Sunday, March 25, 2012

Apple’s Dividend – Good Financial Strategy?

Apple Computer announced this week that they were going to initiate a $2.65 per share quarterly dividend along with a $10 billion share buyback program, for a total distribution to shareholders over the next 3 years of approximately $40 billion.
This decision reportedly goes against a long-standing Steve Jobs philosophy of not making dividend payments and holding on to cash in order to fund acquisitions and other investment opportunities.
Was this the correct approach for Apple to take?

Does This Decision Even Matter?
Whether an organization pays dividends, executes a share buyback, or holds on to cash for future investment is irrelevant under a perfect capital market set of assumptions. These assumptions are:
·         Perfect Market Information by all Participants
·         Absence of Taxes
·         Absence of Financial Distress Costs
·         Rational Investors and Management
·         Absence of Transaction Costs
We all know that these assumptions do not hold true in real life. But as we discussed in CAPM - The Theory of Theory they are a convenient way to simplify the items under consideration in order to focus on explanation.

How is it that Dividend Decisions do not Matter?
In order to illustrate why the decision is irrelevant, we will assume that we have a 10% opportunity cost of capital and we invest in a firm that earns cash at a rate of ²10 per year (the symbol ² stands for Treasury Café Monetary Units, or TCMU’s) and this will continue forever. We also assume that the firm’s cash flow comes from investments that require a 10% return for the amount of risk they entail (i.e. the cost of capital is the same as ours).

Figure A - Dividend Discount Model
We will use the equation shown in Figure A (which is called the Dividend Discount Model or the Gordon Growth Model, depending on who you are listening to) to analyze the firm’s decision to do one of two things – a) pay ²10 to investors as a dividend tomorrow, or b) retain ²10 in the company and undertake a new investment that will forever earn 10%, which is the firm’s cost of capital
Pay ²10 to Investors – in this case D = ²10, r = 10%, and g = 0%, and therefore by the equation in Figure A we know our shares are worth ²100. In addition, we will have ²10 in cash from our dividend payment, for a total of ²110.
Retain ²10 in the firm and make a new investment – at first glance the Figure A equation does not immediately help us because D = ²0; the firm is keeping the money to invest. But we do know that the firm is earning ²10 right now, and with an additional ²10 in investment will earn ²11 next year. If we assume that this will be a dividend next year, we use D = ²11 in ur equation and the value of our shares are worth ²110.
In both scenarios we arrive at a value of ²110, and therefore as an investor we are indifferent between the two. One hundred percent dividend or one hundred percent retention? It is all the same to us! Both are equally valuable.
The same conclusion, under the perfect market assumptions discussed above, would hold true for the share buyback as well (but you will need to take my word for it for now until we cover this in another post).

Let’s Talk Reality
As mentioned, the perfect capital market assumptions do not work in reality. Why? Let’s take each assumption in turn with a small example:
·         Perfect Market Information by all Participants – do you know more than the management about what is going on in the company?
·         Absence of Taxes – this will occur when there is absence of death as well!
·         Absence of Financial Distress Costs – nobody was hurt by the 2008 financial crisis, were they?
·         Rational Investors and Management – people are irrational, at least sometimes, and some more than others, always.
·         Absence of Transaction Costs – have you been able to buy a stock, bond, or commodity for free, and/or at the same rate at which it would be bought back from you?

Why Have the Theory?
So why do we go through the shenanigans in the last section if none (let alone all) of these assumptions actually applies?
The answer to this question is that by establishing the case that investors are indifferent between dividends, firm retention, or share repurchases under perfect capital market assumptions creates a baseline that we can use as we progress to the next level. By establishing this baseline, we can make forays away from it without “losing our way”, much as we might unwind a string as we begin exploring a cave. If we need to pursue another line of thought, we are able to find our way back in order to investigate a different path.

