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Should Apple, Inc. Take A Page From International Business Machines Corp.'s Playbook

 March 08, 2013 10:24 AM

(By Mani) Apple, Inc. (NASDAQ: AAPL) and International Business Machines Corp. (NYSE: IBM) are different animals but now share some characteristics.

IBM is a slow top-line growth company with strong cash flow, with an average sales growth of just 1.1 percent in the past five years, compared to Apple's 45 percent.

That said Apple might struggle at the top line given prior iPhone success but will generate cash. The company is facing saturation in the US iPhone market and expanding in emerging markets, where it faces cheaper Android variants. Apple's next leg of growth is rumored to be in the much speculated iWatch and iTV.

[Related -Apple Inc. (AAPL): How Q1 Earnings Will Fare?]

Both technology giants have an ROIC of about 30 percent though IBM enjoys a higher multiple. Apple shares trade 9.66 times its 2013 consensus earnings estimate, while IBM trades at 12.5 times.

"Both emphasize quality of revenue—IBM in high value segments and Apple in building great products," UBS analyst Steven Milunovich wrote in a note to clients.

IBM scores over Apple in better capital management. IBM was one of the early vendors to deal with maturity and make it a strength by consistently giving back up to 80 percent of its free cash flow to investors. It has a payout ratio of 23 percent versus Apple's 18 percent.

Cupertino, California-based Apple currently pays $10.6 a share dividend for the full year, representing a yield of 2.2 percent. This compare with 4.3 percent for Intel Corporation (NASDAQ: INTC), 3.4 percent for Microsoft Corporation (NASDAQ: MSFT), 2.7 percent for Cisco Systems (NASDAQ: CSCO).

[Related -Apple Inc. (AAPL): iPhone Trending into Another Carl Icahn Disappointment?]

IBM, whose dividend yields only 1.6 percent, returns much of its cash in the form of buybacks. In 2012, IBM returned $15.8 billion to shareholders through $3.8 billion in dividends and $12.0 billion of share repurchases. IBM ended 2012 with $11.1 billion of cash on hand and generated free cash flow of $18.2 billion excluding Global Financing receivables, up about $1.6 billion year over year.

It is obvious that Apple investors need more of the $137 billion cash, and that is why hedge fund activists such as Greenlight's David Einhorn is criticizing Apple's capital allocation policy.

Last week, Greenlight proposed that Apple issue "iPrefs," preferred shares with a perpetual 4 percent dividend as a way to return some of its $137 billion cash to investors. Distributing a total of 5 iPrefs per common share would be the equivalent of almost "doubling the dividend", Greenlight said.

Other technology behemoths such as Intel, Cisco, and more recently Dell, Inc. (NASDAQ: DELL) and Texas Instruments, Inc. (NASDAQ: TXN) have made strong commitments to returning cash.

"We believe Apple needs to do the same and, from all signs, is likely to meaningfully boost cash return in the next few months, most likely through buybacks," Milunovich noted.

Investors are wondering why Apple can't return more cash. This might be one of the reasons. Apple's 70 percent cash is overseas. So, a change to capital allocation that triggers repatriation taxes would be a negative. Assuming the entirety of Apple's cash balance is repatriated and taxed at the 35 percent corporate rate, Apple would lose $33 billion in total cash.

Still, Wall Street has been pressing Apple to unlock shareholder value as its cash balance is one of the highest among the U.S. technology giants.

Apple, which makes the iPhone and iPad, has been apprehensive about returning cash to shareholders, and instead using it for R&D, acquisitions, new retail store openings and capital expenditures in its supply chain.

There is no harm in re-investing cash in to business, but with $43 billion in current domestic cash and about $45 billion in annual free cash flow, there is room for additional cash to be returned to shareholders.

Another area where IBM holds an edge over Apple is increased transparency. In 2005, IBM told the Street it could grow earnings double-digit, but the company was so complicated that analysts didn't believe it.

IBM's earnings roadmap has been a great success in increasing understanding of the company. In the past five years, IBM's earnings have increased 14.98 percent and is expected to rise 9.86 percent in the next five.

On the other hand, Apple recorded 62 percent earnings growth in the last five years. However, the booming growth is expected to slow in the years to come and earnings are expected to grow 19 percent in the next five years.

Again, we are not taking anything away from Apple, which is still as large as any other stock with market capitalization of over $400 billion despite being off 38 percent from its 52-week high of $705.07. The growth could slow down with iPhone reaching a saturation point, and upcoming products are not expected until late 2013.

"In its own way, Apple needs to be more transparent, perhaps beginning with an analyst meeting. Without pre-announcing products, management should be able to outline how it thinks, highlight strengths, and showcase management depth," Milunovich said.



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