Thursday, April 24, 2014

Will AAPL Outperform Based Only Its Corporate Finance Activities?

What happens to Apple (AAPL) matters greatly to the market. AAPL is the largest capitalized company in the US. Its weighting in QQQ is about 12%; in SPY, it's about 3%.

After the close, AAPL announced an increase in its share buyback program (from $60b to $90b) and an 8% increase in its dividend. In response to the news, AAPL shares jumped 8% in after hours trading.

Aside from in the short term, will these non-operating actions make AAPL a better performing stock? Probably not.

To be clear, this discussion is completely independent of AAPL's operating fundamentals or valuation attractiveness. We have no view on these except to say that both are key drivers of the share price.

And that's the main point: operating fundamentals and valuation matter, corporate finance activities like these generally do not. If investor's liked AAPL before, these activities should make it no more or less attractive.

Let's take the stock split, the dividend increase and the share buyback issues separately.

First, AAPL's plan is to split it's shares 7:1, reducing the share price to $75-80.  Companies normally split their shares because they have been rapidly appreciating. In other words, companies that split their shares are doing well. And in fact, if you look at a portfolio of companies that have split their shares, it generally outperforms the SPX.

That should not be a surprise. The stock split portfolio is made up almost exclusively of companies whose shares are quickly rising, necessitating a split: if the shares were in demand before, they will continue to be in demand after the split as well. The per share valuation and earnings growth is unchanged.

Importantly, that pattern doesn't fit AAPL. It's shares have been underperforming the market for the past year.

One argument being put forward for AAPL is that, at over $550, its shares are too expensive for retail investors to trade. But that doesn't seem to be true. TD Ameritrade, a retail broker, says that:
“Every single month in 2013, AAPL was our leader in terms of (trading) volume", more than FB or TWTR whose shares are already trading in $50 range.
Second, AAPL's plan to increase its dividend is largely pre-tax neutral. On the ex-dividend date, the share price will be reduced by the amount of the dividend. Individuals might prefer not receiving a dividend as long-term capital gains carry a lower tax rate.

Investors disposition to high dividend paying stocks versus growth stocks varies with the market environment; they favor the former when risk is off and the latter when risk is on. The overall effect balances out over time. Over the past 8 years, the S&P high yield dividend aristocrats has performed almost exactly in-line with SPY.  It's hard to say this will be a key driver for AAPL's share price.

Finally, what about the stock buyback plan?

Buybacks are, in a sense, the opposite of a dividend. Dividends pay investors cash and reduce the share price by the same amount. Buybacks use the cash to buy shares, reducing the number of shares outstanding and thereby increasing EPS; the value of the remaining shares are meant to increase in value. Instead of getting a dividend, investors are getting a better capital gain.

In practice, the math is not so neat. A dividend is a set amount paid to each shareholder. A buyback is an indirect way to increase the share price. Whether the price increases by the amount of the buyback in the time the investor is able to realize the gain is not a given.

Also, executives are given compensation in share options; buybacks have become a way for the company to mop up the resultant increase in shares. Put another way, buybacks are often a way for companies to help increase the value of share options for their employees.

Moreover, companies are notoriously bad at timing their buybacks. You would ideally like to see buybacks spike higher when valuations are lowest, like in 2009-10, and to taper off when valuations are highest, like in 2007 or 2013. In fact, it's the exact opposite. Companies buy the most stock when valuations are the least attractive (chart from Yardeni).

How have the buybacks worked so far for AAPL? AAPL announced its first buyback plan in March 2012 (green arrow). The original amount was $10b. In April 2013, those buybacks were increased to $60b (blue arrow). The majority of this program has now been executed. Here's how AAPL's stock has performed relative to the SPX during this time.

AAPL was trading at $575 when the first plan was announced. Yes, it likely ran up ahead of the announcement. But more than 2 years later, it is trading around $550. Relative to the SPX, it has underperformed by 30% after spending nearly $60b in share purchases and nearly $100b in total on shareholders, including on dividends.

The blue arrow shows the announcement of the larger buyback program. Like the first announcement, AAPL briefly outperformed SPX and then gave back those gains.

This is where teasing the impact of the corporate finance activities from the the fundamentals becomes difficult. At around this time, an NYU professor and several others became vocal about AAPL shares being undervalued. And in August 2013, Carl Icahn announced that he was buying AAPL shares; the impact on the share price is easily noticeable in the next chart.

But, a concentrated example of how the buyback program has had only a short effect and underwhelms the fundamentals comes from February 2014. AAPL announced unimpressive earnings results in late January and the shares fell from roughly $550 to $490. In the first two weeks of February, AAPL spent a massive $14b on buybacks. The shares rose back to $550. By last week, AAPL shares had given back 80% of those gains and was trading near $510. Relative to the SPX, the shares have performed exactly in line despite the massive buying.

The stock split, increase in dividends and further buyback will likely boost AAPL shares in the short term. That's a typical reaction, as can be seen in the examples above. That reaction, in the absence of better operating performance or further evidence of AAPL shares being undervalued, will more likely fade after the June split. The table below shows how shares normally trade after a share split announcement.

There will likely be net upside to AAPL until this split is executed. All else being equal, that should help SPY and, even more so, QQQ.

Beyond that point, the shares will trade based on its non-corporate finance activities. Longer term, investors that liked AAPL before these announcements should not like it anymore more so now. And, via Sentimentrader, the longer term effect of AAPL on the indices after similar activities has also been relatively short-lived.