For Apple Inc. (NASDAQ:AAPL), success has led to a strategic question: What should it do with all that cash? AAPL stock owners have enjoyed a windfall, as the company has showered shareholders in money. The company has executed the capital return both through an increasingly generous dividend and also the stock buyback.
Apple has bought back a ton of stock in recent years. The company’s share count topped out at 6.6 billion in 2012 and it is down to 5.26 billion today. That’s a more than a 20% reduction inside of five years.
That’s great efficiency for a mega-cap company. And in addition to that, shareholders have also received their steadily increasing dividend.
Investors should be thrilled, right?
Better Alternatives to the Capital Return: Acquisitions?
However, there are always folks who complain about the share buyback. These fall into several categories. The first is that AAPL should be investing the capital in some growth avenue rather than simply sending the money back to shareholders via either dividend or buyback.
Fellow InvestorPlace contributor Nelson Smith made this argument. He suggested that Apple should cut its dividend and use the retained capital to make acquisitions. He wrote that: “There’s a reason why AAPL trades at the same multiple as the rest of the market. Investors assume — rightfully so — that it is a mature company with no immediate growth prospects. If Apple slashed its dividend and announced it was using that money for acquisitions, investors would sit up and take notice […] if executed right, such a strategy would make Apple shareholders richer in the long run.”
This approach would call for Apple to be more like Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL), investing in many big opportunities instead of paying dividends. Making a big purchase, such as Netflix, Inc. (NASDAQ:NFLX) would allow Apple to develop large new revenue streams. This would further reduce Apple’s reliance on hardware sales and offer Apple synergies with media and Netflix’s content library.
Acquisitions: The Numbers Don’t Look Big Enough
Apple generated $220 billion in revenues last year. You hear people saying Apple should make a car. Should they though? Ford Motor Company (NYSE:F), only generates $150 billion a year in revenue. And that revenue makes only a tiny fraction of the profit margin that Apple’s business does. An Apple car would be a big headache operationally that wouldn’t likely generate all that much more incremental profit. You can go through other businesses people would like to add to Apple’s enterprise. The math doesn’t turn out much better.
Apple could buy Netflix even at a large price premium without the slightest bit of balance sheet issues. But Netflix is only a $10 billion/year in revenue business; that’s a rounding error to a company of AAPL’s size.
Yes, Apple could try to innovate something in-house. But again, what? Virtual reality isn’t going to be a $220 billion business anytime soon. I’m sure Apple is trying to figure out the next hot consumer electronics product, but until they do, there’s no rushing it. Just throwing around large piles of money on R&D isn’t that wise unless there’s some rhyme or reason to it.
AAPL Can’t Grow Its Way to A Higher Market Valuation
Tim Cook may be no Steve Jobs, but he isn’t an idiot either. I firmly believe that if he were aware of a good way to reinvest Apple’s capital into organic growth, he would do so. But since Apple is so huge, there simply aren’t many outlets where Apple can deploy enough capital to make it worth their while. This is the simple curse of getting too big; management can only look at things that will generate tens of billions of dollars of revenue, everything else is pretty much too small to be worth their time.
The largest stocks in the S&P 500 almost always underperform the index historically due to this exact problem. Once you’ve gotten to the top of the heap, it gets a lot harder to keep growing. And executives tend to get complacent — when you have a great cash cow to milk, innovation tends to suffer. If you’re a talented young engineer, would you rather take a decent salary at Apple or go work for a start-up where your stock options could make you a multi-millionaire in a couple years?
Furthermore, if Apple does start making acquisitions outside of its core space, its market valuation would likely fall. Investors generally pay less for companies with several major lines of business. This is known as the conglomerate discount. A large company like Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) tends to trade below the market’s valuation ratio.
Investors that would just want to own Berkshire’s insurance business, its railroad, or access Buffett’s stock-picking have to buy the rest of the business whether they want it or not. If Apple becomes a diversified conglomerate, investors who own AAPL stock for the hardware or services business might lose interest.
A Better Approach for AAPL Stock
While some well-designed acquisitions might make sense, Apple needs a different strategy for its massive cash pile. The buyback had been performing well. But since AAPL stock has run up from $100 to $145 in recent quarters, the buyback is now much less effective.
At today’s 17 price-to-earnings ratio, Apple stock isn’t cheap anymore. The company’s growth prospects are limited; revenue growth largely offsets coming declines in phone sales as smartphones become increasingly commoditized.
A stock buyback represents a 6% return on investment at a 17 P/E ratio. That’s opposed to a 9% return AAPL could earn buying back its own stock at 11x earnings. Even 6% beats the 2-3% Apple is likely earning on its portfolio of more than a hundred billion dollars worth of bonds. But 6% isn’t that great.
Apple is still a great company. It should be able to generate more solid returns for investors going forward. However, it needs to get rid of the dead weight of hundreds of billions of dollars of excess cash that currently earns paltry returns. Buying back stock at a high P/E multiple is hardly the best solution.
Instead, AAPL should consider a large special dividend. Pay back tens of billions of dollars in profits directly to shareholders. Instead of being stuck in low-paying bonds, or pursuing risky acquisition strategies, Apple can then let shareholders decide how best to use the windfall iPhone profits. If an AAPL stock holder still likes its prospects, he can reinvest the special dividend back into Apple shares. For other investors, they can surely find some investment that returns better than the low single digits Apple is earning with its excess cash today.
A share buyback seems great as long as a stock is going up. But AAPL stock, like everything else, will correct sooner or later. At Apple’s current price, the risks outweigh the rewards of continuing the aggressive share buyback. A special dividend would go a long way in unlocking value for Apple stock.
At the time of this writing, Ian Bezek held BRK.B stock. He had no positions in any of the other aforementioned securities. You can reach him on Twitter at @irbezek.
