Why Apple’s Buyback Plan Misses the Mark

by Will Ashworth | March 21, 2012 11:30 am

Why Apple’s Buyback Plan Misses the Mark

It’s not every day that a CEO gets to dole out billions in shareholder rewards. But that’s exactly what Tim Cook will do now that Apple (NASDAQ:AAPL[1]) made its groundbreaking announcement[2] Monday that it’s initiating a quarterly dividend of $2.65 and a $10 billion share repurchase plan. Over the next three years, it intends to give back $45 billion to shareholders.

The analysis of these moves has been relentless. But it will be years before we know whether this decision makes sense, and by then Tim Cook will probably have moved on. Personally, I think Apple’s board made the move because if it didn’t, it would have an even bigger problem with every passing day.

But Apple still has a problem, and it’s not that Cook and the board took action — it’s what they chose to do that’s questionable. Apple could — and should — have done it differently.

Over the past decade, Apple has increased its share count by 3% annually, averaging 25 million new shares per year. Its share repurchase calls for buying back $10 billion of its stock. If it were able to use all $10 billion to buy its shares at the March 19 closing price of $601.10, which we know would be impossible, it could buy back 16.64 million shares, reducing its share count by just 1.8%. That’s less than one year’s increase.

Are we really supposed to believe that suddenly it’s going to be able to slow the dilution of its stock? That’s how Cook is selling the buyback plan. I’m not buying it. This is only the beginning of an incredibly expensive cash outlay by management, even though stock buybacks have so often proven ineffective[3]. This will go well beyond $10 billion. Here’s why.

Even in the past five years, while share dilution has slowed, Apple’s share count still increased by 13 million per year. With the company performing extremely well, I find it difficult to believe this number won’t increase due to executive compensation. It has to.

Therefore, using the hypothetical 16.64 million share repurchase, Apple will neutralize dilution at most for the next year-and-a-half — and that’s only if it’s able to buy those shares now and at current prices, which of course it can’t.

So, two things could happen: Apple doesn’t buy back any shares because they’re too darn expensive at this point (that would be the smart decision), or it intensifies its efforts. I’m betting on the latter. Shareholders hell bent on receiving their dividends won’t be satisfied with any dilution, and management will cave to the pressure just as it has with Monday’s announcement.

Once Apple starts its repurchase program, it will be difficult, if not impossible, to turn off the tap. After deploying its original $10 billion commitment, Apple will likely authorize a new and bigger amount.

Before getting too excited about the prospects of owning a larger piece of a smaller pie, remember that Apple is also likely to be forced to increase its dividend by 10% a year or more. Where does this leave shareholders?

Again continuing with my assumption, let’s move ahead to September 2013. Apple will have neutralized its share count for the last 18 months meaning 941.6 million shares are still outstanding. In year two, the dividend-friendly regime will be paying an estimated $2.92 per share per quarter. In the third year, the quarterly dividend is ratcheted up to $3.21 a share. Lo and behold, your $45 billion has just been spent.

But now Apple has 961 million shares outstanding, and the count is rising by 13 million a year. To counteract this, it announces a $20 billion share repurchase program, also to run for three years.

Let’s assume the share price in 18 months is $800. Buying at that price, again unlikely, gets Apple 25 million shares. Subtract the 25 million shares from 941.6 million (the share count in September 2013 after $10 billion share repurchase) and then add 19.5 million shares (year-and-a-half dilution) and you’re sitting at the end of its original three-year program having spent $30 billion in share repurchases at an average price of $720 a share. The real total is now more like $65 billion or more. Let’s hope Apple’s business stays strong.

Matt Nesto, a writer for Yahoo Finance’s Breakout segment, wrote a quick missive Monday suggesting “5 Ways Apple Could Have Better Used $100 Billion.”[4] He was vilified in the comments section for having the audacity to suggest Apple should have made a one-time payout of $25 billion instead. Many of the remarks felt this was a dumb idea because it wouldn’t encourage new funds to buy the stock.

Might I remind investors that management’s job isn’t attracting new funds; it’s operating the businesses efficiently and allocating capital effectively. That’s it. Apple does the former to a tee, but I agree with Nesto that it’s dropping the ball on the latter.

Special dividends can be an effective method for attracting new funds when used judiciously. Take Buckle (NYSE:BKE[5]). It doesn’t generate nearly the cash flow Apple does, yet it has paid out a special dividend averaging $2.08 a share in each of the last four years, along with its regular quarterly dividend of 20 cents. Buckle has used share repurchases only sparingly in this period. Yet it has managed to produce an annualized total return of 21% over the past five years. Special dividends work.

Bottom Line

Apple’s new dividend yields 1.8% at of its March 19 closing price. If the stock goes to $800 by September 2013, the yield is down to 1.6%. Sure, the very fact of having a dividend will bring income investors into the fold, but at what cost?

Have you ever heard of the expression, “Go big or go home?” Apple should go home because this new payout and buyback plan accomplishes nothing for shareholders. In two or three years, it’s going to have to make a bunch of additional capital allocation decisions as a result of its meek move into dividend-paying status. This is not Apple’s finest move.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. groundbreaking announcement: http://investorplace.com/2012/03/does-apple-dividend-signal-end-of-growth-aapl/
  3. stock buybacks have so often proven ineffective: http://investorplace.com/2012/02/conocophillips-cop-shows-why-stock-buybacks-are-a-waste-of-money/
  4. “5 Ways Apple Could Have Better Used $100 Billion.”: http://finance.yahoo.com/blogs/breakout/5-better-ways-apple-could-used-100-billion-141624509.html
  5. BKE: http://studio-5.financialcontent.com/investplace/quote?Symbol=BKE

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