Apple Inc. (AAPL, Financial) has been one of the rockstars of post-Great Recession bull market. As one of the market’s most popular high-flying tech stocks, Apple has seen explosive growth in its share price over the past decade.
However, that upward charge began to falter in the fourth quarter of 2018. Shares are now down more than 30% since the start of the quarter, despite an aggressive share buyback effort this year.
There are many explanations for Apple’s flagging performance, but that is beyond the scope of this research note. Today, we address a particular criticism of Apple: the decision to use the windfall from the Trump administration’s tax reform bill to buy back billions of dollars’ worth of shares.
A Wall Street Journal article published on Dec. 27 suggests that the decision to use billions of dollars in hoarded cash to reduce the number of shares outstanding was faulty. Instead, the authors argued, Apple would have been better off returning cash to investors through dividends.
Let’s discuss.
Buyback binge
For years, Apple has been a reliable winner. Over the past five years, shares have appreciated in value by more than 90% (as of the market close on Dec. 27). While impressive, the growth of the past half-decade pales next to a longer time horizon. Apple is up more than 1,000% from the start of 2009.
A major driver of that growth has been the popularity of the iPhone, which has carved out a preeminent position in the global smartphone market. Apple has enjoyed huge profits since the advent of the iPhone and has raked in staggering amounts of cash.
Apple is so awash with money that its finance arm, which puts that cash hoard to work, now rivals the core business in sheer scale. But the tech giant is not just investing its cash. It has also been buying back shares at a furious pace, as Michael Rapoport and Theo Francis wrote in their Dec. 27 article for the Wall Street Journal:
“When the market was riding high, companies bought back shares at a furious pace, juiced by the tax savings they reaped from the December 2017 passage of the Tax Cuts and Jobs Act. The law enriched companies by slashing the corporate tax rate to 21% from 35% and making it easier for firms such as Apple to shift foreign earnings to the U.S.”
Buybacks are a popular way for companies to improve their share price. As some shares are removed from circulation, each remaining share grows in value to reflect a greater percent of ownership of the company. Additionally, because the share count is reduced, earnings per share get a boost from buybacks.
Apple went on a buyback binge with cash repatriated overseas and from the Trump tax windfall. In the first three quarters of 2018, it spent an eye-watering $62.9 billion on buybacks, reducing the share count by 6.7%. That was supposed to juice the share price. Yet, the stock is down 30%. What gives?
Buyback blues
Rapoport and Francis argued that Apple (and other companies that indulged recently in big share buybacks) made a mistake:
“Like many large companies, Apple has used much of its windfall from the 2017 tax overhaul to buy back shares. But the recent plunge in stock prices has made that look like a bad idea ... In effect, the market has told them they overpaid by billions of dollars.”
The authors went on to suggest that the recent share price decline -- in spite of hefty buybacks -- might indicate that such financial actions are not as beneficial as corporate financiers believe:
“Companies contend that buybacks are a good way to return excess capital to shareholders and that the paper losses can reverse themselves if their stocks rebound. But the sharp declines call into question their decision to devote so much of their tax savings to buybacks, rather than using it to invest in their businesses, raise employee pay or pay higher dividends.”
Rapoport and Francis contended that, instead of committing to share buybacks, Apple would have been better served reinvesting its tax windfall elsewhere, such as in growth or in its employees. Obviously, a company needs to invest in its plant and talent to grow. So this recommendation makes sense.
The authors did not stop there, however. Rather, they added another option, which is a bit of a head-scratcher at first glance. Specifically, they contended that Apple would have been better off returning the cash to shareholders in the form of dividends rather than using it to buy shares. But does that make sense?
Dividends vs. buybacks
The pro-dividend case put forward by Rapoport and Francis boils down to a simple idea: Apple overpaid for its own shares.
Apple bought back its stock at a significantly higher price than that at which it now trades. Indeed, considering the current prevailing share price, Apple appears to have overpaid by $9 billion. That is no small chunk of change. Indeed, as the authors pointed out, a $9 billion writedown on an acquisition would be considered disastrous. Looking at the buyback through that lens, it is easy to understand the reasoning in favor of a straight cash payment to shareholders.
While the argument makes intuitive sense, it is not sufficiently rigorous. Rapoport and Francis failed to address the most important consideration, from a shareholders perspective, when making the comparatison, namely, how dividends and buybacks are treated for tax purposes:
“The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current timeframe that will be taxed by the taxman, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold. Note that in the United States, qualified dividends and long-term capital gains are taxed at 15% up to a certain income threshold that is quite high ($425,800 if filing singly, $479,000 if married and filing jointly), and at 20% for amounts exceeding that limit.”
Thus, the relative attractiveness of a buyback or dividend is dependent on tax status to a large degree. Rapoport and Francis did not discuss this, which leaves their pro-dividend case somewhat lacking in concrete terms, though it remains compelling from an intuitive viewpoint.
Verdict
So, did Apple miss a trick opting for buybacks over issuing dividends? Alas, there is no clear-cut, definitive answer to the general question of the relative merits of share buybacks and dividends.
A buyback is arguably more straightforward and is equally beneficial to all shareholders, regardless of their financial circumstances. Dividends, on the other hand, are affected by a multitude of tax considerations. Thus, a dividend might be preferable to some investors, but not others. A buyback might therefore be considered a “cleaner” approach.
That said, the particular case of Apple might incline one more toward the pro-dividend camp. The reason for this is what Rapoport and Francis observed: Apple appears to have overpaid for the shares it retired by a shocking $9 billion. The problem facing Apple at the start of the year was that it already had a huge market capitalization. While there was anticipation of considerable future growth, its valuation multiples have looked quite dear. A buyback at an elevated share price is not a great idea.
Thus, while buybacks may prove to be a broadly easier and cleaner option for many companies, Apple might have done better sending its shareholders checks rather than buying back shares at an inflated valuation.
Cash is always king.
Disclosure: No positions.
