George Salmon, Equity Analyst 10 May 2019
When you invest in a company, you’d usually want it to be putting its assets to good use, not hoarding cash on the balance sheet.
It might be one of the nicer problems to have, but with analysts expecting the five FAANG stocks – Facebook, Amazon, Apple, Netflix and Google owner Alphabet – to have a net cash position of $300bn between them this year, it’s an issue that deserves attention.
Apple and Alphabet are the biggest ‘culprits’, with over $100bn each. In recent years both groups had been storing cash overseas, fearful of the punitive taxes they’d incur for bringing it back home.
A recent change to the law means the government’s slice of repatriated money is much smaller now. So what are they doing with it?
This article isn't personal advice. All investments and any income from them can fall as well as rise in value so you could get back less than you invest. If you're not sure if an investment is right for you please seek advice.
The change prompted Apple to move towards being ‘cash neutral’ over time. But to go from such a large net cash position to nothing takes some doing. Rather than anything drastic, we think Apple will be taking a slow and steady approach.
CEO Tim Cook has said he’s “not a fan” of special dividends, which implies the group will apply a two-pronged approach of share buybacks and the ordinary dividend.
Chart showing Apple's buybacks and dividends
Scroll across to see the full chart.
Past performance isn't a guide to future returns. Source: Apple annual report, 2018.
It looks set to generate around $61bn of surplus cash next year. Combined with the $130bn already on the balance sheet as cash or cash-like assets (like government bonds), that underpins our confidence in the group’s plans, although there are no guarantees.
The shares offer a prospective yield of 2% next year but that yield is only so appealing. Remember yields aren’t a reliable indicator of future income. For Apple to deliver for shareholders in the long term, it’ll need to prove it’s capable of increasing the payout. And once the cash pile is wound down, that will mean growing earnings.
Declining hardware sales are proving a challenge, and weakness in China has disrupted one of Apple’s growth markets. The group hopes the high margin Services business can come to the rescue, but only time will tell if that proves to be the case.
Alphabet is playing its hand a bit differently. The group doesn’t pay a dividend, and while it is buying back stock, net repurchases are minimal.
Alphabet is investing heavily in projects from cloud computing to driverless cars and life sciences, but it’s still generating more cash than it’s spending. In fact, with free cash flow exceeding the buyback by some margin, last year saw Alphabet’s cash pile grow by $7bn. Unless things change soon, it could swell to over $200bn by 2021.
Now, let’s get one thing straight. Having more cash than you need is a fantastic position to be in, and is testament to what we think is an immensely impressive business model.
However, shareholders can justifiably ask what the group’s doing holding hundreds of billions dollars’ worth of cash and cash-like assets. Alphabet should be a fast moving tech company, not part fast moving tech company, part short-duration bond fund.
So what else could Alphabet do with the money to address this most desirable of problems?
One option is to allocate more of it to side projects like Waymo self-driving cars. However, Alphabet shouldn’t be just throwing money at these ideas. Budgets have to be calculated sensibly. And we’ve no reason to assume it hasn’t got it right already.
It could start paying a dividend, but management has made it clear it’s unlikely to start doing so anytime soon. That leaves a choice between spending the money on acquisitions or buybacks. We think management could give both serious consideration.
Is M&A the answer?
Mergers and acquisitions aren’t for everyone. After all, every time a company gets the chequebook out, it runs the risk of overpaying. But the right deals at the right prices can be a great way to deliver rapid growth.
Take Waymo, for example. Alphabet is already investing in its self-driving capabilities, but bringing new expertise on board could help the group find the next gear. With the race to roll out a fully autonomous driving network possibly a winner takes all affair, rapid breakthroughs in technology and infrastructure could be worth their weight in gold.
What about a buyback?
On the other hand, a share buyback has the potential to meaningfully grow earnings per share. Companies doing buybacks also avoid all the risks of M&A, although of course they will run the risk of overpaying for their own shares.
Buying back stock reduces the number of shares in issue, meaning profits have to be distributed between an ever smaller number of shareholders. So if Alphabet followed in Apple’s footsteps and moved towards a cash neutral position by repurchasing, say, $50bn of stock a year, it could seriously improve its earnings per share.
All else being equal, that would also reduce the P/E ratio. In this example, by about 17% by 2021.
What could a buyback do for Alphabet?
|Expected earnings (existing net income forecast)||Number of shares||Earnings per share||Price to earnings ratio (using current price)|
|With extra buyback||655m||$55.20||22.86|
|With extra buyback||615m||$62.31||20.26|
|With extra buyback||576m||$76.94||16.40|
Of course, these figures are for illustration only. We’ve made several assumptions, not least that Alphabet can buy its stock at the current price over the next three years.
However, the point is Alphabet has options available. And with competent management, options are a good thing to have.
A connected party of the author holds shares in Alphabet.
Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
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