Share buybacks have once again come under fire. Some companies that were recent buyers of their shares now find themselves in financial distress and seeking bailouts due to economic fallout from the pandemic. Set within this environment and backlash, Apple is scheduled to provide an update next week on its capital return program, including its share buyback program. The announcement will provide clues for how the poster child of responsible share repurchases is financially navigating the pandemic.
Buyback Pace
Since kicking off its repurchase program in 2013, Apple has spent $327 billion to buy back 2.5 billion shares at an average price of $131 per share. The following exhibit shows Apple’s buyback activity on an annual basis:
Exhibit 1: Apple Share Buyback Pace (Annual - FY)
The pickup in Apple’s buyback pace in FY2018 and FY2019 was due to U.S. tax reform and Apple utilizing cash that had been in non-U.S. subsidiaries. Last year, Apple spent $55 billion buying back 283 million shares (at an $194 average price) in open market transactions. Adding this total to $12B of accelerated share repurchases, Apple spent a total of $67 billion on share buyback. To put that total in perspective, it’s more than the market capitalization of 85% of the companies in the S&P 500.
Buyback Authorization
Every April, Apple’s board of directors, in consultation with management, assesses business trends, the operating environment, and Apple’s financial position, to arrive at an appropriate level of capital return (share repurchases and quarterly cash dividends).
The board has authorized seven consecutive increases to Apple’s share buyback program since the program launched in 2012:
2012: $10 billion buyback authorization
2013: $60 billion (increase of $50 billion)
2014: $90 billion (increase of $30 billion)
2015: $140 billion (increase of $50 billion)
2016: $175 billion (increase of $35 billion)
2017: $210 billion (increase of $35 billion)
2018: $310 billion (increase of $100 billion)
2019: $385 billion (increase of $75 billion)
At the end of December 2019, Apple had $59 billion of share repurchase authorization remaining. Assuming Apple bought back at least $10 billion of shares in FY2Q20 (January to March 2020), the company likely had somewhere closer to $50 billion of authorization remaining at the end of March. This means that without additional authorization, Apple would have about seven months worth of share repurchases remaining. Accordingly, there is a strong likelihood of Apple’s board announcing the eight consecutive increase in share repurchase authorization next week.
My expectation is for Apple’s board to announce a $75 billion increase to buyback authorization next week. This would allow Apple to continue buying back shares at the same pace that it has for the past 24 months. Such an authorization would bring Apple’s total repurchase authorization since 2012 to $460 billion. In order to add flexibility to such authorization, especially given the current environment, Apple will likely have more than 12 months to utilize the authorization. This means that if operating conditions continue to deteriorate over the next 12 months, Apple will have the ability to slow down its share buyback pace and run with a higher level of untapped repurchase authorization.
Although companies are not under obligation to utilize share repurchase authorization, Apple has approached its authorization differently. Many companies announce a new share buyback program in order to benefit from the near-term stock price bump often associated with the announcement. These companies never actually intend to utilize the full buyback authorization. Meanwhile, Apple has been an aggressive repurchaser of its shares, which require material increases in buyback authorization every year.
Buyback Criticism
In recent weeks, share buyback has once again been put under a microscope. The act of taking cash on the balance sheet to buy back shares from shareholders willing to sell is no stranger to criticism. Prior to the pandemic, the most recent uproar regarding buyback occurred during the U.S. tax reform debate as some felt it wasn’t right for companies to use repatriated cash to repurchase shares (and pay cash dividends).
With passenger airline travel coming to a near halt, the airliners find themselves in a dire financial situation. Delta is burning through $60 million of cash a day. The airlines were quick to seek U.S. taxpayer-funded bailouts in the form of grants and loans. The entire episode has left a bad taste in many mouths as the airlines had been aggressive share repurchasers. Instead of establishing some kind of rainy day fund, the airlines used free cash flow to fund share repurchases at prices significantly higher than current stock prices.
Past financial crises have also provided examples of share buyback gone wrong. Some insurers who were busy buying back their shares in 2007 ended up needing to issue shares at significant discounts not long after due to holding toxic mortgage investments. The gas and energy industry turned to share repurchases when oil was at $100 a barrel.
