Memo to Apple: Ignore Investment Bankers and Financial Shenanigans
Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Over the last few years there has been a lot of talk about what Apple (NASDAQ: AAPL) should do with their enormous cash hoard.
Some analysts and market commentators have suggested Apple take on additional debt and pay out an enormous dividend. In theory, Apple could borrow $50B-$100B. By replacing expensive equity with cheaper debt, a large debt issue would increase the value of the firm and provide a nice cash check to shareholders.
This is an absolutely terrible idea.
Let’s review the effects of a debt issue on Apple’s share price and possible negative consequences.
Back of the Envelope Calculation
To illustrate the concept of a large debt issue, let's value Apple as conservatively and simply as possible.
- Value business as a perpetuity with no excess return period.
- Assume Apple’s return of capital (ROC) will be cut almost in half to 20%. For comparison, Microsoft (NASDAQ: MSFT) has been able to maintain a 30% ROC over the past five years.
Assumptions for debt issue:
- A new debt/equity ratio of 20%. This is in line with other large cap tech giants such as Microsoft and Intel (NASDAQ: INTC).
- Assume the bond market will be very receptive to a massive $75B-$100B Apple debt issue. The debt market has been extremely accommodating for other large tech companies. IBM (NYSE: IBM) recently sold $1.5 billion of 3 year notes 0.55%, and $1 billion of five-year notes at 1.25%. I estimated Apple’s cost of debt by using comparable 10-20 year Microsoft and Intel bonds and took the middle of the range.
This is actually quite impressive at first glance. By issuing $87B worth of debt and paying out a $185/share dividend, we created $50B in shareholder value. Based on this simple example, we see a nice 10%-12% stock price pop.
How Issuing Debt Creates Wealth
Some readers may be wondering how pushing around pieces of paper can create wealth.
Businesses fund their operations through a combination of debt and equity. Because debt is cheaper than equity (as it’s a safer investment), using debt reduces the discount rate we apply to future profits, increasing the value of the firm.
Seems like an open and shut case. Uh, wrong again Bob.
Apple’s cash pile is a major competitive advantage and management is slowly but strategically deploying its cash in ways that enhance shareholder value.
As described in this Forbes column, Apple is using its cash to gain complete control of its supply chain. The firm is spending billions of dollars outfitting Asian component suppliers in exchange complete exclusivity. No other company in the industry has this type of control over its supply chain.
A large cash pile also buys the company time in the event there’s a shift in the marketplace and Apple is no longer competitive.
This is the same benefit Research in Motion (NASDAQ: BBRY) received with its large cash pile. Ample cash reserves have allowed the company to take one more shot with its BB10 operating system. While a large debt issue in 2007 may have made sense for the same reasons discussed above, RIM would be bankrupt today if that had happened.
For a 10% stock price pop, a large debt issue significantly impairs Apple’s future and erodes a key competitive advantage.
Until Apple starts destroying shareholder value with overpriced acquisitions and unfocused side ventures, shareholders should end their calls for higher dividends and debt issues.
Foolish Bottom Line
Just say no to investment bankers and financial shenanigans.
NOTE: I used Aswath Damodaran’s value enhancement spreadsheet to provide a quick and dirty estimate of the effect of restructuring Apple. You can find the spreadsheet here. His website is a wonderful resource.
Also, feel free to ask about any assumptions in the comments below.
RobertBaillieul has no position in any stocks mentioned. The Motley Fool recommends Apple and Intel Corp. The Motley Fool owns shares of Apple, Intel Corp, International Business Machines Corp., and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!