I receive many questions about Apple from Above Avalon readers, listeners, and members. In previous years, one topic has been far ahead of any other as a source of questions. Everyone wanted to know about Apple’s share buyback program.

Why is Apple buying back its shares?
Is Tim Cook trying to take Apple private?
Does buying back shares signal anything about Apple’s future product plans?
Why doesn’t Apple use cash to buy larger companies instead of buying back its shares?

Something interesting happened in 2020. I received far fewer questions about Apple’s share buyback program. To be precise, I didn’t receive an incoming question about buyback in nine months - from when the stock market put in a bottom in April 2020 to the start of 2021. What explains such a dramatic change? The Apple share buyback debate ended, and Apple was declared the winner.

How It Started

In the early 2010s, many on Wall Street viewed Apple as the iPhone company, and the iPhone was said to be “dead in the water.” A few activist hedge funds began circling around Apple shares due to their low valuation metrics relative to peers and the overall market. Apple was trading at a single digit forward price-to-earnings multiple – a valuation typically afforded to companies with little to no growth potential. On a free cash flow yield basis, Apple was priced like a junk bond.

In March 2012, after consultation with top shareholders, Apple announced it would begin paying a quarterly cash dividend and buying back shares. While Wall Street mostly applauded the move, Silicon Valley was convinced Apple had made a big mistake. Some thought Tim Cook was pressured into buying back Apple shares. Those who followed the “what would Steve Jobs do” doctrine were convinced that Cook had placed Apple on a path to ruin since Steve Jobs had famously viewed dividends and buyback as nothing more than distractions. At the time, none of Apple’s high-growth peers were buying back shares, which made Apple look even more like an outlier.

The primary concern held by those skeptical of Apple buying back shares was that by using cash to repurchase shares, Apple would have less cash to spend on capital expenditures (capex), research & development (R&D), and mergers & acquisitions (M&A). Said another way, some thought Apple was sacrificing its growth potential just to buy back shares.

Repurchase Pace

When looking back at Apple’s share buyback activity, one event stands out: passage of the Tax Cuts and Jobs Act of 2017. Prior to U.S. tax reform, Apple was constrained in terms of the amount of cash that could be spent on buyback. The company was penalized for bringing foreign cash back to the U.S. to fund share buyback. As shown in the exhibit below, Apple kept share buyback to a $30 billion to $45 billion per year pace despite having more than $150 billion of net cash on the balance sheet. Following U.S. tax reform, Apple was able to repatriate its foreign cash at more attractive tax rates. Apple’s share buyback pace shot higher and has been trending at $70 billion per year.

Exhibit 1: Apple Share Buyback Pace (Annual - FY)

Apple Share Buyback Pace (Annual - FY) - Above Avalon

Judging Apple’s Buyback Program

Since beginning to repurchase shares in 2013, Apple has spent $380 billion to buy back 10.6 billion shares at an average price of $35.80 per share. It’s tempting to think that Apple’s share buyback has been a success because Apple shares are trading 265% higher than the average price management paid to repurchase shares. However, one cannot judge buyback’s effectiveness or success by merely looking at the current stock price. Apple retires repurchased shares so there aren’t unrealized gains on the balance sheet from previously repurchased shares.

Share repurchases aren’t meant to boost stock prices even though some management teams may strive for such an outcome. Instead, share buyback is a tool for removing excess cash from balance sheets. In the process, a wealth transfer event is possible as ownership is shifted from shareholders willing to sell shares back to the company to those shareholders not selling shares. This is one reason why share buybacks are not created equally. Some companies incorrectly think buyback is a way to solve a problematic business model or lack of future growth while other companies see share buyback as a tool for balance sheet optimization.

The Above Avalon Report, “Share Buyback 101: An Examination of Apple’s Share Repurchase Strategy” contains much more detail on the wealth transfer dynamic found with share buyback. The report is available exclusively to Above Avalon members.

By repurchasing shares, a company doesn’t face brighter future prospects or even a higher stock price. The list of companies with stock prices that declined precipitously once share buyback concluded is long. Accordingly, a share buyback program’s effectiveness cannot and should not be judged by a company’s stock price.

