Apple Dividends: Reverend Cook, Please Increase The Dividend By 25%

Summary

• Apple's dividend growth has been phenomenal and yet it might still be on the conservative side.
• Apple generates enough cash to substantially increase its dividend without so much as a hiccup.
• An appropriate dividend payout ratio should be 34% - a 25% increase to the estimated 2017 dividend.

I get asked all the time what I think about investing in Apple (NASDAQ:AAPL) stock. However, I think the people that ask simply want to hear confirmation for a decision they have already made. In fact, I had a client at a previous employer who after hearing my recommendation to reduce his Apple exposure from 40% to 20% of his portfolio due to concentration risk, defiantly said,

Apple is my religion and I am a devoted follower

So that was that. I knew he would never reduce his exposure to Apple, but for compliance reasons and because I was obligated to give my advice regardless of whether the client would act on it or not, I kept repeating my recommendation every time we talked or exchanged emails. It’s not that I didn’t like Apple, I just didn’t think it should be 40% of someone’s portfolio.

The last time I wrote an article about Apple on Seeking Alpha was July 2014, when I highlighted its high but decreasing return on equity as a potential harbinger of a price decline. I highlighted a few ways the company can reverse its downward trend: increase margins through either price increases or cost cuts, return cash to shareholders, or continue to increase leverage.

The stock proceeded to climb another 42% through May 13 ^th, 2016 before coming all the way back down to the levels it was trading at when I wrote the article. But since then, it has popped again , appreciating over 62% for an annualized return of over 17% since my article was published.

It was a wild ride, to say the least, but I missed the boat, you might say. But it was more because I stopped paying attention to the stock and not because I was wrong in my assessment. It turns out, Apple did increase leverage over the last two years from 2x to 2.5x as measured by Assets/Equity. The chart below shows the spike in leverage starting right around 2013 and continuing through 2016. During this time, Apple increased long-term borrowings from $56 billion to $114 billion. Net margins meanwhile, remained relatively flat, and asset turnover continued the downward trend I highlighted I 2014.

And the company did return cash to shareholders as I had also suggested - by increasing dividends from $1.86 in FY 2014 to an estimated $2.42 per share for FY 2017 ending in September 2017.

So why am I not currently invested in Apple? Unfortunately, it doesn’t fit any of the criteria of the portfolios I am currently managing. The Strategic Income Growth portfolio has a mandate to invest only in stocks with a dividend yield above that of the 10-YR Treasury rate - which Apple doesn’t meet with current dividend yield of 1.75. The Heard on the REITs portfolio is not a good fit for Apple either, because put simply, it’s not a REIT. And finally, the third portfolio, the Go-Growth (or go-home) portfolio is just launching - and as much as I might think Apple has more growth potential, it exceeds the $1 billion market cap we have set as a parameter in that portfolio.

The Apple Trigger

That leaves only the Strategic Income Growth portfolio as a practical option to add Apple to. But it must meet the criteria for the portfolio or it defeats the purpose of having a defined investment mandate and goes against all of the principles of disciplined investment management, whether you’re a proponent of Buffett, O’Shaughnessy, or Bogle.

So what needs to happen for the SIG portfolio to take a bite out of Apple?

• A Pullback in the Stock – this one is obvious. Based on FY 2018 dividend estimates of $2.66, a price of $120 would indicate a dividend yield of around 2.15%. It’s not quite the 2.37% at which the 10-YR Treasury closed today, but its close enough. To get there would require a 15% pullback from the current price of around $144 - unlikely to happen unless the next iPhone launch is disappointing.
• A surprising increase in dividend payments. Specifically, the dividend would have to increase to $3.17 per share for the dividend yield to be 2.2% at current prices. This move is also not likely unless the payout ratio reaches 36%, the highest payout reaches since the first year Apple paid a dividend. A payout ratio of 36% is hardly a risk to a cash cow like Apple and I for one would be an advocate for increased dividend payments. As the chart below shows, dividends aren’t keeping up with earnings per share. A payout ratio of 33-34% is about where I think it should be even though that still probably wouldn’t be high enough to pass our filter. - That's an increase of 25% above estimated FY 2017 dividends.

Not Gonna Happen

Josh Arnold recently wrote an article on Seeking Alpha titled “Apples Dividend Potential Almost Unbelievable”

Josh does a great job of pointing out how much free cash flow Apple generates and how easily it can triple its dividend without so much as a hiccup. He points out something I have yet to mention which is very relevant to my approach and yet gives me no comfort – that part of the reason Apple’s dividend yield is just 1.75% is because it has already appreciated 25% this year. On December 30^th, 2016, it was trading at $115.82. At a trailing 12-month dividend of $2.23, it was yielding almost 2%. Unfortunately, it still wasn’t quite where the 10-YR was trading. For income investors, Josh says it best, referring to the most likely way investors will get cash back from Apple. It won’t be the dividend.

The dividend will be second best to the buyback and for income investors that's not good news. The potential is certainly there for the yield but until management makes it a priority, Apple's dividend will never achieve its potential.

The Religion of Apple

I understand the magnetism that Apple has both as a company and a potential investment. But as a portfolio manager and investment advisor, this omnipresent spiritual enthusiasm must be tempered with common sense, strict investment criteria, and discipline to stay the course. Should investors have Apple in their portfolio? Yes, of course, in an allocation size that is warranted for the risk/return profile of the investor and only if it meets the criteria established for the portfolio.

Returning to my old client with 40% of his portfolio in Apple – he eventually did sell half his position – diversifying into other stocks that had very little correlation to Apple. And the Strategic Income Portfolio? I’ll wait patiently for the right opportunity and if I miss another leg up, that’s OK, I’ll sleep well at night knowing I stuck to my guns. As investors, so should you.

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Disclaimer: Please note, this article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It is intended only to provide information to interested parties. Readers should carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.

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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.