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Digging into Apple’s Financial Decisions

Apple has always come off as frugal, with the amount of money it has squirreled away in cash and short-term investments nearly doubling since July 2011, to $144.7 billion. As such, it was surprising enough last year when Apple announced a $10 billion stock repurchase plan and quarterly dividend (see “Apple to Pay Quarterly Dividends and Repurchase Stock,” 19 March 2012). Even more shocking was the recent announcement that the company would increase the buyback amount to $60 billion and increase the dividend by 15 percent.

These decisions mark the beginning of a new financial strategy that has Apple spending cash in unprecedented volumes. Or not. At least not precisely. It turns out that Apple is not using its own cash to buy back these shares over the next two years, but is instead borrowing the money. Why would a company with nearly $145 billion in the bank need a loan? And why is Apple suddenly starting to dip into its cash hoard now? Apart from the little-known fact that the company money pit is in fact full, it seems that Apple wants to return money to its shareholders, as inexpensively as possible.

To put this story in context (see “Apple Q2 2013 Results Show Higher Revenues, Lower Profits,” 23 April 2013), Apple reported second quarter earnings for 2013 two weeks ago. The company beat Wall Street expectations slightly but had a year-over-year decline in profit for the first time in a decade. Other key metrics, like earnings per share and gross margin, also fell, and Apple issued guidance for the third quarter that was below most analysts’ expectations. While all of this may sound bad, Apple is still making huge sums of money — $43.6 billion in revenue and $9.5 billion in profit
in just the second quarter of this year. The worry is that Apple may be moving from being a growth stock to becoming a value stock, whose shareholders derive most of their gain from regular dividends. Instead of a potential jackpot, investors may now be seeing Apple as a slower moving, long-term investment.

In that earnings call two weeks ago, Tim Cook announced that Apple is going to start putting its money to work in two major ways. First, the company is increasing its stock buyback program by $50 billion, from $10 billion to $60 billion. Second, Apple’s quarterly dividend will increase by 15 percent, to $3.05 per share. Cook’s goal is to return $100 billion to investors by 2016. That may sound like a lot of money, but the recent fall of Apple’s stock price, from a high of just over $700 to its current spot around $460, erased over $200 billion in market capitalization. And, of course, Apple anticipates making
plenty more money during that time.

Buybacks and dividends are a new direction for Apple. This move would have been almost inconceivable until last year, given that Apple’s most recent dividend was distributed in 1995. And despite advice from legendary investor Warren Buffett, Steve Jobs had resisted a buyback several years ago, when Apple’s stock price was in the $200s.

Most interesting about this decision is that Apple will be borrowing money to fund all of these endeavors, despite having around $145 billion in the bank. This makes sense once you look below the surface of that very large number. Since about $100 billion of Apple’s cash is offshore, repatriating it for use in the buyback would impose substantial tax burdens. Experts estimate that Apple might have to pay between 10 to 30 percent more in taxes if the company was to bring the money back into the United States. According to bond rating service Moody’s, Apple will save $9.2 billion by not repatriating its offshore cash, which would be taxed at 35 percent, and the $100 million a year of interest it will pay on the bonds is tax-deductible. So last week, Apple made the biggest non-bank bond deal ever by issuing $17 billion of bonds, and even then the supply apparently wasn’t sufficient to meet demand.

Taking out a loan to buy back shares has two notable advantages. The first and most obvious is that buying back shares reduces the amount in dividends the company must pay, an amount that would be even higher now that Apple is raising its dividend. The second, less obvious reason, is that the interest on the loan is tax-deductible. In essence, by borrowing the money, Apple has figured out how to get the best of both worlds. It reduces its dividend liability by buying back shares and gets to deduct interest on the loan it is taking to finance the buyback.
Presumably, Apple also believes it can earn more on its cash than it’s paying on the bonds.

Buying back shares also helps Apple employees. Apple has an Employee Stock Purchase Plan that, up until a few months ago, appeared to be an investment with a high return. The program allows employees to use up to 10 percent of their salary (with a maximum of $25,000) per year to buy shares of AAPL at a 15 percent discount. Among other benefits, share buybacks are considered a tax-efficient way to return money to investors, whether employees, other individuals, or institutions, because dividends are taxable. When Apple first announced the stock repurchase program last year,
Horace Dediu, the founder of Asymco, crunched the numbers and determined that “Apple will continue to offer shares as compensation and will do so in a ratio of 1:4 of wages.” The Employee Stock Purchase Plan and grants of stock options are a big incentive to employees, especially for a company like Apple, and by increasing the earnings per share and signifying that the company believes it is undervalued, buying back shares can increase the stock price, benefitting employees and long-term shareholders.

Apple has sat on its cash for years, so why change now? Apple has offered no official explanation, but a number of issues may have prompted these recent decisions. The company faced a lawsuit from activist investor and hedge-fund manager David Einhorn, who was unhappy that the company was holding so much cash. It’s possible that, by buying back shares, Apple can reduce its vulnerability to the whims of large shareholders. Also, when Apple’s stock price was rising, investors had little to complain about, since they were seeing such a substantial return on their investments. If Apple anticipates that its share
price may no longer be able to turn in such consistent increases, shifting to more of a value-stock approach may make the company look better on paper (with increases in earnings per share and return on equity, in particular) and appease Wall Street.

At Apple’s scale, the company cannot focus solely on product engineering, but must also engage in deliberate financial engineering. Until recently, that money management could take place largely behind the scenes (as evidenced by Apple carefully maintaining overseas profits in those countries, rather than suffering the tax burden of repatriating that money). But if Apple’s growth is indeed slowing, as it inevitably must at some point, public moves like this massive share repurchase and increased dividend should help keep Wall Street happy. Some argue that this may presage a leveling off in technological
innovation as well, pointing to the share price and technology stagnation suffered by Microsoft after a similar move. That then is Apple’s challenge — to buck expectations and act like a fast-growing firm at the product level while maintaining the solid financial behavior of a corporate titan.

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