Apple: Pay Off The Debt

Summary

• The tax repatriation bill has made marked progress recently, passing the US House this week and on its way to the US Senate.
• Apple's debt position has now crossed $100bn and serves as a ripe target for repatriated funds.
• A dividend raise, special dividend, or large acquisitions also are waiting in the wings.

Apple’s (NASDAQ:AAPL) cash on hand, and the over 90% that it holds abroad for tax reasons, is a story as old as time: Apple has a huge cash hoard of approximately $265bn and there is no shortage of opinion on how it should spend its money. But a confluence of events may signify the time is now for Apple to embark a nuanced strategy: repatriate overseas funds, pay down corporate debt, issue a higher or special dividend, and end or slow its buyback.

The US House has passed its version of the corporate tax bill this week, portending a lower repatriation rate of somewhere between 7-15% that can be paid over a number of years.

Apple is not alone in its debt binge. In 2017, there has been over $1trn in corporate debt issuance from companies like Microsoft (MSFT), Visa (V) and Home Depot (HD), which have made significant contributions to the overall rise in debt issuance:

We have previously reported on Apple’s ominous appetite for issuing debt: it now has over $100bn in debt on its balance sheet, from nearly $0 at the end of 2011. Now, the Republican tax bill making its way through Congress will pave the way for Apple to repatriate some of its $250bn in cash held overseas while incurring a $30bn tax bill to be paid over a number of years should it bring back the whole pile. Here’s Apple CEO Tim Cook:

Let me now turn to our cash position. We ended the quarter with $268.9 billion in cash plus marketable securities, a sequential increase of $7.4 billion. $252.3 billion of this cash, 94% of the total, was outside the United States. We issued $7 billion in new Canadian and U.S. dollar denominated debt during the quarter, bringing us to $104 billion in term debt and $12 billion in commercial paper outstanding.

How much the company decides to repatriate is anyone’s guess. Yet we believe a methodical strategy beginning with paying down some or all of its $100bn in debt it issued (almost precisely because Apple did not want to pay high taxes on any cash it has repatriated up until now) could strengthen the company’s financial position and provide a boon for shareholders going forward.

After the debt situation is addressed, we expect the company to address its capital return program. Again, here’s Cook:

We also returned $11 billion to investors during the quarter. We paid $3.3 billion in dividends and equivalents and spent $4.5 billion on repurchases of 29.1 million Apple shares through open market transactions. We also launched a new $3 billion ASR program, resulting in initial delivery and retirement of 15.1 million shares and we retire 4.5 million shares upon the completion of our 11th ASR during the quarter. We have now completed almost $234 billion of our $300 billion capital return program, including $166 billion in share repurchases.

The company has repurchased $166bn worth of its own stock. We urge this fact to be viewed in a simple context: the share price has risen considerably throughout 2017. The stock price is no longer as cheap as it once was. And to cite Warren Buffett, a large shareholder of Apple himself:

For continuing shareholders...repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent… It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn't be the case if a management was buying an outside business.

Certainly, there should be some point where the stock price no longer justifies the company’s buyback – we argue that this threshold has long been passed. S&P companies have seen the writing on the wall. Share buybacks have slowed as valuations (read: stock prices) have continued to march higher throughout this bull market. We urge Apple to avoid the pitfalls of buybacks last time overseas revenues were repatriated in 2004, where most companies did little to benefit their companies long term; rather they simply bought back tons of stock.

Instead, we have called on the company to focus on other uses of cash upon repatriation, rather than buying back more shares. Investors are to be watchful of a potential special dividend as Apple stands to benefit from repatriation as much as any other company in the world. Some analyses are coming out citing a potential $15-$20 per share at a cost of upwards of $100bn, something easily achievable once $250bn has returned from overseas.

Alternatively, raising its dividend to a higher %, while benefitting large shareholders like Buffett and Cook, is another downpayment on its confidence in the iPhone landscape. It will also mitigate any potential shock to the stock upon a potential announcement that it would no longer be repurchasing such a large amount of shares. While normally such a press release would be viewed as a negative, if it is coupled with a dividend raise or a special dividend, the impact would surely be buffered.

Conclusion

Now more than ever is the time for Apple to ready the market by tempering expectations of a significant increase in its share repurchase program. Apple should embark on strategies that are intended to grow the earnings – acquisitions, sensible capital deployments, investments in its supply chain – instead of strategies like buybacks intended to inflate EPS under the guise of value. The prospect of a special dividend is really only on the table because Apple could retire its entire debt load, pay its taxes, invest in its business, and still have billions left over. Navigating the 2017 repatriation waters will dictate Apple’s strategy for years to come.

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.