When I first set-up a facebook account (pre-2008, I’ll have you know)*, I made this little announcement in the “About Me” section:
“I am a fan of debt finance. Those who are not fans of debt financing, I rebuke in the name of the mortgage, the bank, and the title deed. The rich don’t get richer with their money; they get richer with yours…”
Which might well be the most embarrassing faux pas ever. Because I wasn’t being ironic (although, by all means, please give me the benefit of that doubt).
Nevertheless, there is a case to be made for debt finance. And Apple is making it…
Apple’s Earnings Announcement Yesterday
- Quarterly earnings declined by 18%.
- Gross margins narrowed from 47.4% to 37.5%, which is what happens when you start subsidising
The highlights (yes – there were some):
- An increase in the dividend from $2.65 to $3.05 per share.
- An increase in the share buyback program from $10 billion to $60 billion***.
- AND the share buyback program is going to be financed by debt.
How Apple can create value without launching a new product
So Apple, being a tech company, doesn’t borrow very much money. Or any, actually. As evidenced by the fact that it sits on a stockpile of cash and investments (about $145 billion worth). Which is what so many investors have complained about, because:
- when investors give you money, it’s usually because they want to benefit off the growth potential in your operations.
- and when their cash is not being used to fund operations, you’re not giving them what they want.
- so effectively, when Apple holds a cash and investments pile equal to around 40% of its market capitalisation, what Apple is doing is forcing investors to place 40% of their money into “the Apple Long Term Stable Investment Fund”.
Apple’s argument for this, in the past, has been that Apple likes to hold the money to fund future projects. And, like, heaven forbid that they depart from the Steve Jobs vision on that front. Only, when Steve made that statement, the cash pile wasn’t even a third of what it is today. So times have changed.
But now, what to do with all that extra money? And that’s where the debt finance comes in.
- Borrow $60 billion;
- Use the $60 billion to buy back some shares; and
- Apple can continue to sit with its cash pile.
And this solves the problem, because it splits the investors into two camps:
- The $60 billion debt-holders, that will earn interest off the Apple stock pile (they’re buying into the Apple Long Term Stable Investment Fund); and
- The $320 billion equity-holders, who will continue to earn profits.
The Status Quo
Apple has 950 million shares in issue, earning about $41 per share (as of yesterday’s earnings announcement).
If Apple Uses $60 Billion of its Cash to Buy Back Some Shares
At today’s share price, that would equate to about 150 million shares being repurchased. And because the cash is just sitting around, this would have no impact on the profit Apple is producing. After the buy-back, each Apple share would be earning $49 – so all things being equal, that should push the share price up to $473 per share.
If Apple Borrows $60 Billion to Buy Back Some Shares
Let’s assume that Apple doesn’t want to bring $60 billion back into America (from overseas) to do the buyback because it would result in paying tax in the US (that is exactly why they don’t want to do it).
So they borrow the money at today’s ridiculously low rates in the US (say 2%). That means that the profits earned for shareholders are reduced by the interest payment to the lenders. But that still leaves earnings at around $38 billion, split between the 800 million shares – and we’re left with an implied share price of around $466.
Ta-dah. Without doing anything but reorganise money that they’re not using, Apple can create value for their shareholders. And they’re going to do it by borrowing $60 billion****.
Also, while we’re on the point, Apple has a lower Price to Earnings ratio than 94% of all other listed firms in America.
There is just no way that a firm that generates these levels of excess cash can be valued as relatively-less than 94% of all other listed companies.
The tide will turn.
*It’s amazing that life without facebook was only, like, 7 years ago.
**Have a look at news item 2 from my post on Monday October 8th – I’m still really proud of that observation. You can also have a listen to the podcast I made on the topic of Foxconn toward the end of October last year.
***If you want to know why share buybacks are favoured by shareholders, have a read of Observation Number 15.
****If you want to get technical about it, the reason for the difference is that equity is currently asking for a 10% return on its investment. Debt requires a 2% return. If you substitute some equity for debt, you can take the 8% saving on the substituted portion and distribute it out amongst the remaining shareholders. Hence the higher share value.