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Buybacks: The Rationale and the Evidence

October 06, 2014 | About:

This behavior turns the stomachs of value investors, but it’s par for the course for most managers. The Henry Singletons are few and far between. No manager focused on intrinsic value could behave this way.

These are sins of commission. Less visible, but equally impoverishing, are sins of omission: When undervalued, overcapitalized companies fail to grab a rare opportunity to buy back stock at a wide discount from intrinsic value. Where such unexploited opportunities exist, activists are incentivised to establish a position in the company and agitate to have management undertake a buyback. In Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance, 2014), I examined one such example of an undervalued, overcapitalized company that failed to take its opportunity until two activists stepped up the pressure, and the outstanding returns that followed.

In early 2013 Carl Icahn (Trades, Portfolio) began agitating to have Apple, Inc. use its enormous cash holding to buy back its very undervalued stock. Icahn would propose in an open letter to Tim Cook, Apple’s CEO, that Apple undertake a $150 billion buyback:

When we met, you agreed with us that the shares are undervalued. In our view, irrational undervaluation as dramatic as this is often a short-term anomaly. The timing for a larger buyback is still ripe, but the opportunity will not last forever. While the board’s actions to date ($60 billion share repurchase over three years) may seem like a large buyback, it is simply not large enough given that Apple currently holds $147 billion of cash on its balance sheet, and that it will generate $51 billion of EBIT next year (Wall Street consensus forecast).

With such an enormous valuation gap and such a massive amount of cash on the balance sheet, we find it difficult to imagine why the board would not move more aggressively to buy back stock by immediately announcing a $150 billion tender offer (financed with debt or a mix of debt and cash on the balance sheet).

Icahn believed that if Apple decided to borrow the full $150 billion at a 3 percent interest rate to undertake a tender at $525 per share, the result would be an immediate 33 percent boost to earnings per share and, assuming no multiple expansion, a commensurate 33 percent increase in the value of the shares. He saw the shares appreciating over the following three years from $525 to $1,250, assuming sustained 7.5 percent annual growth in Apple’s EBIT and an EBIT multiple of 11 from Apple’s 2013 EBIT multiple of 7. Icahn wasn’t the only activist to complain about Apple squandering an opportunity to buy back stock.

Around the same time Icahn sent his open letter to Cook, David Einhorn (Trades, Portfolio), speaking at the Ira W. Sohn Conference, also made an argument for Apple undertaking a buyback. Einhorn’s proposal was half the size of Icahn’s and didn’t require the company to take on debt. He noted that with close to $137 billion in cash on its balance sheet, Apple held more cash than “the market capitalization of all but 17 companies in the S&P 500,” the size of which “reveal[ed] a basic flaw in Apple’s capital allocation.” The problem with holding so much cash, according to Einhorn, was its opportunity cost. It earned only a small amount of interest, which meant a return below the rate of inflation. He likened it to “decaying inventory,” arguing that the real value of it declined a little bit every day:

Even worse, the return is far below the cost of capital. For companies with all-equity balance sheets, the cost of capital is particularly high, because expensive equity capital supports both the business and the foreign cash.

Finance theory suggests that an unlevered or net cash balance sheet should be rewarded with higher P/E multiples. In practice, the market assigns a discount for this level of overly conservative long-term capital management.

Not only does the cash earn a return below the cost of capital, it is evident that future profits will probably also be reinvested at a low return. As a result, the market not only discounts the cash sitting on the balance sheet, it also drives down the P/E multiple due to the anticipated suboptimal re-investment rate for future cash flows.

Einhorn argued that, at a 10 percent cost of capital, the cash represented an opportunity cost of close to $13.7 billion per year, or $14 in earnings per share.

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