I am drafting my quarterly letter to clients right now and given the poor performance of Apple (AAPL) shares during the first quarter, it is a stock I have been adding to lately on the long side, even as it has clearly negatively impacted portfolio performance so far in 2013 (down 16% vs S&P 500 up 10%). The bullish argument is quite simple; the stock trades at a discount to pretty much every other large cap technology company. The lack of momentum in their business right now is clearly hurting the stock, but the lack of a cash plan is just as important, in my view. They need to take decisive action soon, if for no other reason than it will allow them to not keep hearing about it quarter after quarter in the future.
There is an argument out there that shareholders should not care if Apple holds its cash or uses it to buyback stock or pay dividends to shareholders. It’s an academic argument really, as finance textbooks insist that a $50 per share dividend will decrease the value of the stock by exactly $50, so shareholders are not better off one way or the other.
But think about this. Right now Apple is earning about 1% on $137 billion of cash (actually, the quarter just ended so they likely have closer to $150 billion as of today, although they won’t report earnings for a few weeks). They have two other options for that cash; repurchase stock or pay dividends. The idea that shareholders should be indifferent to those three choices is just silly. If Apple repurchased shares, the stock would only have to rise by more than 1% per year in the future to be serving shareholders better than their current hoarding strategy (even Apple bears would likely concede that a 2% annual return is a reasonable future outcome).
The case with a dividend is a bit more complex, but still easy to understand. If Apple pays out its cash to shareholders, the shareholder would have to reinvest it themselves and earn more than 1% per year on their own in order to be in a better situation than they are now. We could easily achieve that hurdle rate. What if you own Apple in a taxable account and have to pay taxes on those dividends? Instead of beating 1% per year you would have to earn about 1.2% per year. Again, piece of cake. What if Apple had to repatriate the cash from overseas and pay income taxes on that money before paying out the dividend? Instead of needing to earn 1.2% per year, shareholders would have to earn about 2% per year investing the money themselves. Again, piece of cake.
The math: $1 of overseas cash after repatriation taxes becomes about 70 cents, and after a 15% dividend income tax, comes out to about 60 cents net to the shareholder. Apple currently earns 1-cent per year on that $1 of overseas cash (1%). In order to be better off, the shareholder would have to earn more than 1 cent on the 60 cents they receive after all taxes are paid. That equates to just a 2% annual return.
Although hedge fund manager David Einhorn took some heat for suggesting that Apple’s share price multiple would increase if the cash were used in a more shareholder-friendly way, it is hard to argue that the market is giving Apple credit for its vast cash hoard right now. The stock currently trades at around $435 per share. Net cash is likely to be around $160 per share as of March 31st, so you are paying $275 for the actual business. That business will earn $40 billion (over $40 per share) this year, more than any other U.S. company.
The idea that Apple should trade at a 7 P/E simply makes no sense. There are many reasons why it does today, and the fact that they have $150 billion stashed away earning 1% per year is a major reason why. I am buying more of the stock at current levels because I am betting this cannot go on forever. Just including the cash and using a 10 P/E (in-line with other large tech stocks) on the operating earnings of the business nets you a $600 price target for the shares (38% above current levels). Even though Apple’s management team has been completely dismissive so far, I still feel strongly that this is a bet worth making. And that is what I will be telling my clients in this quarter’s letter.
Full Disclosure: Long Apple at the time of writing, but positions may change at any time