Feb 11 2014, 9:30am CST | by Forbes
Tim Cook may not look like a fighter, but compared to Carl Icahn, he’s Muhammad Ali. Using Ali’s famous rope-a-dope strategy, Cook let Icahn punch himself out over the span of several months. As a result, Icahn — who originally demanded Apple repurchase an additional $150 billion worth of its stock beyond the $60 billion it had already committed to — has channeled another famous boxer, Roberto Duran, and basically declared “no más“. After backing his request down to just $50 billion more, Icahn is now pretending Apple is doing that (it isn’t) and saying nice things about the company and its chief executive. So Cook certainly wins this clash of the titans, basically by having dinner with Icahn, taking a phone call and otherwise blowing him off. But did he solve any of Apple’s capital allocation problems? Not really. Let’s take a look at why and what Apple might do about it.
$100 billion ‘returned to shareholders’
When Apple announced it was returning $100 billion to shareholders over 3 years in the form of dividends and $60 billion in share repurchases, I explained why that wouldn’t dent Apple’s cash balance when all was said and done. In the past 5 quarters, Apple spent $41 billion on those activities (not including the recent $14 billion in share buybacks that occurred after the most recent quarter ended). During that time, the cash on its balance sheet actually grew to $158 billion from $147 billion. Now, in fairness, the recent repurchase will bring that number back in line with where it was when Apple expanded the buyback to record levels. It also took on $17 billion in debt. But the company made $37 billion last year and started fiscal 2014 with $13 billion more. The fact is, if you assume zero earnings growth, Apple will net $60 billion more in the balance of the next 2 fiscal years, spend $20 billion on dividends, $20 billion on share buybacks and could reserve $20 billion for retiring debt. After all that math, it winds up back where it started.
And that spot is at close to $150 billion in cash. Even if Cook does find a company worth $10-20 billion to buy, as he said recently he might do, Apple would still be holding more cash that any company and more than any possible scenario could reasonably justify. So if not Icahn’s plan for a massive expansion of the buyback, what then? There are a number of interesting strategic options (one this space has looked at before, which it will revisit again in the very near future), but today’s installment is limited to financial discussions.
A smaller fixed buyback program
Though I personally don’t believe in buybacks and academic research tends to back up the belief they are of dubious merit, here are some numbers to chew on. If Apple committed to buy back $10 billion worth of stock each year beyond the current commitment, that would retire 18 million additional shares at a price of $550 per share. (The assumption here is the stock will be worth a bit more, at least, by 2015 when this program would begin). Apple currently has under 900 million shares outstanding, so everyone who didn’t sell would effectively own 2% more of Apple in the first year of this program.
The reduction in shares outstanding saves Apple $220 million in dividend payments using the current dividend. which is true not just in the first year, but every year going forward. Taking the present value of those dividends produces a value of about $3.5 billion using a 6% discount rate. Given Apple’s oddly conservative cash management for the past several years — it mostly keeps its money in short term T-bills earning less than 1% — you might be able to make a case for a lower discount rate and a higher number, but treating the dividends as perpetual is also a bit fraught, so the $3.5 billion seems fair. In this event, Apple is basically taking $10 billion and turning it into $3.5 billion, but also making every shareholder 2% richer. (Should the company decide to finance these repurchases with short-term bonds, it would likely borrow $200 million or so come 2015 and get back $50 million in tax savings. The stock market might value Apple higher with the additional debt due to the perverse nature of such things, but it’s hard to project that.)
Apple currently pays out $12.20 per share annually, or a bit over 2% against the share price. The company could do all sorts of things like target a 3% dividend, which would raise the payment to $16 or so. That would cost remarkably little, say $3 billion annually depending on the precise numbers. It could also announce a formula for dividend payments as a function of income. Right now, dividends are approximately 27% of earnings. The company could raise the target to 35% or 40%. By using a formula, the board would then be in a position to signal the market about business prospects by changing the formula from time to time. If the percentage was raised, it would indicate Apple believed even more cash was coming in. If lowered, it would be a way of saying Apple was tightening its belt for tougher times.
The judge’s scorecard
The astute reader has probably caught on to a flaw in the above. Apple still doesn’t end up spending any of its money unless it picks a larger buyback number or an even more aggressive dividend formula. Because some investors don’t like dividends — those not holding shares in tax-advantaged accounts and those in the highest brackets, for instance — there is probably a limit on how high the dividend ought to be. But even still, a 5% yield on the common stock would not be sufficient to dent the cash hoard. Nor would such a dividend combined with a $10 billion annual buyback.
This leaves Apple having beaten back Icahn’s agitating much as it had with David Einhorn, another hedge-funder a year ago. But it leaves the company no closer to addressing the $150 billion elephant in the room. And the fact remains that the pile of cash is dragging on the company’s stock. Investors look at it and wonder if it reflects a company out of ideas on what to do with the money or one desperately afraid of a future where it will be much less profitable than it is today. The point isn’t whether those concerns are entirely well-founded, the point is they’re real. Apple has now been sitting on more than $100 billion since early in 2012. If it wants to be treated better on Wall Street — and actions like the capital return program certainly are evidence that it does — it will need to find a way to start moving back toward that number.
Source: Forbes Apple
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