Merely days after announcing a $100 billion capital return program for investors, Apple (NASDAQ:AAPL) raised $17 billion in debt from a wildly popular bond sale that saw demand outstripping supply by a ratio of 3:1. The demand was so high that despite being rated a rung below companies such as Microsoft (NASDAQ:MSFT), which has the highest triple-A credit rating, the yield on Apple’s debt fell to among the lowest in corporate America. Apple’s bond offerings included a mix of six fixed-rate and floating-rate securities with maturities ranging from three to thirty years. The biggest of the lot, a $5.5 billion 10-year offering, was sold at an annual yield of about 2.4%, at about exactly the same risk premium as the higher-rated Microsoft’s which was sold a few days back.
Overall, the effective interest rates applicable on Apple’s debt in the first few years will be about 1.85%, a little over 150 basis points higher than the government-backed 10-year Treasury bills. Apple seems to have done really well in tapping the debt markets at a time when credit has become really cheap with Treasury securities hitting their lowest yields this year. The cheap debt has helped lower the cost of capital for the company and will also lead to some cash savings as it repurchases shares at depressed valuations.
Our $625 price estimate for Apple is about 45% ahead of the current market price.
Cheap Debt Unlocks More Value
Apple plans to use the debt proceeds to fund its dividend payout and share buybacks, which it increased by another $55 billion last week to satisfy investor demands of capital return. Apple now plans to return about $100 billion by the end of 2015, in the form of increased dividends and bigger share buybacks. However, in order to fund this huge capital return program, Apple would have to bring home some of its huge cash hoard sitting overseas, which would be highly tax-inefficient. Nearly two-thirds of its $145 billion cash lies in foreign accounts. Raising debt at this time allows the company to meet its target payouts while waiting for a tax holiday to repatriate the overseas cash.
It is probably the icing on the cake that Apple was able to raise debt at historically low levels. With a coupon rate of 2.4% for the 10-year note, Apple’s interest rate is lower than its dividend yield of 2.76% (4*quarterly dividends of $3.05 / current market price of $442). What this means is that as Apple repurchases more of its own stock, it actually saves more on dividend payouts than it is liable to pay as interest.
So for every share that Apple repurchases at the current market price leads to one fewer share for which Apple would pay a dividend. This implies a positive pre-tax savings of 0.36% of the share price (2.76%-2.4%) as compared to if the company had been paying the dividends out of its existing cash hoard. Apple will therefore continue to generate positive cash savings from share purchases as long as the stock price remains below $508 due to the extremely low interest rate at which it has borrowed money. At about $508 per share, Apple’s dividend yield approaches 2.4% (4*quarterly dividends of $3.05 / estimated market price of $508) and share repurchases become costly enough to offset the pre-tax positive impact of the low interest rate. Since interest payments are tax deductible, the savings from this move are actually more than the above example.
It is noteworthy that we have taken the 10-year 2.4% coupon rate to make the above calculations. In the first few years, however, Apple will be incurring an interest expense of only about 1.85% due to the low interest nature of the short term floating-interest debt it has issued. This means that Apple’s net pre-tax cash savings in the initial years will remain positive from this little piece of financial engineering so long as its stock price remains under $660. The fact that only about a sixth of the debt is subject to interest rate fluctuations means that there is little upside to the net interest rates that the company is liable to pay in the near term.
As far as our model for Apple is concerned, we will need to incorporate the effect of the debt on our discount rate estimates. Taking on cheap debt has decreased the cost of capital for investing in its businesses, which will in turn lead to more value unlocking for Apple. Share repurchases, of which Apple plans to do almost $50 billion more of until 2015, will also send the right signals to the market about the management remaining confident in the company’s future growth trajectory. More importantly though, now that a big part of the cash turkey is off the management’s back, Apple can go back to focusing one hundred percent on its next product, or devising ways of increasing its market share in the emerging markets. (see Apple’s Mixed Report Shows Need For Faster Emerging Markets Growth)