With each example, we have boards and management teams who felt it was prudent in good economic times to buy back their shares. It’s fair to ask if some of these companies used share buyback primarily to hide financial and business shortcomings elsewhere. Bad actors can utilize share buyback for near-term manipulation either through improper signaling to the market or financial engineering. Reducing the number of shares outstanding via buyback results in higher earnings per share figures and return on equity percentages, all else equal.
The Poster Child
And then there is Apple. A very good argument can be made that Apple has become the poster child of responsible share repurchases. The company has relied on its stellar free cash flow to fund share repurchases over the years. Prior to U.S. tax reform and Apple keeping cash generated outside the U.S. in foreign subsidiaries, Apple issued debt at roughly the same pace as foreign cash generation. This resulted in Apple having $285 billion of cash, cash equivalents, and marketable securities on the balance sheet at the end of 1Q18. After two years of aggressive share repurchases, Apple’s cash total is now closer to $200 billion.
By funding buyback with free cash flow, share repurchases have had zero impact on the amount of cash Apple wants to spend on organic growth initiatives including R&D, M&A, and capital expenditures. Apple is using truly excess cash that it has no use for to repurchase its shares.
Partly to provide a buffer against adverse market conditions and to retain M&A flexibility, Apple is following a net cash neutral strategy which means that the amount of cash held on the balance sheet will eventually equal the amount of outstanding debt. Given Apple’s current debt holdings, this amounts to holding approximately a $100 billion cash cushion in the event of a rainy day. On top of that, given Apple’s unique capex-light business model, the company is able to generate tens of billions of dollars of free cash flow each year even with lower sales due to a global recession.
Since share buyback makes financial sense when repurchases are done at a share price that is less than a company’s intrinsic value, it is much harder to assess a buyback’s effectiveness, or the amount wealth transferred between shareholders selling and holding shares.
The Above Avalon Report, “Share Buyback 101: An Examination of Apple’s Share Repurchase Strategy” contains much more detail on the wealth transfer dynamic found with share buyback. The report is available exclusively to Above Avalon members.
In theory, management teams are in the best position to estimate their company’s intrinsic value. However, it’s easy to see hubris enter the situation with management teams overestimating their strengths while ignoring or downplaying weaknesses and risks. Since Apple is a design company tasked with making tools for people, having an inside view of the product pipeline plays a major role in estimating Apple’s intrinsic value. This may end up giving Apple management an advantage when it comes to assessing buyback’s effectiveness.
Buybacks and the Pandemic
The pandemic has changed the buyback discussion for every public company. Using Apple as an example, it’s not that the company’s intrinsic value, which reflects Apple’s cash flow generating capability in the future, has changed because of economic fallout related to the pandemic. Instead, market dislocations in credit markets have led to a renewed focus on liquidity and balance sheet preservation.
Apple has shown the willingness in the past to pause share repurchases based on adverse market trends. It is possible that Apple paused the buyback last month while credit markets were acting abnormal or the situation in China didn’t bode well for the rest of the world. However, given its stellar balance sheet, there likely is no company in a better position than Apple to buy back shares during a pandemic.
Harsh Reality
The harsh reality found with share buyback is that not every company should buy back their shares. While we can debate just how much of a financial cushion a company should keep in case of a pandemic or natural disaster, it’s much easier to say that overextending a balance sheet in order to buy back shares is unwise.
As the airline industry shows us, additional considerations that should be prioritized when assessing a share repurchase program are the company’s business model, ability to access capital in adverse market conditions, and difference between share price and intrinsic value. A company’s intrinsic value should reflect the sustainability, or lack thereof, of the future cash flow stream.
Share buyback is one of a handful of tools that boards and management teams have to properly manage balance sheets. While some companies have no purpose using the tool, others can benefit immensely from the same tool. Instead of simply casting off share repurchases as ineffective, inappropriate, or even dangerous, attention should go to assessing how a company is using share buyback.
Listen to the corresponding Above Avalon podcast episode for this article here.
Receive my analysis and perspective on Apple throughout the week via exclusive daily updates (2-3 stories per day, 10-12 stories per week). Available to Above Avalon members. To sign up and for more information on membership, visit the membership page.