Apple: How To Return $750 Billion

Feb. 20, 2018 2:54 PM ETApple Inc. (AAPL)141 Comments
Gary Morton profile picture
Gary Morton
253 Followers

Summary

  • The largest return of capital in history is coming to Apple shareholders.
  • Many believe the company's dividends should only rise slowly, with most of the funds going into share repurchases.
  • Others recommend massive dividends or even special dividends.
  • A balanced approach actually maximizes the benefits for the buyback advocates and for dividend enthusiasts.
  • With so much cash, Apple shareholders can have their cake and eat it too.

How Should Apple Return $750 Billion?

Two weeks ago, my Seeking Alpha article "Apple: Returning $750 Billion to Shareholders" went viral. That article included a proposal/forecast for Apple’s capital return program consistent with the framework that CEO Tim Cook and CFO Luca Maestri outlined in the company’s Q1 FY2018 conference call. The financial model in the article analyzed the impact that following the framework would have for Apple shareholders. What surfaced as the most controversial suggestion in the model involved my proposed 50% increase in the dividend this year and then 15% annual increases over the planning horizon. Many joined the chorus for a large bump in the dividend. An equal number of commenters and others interviewed on CNBC and in Apple blogs oppose any large dividend bump and believe as much cash as possible should go into buybacks.

Analysis of Dividends vs. Buybacks

This article will consider the various arguments for buybacks versus dividends in Apple’s current situation. First, I will analyze the buyback enthusiasts' argument (those who advocate for funneling the vast majority of the cash into buybacks) and show that even for those seeking long-term appreciation of Apple stock in their portfolio, the balanced approach proposed in my model (large buyback and substantial dividend increases) meets every shareholder’s needs better than a low-dividend, spruced-up buyback approach. In fact, investors who want to focus on their total long-term return merely need to reinvest their dividends and, with all other things being equal, they will experience a higher return than if the company used the dividend money for buybacks. This straightforward math runs counter to the intuitive sense of many buyback advocates.

Second, since the math shows that reinvested dividends are actually better for those wanting maximal long-term return on their Apple holdings, some may ask why not just pay out all the capital return in dividends? A deeper dive into such a dividend enthusiasts approach will discuss the benefits and detriments, should Apple emphasize the dividend over buybacks. Here, key components of the financial model bring the dividend heavy approach into question. This discussion highlights some of the factors the company’s board will likely consider when deciding on the future of the capital return program. Again, the balanced approach surfaces as the best option.

Buyback Enthusiasts Actually Limit Their Gains

Although Apple has enough cash to do the initial 50% dividend bump, 15% annual increases thereafter, and the largest stock buyback in history, buyback enthusiasts attack the large bump in the dividend. Generally, they posit two prominent downfalls with any large dividend increase. First, they believe that larger buybacks would, over the long term, best return the cash to shareholders through an even higher stock price. They argue that they do not personally need the cash from dividends, and would rather have a higher stock price. Second, they do not want to dilute their potential gains by having to pay taxes on the higher dividends which they would have to do each year as Apple paid out the dividends.

The buyback advocates are essentially wanting to maximize their long-term capital appreciation. However, a more balanced approach will better achieve their desired end. Below is an analysis of two scenarios based on the financial model in my original article. In the first (Buyback Enthusiasts), Apple only increases the dividend by 10% per year, with no extra bump-up in 2018. The second scenario (Balanced Approach) includes the 50% bump in 2018, and 15% annual dividend increases thereafter. In each case, we will deduct taxes at the federal rate of 23.8% and reinvest the dividends in Apple stock essentially as they are paid.

The analysis demonstrates that you can have your cake and eat it too. Those looking for capital appreciation could take their dividend payments and simply reinvest them by purchasing more AAPL shares on the open market. Oh, but what about the taxes? Buyback advocates worry that the taxes will dilute their returns. Indeed, high-income shareholders in the US would lose 23.8% of the dividends to federal taxes each year. The analysis takes out the taxes before reinvesting the dividends. In analyzing other tax scenarios, even if the tax rate went to 50%, the balanced approach with reinvested after-tax dividends still yields a slightly better long-term return.

