With Apple having completed 75% of it's current share repurchase program, and a recent increase in chatter concerning whether share repurchases are the best use of Apple's cash, it is a good time to review Apple's share buyback program and assess its logic and success. It is important to first understand what a stock repurchase program is and how companies use buyback as a signaling mechanism when framing Apple's decision to initiate the largest capital management program in history. I estimate Apple's ongoing share repurchase program has added $80 billion of price to Apple's stock, benefitting current shareholders as the gap between Apple's stock price and value has narrowed. Despite committing to $90 billion of share repurchases and having $22 billion of buyback authorization remaining, Apple has kept all of its options open for creating additional shareholder value through funding sensible M&A and capital expenditures.
What are Share Repurchases?
A share repurchase program, often called share buyback, is the process of a company buying back its own shares either through the public market or private transactions. Share repurchases, along with cash dividends, are two of the primary ways companies can return excess cash to shareholders. The mechanism of share repurchases are not controversial; as shares are repurchased, a company's outstanding share count declines, thereby boosting each remaining share's ownership percentage. Consequently, each remaining shareholder that did not sell shares to the company would then have a higher share of earnings and cash flow. Exhibit 1 demonstrates this process as a hypothetical 10% share buyback lowers shares outstanding, while having no impact on earnings, leading to higher EPS and a higher overall ownership share for the top shareholder assuming no shares were sold. I assume it was an all-cash share buyback in a low-yielding environment with no loss of investment income.
Exhibit 1: Hypothetical Share Repurchase Program's Impact on Top Shareholder Ownership and EPS
The principal-agent dynamic underlying publicly-traded companies drives capital management decisions. Executives (agents) are hired with the goal of utilizing a company's assets in order to earn a return on shareholders' (principals) investment. The board of directors are elected by shareholders to monitor that management is considering shareholders' best interests. Management teams determine if share repurchases or dividends are appropriate when a company is sitting on excess capital, which may negatively impact financial metrics such as return on assets and equity, while the board of directors officially authorizes capital management actions.
This principal-agent relationship doesn't always work in shareholders' best interest as conflicts and differing incentives complicate matters, as seen with the recent string of corporate boardroom raiding by hedge funds. It's in this setting that Tim Cook is tasked with balancing Apple's long-term well-being with Apple shareholders' best interests in terms of excess cash on the balance sheet.
Share repurchases also have a "signaling effect", impacting how investors view a company's future. By initiating a share repurchase program, it is believed that management views its shares as undervalued and its future is bright enough to part with excess cash. Share repurchases have increased in popularity in recent years as capital gains are often taxed at lower rates than dividends, there is less risk of management teams wasting excess cash on M&A (which there are numerous examples of in the technology sector), and there are fewer side-effects from slowing or stopping buyback programs compared to dividends.
Apple's Share Repurchase Program
Apple has the largest share repurchase program in history, which stands as a testament to the company's successful products. Exhibit 2 highlights the pace at which Apple has repurchased shares. Since 2012, Apple has spent $68 billion on buyback repurchasing approximately 10% of common shares outstanding, with approximately $22 billion remaining in the current authorization.
Exhibit 2: Apple Share Repurchases - Open Market and Accelerated Share Repurchase (ASR)
Logic for Apple Share Repurchase; How Shareholders Have Benefited by $80 Billion
Using today's stock price, Apple's $68 billion of shares repurchased over the past two and a half years would be worth approximately $108 billion, or nearly 40% higher. In reality, this return is hypothetical since Apple does not benefit from previously repurchased stock rising in value, but it does help break apart the thesis that Apple has squandered money on buyback. If one was to look at the impact that Apple's buyback has had on the company's reported financials, EPS has risen approximately $0.50/share, all else equal, as depicted in Exhibit 3. Similar to Exhibit 1, I assume cash was invested in low-yielding short-term investments that did not produce significant income.
