Apple raised another $6.5 billion of debt this week, bringing total debt raised to $39 billion. Why is Apple issuing debt despite holding $178 billion of cash? With approximately 89% ($158 billion) of Apple's cash held by foreign subsidiaries, management is relying on free cash flow and debt to fund share repurchases and quarterly cash dividends. Given the low interest rate environment, management is improving Apple's overall cost of capital by borrowing money for less than 1.5% (after-tax cost) in order to repurchase AAPL shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% free cash flow yield.
Current Capital Return Program
Last April, management increased the share buyback program to $90 billion from $60 billion. Along with the quarterly cash dividend, the total capital return program totaled $130 billion. Apple currently has $17 billion of share buyback authorization remaining and will undoubtedly increase the program in April, as well as raise the quarterly dividend.
Available Cash for Capital Return Program
Apple had $20 billion of cash available for capital management activities and U.S. investment needs at the end of 1Q15. After Monday's debt issuance, Apple now has more than $27 billion of cash in the U.S. If management were to use the $158 billion of cash located offshore for share buyback or dividends, Apple would be liable to pay 35% U.S. income tax on the repatriated funds. Considering that Apple is able to issue debt at a 2-3% yield with a tax break related to interest expense, it is easy to see that paying 35% tax on offshore cash is not in Apple's best interests. While there are financial techniques that allow Apple to "use" funds located in offshore subsidiaries for U.S. business purposes, the intricacies of such arrangements are for another post.
Due to Apple's global operations, approximately 40% of total free cash flow is available for capital management and routine cash needs in the U.S. If Apple were to pin its share buyback to just U.S. free cash flow, Apple's overall cash total would grow to hundreds of billions of dollars and investors may start to discount the cash (one of the primary reasons for the buyback). Instead, Apple has set a buyback pace that exceeds annual U.S. free cash flow, requiring management to raise debt (both short-term and long-term, as well as commercial paper, which is very short-term debt) to supplement free cash flow.
Apple's 1Q15 Cash Flow
A look at Apple's 1Q15 10-Q helps frame the math behind Apple issuing debt to fund share repurchases. For the three months ending December 27, 2014, Apple reported operating cash flow of $34 billion, which reflects net income and then all of the other non-cash line items that flowed through the income statement, but had no impact on cash. In terms of capital expenditures, Apple spent $3 billion on property, plant and equipment. This can be a range of items and for this exercise it really isn't that important. Subtracting the $3.2 billion from $33.7 billion, would give free cash flow (FCF) of $31 billion. A few weeks ago, I recorded a brief tutorial on free cash flow, which is a better representation of a company's underlying financial health than earnings. Keep in mind, this $30.5 billion of FCF is for the entire company. A few other calculations would suggest that approximately 40% of FCF, or $12 billion, is available in the U.S.
Moving down the cash flow statement to cash flow from financing, Apple spent $3 billion on dividends and $5 billion on share buyback in 1Q15. Proceeds from debt (the Euro denominated debt) totaled a little more than $3 billion, while Apple repaid $2 billion of commercial paper, leaving $1 billion of net debt issued. Subtracting the issued debt from dividends and share buyback cash flows leads to cash flow from financing of $7 billion, which means Apple used $7 billion of cash to cover share buybacks and dividends last quarter. Since U.S. FCF was $12 billion, Apple had enough to not only cover its capital return program, but also add to cash levels.
While Apple had enough FCF to satsify its capital management initiatives last quarter, Apple's holiday quarter is historically the largest quarter from a revenue and profit viewpoint with declining cash flow levels for the rest of the fiscal year. In addition, Apple's capital management pace is much more robust than $5 to 7 billion a quarter. Apple's accelerated share repurchase program meant that Apple prepaid $9 billion in 4Q14 for shares repurchased in 1Q15. Going forward, Apple is more likely to be on a $10-$12 billion quarterly pace for share buyback and dividends, which would require additional debt issuance.
Math Behind Issuing Debt to Fund Share Buyback
Running with a hypothetical example using the $6.5 billion of debt issued this week, as seen in Exhibit 1, Apple could take the additional capital, buy back 54 million shares, save on dividend expense, and essentially end up paying a net of $46 million per annum to borrow $6.5 billion.
Exhibit 1: Hypothetical Apple Scenario for Issuing Debt to Fund Share Buyback
Apple's $39 billion of long-term debt has a 2.0% average effective interest rate. Taking into account that interest payments are tax deductible, Apple is effectively paying 1.3% per annum to borrow cash. With shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% FCF yield, taking excess capital to buy back stock is a cost effective way of improving Apple's cost of capital. I wouldn't expect any significant change to this strategy in the near-term as long as interest rates stay low and Apple's business prospects look promising.