Apple was back in the headlines last week (to be fair they never really leave) when CEO Tim Cook was brought before a Senate hearing to discuss Apple’s tax strategy. Like all multi-national companies, Apple earns a large amount of money from their overseas operations. If they decide to bring those profits back to the US they are required to pay the 35% corporate tax rate to repatriate those funds. In order to avoid paying this tax, Apple devised an elaborate strategy to keep the funds offshore and in countries with very low corporate tax rates such as Ireland. Even though everyone, including the Senators chairing the committee, agreed that what Apple was doing was completely legal, Apple was still chastised in the press for “tax dodging.” In actuality, the management team at Apple was simply executing on what they have been hired to do which is to maximize profits and shareholder value within the scope of US and international law. If nothing more, the hearing shed a huge spotlight on the massive shortcomings of our overly complex tax code. In response to the hearing, Senator Rand Paul went on record to express his disgust with the whole dog and pony show when he stated:
I’m offended by a four trillion dollar government bullying, berating and badgering one of America’s greatest success stories…If anyone should be on trial here, it should be Congress. I frankly think the committee should apologize to Apple. I think that the Congress should be on trial here for creating a bizarre and Byzantine tax code that runs into the tens of thousands of pages, for creating a tax code that simple doesn’t compete with the rest of the world.
Apple is not the first company to use legal accounting strategies to minimize their tax bill, and they won’t be last. In fact, they don’t even have the largest overseas cash pile amongst US corporations. That honor belongs to none other than General Electric with over $108 billion in cash held offshore. Your guess is as good as mine as to why Apple and not GE received the honor of being the tax dodging scapegoat, but that is a discussion for another day. It might be because they are exploiting the Fed’s commitment to artificially suppress interest rates by issuing debt to raise dollars here in the US rather than repatriating any of the funds held outside the US. To explain this in more detail we need to rewind to last month’s earnings release by Apple.
For the first three months of operations in 2013 Apple reported earnings that were pretty close to in-line with Wall Street’s expectations. The interesting part of the release was the company’s intention to significantly increase their share repurchase program in addition to increasing their dividend by 15%. From the Apple press release…
The Company expects to utilize a total of $100 billion of cash under the expanded program by the end of calendar 2015…As part of this program, the Board has increased its share repurchase authorization to $60 billion from the $10 billion level announced last year. This is the largest single share repurchase authorization in history and is expected to be executed by the end of calendar 2015.
A share repurchase program of this magnitude shows that management believes the best way they can allocate their capital is by purchasing their own undervalued stock. If management felt the stock was fairly or even overvalued (a rarity in the eyes of most executives), they would choose to use their cash in other ways like issuing special dividends and buying out smaller, complimentary businesses to increase shareholder value. In order to deliver on both the increased dividend and share repurchase, Apple was going to need more cash than what they had and what they expected to make over the next couple years here in the US. As everyone knows, Apple has a veritable mountain of cash on their balance sheet to the tune of around $145 billion, but as previously mentioned, a good chunk of this cash is held outside of the US and Apple doesn’t want to pay the 35% corporate tax rate to repatriate those funds. In order to avoid this tax, Apple decided to tap the corporate debt market for $17 billion, making it the largest corporate bond offering ever. It also marked Apple’s first debt offering in over 20 years. The offering included a wide variety of debt ranging from short-term floating rate debt to 30 year fixed rate debt. The blended rate, which will change since some of the shorter-term debt is floating rate, on the $17 billion offering came out to only 1.85%. Moody’s estimated that this move to raise debt rather than repatriate offshore funds might have saved the company as much as $9.2 billion in taxes.
The brilliance of the strategy of raising debt to repurchase stock rather than repatriate earnings is that the blended interest rate on the debt (e.g. cost of borrowing) is already below the current dividend yield on Apple’s stock of 2.75%. When Apple repurchases their stock, the stock is retired and the dividend payment attached to that stock is cancelled. So in a way, Apple is simply refinancing a more costly obligation of the 2.75% dividend yield on their stock with a less costly option being the 1.85% in interest on their debt. Refinancing isn’t the perfect phrase because these are different forms of capital (equity vs. debt), but it helps to explain the cost savings on the interest/dividend obligation. This strategy can get companies in trouble if they over-lever their balance sheet, but Apple is a far from that point with the amount of cash and other assets on hand.
The million (or should we say multi-billion) dollar question now becomes what can Apple do with all its overseas cash if it never plans on repatriating it? In 2005, the US issued a corporate tax holiday to stimulate job growth in the aftermath of the “Tech Wreck” recession. For that one year, the corporate tax rate on repatriated funds was dropped from 35% all the way down to 5%. If our current sluggish recovery rolls over into another recession, politicians may once again bring this type of idea to the table to save their jobs…I mean, stimulate job growth in the economy. Under such a scenario, Apple’s decision to delay the repatriation decision will have paid off in spades. The other, more obvious option is to simply reinvest these funds in their local markets. This option doesn’t create American jobs, but it might be the best option for Apple which is becoming a much more globally balanced company as shown in the chart below.
Back in late January we wrote a post entitled Buying A Four-Letter Word in which we outlined our bullish thesis for Apple stock. At the time, many analysts were very bearish on the stock and the future prospect of the company based on the fact that their earnings growth was slowing and they hadn’t released a new product in the post-Steve Jobs era. We felt the pessimism was overblown and was more of a natural process for any stock transitioning from being the bell of the growth stock ball to just a plain old value stock. Oddly enough, the price of Apple shares today are pretty close to where they were back in January when we wrote that post. At one point the shares traded under $400 at the peak (at least for the time being) of the Apple pessimism bandwagon. We used that opportunity to take a “second bight at the Apple” and pick up some more shares in our client portfolios. We are still very bullish on the stock and we applaud the management team for their decision to increase their dividend and share repurchase program while finding creative solutions to avoid a huge tax bill.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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