Exhibit 3: Share Repurchase Impact on Apple's Net Income, Shares Outstanding, and EPS
Taking this additional $0.48 of EPS resulting from fewer shares outstanding and multiplying it by Apple's current 15x forward P/E multiple would result in approximately $7/share of additional stock price. However, one also needs to take into account any change in P/E multiple as a result of the buyback. Obviously, this part of the exercise is up for debate given different variables impacting valuation multiples, including higher EPS revisions resulting from iPhone strength. Apple's forward P/E multiple has expanded from 13x to 15x since the stock buyback program was put into place. Giving equal weight to buyback and iPhone strength as causing the P/E multiple to rise, another $5-$7/share of stock price can be attributed to buyback (2 (P/E multiple expansion) x $5.97 (Apple's 2014 EPS without EPS accretion resulting from buyback) x 0.5 (to reflect iPhone strength's impact on higher P/E multiple)). Said another way, the market has assigned approximately $13/share of additional price ($80 billion) to Apple's stock due to share repurchases.
Stock buyback shouldn't have much, if any, impact on Apple's value, aside from lowering the cost of capital if there have been corresponding debt issuances. However, the gap between Apple's stock price and value is closing because of the ongoing share buyback program.The marketplace went from not appropriately valuing Apple's cash to now willing to pay more for Apple's cash and additional capital management actions that may lie in the future.
While Apple's shareholders have benefited by buyback, has Apple, the company, benefited? To answer this question, one has to consider other options Apple could have taken with the $68 billion funneled into buyback.
A) Large M&A. Management could spend excess cash on a few large acquisitions. As I explained in my article "Large M&A is Not in Apple's DNA: Case Study of Why Apple Won't Buy Tesla", Apple's product success is built on collaboration and design and reinforced by Apple's organizational structure, leaving no room for large M&A. Instead, Apple continues to be an active acquirer, having bought approximately 35 smaller companies since the beginning of 2013, most of which were never made public. Apple looks at acquisitions as a way to fill talent and resource holes that could only be addressed in a timely manner by acquisition (such as Authentic and fingerprint sensor technology).
B) Dividends. Apple could issue a special one-time dividend or increase its quarterly cash dividend. Obvious drawbacks to issuing dividends include shareholder tax implications and negative signaling that management doesn't view it's stock as undervalued and worthy of share repurchases.
Instead, Tim Cook and the board are using Apple's $150 billion of cash to fund dividends and buyback, while keeping enough ammunition to create shareholder value through organic and M&A possibilities, including significant capital expenditures, which topped $11 billion in 2014 and is expected to reach $13 billion in 2015.
Stock Buyback's Long-term Implications on Apple
As I wrote in my article, "AAPL and $700 Billion", short-term stock price swings don't give much indication as to how Apple, the company, is faring due to many moving variables involved in how a stock's price is determined. While the market was concerned about Apple's iPhone business and declining margins in late 2012 and 2013, Apple was busy developing the Apple Watch. Apple's stock underperformance had little to no impact on Apple's R&D and future plans. While I will admit that a company's stock serves as an incentive mechanism for employee morale, I believe any short-term reactions tend to correct themselves overtime, limiting the long-term impact on employee morale.
Apple's stock buyback program highlights that Tim Cook and the Apple board are fostering a shareholder-friendly environment, which stands in contrast to a few tech behemoths with anti-shareholder voting structures. Despite the $68 billion spent on share repurchases since 2012, Apple still has more than $150 billion of cash, thanks in part to $29 billion of debt issuances. Ultimately, Apple's long-term buyback plans will depend on how the product pipeline materializes. It wouldn't be a stretch to assume Apple will utilize share buyback during periods of stock price underperformance and low valuation, while buyback is limited during periods of stock price greed and optimism. Given the current environment and product portfolio, as well Apple's stock valuation, Tim Cook and the board are doing the right thing buying back shares.
This report was produced by Neil Cybart on December 1, 2014.
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