Apple: Addressing The Elephant In The Room

Since early October, Carl Icahn has been pressing Apple's (AAPL) management to embark on a $150 billion buyback . This article will not address Apple's future product line up or growth prospects, nor does it serve to advocate buying or selling shares of the company. Those topics have already been discussed thoroughly here on Seeking Alpha. This article will focus only on the reasons behind and outcomes of the $150 billion share repurchase plan. Apple shares are still far from their 2012 highs despite the company's continued success. At the end of September, activist investor Carl Icahn disclosed he had purchased a considerable stake in Apple. True to his reputation, within several weeks Icahn began pressuring management to begin a $150 billion tender offer share repurchase program. The buyback has been hotly discussed in the weeks following Icahn's announcement. After running some numbers, the buyback proposal seems to be in the best interest of shareholders.

Financial Strength

Apple is in excellent financial condition. The company currently has over $40.55 billion in cash and cash equivalents and an additional $106.22 billion in investments. Unfortunately, these are mostly held overseas and will be largely useless for the buyback as Apple would need to pay repatriation taxes on the money. Due to this, it would appear wise for Apple to fund the buyback with debt. Apple is one of the few companies on the planet capable of paying back $150 billion over a short period of time. Apple generated $44.59billion in free cash flow over the past twelve months. Assuming similar or greater levels of cash flow continue in the future, Apple would be able to pay this debt back very quickly without needing to tap into their cash reserves. Apple currently has roughly $17 billion in debt, for a debt to equity ratio of .14. If Apple were to take out $150 billion in debt, their debt to equity would stand at a reasonable 1.35. While this is much higher than their current ratio, it is still well within the normal range for large corporations. Apple's strong balance sheet leaves the company able to afford the buyback.

Interest Rates

Since this buyback would need to be funded with debt, it is imperative to explore the current interest rate environment. Current interest rates are exceptionally low and would make Apple's borrowing relatively painless. Apple has a sterling AA+ credit rating and this borrowing, while large, isn't likely to change that. Since Apple could theoretically repay the $150 billion after five years, the possibility of funding the buyback with five year notes should be considered. Apple's existing five year bonds have a 1.03% current yield. Carl Icahn has publicly stated that the company should borrow $150 billion at a 3% interest rate. Icahn did not specify a time frame for the notes, but 3% is a slightly higher rate than the current yield of Apple's ten year bonds. Funding the buyback at the five year rate would cause the company to have $1.55 billion in interest expense per year. At 3%, Apple's interest expense would increase to $4.5 billion. Should Apple keep its dividend at $12.20 per share after the buyback, they would save between $2.94 -$3.35 billion each year. Current interest rates are so low, that the interest expense at five year rates would be entirely offset by dividend income that no longer needs to be paid. Should Apple finance the buyback at 3%, the dividend savings would still offset over half of the interest expense. Of course, if Apple continues to payout 28.5% of its income to shareholders then they will need to cover the entire interest expense with free cash flow. Conditions are ripe for Apple to raise a significant amount of capital by issuing debt.

The Tender Offer

The primary variable when calculating the benefits of this buyback is the price at which Apple will repurchase shares. When Icahn initially proposed the buyback, he suggested $525 per share be the price. However, at the time the price of Apple shares was below $500. At current prices, a $525 tender offer represents less than a 1% premium to shareholders. Since it would be next to impossible for Apple to repurchase almost one third of its shares at such a low premium, other price targets need to be considered. For the purpose of this discussion, the effects of a tender offer will also be evaluated at $550, $575, and $600. These approximate premiums of 5%, 10% and 15% respectively to the current stock price. $600 seemed a logical point to stop as the purpose of a buyback is to purchase undervalued shares. At $600, shares certainly still have upside, but barely enough to warrant a buyback. This leaves $550 and $575 as the logical middle ground where shares are still significantly undervalued and a decent premium is offered to investors. The price at which a tender offer is made will play a large part in the long term success of the buyback.

