the smartest capital allocations in history. After all, they have made Disney the undisputed king of global films, thanks to its ownership of the Marvel cinematic universe, Star Wars, Pixar, Pirates of the Caribbean, Indiana Jones, Disney Animation, and the growing and explosively successful number of live action remakes of its classic animated films.
But the key to these historic successful examples is that each one was a small- to medium-sized purchase that naturally fit into the acquiring company's core business. In contrast, let's take a look at what an acquisition of Netflix, Tesla, or Disney would cost, assuming a 50%, 50%, and 25% share price premium, respectively.
|Acquisition Candidate||Market Cap||Enterprise Value||Buyout Price||Total Cost To Apple Shareholders|
|Netflix||$62.8 billion||$64.5 billion||$94.2 billion||$95.9 billion|
|Tesla||$42.3 billion||$46.9 billion||$63.5 billion||$68.0 billion|
|Disney||$178.4 billion||$199.1 billion||$222.9 billion||$243.1 billion|
As you can see, Apple could easily swallow up Netflix and Tesla, and in 12-18 months, even Disney. However, acquiring Disney would likely consume all of its cash, meaning it wouldn't be available to pay down the company's debt.
|Company||2016 Sales||2016 Net Income||2016 FCF|
|Apple||$218.1 billion||$45.2 billion||$52.5 billion|
|Disney||$55.2 billion||$9.0 billion||$7.6 billion|
|Apple + Disney||$273.3 billion||$54.2 billion||$60.1 billion|
Now, as far as giant acquisitions go, buying Disney is probably the least dumb move Apple could make. After all, it would certainly be a needle-moving purchase, with sales, earnings, and FCF jumping by 25.3%, 19.9%, and 14.5%, respectively. In addition, it would make Apple's future growth easier, thanks to Disney's likely continued dominance in entertainment and its fast-growing earnings and FCF.
That being said, some of the reasons that people give for Apple acquiring Disney, such as making its content exclusive to Apple TV, or a potential future online streaming media platform, are just silly.
Remember, what makes Disney such a powerhouse is that its content distribution channel is global and wide-reaching. The same goes for Netflix and its growing library of exclusive shows and movies. In other words, buying either Disney or Netflix just to get its content and then wall it off within Apple's ecosystem would destroy the very value (and cash flow) that was the reason for the acquisitions in the first place.
And then there's the often overlooked fact that neither Netflix or Tesla is actually profitable. Granted, Netflix is growing like a weed, thanks to its global launch that puts it in over 190 countries. The same with Tesla, which plans to be producing 1 million cars a year by 2020.
However, we can't forget that such lofty growth ambitions don't come cheap. For example, at the end of 2016, Netflix had $14.5 billion in streaming content obligations, thanks in large part to the aggressive pace of new exclusive content deals. While exclusive content is likely to prove far more profitable for the company in the long term (because it can amortize the costs over its global subscriber base), in the short term, buying Netflix wouldn't boost Apple's earnings or EPS at all.
And as for Tesla, I remain skeptical about its growth plans. Don't get me wrong, Elon "Iron Man" Musk is a personal hero of mine. I sincerely hope that the company becomes a global automotive and energy powerhouse. But we can't forget a few key things about Tesla that make it a potentially terrible investment for Apple.
First and foremost, Tesla's plans essentially force it to recreate the same infrastructure that the global automotive industry has spent over a century building, but in about 20% of the time. That's because of its unique direct-to-consumer business model, which essentially means that only Tesla service centers can service its cars.
Up until now, Tesla's vehicles have had a myriad of reliability issues, which are understandable given its young age, and quick rate of growth. However, as the Model 3 launches and ramps up, and the Model Y (a crossover based on the Model 3) comes down the road in 2018-2020, Tesla will have to prove that it can greatly cut down on reliability and quality control issues.
And even if it does, it will still have to massively expand its global service center infrastructure as well as the supercharger network. Not only will that cost several billion, but Musk has said that by year end, Tesla will announce the locations of Gigafactories 3, 4, and 5 (Gigafactory 2 is the solar panel factory in Buffalo, New York, that is almost complete).
