Why Apple Could Soar on a Dividend Announcement

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Analysts are suggesting that Apple (NASDAQ: AAPL) will announce a substantial new dividend when the company declares its quarterly earnings in May.

This is big news for tech investors. After all, analysts expectations help shape reality, and companies that don't keep up with expectations are sold off heavily in the days that follow.

A Bernstein analyst, Toni Sacconaghi, was most outspoken about a higher dividend. In a note, he suggested that Apple:

  • Should pay out at least 50% of its free cash flow to shareholders each year. Using trailing numbers, this works out to $22 billion in dividends to investors.

  • Could see its stock price rise by as much as 7% on the announcement of a richer dividend policy. No announcement, then, would lead to a similarly sized loss to the company's stock price.

  • Can afford to use debt to finance a bigger dividend program.

Sacconaghi's analysis is reasonable and thoughtful.

First, Apple does owe shareholders a larger dividend. The company has no need for a large stockpile of cash that it cannot reinvest in its own business. Cash building on Apple's balance sheet is invested in a mix of short and long term government bonds and corporate securities via its well-known “hedge fund” Braeburn Capital.

Secondly, Apple can afford to distribute 50% of its free cash flows to shareholders without paying taxes on its overseas cash. Apple would have to cover American corporate tax rates of 35% if it were to bring its cash back home.

Apple doesn't have to pay the tax man to pay a bigger dividend. The company can make use of record low borrowing costs to defer payments on income taxes.  Google (NASDAQ: GOOG) used this strategy to bring $3 billion in cash to the United States. Like Apple, the search giant has more than $50 billion in cash earned in foreign tax havens.

Google's $1 billion bond issuance maturing in May 2016 has a yield-to-maturity of 0.58%, implying that Apple could borrow on the short-end of the yield curve for a post-tax cost of mere basis points to pay out a larger dividend. 

Debt investors will salivate at the near risk-free opportunity in Apple debt secured by overseas cash. In the worst case scenario, Apple would have to bring back foreign earnings to the US, pay out as much as 35% in US income taxes, and then have $.65 for every dollar of free cash flow, which would more than cover the cost of servicing its debt.

Apple would be a bargain with a larger dividend

Supposing that Apple goes forward with a dividend plan to pay out 50% of its free cash flow, investors would receive $22 billion in dividends as a base case scenario.

That would give Apple a 5.5% annual dividend yield at the current price, making Apple's stock a rock star in the world of dividend-paying equities. The tech giant would yield more than the Utilities SPDR (NYSEMKT: XLU) which yields 3.6%, and the Vanguard REIT ETF(NYSEMKT: VNQ) which yields 3.2%. Can you imagine what would happen to the stock price if a growing tech company were to pay more in dividends to investors than a mix of REITs and utilities – companies that investors buy exclusively for their yield?

The base case also ignores the fact that Apple would have another $22 billion in free cash flow to sit on each year, adding to its $140 billion stockpile of cash it already has.

At a minimum, a goal to pay out 50% of free cash flow in the form of dividends would excite analysts about Apple's future growth, since growth in free cash would mean growth in the dividend. It's difficult to get excited about Apple's forward growth, since no one knows if earnings will ever make it to the hands of shareholders.

Bottom line

Apple needs to do something with its cash. If it cannot invest in its own business, the cash should be returned to shareholders in the form of dividends.

Investors are certain to be rewarded with a much higher share price should Apple announce a large-scale dividend increase. Apple can easily afford to pay out 50% of its free cash flow to investors, financing the dividends with low-interest bond issues at a time when interest rates are at rock bottom lows. If a dividend is announced at the next quarterly earnings call, Sacconaghi's projection of a 7% increase in the stock price is likely understating the value creation that would take place from a robust quarterly dividend. Expect Apple to soar on a dividend announcement, even if earning are less than incredible.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. 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!

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