Tender Offer Price	$525.00	$550.00	$575.00	$600.00
Premium to Current Price	0.24%	5.01%	9.79%	14.56%
% of Shares Repurchased	31.76%	30.31%	28.99%	27.79%
Shares Retired	285,714,286	272,727,273	260,869,565	250,000,000
Shares Remaining	614,025,714	627,012,727	638,870,435	649,740,000
New EPS	$60.32	$59.07	$57.97	$57.00
Share Price at Current P/E	$767.44	$751.55	$737.60	$725.26
% Increase in Price	46.53%	43.50%	40.83%	38.48%
Share Price at P/E of 15	$904.77	$886.03	$869.59	$855.04
% Increase in Price	72.75%	69.17%	66.03%	63.26%
Potential Savings From Dividends	$3,354,619,906	$3,202,137,183	$3,062,913,827	$2,935,292,417

As seen in the table above, the buyback has the potential to unlock significant shareholder value. Apple's market cap currently stands at $468 billion. By executing this repurchase, Apple will be reducing between one quarter and one third of its outstanding shares. This will significantly raise the EPS and price of the remaining shares. As shown on the chart, the share price would be expected to rise to between $725.26 and $767.44 presuming Apple maintains its current earnings multiple. This would give investors a return between 38.48% and 46.53%. The stock stands to appreciate further as this buyback could be the catalyst that causes the market to finally recognize the true value of Apple shares. Applying a P/E of 15 to the remaining shares leaves Apple worth between $855.04 and $904.77. Should this occur, returns would be between 63.26% and 72.75%. As seen on the P/E chart below, a P/E of 15 seems reasonable for Apple. Also, analysts project Apple's earnings to grow at 14.27% over the next five years. A P/E of 15 would give the stock a PEG of 1.05 which is nearly the definition of fairly valued. The numbers indicate that a buyback should enrich shareholders.

(Click to enlarge)

AAPL PE Ratio (TTM) data by YCharts

Opposition

From the minute the $150 billion buyback was proposed many spoke out against it. These objections primarily center on the Apple's ability to handle this debt burden. Many believe that the buyback will negatively impact Apple's future by leaving them with a crushing debt burden. However, as shown in the above table, the interest expense will largely be covered by the money saved on dividend payments. Furthermore, the company generates $44.59 billion in free cash flow per year. This will more than enable them to repay the debt. Questions have also been raised as to how this buyback will affect Apple's ability to spend on R&D. An examination of Apple's financials should assuage most of those fears as Apple has the means to both repay its debts and continue to fund innovation. Furthermore, earlier in the year, Apple's management had announced that they plan to return $100 billion to shareholders in dividends and repurchases. If management believed funds were urgently needed for R&D, they would not be returning such a large sum of money to shareholders. As shown, Apple seems more than able to weather having $150 billion in debt.

Some are also opposed to the buyback as they mistrust Carl Icahn. It seems to be a popular view that Carl Icahn does not care about the future of the company and is only looking for a quick profit with the buyback. To assuage these fears, Icahn has stated his shares would not be involved in any tender offer. This ensures that he at least believes the buyback will increase Apple's share price permanently. To say he does not care about the company is foolish as he wants what every other owner of Apple wants: an increase in the value of their ownership stake. His track record shows a history of pursuing shareholder friendly initiatives that generate excellent returns for owners. Icahn has made a living strong arming management and this buyback proposal appears to continue that trend. Whether or not Apple owners like Carl Icahn as a person, history suggests his presence will benefit them.

Conclusion

The $150 billion buyback appears to benefit Apple shareholders. As shown earlier, the numbers indicate that a buyback would immediately give investors a sizeable return. Apple is able to handle the debt, interest rates are incredibly low, and the repurchase will unlock significant shareholder value. Readers should keep in mind that this is just one of many directions an Apple buyback could take. Should the company repurchase shares on the open market, change the amount of the buyback, see the price of its shares change, or borrow money at different interest rates, then new calculations would need to be performed to determine the results. At the prices and interest rates discussed in this article, Icahn seems to be correct in calling for a buyback.

Source: Apple: Addressing The Elephant In The Room

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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