The analysis does show that buyback enthusiasts are correct in their belief that the larger buyback will lead to a higher share price. The model has AAPL share price reaching $524 versus $492. This is primarily driven by the lower number of shares outstanding (see Bill Maurer's recent article). However, the total return maximizer who reinvested after-tax dividends under the balanced scenario would have acquired an additional 194 shares, versus just 115 under the buyback enthusiast’s scenario. The difference in share price is not enough to make up for the 41% lower number of added shares.

Moreover, if we consider the potential after-tax return should all of the stock be sold at the end of 2026, the enthusiast would have capital gains to pay on a larger base, since the balanced approach’s greater number of shares bought with reinvested dividends have a higher basis. The total after-tax value is higher under the balanced scenario. The analysis clearly shows that Apple could best satisfy the diverse financial needs of its shareholders with a balanced approach to its upcoming capital return re-evaluation, rather than a funneling an even greater majority of funds into buybacks.

So, Why Not Just Dividends?

Understanding this math, dividend enthusiasts may argue that Apple should only pay dividends. Such an approach would give shareholders maximum flexibility. Those that want portfolio appreciation in their AAPL holdings could simply reinvest their massive dividends. Devout dividend advocates might claim that a dividend-heavy capital return program would allow each individual shareholder to decide if they want to reinvest in the company’s shares with their money. While such an approach may seem appealing to some, I strongly argue against it.

A sensible balance between dividends and buybacks helps to uphold a key assumption in the analysis and the model presented in the previous article. The model holds Apple’s P/E ratio at 15.6 over its time span. The use of average share prices during each year accounts for temporary, reasonable fluctuations in the P/E over the time horizon. However, the long-term expectation is that at 6.9% average annual growth in net income (2018-2026), the market will bestow a similar P/E that it has given the company over the past 5 years. 6.9% net income growth is what Apple has averaged since launch of the iPhone 5.

Essentially, the model is consistent with a philosophy that financial engineering does not impact the earnings multiple that investors will pay for a company’s earnings over the long term. Because investors generally give little value to cash on a balance sheet, capital return programs can, however, profoundly impact the price of a single share of stock. Nevertheless, an increase or decrease in the P/E would only be driven by the company delivering greater or less than 6.9% growth in net income from 2018 to 2026, or some other factor that shifts investor sentiment.

Special or Declining Dividends Likely Erode a Company’s Valuation

For most stocks, a declining dividend per share, or one that is expected to decline in future years, is one of those significant factors that would be highly likely to impact valuation. Even the most unseasoned investors would recognize that no company paying out greater than 100% of its free cash flow in dividends could sustain such a practice for long. There would be an artificial incentive to hold the shares while the oversized dividend payouts were occurring, and dump them when the dividend inevitably started to decline. Many investment models would also shy away from stocks with declining dividends. Tim Cook stated at the recent annual shareholders meeting that he is not a fan of special dividends, and I could not agree more with him.

Dividends do give shareholders the maximum return and flexibility in a capital return program, but only to a point. There is a sweet spot for dividend payouts that provides optimum benefit to long-term shareholders. I contend that Apple is slightly missing that mark with its current dividend yield and payout ratio, but in the pre-Tax Cuts and Jobs Act (TCJA) era, the company did not have unencumbered access to all its cash flows. Now that it does, Apple’s opportunity to be in that sweet spot is reflected in the balanced approach proposal.

While the exact numbers for a dividend sweet spot are not precise, a dividend level for a large-cap company that reflects market dynamics and averages is probably best. In that regard, the post-financial crisis yield for S&P stocks is about 2%, and the balanced proposal gets Apple’s yield into that zone. The payout ratios on net earnings for the S&P 500 have historically averaged above 50%, but this has declined in recent years to about 30%. Again, the balanced proposal puts Apple right in that payout ratio range.

