Apple 10-Year Thesis / by DED

Summary

Apple has disclosed the approach it will take to cash management in light of the new flexibility in the US tax code. The company has full access to its $285 billion today. Grasping the size and extent of Apple's cash stockpile and its ability to generate additional cash is awe-inspiring and not well-understood. By 2026, a share price of $500 and $11.50+ annual dividend per share is not really a stretch.

A Tale Of Two Reactions

In the after-hours session on Thursday, Feb. 1, 2018, following Apple's Q1 FY18 earnings release, shares initially dipped 2-3%. However, as investors digested the information and CEO Tim Cook and CFO Luca Maestri went through the conference call, shares recovered, ending the evening session up about 4%, around $174. The next day in normal trading, amidst the backdrop of a large general market decline, Apple stock was slammed as the shares fell to $160.5. At the time, that was the lowest closing price for the year.

I believe Thursday's after-hours traders grasped the profound news from the conference call in a way that traders the next day did not. Some of the analysts that follow the stock touched on the paradigm shift in Apple's use of cash, but few have had the chance to update their financial models and grasp all of its implications. This article will explain what the traders in the later hours of the extended session on Feb. 1 appeared to intuitively have understood.

No More "Foreign" Cash And Apple's Plans

Due to the Tax Cuts and Jobs Act (TCJA), Apple now has access to all of what used to be its foreign cash. The company has stated that it will pay $38 Billion in repatriation fees in accordance with the law. Many analysts and investors are still thinking under the old paradigm that Apple can only access the cash on which the repatriation tax has been paid. That is not how the new law works. It is a "deemed repatriation" with the 15.5% tax on past foreign earnings due according to a specified schedule over the next eight years. Apple has full access to all $269 Billion of its "foreign" cash today.

Maestri and Cook provided a conceptual framework for how the company is viewing its capital return program and cash management in light of the new law and the company's full access to its cash pile. Maestri stated, "We are targeting to become approximately net cash neutral over time."

Later in the call, he expounded, "And so we are now in a position where we have $285 billion of cash, we've got $122 billion of debt for a net cash of $163 billion. We have now the flexibility to deploy this capital. We will do that over time, because the amount is very large. As I said earlier, we will be discussing capital allocation plans when we review our March quarter results. And when you look at our track record of what we've done over the last several years, you've seen that effectively we were returning to our investors essentially about 100% of our free cash flow. And so that is the approach that we're going to be taking."

Summing up the discussion at the end of the earnings call, Cook stated, "What Luca is saying is not cash equals zero. He's saying there's an equal amount cash and debt, and that they balance to zero. Just for clarity."

Simple assessments may look at the $163 Billion in net cash and attempt to project an impact to the capital return program and future business decisions based on that sum alone. But that is only part of the equation, and actually, the minority part. Apple has a business model that generated $47.7 Billion in Free Cash Flow (FCF) in FY17 and is on track to generate $54 Billion+ in FY18. A long-term analysis of how Apple gets to a cash neutral position as Cook/Maestri indicated over time must also consider all of that FCF.

Capital Return Forecast/Proposal

This article outlines a conservative plan for the capital return consistent with Apple's stated objectives. It then provides a comprehensive financial impact assessment that helps reveal the profound impact that the company's pursuit of its stated goals for cash management will have for shareholders. It represents one long-term shareholder's thoughtful recommendation for the board and executives, covering an 8.75-year period through the end of Fiscal 2026.