Not just that, but Tesla is in the process of doubling the production capacity of its Freemont, California, factory so it can produce 1 million cars/year. And with Musk's Phase 2 plan also calling for a Tesla pickup truck, sem trucks, and buses (as well as a new roadster), it makes total sense why the company is going to need a fleet of high-tech and gigantic factories across the globe.
But the cost of doing all this over the next nine years is going to be staggering. Even if each new Gigafactory (and there will likely be more than five by the time phase 2 is complete in 2026) isn't as high as the first Gigafactory's $5 billion, the company could easily be looking at $20-30 billion in needed capex to meet its growth potential and goals.
And that may end up being a conservative estimate when you consider what Musk has said about Gigafactory 3, which is to be built somewhere in Europe. Specifically, Musk wants this to be the world's largest factory, even bigger than Gigafactory 1 in Sparks, Nevada. That's because it will be a combined battery/car manufacturing plant, one that is the most automated in the world.
As I said, I'm a huge fan of Tesla, and I hope that the company ends up building dozens of Gigafactories, hundreds of service centers, and thousands of superchargers around the world. However, as an Apple shareholder and a dividend growth investor, I'm not exactly eager for Apple to foot the bill, likely to rise into the tens of billions, to see that happen.
Why A Special Dividend Is Terrible Idea
The next worst thing Apple could do with its post-repatriation cash hoard is to pay a giant special dividend. In recent months, there has been a lot of speculation about this kind of move, with the size of a special, one-time dividend ranging from $15/share to $35/share.
I get why the idea of a 10-25% special dividend may seem appealing, especially to investors who bought a lot of Apple stock years ago and are now sitting on large positions of 1,000-plus shares. However, before you salivate over the potential for a big payday, consider this. The entire point of Apple restarting its dividend back in 2012 was to attract a new kind of investor, specifically of the dividend growth variety.
We dividend investors prize secure and steadily growing payouts above all else, because historically, total returns track the formula yield plus dividend growth.
|Company||Yield||TTM FCF Payout Ratio||Projected 10-year Dividend Growth||Potential 10-year Annual Total Return|
(Sources: GuruFocus, Morningstar, FactSet Research, F.A.S.T. Graphs, Multpl.com, Moneychimp.com)
In fact, the kind of long-term, double-digit annual dividend growth is the very reason that investors like me are long-term bulls on Apple, despite the paltry current yield. In other words, the ability to count on consistent income growth, which results in steadily rising yield on invested capital, attracts long-term, buy, hold, and add-on-dip investors to the stock.
What about a special dividend? Well, for DGI investors, this is a largely useless financial engineering gimmick. That's because the share price will decline by the amount of the dividend, which means there is no real benefit to us.
Sure, a big one-time payout can be useful in terms of giving us dry powder to reinvest elsewhere. But one of the biggest long-term benefits to a dividend growth stock is that as long as management is providing consistent growth, an investor is likely to reinvest the dividend into the same stock (such as through a DRIP plan).
Or, to put it another way, a good amount of the dividend paid out each year will wind up providing increased demand for shares. This creates a kind of "shadow" buyback effect, in which a large number of shareholders are constantly buying adding shares over time. This ultimately helps to support, stabilize, and increase the share price.
A one-time dividend takes that steady demand and wastes it. After all, let's say that Apple were to announce a one-time $35/share special dividend, which would burn through $189 billion of the company's cash. Most likely, the short-term pop this news would generate (from investors foolishly chasing the payout, not realizing that it is neutral to the value of their shares) would lower Apple's yield even more.
That means that dividend growth investors would have very little reason to reinvest that dividend money back into Apple shares. And after the dividend is paid out? Then, the share price would fall by $35 and likely right back to today's levels.
In other words, rather than providing a long-term, cumulative and compounding boost to shareholder value, a special dividend is a terrible way to attract short-term investors that are just out to make a quick buck.
And once that money is gone, it's gone. That means massive lost opportunity to do the things that actually increase shareholder value over time.
Here's What Apple Should Do
Historically speaking, the best uses for shareholder cash are as follows:
- Reinvest back into the business
- Pay growing dividends over time
- Pay down debt
- Buy back shares
Now, I've heard from many readers who think Apple needs to double down on its R&D efforts and develop its next "world-changing" product, along the lines of the iPod or iPhone.
