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Apple - How You Admit You're Out Of Ideas

 April 25, 2013 09:47 AM

I have long maintained that dividends are what companies that are doing well use to distribute the profits of operation to their shareholders, and form the only basis of long-term value in equity.

I have also long maintained that stock buybacks are what companies do when they have nothing productive to do with the funds they generate from operation.  Companies that buy back their own shares are making a declaration that they are out of innovative ideas to grow their business and thus instead choose to machine their stock price.

There are legitimate execptions to this general rule.  A firm trading well below book value has an argument for buying back its own stock, because the market values the firm so poorly that it is able to reduce the outstanding equity for less than the market values it at.  If a company is trading at 0.7x book, for example, but has cash, then choosing to buy back its own equity has a "free" 30% boost to the activity, which likely exceeds the gross margin it can earn from operations.

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But note three things here, and how rare they are:

1. The firm has to have cash to do the buying with.

2. The firm must be trading well below book value.

[Related -What does Istanbul have to do with AAPL?]

3. The book value must be real; if there is any "cooking" of said "value" then this is an idiotic strategy as if that is exposed the share price (and quite-possibly the entire company!) will collapse.

Apple doesn't meet any of these tests.  It is not buying the stock with cash, they are borrowing the money so as to evade paying taxes on overseas funds.  This sort of corporate shenanigan is extraordinarily dangerous as you are now arbitraging two (or more!) national tax policies you do not control.  It is trading (despite the fall in share price of late) at approximately 3x book value.  And the alleged "book" value has a very large contribution from intangibles -- that is, things like intellectual property which are notoriously hard to put a true market number on and are usually both overstated and decaying assets.

A company with a cash hoard of some $40 billion on the balance sheet that decides to buy back shares is a firm that is telling you it has nothing in the oven that is revolutionary to drive future EPS with.

Reducing the share count boosts EPS and thus makes earnings "beats" look easier.  But reducing the divisor is not "free"; it equally increases the amount of earnings misses and, if a loss is taken, magnifies those as well.

Borrowing to buy back shares is outrageously stupid.  In a world of "cheap money" there is always an argument that one can obain a "nice" return by doing so.  But this assumes several things that are not knowns (and in fact are all risks):

1. Rates will stay low.

2. If they don't, the term of the borrowing is long enough that the firm will be able to pay both the coupon and retire the debt without materially impairing operations.

3. The firm's prospects are bright enough in new products and services that expansion of the firm's revenue and earnings will overrun the borrowing.

But wait -- #3 is in direct conflict with the statement coming from management through the act itself -- that the company has no better and higher use for its cash than to buy back stock in the first place!

In Apple's case the bigger problem the firm has is the enormous deterioration in margins.  About a year ago I warned people that the margins they were reporting were utterly impossible to maintain, and that hardware companies all trend toward commodity status, which typically earns a 10% gross margin or less.

The only way to evade that outcome is to continually innovate so as to always be first and best.  But once you start buying back shares you've declared that you can't do that any more.

People on the earnings call appear to have figured this out rather quickly; the initial "pop" on the release of the plan to buy back stock and increase the dividend bled off through the call as the company failed to disclose anything new that would make the above formula work, closing in the after-hours session down somewhat.

On a fundamental basis the problem the firm has is that the $42/share the company currently claims in cash will be depleted and the reduction in operating margin means that re-filling that cache will become more difficult.  Any attempt to move more product by coming up with "lower end" products will further erode margins and make the situation worse.

Apple is trapped without new fad products and drivers of their cult mania, in short, and the deterioration of margins plus issuance of debt adds leverage (read: risk) in execution.

I would not be surprised -- even a little -- to see the firm's stock trade down to $100 over the next couple of years.  This sounds ludicrous given the current metrics but everything the company is doing right now damages the pillars on which the stock price rests -- cash on hand, margin, cachet among the "faithful" and innovation.

Put a fork in this company as a "market leader" -- they're done.

Disclosure: No position.



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