Here are the major assumptions and tenets of the program:

  • Apple executes the Cook/Maestri plan with the now repatriated funds over the next eight years, decreasing the $163 Billion in net cash to approximately $0. For simplicity, it assumes a debt balance close to current levels at the end of the time period.
  • Net income, following the initial lift from lower taxes in 2018, grows at a rate of 6.9% annually through 2026, consistent with the growth since introduction of the iPhone 5 and Apple's expansion in China.
  • Free cash flow follows net income growing 6.9% annually 2018-2026.
  • The modified FCF in the model builds in the continued acquisition of new small businesses at the current rate + 6.9% additional per annum.
  • Apple pays its $38 Billion repatriation tax per the statutory schedule.
  • Apple front-loads the share repurchases. 18th (taking advantage of lower per share prices). It spends $84 Billion for repurchases in FY18 and an amount that declines by 10% annually in each of the ensuing eight years, leading to $36 Billion in buybacks for FY26.
  • Apple increases its quarterly dividend by 50% for 2018 and 15% for every year thereafter, maintaining a yield in the 2.0-2.3% range.
  • Purchases of stock for Net Share Settlement total $2.1 Billion in 2018 and increase 6.9% per annum through 2026. This results in no impact on share count for the stock-based compensation.
  • Apple's trailing Price/Earnings (PE) multiple hovers around 15.6. While this seems significantly under-priced relative to the market and its technology mega-cap peers, it is what investors seem to be willing to pay for AAPL, so I won't argue that one here.

Capital Return Program's Impact

  • Share count drops from 5.18 Billion at the end of FY17 to 3.21 Billion at the end of FY26, a 37.8% decrease in shares outstanding.
  • Quarterly dividend reaches $2.89/share, $11.56 annually. The payout ratio by 2026 would amount to about 38% of modified FCF.
  • Apple's market capitalization would surpass $1 Trillion by the end of 2019 and reach $1.6 Trillion by the end of 2024, a 7.5% Compound Annual Growth Rate (CAGR) from current levels ($160.5/share), in line with likely broad market returns.
  • With the constantly declining shares outstanding, Apple's share price would reach $492 per share by the end of FY26, a CAGR of about 13.8% from the end of FY17, well ahead of likely market returns.
  • Earnings per share in 2026 would total $31.6 with the reduced share count.

Conclusion

Most long-term Apple shareholders would be quite happy with a $500 share price and an almost $12 annual dividend rate by 2026. This proposal is a forecast that follows the outlines of the cash use philosophy CEO Tim Cook and CFO Luca Maestri discussed in the Feb. 1, 2018, conference call.

When the market closes on Monday, Feb. 5th, the quarterly blackout period for Apple's share buybacks will end. It will be prime time for Apple's cash machine to get back to work and take advantage of the misplaced reaction to the company's Q1 FY18 results. The company has $44 Billion in buyback authorization remaining until April's capital return update, and it should buy as much as possible in the range of $155/share. Investors might consider whether they should too.

Primary Principles Of The Program

  1. Front Load. It is very beneficial for Apple to front-load the buyback program. This maximizes the impact for long-term shareholders. My proposal is for a minimum of $84 Billion in share repurchases in FY18. This takes advantage of the low share prices of today for a greater reduction in the number of shares over the eight-year window. Others may recommend a larger repurchase in 2018, but I believe $84 Billion is in the sweet spot. Apple can realistically execute it within the guidelines of statutory and SEC limitations. It is also not so large as to raise the ire of political backlash against the whole program.
  2. More Dividends. Apple should get its dividend up to par with other large-cap companies. Since the financial crisis, S&P 500 yield has hovered between 1.8% and 2.2%. The long-term average is 4.36%. Implementing the 50% increase this year and 15% over the time horizon keeps Apple in line with the post financial crisis S&P average and maintains flexibility to increase the dividend should rates or inflation move significantly higher.
  3. Reasonable (Conservative) Growth Expectations. 6.9% annual growth in net income following the large tax reform stimulated bump in 2018 reflects the level of net income growth Apple delivered since the iPhone 5 launch. Moreover, the future for Apple looks very bright. 6.9% income growth may be too low, given the strong growth in high margin service revenue, the resurrection of iPad unit growth, continued increases in global iPhone demand, expected growth of the middle class in emerging markets, especially China and India, transition to 5G over the nine-year time horizon, likely introduction of one or two additional new product categories, and continued solid management of spending and expenses. Keeping the analysis conservative, however, it seems like a very reasonable number