High-flying Apple facing financial dilemma

If Apple’s slowdown in product innovation is not enough of a problem, its financial policy – i.e., the appropriate level of its debt and common stock to have outstanding, amount of dividends to distribute to shareholders, and the number of shares of its common stock to buy back – vies for public attention as well.

On April 24, Apple CEO Tim Cook announced a 15 percent dividend increase, on top of a $50 billion increase in the repurchase volume of its common stock over the period ending year-end 2015. Cook also indicated that the board of directors would issue $17 billion of long-term debt – the largest corporate bond offering in history.

 

OVERALL THIS involves a lot of cash. Investment bankers provided Apple with tons of advice on the wisdom of these actions. In a nutshell, what is this clamor all about? One need not be a rocket scientist to grasp the gist of the debate.

As background for these decisions, note that although Apple has about $150 billion in total cash, about half of it remains abroad, because to bring it to the United States would subject it to U.S. corporate taxes. So it remains effectively frozen for U.S. use, but may be employed abroad.

A well-respected principle of corporate financial policy advises management to act in the best interests of its shareholders, which points to maximizing shareholder wealth by maximizing after-tax profits. This rule is so misunderstood and so misinterpreted by the general public, especially by journalists, that it warrants clarification.

It does not mean that the firm is to pursue this objective at all costs, to recklessly violate all laws, to mistreat employees, suppliers, landlords, lenders, and its customers. The costs incurred in doing these acts overwhelm any short-term profits that may be gained, leaving the firm worse off.

 

MOREOVER, management ethical constraints also play a role in curbing such conduct. But management’s ignore stockholder interests at their peril. Wall Street is strewn with the corpses of managements that did not heed this dictum, or that failed to perform.

A second principle provides that management should seek investment opportunities (new, exciting products) that promise excellent after-tax profits. With Apple these opportunities are financed with cash generated from existing investments (such as iPhones and iPads); from cash hoards; or from raising new capital (sale of debt or stock).

To help finance these opportunities, Apple issued the previously noted $17 billion in bonds. Can you blame them? Interest rates are at historic lows, thanks to Federal Reserve Chairman Ben Bernanke’s policy of suppressing both short- and long-term rates. Such a policy handily facilitates President Obama’s aim to minimize the cost of Treasury borrowings. Apple, however, achieves this financing at the cost of a modest increase in its financial risk.

But this action makes sense. To the extent that the funds are used in whole or in part for buying back some of the company’s stock, the transaction amounts to a substitution of debt for equity (common stock) in Apple’s capital structure. This rise in its debt-to-equity ratio is a measure of its increased financial risk. Nonetheless, Standard and Poor’s current rating of Apple is AA-plus, which is the same, by comparison as U.S. Treasury bonds.

Following the second principle above, Apple’s increased dividend of 15 percent might be a signal to the market that the outlook for increased earnings from current investments (iPhones, iPads, iMacs) is zero to modest. The success of its still-on-the drawing-board opportunities – such as rumored TV projects, watches and other innovations – remain to be seen.

 

BUT IF MANAGEMENT senses that the attractiveness of these opportunities is weak, then it will lean toward returning firm capital to its shareholders through increased dividends, share repurchases or both. These forces are fundamental drivers of such decisions, but not the sole factors.

While this may seem implausible, another widely accepted principle of financial management for medium to large firms is that, as long as the firm wisely chooses among excellent investment opportunities, what it opts to do as a dividend policy (the proportion of average earnings to allocate for dividends or share buybacks) is unimportant to the total return received by shareholders.

But its dividend policy, and indications of the attractiveness of its opportunities, should be clearly stated to the market. Therefore, by increasing its current dividend a firm with a well-disclosed policy could be signaling to shareholders a future increase in earnings.

 

SO WHEN APPLE increases its dividend, what signal is it trying to send? Is it that its inventory of profitable projects is running low, or that they are becoming more attractive? Apple has yet to state a clear dividend policy. Making its future even murkier, Apple is notoriously shy about disclosing the attractiveness of its investment opportunities, ostensibly to avoid giving information to rivals.

Nevertheless, my suggestion to Apple is: Loosen up a bit. All of this highlights the importance of management providing clear guidance to investors about its dividend policy and investment opportunities. Because of this investor uncertainty, many stock investors diversify not only across industries, but across dividend policies as well.

 

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

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