Introduction
By the early 2010s, Apple was so successful that the firm was drowning in more than $100bn of cash on its balance sheet. The company was under pressure by activist investors, such as Carl Icahn, to return cash to shareholders through higher dividend payments and share buybacks – where a company repurchases its own shares.
Senior executives at Apple broadly agreed with the activist investors. The firm's capital structure (composition of debt and equity) was suboptimal. At the time, the US corporation tax rate was 35% – amongst the highest in the world. It meant that if Apple repatriated profits from offshore subsidiaries, it would incur a hefty bill for the marginal difference in taxes.
To circumvent the problem, Apple embarked on one of the most successful exercises in financial engineering: Apple's parent company, Apple Inc, issued tens of billions of dollars (USD) in (debut) bonds with maturities ranging between 3 to 30 years. The proceeds from the bonds sale were used to return cash to investors in the form of an extraordinary dividend and share buybacks. At the time, the major credit rating agencies (S&P and Moody's) deemed Apple's creditworthiness as only slightly more risky than the US Government.
Today, Apple continues to return roughly $20bn every quarter to shareholders via share buybacks and dividends. Despite releveraging its balance sheet, Apple continues to enjoy the highest possible credit rating (Aa1) by Moody's. Apple borrows long term (unsecured) money at interest rates only slightly higher than the US Government. Corporate bond investors queue to buy Apple's new bonds like the release of the latest iPhone.
Almost a decade since Apple issued its debut bonds, the firm has achieved an optimal capital structure which satisfies the demands of management, shareholders, and creditors.
Apple stakeholders' expected returns
Apple Common Equity
The stock performance speaks for itself. Apple's return on common equity, a cleaner measure of operating performance, averaged around 50% over the past 5 years (ranging from 33% to 74%). Like other US tech giants, Apple not only generates lots of Free Cash Flow (FCF), but also enjoys double digit revenue growth.
Expected return: 50% p/a
Uncertainty: High
Maximum potential loss: 100%
Apple Bondholders
The credit spread of a bond is the additional yield investors demand over a similar maturity US Treasury (risk-free rate) to compensate for higher risk of non-payment (default) in the future.
At the time of writing, Apple 10-year bonds yield 20-30 basis points (0.2-0.3%) above the benchmark US Treasury. It equates to a coupon payment stream of ~1.5% per annum and the principal investment paid back in 10 years.
Expected return: 1.5% p/a
Return uncertainty: Very Low
Maximum potential loss: 100%
We assume US Treasury bonds are risk free of default.
Of course, when one studies the history of Nokia, Motorola, or even Apple flirting with bankruptcy in the 1990s, the top credit ratings currently assigned to the technology sector may be mischaracterizing inherently risky businesses.
Management and Employees
A strong stock price performance boosts employee stake ownership, helping to attract and retain the industries best talent.
Risk profiles and discounted cashflows
The returns expected by Apple equity and bond investors are vastly different, 50% and 1.5%, respectively. Apple is highly profitable and continues to grow revenues and expand into new business opportunities. It also benefits from a top notch investment grade rating – a somewhat unique position.
Are Apple bondholders adequately compensated for risk?
Consider the following two investment portfolios (A/B) held till maturity:
- Portfolio A consists entirely of Apple 10-year bonds.
- Portfolio B is 95% invested in US Treasury 10-year and the remaining 5% in Apple shares.
| Portfolio A | Portfolio B | |
|---|---|---|
| Composition | 100% Apple 10-Year Bond | 95% US Treasuries + 5% Apple stock |
| Expected return (annualized) | 1.5% | 3.7% |
| Potential to significantly underperform | Very Low | Low |
| Potential to significantly outperform | Zero | Low |
| Maximum potential loss | 100% | 5% |
The daily returns of the two portfolios are highly correlated – primarily driven by fluctuations in 10-year yields. Depending on individual investment mandates and risk preferences, the expected returns of portfolio B and distribution of outcomes are more attractive. Exposure to Apple is significantly less.
Ordinarily, pools of capital are allocated by asset class as per industry specializations. Therefore, most investment mandates prohibit holding debt and equity instruments in the same portfolio. It provides opportunities for alternative strategies which exploit relative value across the capital structure. For example, Private Equity (PE) investors purchase stakes in highly profitable businesses with stable margins on attractive debt financing terms.
Replicating the Apple Treasury trade
When Apple issues bonds to repurchase shares, it effectively sells portfolio A and buys portfolio B. Over time, US Treasury holdings are reduced to finance share buybacks.
The share buyback program enabled Apple to:
- Avoid repatriating cash held in offshore entities, thus, having to pay more towards US corporate taxes.
- Increase the relative composition of debt to equity in the firm's capital structure. Taking advantage of cheap debt financing to lower the firm's weighted average cost of capital (WACC).
- Deduct interest expenses on debt securities against operating profits.
Through the years, many analysts have suggested that as bond yields rise, equity valuations ought to decline due to lower discounting of future earnings. In the case of Apple, equity financing far exceeds the cost of debt raised in bond markets. Meaning, rising bond yields is a bad reason to sell Apple shares.