Other Buyback or Dividend Enthusiast Arguments

There are a number of other arguments a buyback enthusiast may make for even greater emphasis on the buyback than the balanced approach suggests. In general, these arguments do not pass the analytical sniff test for the same reason - investors could simply reinvest their dividends and get better returns for themselves. For example, one very reasonable opinion is that if a company’s P/E is somehow artificially or temporarily low, the company should take advantage of such an impermanent market anomaly. Indeed, should Apple’s board judge that the company is likely to deliver greater than 6.9% in annual net income growth over the planning horizon, then, with all other things being equal, the 15.9 P/E would likely be too low and should eventually rise. However, the same logic of the company repurchasing shares that are temporarily undervalued would also apply to the dividend re-investor who could purchase additional shares using the cash from their dividends.

Dividend enthusiasts may argue against the buybacks by noting the practical considerations Apple would encounter executing such massive share repurchases. Even in the balanced scenario, the buybacks are still enormous and are the predominant use of cash. There are non-trivial considerations about how many shares the company can reasonably repurchase given the size of its cash pile and future cash flows.

Amongst these considerations are statutory limitations on open market purchases that prevent companies from trading during certain quarterly windows, prohibit trading at particular times of the day, and limit daily repurchase volumes based on average market volumes. Apple would not want to be so aggressive as to increase daily demands for its shares in a way that could significantly alter the share price, defeating the intent of buying shares that are temporarily undervalued. The balanced scenario repurchase amounts push the envelope of the statutory limits and market impact considerations, especially in the first years. Nonetheless, I propose that it represents the best option for Apple shareholders.

Balance is Best

When considering complex financial scenarios, it is often revealing to “do the math” before reaching conclusions. What may seem counterintuitive at the outset becomes clear in the logic of the numbers. An analysis of buybacks versus dividends in a capital return program is an interesting example. All other things being constant, a bias toward greater buybacks is usually not more beneficial for generating long-term shareholder value. Paying dividends allows shareholders to decide on the use of their cash. Those who want long-term appreciation can reinvest and, in most situations, gain a slightly greater return than if the company repurchased shares. This is true even after paying taxes on the dividends. Other arguments for overemphasizing buybacks over dividends generally fail if the dividend reinvestment option is considered. There are also legal and practical limits to consider with large share repurchases.

However, the benefit of dividends over buybacks has limits as well. Inconsistent or declining dividends blow up the valuation models and similarly turn the tables on buyback versus dividend analyses. There is a sweet spot for dividends to maximize shareholder flexibility and return. With Apple’s newfound access to all the cash on its balance sheet and future cash flows, the company is currently below that sweet spot. A balanced approach (50% increase in 2018 and 15% annual increases for future years) proposed in my previous article would get the dividends into the sweet zone. This approach also includes the most massive share buyback program in history. You can have your cake and eat it too.

This article was written by

Gary Morton profile picture
253 Followers
West Point distinguished graduate and senior co-founder of Stryker Corporation's world leading EMS business, Gary Morton is the author of the Amazon bestseller Commanding Excellence: Inspiring Purpose, Passion, and Ingenuity through Leadership That Matters. In the book, he reveals the secret sauce that led to extraordinary success in two different organizations: the only US Army maneuver task force that has ever won every battle at the grueling National Training Center and Stryker Corporation which grew its earnings 20% or more every quarter and every year for 28 consecutive years. Finding businesses that exhibit the key elements of this secret sauce will help investors discover companies that are likely to deliver truly exceptional market returns as Stryker did in its 28 year run under former CEO John W. Brown.

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.

Additional disclosure: I am a long-term Apple shareholder and trade options in AAPL. Past performance is no guarantee of future results, and any projections or forward-looking statements in this article are just that - projections. Actual results could differ substantially from these projections.

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