Apple Inc. (AAPL, Financial) is one of the most-followed stocks in the market today. According to Forbes, the company has an unmatched brand value among all corporations in the world and its products, as we all know, are of high quality. The launch of the first-ever iPhone in 2007 marked the beginning of a new growth phase for Apple, and the company has never looked back. Despite the mature nature of the company, Apple continued to grow in size over the last five years, supported by the increasing popularity of its wearables such as AirPods and the Apple Watch. This led to a stellar performance of its shares.
Investors do not expect growth companies to distribute the bulk of their earnings as the funds are better allocated to investments that could earn higher yields in the future. However, the case with Apple is different. The company is still pursuing growth opportunities, but the massive net cash position is something the company executives have been worrying about for the last couple of years. Apple brings in billions of dollars in free cash flow every year, which played a major role in the dividend growth over the last seven years and the massive growth in share buybacks. Going forward, the company might choose dividends over repurchasing shares for several reasons.
Apple’s view for its massive cash balance
In February of 2018, Luca Maestri, the chief financial officer of Apple, emphasized his goal of bringing the net cash position to zero over time:
“Tax reform will allow us to pursue a more optimal capital structure for our company. Our current net cash position is $163 billion and given the increased financial and operational flexibility from the access to our foreign cash, we are targeting to become approximately net cash neutral over time. We will provide an update to our specific capital allocation plans when we report results for our second fiscal quarter, consistent with the timing of updates that we had provided in the past.”
Net cash is a term used to refer to additional liquidity on top of the total debt of the company. Therefore, a net cash neutral position would mean the company holds on to a cash balance that is approximately equivalent to the amount of debt on its balance sheet.
For any company, there are three primary ways to expend cash.
- Distribute to shareholders via dividends.
- Buy back its own stock.
- Acquire a target company in hopes of realizing revenue or cost synergies.
For Apple, the third option seems very unlikely due to the significant regulatory pressure the company would have to face because of its massive scale. As a result, Apple has chosen to use both buybacks and dividends to achieve this objective.
According to data from company filings, Apple had $98 billion in net cash at the end of September and will likely choose either dividends or buybacks to bring this to zero in the future. Even though the latter has been preferred by the management in the past (which is exhibited in the above graph), it looks as if 2020 will be a good one for dividend investors.
Valuation is tricky – a reason for Apple to consider alternative options to distribute wealth
Analysts, economists and investors have long debated about the true value of share buybacks. Apple has so far been able to create shareholder value through its repurchases. For instance, the company reported a net income decline of 7% in 2019 in comparison to the previous fiscal year, but earnings per share contracted only 0.37% as Apple retired approximately 6% of its share count in the last 12 months. If not for this, the company would have reported a mid-single-digit decrease in earnings per share, which could have caused the stock to tumble.
Shares, however, are trading at a price-earnings ratio of 25.6, which is a 10-year high.
The current earnings multiple seems unreasonable considering the slow growth of global smartphone shipments. For instance, the industry grew at double-digit rates in the first half of the last decade, but has slowed down since then, as illustrated below.
Worldwide smartphone shipments by year
Source: Statista
Even though Apple has diversified its revenue streams over the last several years, the company still relies on the iPhone segment to drive growth. For example, according to the latest annual report published in October 2019, iPhone sales accounted for 54.7% of total revenue. Therefore, the expected slowdown in unit sales in the future will have an impact on company earnings, and the current valuation multiples do not reflect this risk.
Apple's management, who are fully aware of this situation, might take a step back in 2020 and reduce the funds allocated to share buybacks as the stock can no longer be categorized as undervalued. In such a scenario, Apple would have to hike dividends to meet the net-cash neutral objective.
The power of buybacks are declining; another reason for Apple to think about hiking dividends
From the perspective of investors, the more shares a company can retire through its buyback program – the better. The higher the percentage of shares taken off the market, the better the earnings per share and other per-share figures would look. The below table summarizes the effectiveness of repurchases at different share price levels, assuming buybacks totaling $20 billion.
| Share price | $150 | $175 | $200 | $225 | $250 | $275 | $300 | $325 | |
| Number of shares that can be repurchased (millions) | 133 | 114 | 100 | 89 | 80 | 73 | 67 | 62 | |
| Total share count decline | 3% | 2.57% | 2.25% | 2% | 1.8% | 1.64% | 1.5% | 1.38% |
Source: Author’s calculations.
As evident from the table above, Apple’s ability to retire a high percentage of outstanding shares declines as the share price increases.
The attractive performance of shares has pushed the dividend yield below 1% for the first time in five years, which gives management another reason to consider allocating more capital to pay dividends as opposed to share buybacks.
In 2020, the company might rule in favor of dividends after continuing with a repurchase-friendly policy for more than half a decade.
Warren Buffett (Trades, Portfolio) is a fan of buybacks, but paying the right price is important
There’s no doubt that the "Oracle of Omaha" is an admirer of companies willing to repurchase their shares, but at a sensible price. According to CNBC, Buffett has paid an average price of $141 for Apple shares and has not purchased any above $200. This is what the legendary investor had to say about Apple’s buyback program back in the first half of 2019:
“Apple will probably—they may not, but they have said they’re going down to cash neutral. They could do it either by acquisitions, or dividends, or repurchases. And my guess is it’ll be mostly repurchases. They are about $130 billion away from cash neutral now. If the stock were at $200, it would buy 650 million shares. If it’s at, you know $150, you buy close to 900 million shares. We’re way better off, you know, if it’s at a lower price when they’re repurchasing shares. Our partners are selling out to us, and they’re selling out cheaper than otherwise. The worst thing that can happen from our standpoint with Apple is that it sells at $230 or something like that because we don’t like buying as well at that sort of price.”
Evidently, Buffett does not think it’s the right price to continue with repurchases from a shareholders’ perspective. The well-experienced management team at Apple can be expected to respond to the declining power of buybacks by hiking dividends in 2020.
Conclusion
Apple is no longer trading at attractive valuation multiples, meaning the company executives have to make an important decision regarding its buyback program. The company still wants to become net-cash neutral, but relying on share repurchases to do so does not seem to be the best use of company cash currently. The power of buybacks is continuing to decline along with the increase in share price, and the company might be forced to look for an increase in dividend per share as a way to distribute wealth to shareholders and to achieve its objective of reducing the cash balance.
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
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