End of Debate

Consensus agreed that Apple was holding on to too much cash on the balance sheet. However, there were differing opinions as to what Apple should do to remove the excess cash. Some thought that Apple should go on an M&A shopping spree. Twitter? Apple should buy it. Tesla? Apple should buy it. Netflix? Apple should buy it. Others thought Apple should ramp R&D so that as a percent of revenue, its R&D spending would be in line with that of its peers.

Instead of pursuing questionable expenditures such as large-scale M&A, paying special dividends, or simply saying “yes” to every R&D project imaginable, Apple instead saw an opportunity to both manage its balance sheet to a net cash neutral position (the amount of cash equals the amount of debt) and simultaneously invest in its future.

Apple’s share buyback debate didn’t end because Apple shares traded above a certain level, Apple repurchased shares below intrinsic value, or the company’s cash levels declined below a certain threshold. Instead, the buyback debate ended because Apple was able to successfully demonstrate that it can pile cash into buyback at record levels while also investing in its future at the same time. With Apple’s share buyback pace remaining at record levels, the company has been able to ramp up R&D to record levels while continuing to fund capex and pursue intelligent M&A.

What Did People Get Wrong?

Why did so many people underestimate Apple’s ability to both buy back shares and invest in its future at the same time?

People overestimated the amount of cash Apple actually needed to run the business and invest in the future.
People underestimated Apple’s ability to generate free cash flow.

As a percent of revenue, Apple’s R&D has historically been lower than that of its peers. Instead of this reflecting Apple underinvesting in R&D, the lower percentage reflects Apple’s unique culture and approach to product development. A better approach to take when judging Apple’s R&D spending is to compare current expenditures to historical totals. Apple spent more on R&D in FY2020 than the total it spent on R&D cumulatively from FY2010 to FY2014.

Apple’s capex needs are less than those of its peers. Apple has a capex-light business model because the company doesn’t offer free services to billions of people with a monetization strategy revolving around ads. This results in less property, plant, and equipment requirements.

Turning to M&A, Apple isn’t interested in buying products and users – a strategy that would likely be met with failure given the difficulty found with assimilating a target’s culture. Instead, Apple uses M&A to fill asset holes in the form of accessing technology and talent. This lends itself to Apple pursuing smaller deals involving companies with less in the way of thriving business models (and premium price tags).

Based on my estimates, Apple requires $10 billion to $15 billion per year to maintain and invest in property, plant, and equipment, and pursue intelligent M&A. Meanwhile, Apple’s business model predisposes the company to superior free cash flow generation. In FY2020, Apple generated a whopping $71 billion of free cash flow. The lack of significant capex requirements means that a high percentage of its operating cash flow ends up being free cash flow. As shown in Exhibit 2, Apple’s free cash flow has been increasing over time.

Exhibit 2: Apple Free Cash Flow (Annual - FY)

Apple’s superior free cash flow generation, combined with its investment run rate, allows the company to return tens of billions of dollars of excess cash to shareholders each year. This isn’t cash that would have been better suited for more R&D, capex, or M&A. Instead, the cash spent on buyback ends up keeping Apple management more disciplined and focused on proper and intelligent spending.

Big Picture

Apple has become a leader in corporate finance strategy. Following Apple, Google, Facebook, and Amazon have each subsequently announced their own share buyback program. Not surprisingly, none of them faced the kind of pushback that Apple faced during the last decade with its own buyback. Instead, Apple peers were applauded.

Consensus was convinced that Apple was buying back shares at the expense of its future growth potential. In reality, Apple’s growth potential has improved as its well-funded product strategy has allowed the company to pull away with the competition. In just the past five years, Apple has grown the iPhone installed base from 570 million to a billion users, and Apple’s ecosystem growth momentum is building. Apple’s wearables business has grown to the size of a Fortune 130 firm. Apple’s Services business went from a $20 billion to a $54 billion annual revenue run rate. In FY2020, Apple’s non-iPhone revenue growth, one of the best measures of ecosystem expansion, was 16%. Once consumers enter the Apple ecosystem via the iPhone, they proceed to buy additional Apple products and services.

There are still some questions worth asking regarding Apple’s share buyback. For example, with Apple shares trading at premium valuation multiples to the market, what is management’s approach to the buyback pace? However, when it’s a question of whether or not Apple management can buy back shares while also investing in its future, the debate has ended and Apple was declared the winner.

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For additional discussion on this topic, check out the Above Avalon daily update from January 14th.