However, as you can see, the company has hardly been skimping on R&D. In fact, as a percentage of revenue, R&D spending has been rising for the past five years.
I highly doubt Apple doubling its R&D budget to over $20 billion per year is suddenly going to result in a game-changing new product along the lines of the iPhone. While many people understandably give Steve Jobs credit for being a consumer electronics visionary, let's remember that the iPod and iPhone were not Apple inventions.
Rather, they were improved versions of existing devices (as was the iPad, which has proven to be less of a game changer). So, anyone advocating that Apple double or even triple its R&D budget would need to point to some kind of existing device that the company could improve upon to the point of achieving massive market share and truly needle-moving sales, earnings, and cash flow growth.
What about the rumored Apple car, aka "Project Titan?" Well, in recent months, Apple has massively scaled back its investments into whatever this project is. That makes sense when you consider the immense cost of manufacturing an autonomous, electric vehicle, which is what most people expected the company to build.
Tesla has shown the world that even if you can build the best-performing and sexiest cars in the world, making a profit is easier said than done. Sure, Apple could build a car if it wanted, but that would cost tens of billions, because the company would have to essentially do what Tesla is attempting and build all the infrastructure from scratch.
Which basically means Apple gaining market share in the auto sector and at operating margins similar to its current hardware business (40+%) would be all but impossible.
What about paying down debt? While that is generally a good thing, especially as interest rates rise (meaning higher refinancing costs), keep in mind that Apple's debt load is nowhere near dangerous levels.
That's because the current cash position is great enough that the company could choose to repatriate its cash (and take the tax hit) and pay off all the debt at any time. In addition, interest continues to be tax-deductible for now, though this could change with tax reform. In other words, Apple's current, ultra-low interest loans are pretty benign and actually help to boost EPS.
Which brings me to the ultimate point, which is that the best thing Apple can do with its money is exactly what it's been doing.
Shut Up And Let Tim Cook Make You Rich
Over the last year, Apple shares have soared, easily beating both the S&P 500 (NYSEARCA:SPY) and the tech-loving Nasdaq (NASDAQ:QQQ). However, despite shares sitting at all-time highs, Apple still remains highly undervalued.
|TTM FCF/Share||10-year Expected Growth||Fair Value Estimate||Growth Baked Into Current Share Price||Margin Of Safety|
(Sources: Morningstar, F.A.S.T. Graphs, GuruFocus)
In fact, looking at a long-term discounted cash flow or DCF analysis, we can see the shares are only pricing in a paltry 3.3% CAGR growth rate. Given that analysts expect the company to easily achieve long-term sales growth of 3% or so (due to mega iPhone upgrade cycles and steady growth in services) and 5-6% ongoing net share reductions, this is almost certainly a ridiculously pessimistic outlook.
Which basically means that Apple is still priced to smash market expectations and deliver market-thumping total returns, courtesy of its excellent margin of safety.
That's why it makes the most sense for management to use its repatriated cash hoard to keep buying back shares (as long as Apple are 15+% undervalued) and raising the dividend by double digits ($0.06/share this year).
That will allow the company's FCF/share, which ultimately is what funds, secures, and allows for dividend growth, to continue rising steadily over time. Which, in turn, will continue attracting income investors to Apple shares, and causing it to generate solid, market-beating total returns.
Bottom Line: Apple's Current Capital Return Strategy Is The Optimal One For Maximizing Long-Term Shareholder Value
While it can be fun to speculate about what Apple can and should do with its enormous money pile, at the end of the day, what really matters is what will drive up the share price in the long term.
Ill-advised, splashy acquisitions and enormous special dividends may sound good at first glance, but in the long term, the best way that the company can boost shareholder value is with a strategy that maximizes its long-term dividend growth prospects. That means continuing on the current path of buybacks and steady, double-digit dividend growth that will one day make Apple a Dividend Achiever, then a Dividend Aristocrat, and eventually, a Dividend King.
Which is why I, for one, hope that Apple uses its repatriated funds to continue on its current path; steadily buying back boatloads of undervalued shares, and steadily raising its dividend at a double-digit rate for decades to come.
Disclosure: I am/we are long AAPL, DIS, BAC.
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.