First Foray – Imperfect Information
Our first foray will be to look at what happens when all market participants do not have the same amount or type of information, which of course is the case in the real world. Nobody can have information on everything, especially in this world of Big Data.
Since investors do not have the same information as management, company actions and decisions contain an element of communication within them, a process often referred to as “signaling”.
In the case of dividends, the company is communicating its belief in one or more of the following statements:
·         We are confident enough in our cash flow projections to cover this outlay
·         We have more cash than we need
·         We are confident that if we need more cash later, we can get it

The Apple Example

Figure B - Net Income and Dividend
Now we turn to the case of Apple. Figure B shows Net Income over the past 4 years (the orange line) vs. the Announced Dividend (the tan line).
From this we can deduce that Apple has earned enough to cover its prospective dividend the last two years, but did not for the two years prior. Whether two years of experience is a sufficient length of time to decide that the firm can cover its dividend needs to be explored.
One might legitimately worry that should innovation cease to continue at Apple’s historical pace and competitors catch up or leap frog with their product strategies, the 2010-2011 time period might be fondly remembered in the future by Apple as “the good ole days”.
However, if that were a reasonable risk of occurrence, one would conclude that management would not set the dividend level at a rate that could not realistically be covered. So the decision appears to represent confidence in a continued pipeline of great products that will sell really well. They know the pipeline better than we do!
Figure C - Funds From Operations vs. Cap Ex
Just because a firm earns enough from an income statement view, we need to evaluate from a cash point of view as well. Figure C shows Apple’s Funds from Operations (the orange blocks) compared to its Capital Expenditure and Acquisition activity (the tan blocks) over the past four years. This graph shows more than sufficient coverage for a dividend payment in three of the past four years.
The fact that this coverage is more consistent and conservative can either indicate management confidence as indicated above, or that the rate was set so low as to be meaningless with its respect to signaling.
Part of the stated cash-hoard objective of Mr. Jobs was to retain enough cash to go about acquisition opportunities with minimal disruption. Will the dividend decision make a dent in this “financial flexibility”?
Reviewing Apple’s acquisition activity, in any given year they have not exceeded $1 Billion annually at any time (not counting transactions for which no value has been provided). Given that Apple is starting with a “$98 Billion war chest”, reducing this by $10 Billion for a share buyback and as a backstop should operating activities fail to cover the dividend leaves ample (about 80 years worth!) “strategic cushion” for the type of acquisition strategy it has historically pursued. Therefore, the dividend does not appear relevant from a signaling standpoint from this perspective.

Key Takeaways
Dividend policy in the real world diverges from that of pure theory due to a number of factors. One of these is the signaling effect in a world where one party holds a lot more information than the other. Apple’s dividend decision in this context signifies a neutral to conservatively positive expectation as to future performance.

Questions
·         What decision would you have made in Apple’s shoes?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

3 comments:

  1. Dave, good article. I like how you started with the theoretical view of this topic and then transitioned into a more realistic analysis.

    As I was reading your article (and more directly to answer your question), I actually couldn’t help but think about non-financial factors when attempting to evaluate whether Apple is doing the right thing by paying dividends and buying back shares. The factors I am thinking about have to do with the risks that Apple has. What if innovation stalls or they put out a “bad product” that causes a massive loss of customers? What if they don’t develop the “next best thing”? (as hard as that would be to imagine) What if the cost of developing the “next best thing” is $50B+? In the event that one of these things actually happens, Apple would more than likely begin to bleed cash. Whether it’s on R&D, desperate acquisition attempts or simply weathering a period of net operating losses, all of these scenarios involve massive potential cash outlays.

    I would propose that Apple continue the practice of holding on to large cash reserves, while either paying a modest regular dividend or periodic large dividends and/or share buybacks. Just in case the day ever comes when the iPhone is no longer the best phone.

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    Replies
    1. Eric,

      It looks to me like Apple agrees with you!

      In the cash flow graph (Figure C above), the ratio of cash paid out vs. what they received from operations is about 4 to 1, so it would appear that they are retaining quite a bit, presumably in order to guard against some of the events you describe - stalled growth, being leap-frogged, large required investments, etc.

      Thanks for the comments!

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