Since Apple began its capital return program in 2012, share buyback as rightfully received most of the press and attention compared to quarterly cash dividends. Apple has repurchased $73 billion of its stock, nearly three times as much as the $27 billion spent on cash dividends. However, from a signaling effect, cash dividends may do more than share buyback in portraying management's opinions and views about future business prospects.
Management included language in its financial filings that Apple intends to increase its quarterly cash dividend each year. Next month, during the annual review of the capital management program, Apple's board will likely approve an increase to Apple's quarterly cash dividend to approximately $0.50 to $0.51/share, up 8% from the current $0.47/share dividend, which would represent a 1.6% dividend yield at the current stock price. The board approved a 8% dividend increase last year. While dividends have historically signaled a maturing company with slowing growth prospects, Apple looks to be a rare exception where its financial and capital capabilities are being decoupled from a product lineup that continues to see growth and momentum.
Much of the significance underpinning Apple's buyback and dividends has been lost on market observers as the focus remains on the near-term trade, ignoring capital management's long-term signaling effect. While share buyback and dividends (both cash and stock) do not guarantee positive stock price moves in the future, market observers can use such activity as an indicator for how management views the future. By issuing a cash dividend, management is showing confidence that the business is supportive of a recurring cash expense going forward in the form of the dividend.
Exhibit 1 highlights Apple's dividend payout ratios over the past two years in addition to the expected payout ratios through 2016. A dividend payout ratio is simply the cash dividends paid each year divided by annual earnings. The lower the dividend payout, the less of a burden the dividend payment is on overall earnings (and cash flow). A high dividend payout ratio would signify that the company either doesn't see much need to hold on to its earnings, or the dividend is too high.
Exhibit 1: Apple Dividend Payout Ratio
While it is hard to come up with direct peers, if comparing Apple's 28% payout ratio to companies with similarly valuable brands like Disney (20% payout ratio) and Nike (30% payout ratio), Apple is indeed running with an in-line divided payout ratio. Interestingly, given the strong expected earnings growth in 2015, Apple's divided payout ratio is expected to decline to 20% in the near-term.
From management's point of view, it makes more sense to increase the dividend each year at a rate that smooths out earnings volatility. This strategy would imply that even though Apple is experiencing 40% EPS growth in 2015, the dividend increase would likely remain less than 10%. If the situation was flipped and Apple's earnings were declining, the expectation would be that Apple wouldn't need to cut the dividend, but instead continue maintaining an orderly, gradual increase.
Exhibit 2 takes a look at the amount of capital spent on dividend payments, which is found simply by multiplying dividends paid to shareholders by the number of shares outstanding. The data can also be found in Apple's cash flow statement. The key takeaway is that dividend expense is benefitting from Apple's aggressive share buyback program. As excess capital is spent on share buyback, Apple no longer needs to pay dividends on repurchased shares, reducing its dividend obligation. As a result, Apple is able to increase the dividend per share rate, while the total cost of the cash dividends increases at a much slower pace. This is yet another example of how current shareholders benefit from share repurchases. There is a possibility that management will take a look at this data and conclude that Apple can increase the quarterly cash dividend further, but the market has shown no expectation that such a sizable increase is required.
Exhibit 2: Apple Cash Dividends (Per Share and Total)
From an investor's point of view, cash dividends give off much more in the way of long-term management signaling when compared to share repurchases. With a dividend, management is unofficially tying the company to a long-term, recurring use of capital since any shareholder-friendly management team and board understands the negative consequences following a dividend cut. With share buyback, companies are not obligated to complete the program and have a much easier time slowing or ending the buyback without a significant market backlash. While there are few companies that purposely increase their dividends knowing they will need to be cut in the near term, there are some companies that find themselves in cyclical industries, such as energy and mining, where drastic swings in either pricing or demand may bring about the need to cut dividends. Apple's goal when setting its dividend would be to avoid this type of adverse situation where a dividend cut is required to maintain financial health during a more difficult operating environment.
The other benefit of paying a cash dividend is that Apple's investor base is expanded as some institutions only invest in dividend-paying entities. While it is hard to quantify the impact this may have had on Apple's valuation, it is clear that with a $743 billion market capitalization ($605 billion enterprise value), it would be in Apple's best interest to not exclude any large shareholder group due to specific capital return strategies.
Apple is in an interesting situation as fast-growing technology companies have traditionally not embraced paying cash dividends due to the signaling it may give concerning fewer growth opportunities. Apple management seems to be decoupling its financial philosophies concerning excess capital from a product lineup continuing to see growth. In a few weeks, Apple's board will approve an updated capital return program, including a dividend increase, that will align with management's view on Apple's long-term business prospects.
This report was produced by Neil Cybart on March 24, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe.