Case Study of Apple

In 2012, Apple CEO Tim Cook and CFO Peter Oppenheimer were faced with a tough decision. Apple had accumulated $137 billion in cash which it had yet to distribute to shareholders or re-invest. Shareholders were discontent with this decision and demanding answers as to why Apple held so much cash and what value the cash was creating for the company by sitting on Apple’s balance sheet. David Einhorn, the President of Greenlight Capital, wanted Cook and Oppenheimer to return the cash to shareholders, pushing for a new class of preferred stock which he called “iPref”. But Cook and Oppenheimer had other options to consider as well. They could issue a dividend, but were uncertain whether to issue a special dividend or to commit to one over time or they could authorize a share repurchase using all excess cash. In order to determine which one of these options would have the best outcome for both Apple and its shareholders, we performed an in depth analysis of Apple’s strategy, operating performance and the projected outcome of each scenario.

To begin, it is important to understand some history about Apple. Today, Apple is recognized worldwide for its success as a global leader in tech. However, Apple has not always been a leader in the industry. While Apple was founded in 1976, a key turning point in their operations did not come until January 2000 when it was announced that Steve Jobs would officially become CEO. At this point, Apple’s stock price was about $27.97. From 2000 to its peak in 2012, Apple’s stock price increased over 25 times. Apple’s strategy over this time had two main priorities: to maintain the popularity of the iPhone and to come up with an additional new innovative product. Their stock price growth can be attributed to activities which furthered their strategy including a combination of Apple’s products, tech and business modeling which provide new ways to create, deliver and capture value. On the other hand, Apple’s stock decreased 37% from Sept 2012 until March 2013 for three primary reasons: uncertainty caused by Steve Jobs death; the iPhone 5 was not perceived to be a big innovation, and; Apple’s component supply chain began to have supply reliability and quality issues.

Apple technology, paired with sleek products and powerful software, drives sales. A few great examples of Apple innovation and technology are the iPod (2001), iTunes store (2004), App Store (2008) and iPhone (2010). This integration of software, products and technology which are all designed to work well together has come to be known as “the ecosystem”. Apple customers have high customer loyalty because once they own several products, the experience of moving between them is seamless. The innovativeness of these products increased Apple’s sales and gave Apple respect as a status symbol and high brand value, increasing the company’s goodwill. This massive increase in goodwill made Apple an expensive company (high P/E ratio) and allowed them to charge high prices for their products. The introduction of this integration between 2007 and 2012 is a key factor in the 508% increase in the stock price witnessed over this period. ($11.97 on January 1 2007 to $72.80 December 31 2012).

Get Help With Your Assignment

If you need assistance with writing your assignment, our professional assignment writing service is here to help!
Find out more about our Assignment Writing Service

Taking a look at the performance of Apple’s stock from January 2000 to its peak in September 2012 (appendix 1), there is a lot to learn. It is noted that the stock did not much change between 2000 and 2007 when the first iPhone was released. The only major event was the introduction of the iPod in 2001 which generated sales and gave Apple the cash needed to create new innovative products like the iPhone.

Given that the iPhone is the company’s biggest revenue driver, it is important to look at the stock’s performance around the launch of iPhones. Apple’s investors often have a negative reaction to Apple’s stock in the 24 hours after big iPhone reveals (appendix 2). These shifts are typically between a 0-3% change. This very small change is easily explained by the fact that there is usually so much hype and rumors leading up to iPhone launches that there is rarely a surprise. A better gauge of the stock performance is grasped by looking at a longer time horizon of 60 days’ post-launch. As you can see from the chart in appendix 3, most iPhone launches have resulted in positive price performance 60 days after launch. The only exception to this has been the launch of the iPhone 3G in 2008, iPhone 5 in 2012 and iPhone SE in 2016. The negative change in 2008 was due to the global financial crisis and is not surprising. What is more interesting, however, is that the stock price 60 days following the launch of the iPhone 5 on September 18th, 2012, had decreased 18%. This is surprising because as we saw in appendix 2, in the first 24 hours after the launch of the iPhone 5 the stock price had actually gone up 2%, closing above $700 for the first time following an announcement that “orders for its iPhone topped 2 million” (Ortutay, 2012). This was to be the high point for some time to come.

This rapid initial drop in stock price is believed to have happened due to investor expectations not being met. They were disappointed with a lack of distinctive new features. Even more concerning, with the loss of Steve Jobs, were the days of Apple innovation over? By March 2013, Apple’s stock price had decreased 37% from $702.10 to $442.66. There are a number of reasons for this decline. First, Apple has always been known for innovation and since Jobs had passed in October 2011, the company had not released any new, innovative products. Initially, Apple’s stock price only dropped 88 cents following the news of Jobs’ death. Investors had confidence in the new CEO, Tim Cook, and therefore the market hardly moved. However, over the next couple of years, Apple failed to prove that they could innovate without Jobs.

By late 2012, Apple fans were growing restless as no new groundbreaking devices had been launched since the iPad in 2010. The iPhone 4s and iPhone 5 had fewer differences in comparison to previous versions of the iPhone and they failed to meet customer expectations. This left investors wondering if Apple could innovate under the new CEO Tim Cook. Further, the iPhone 5 release in September was the last big announcement of 2012. This is important to note because a large part of the increases in Apple’s stock price is investors’ anticipation about future product releases. Second, iPhone 5’s initial sales were disappointing. The first weekend’s sales number was 5 million; significantly worse than analysts’ predictions which fell between 6-10 million iPhone 5’s sold during the opening weekend (Yarow, 2012). Final results for the fourth quarter 2012 showed that iPhone sales grew only 7%, which was well below the estimated 30% growth rate for the smartphone industry as a whole (Blodget, 2013). Also important operationally, Apple, at the time, obtained components from single or limited sources making it subject to significant supply and pricing risks. Apple sometimes faced industry-wide shortages and significant commodity pricing fluctuations. This was the case at the time the iPhone 5 was released, leading to scarce numbers of iPhone 5’s on the shelves. This had an impact on sales and customer sentiment . One reason for this lack of supply was increasing competition and decreasing market share in the phone and tablet industries due to the entry of Android powered devices. Demand for key components was at an all-time high and suppliers were able to find better deals with Apple’s competitors, forcing the company to widen their supply chain and making it more difficult for Apple to exercise quality control management. Further reducing supply, one of Apple’s suppliers, Sharp, who made the iPhone display for the iPhone 5 was reportedly having supply problems. As a result, Sharp was not able to offer the volume production needed on the launch weekend. Finally, Apple’s profit margin was decreasing from the last quarter of 2012 through early 2013 (appendix 4). Despite Apple’s cash growing significantly over the past decade, shareholders were becoming concerned that Apple was not using it or returning it to shareholders. The decline in margin, the supply chain supply and quality issues, combined with a slowdown in Apple’s revenue due to the smaller growth in iPhone sales, all contributed to a shrinkage in Apple’s earnings. This concerned investors on Wall Street and contributed to the 37% decrease in Apple’s stock price over just 6 months.

Despite Apple’s declining stock price, their cash on hand remained very high. In 2012, they had the most cash on their balance sheet than any country in the world: $121,251 billion in cash, cash equivalents and marketable securities - an increase of almost $40 billion or 49% from September 24, 2011. This increase was mainly attributable to cash from operations of $50.9 billion. Apple was able to accumulate all of this cash due to their high profitability, the reduction of product costs, and efficient management of Apple’s capital structure. Now, you may be thinking - why in the world does Apple hold so much cash? It could be to provide safety to the company and shareholders. Or possibly to be able to take advantage of strategic opportunities that were presented to them. Given the company’s strong cash position, they were in a unique place to take advantage of any great opportunity that presented itself in the future. As the data shows in appendix 4, the gross profit margin increased from 27% in 2000 to almost 44% in 2012. Apple’s EBIT and cash accounts also followed a similar dramatic increasing pattern. This retained the cash was to be used for reinvestment opportunities. Another reason the company claimed to be holding so much cash was because they had so many offshore operations. 61% of Apple’s revenues came from foreign earnings in 2012 and about 69% of Apple’s cash (equivalent to about $94 billion) was held abroad in low-tax countries like Ireland. These profits would undergo taxation if they were repatriated at a tax rate of up to 35% on all foreign reserves.

While this high repatriation tax is daunting, there is still a possibility that an annual dividend, share repurchase, or iPref issuance would actually be a more beneficial use of Apple’s cash. Given that Apple shareholders were becoming restless waiting to see what Apple would do with their excess cash, we do not believe that they would have been content with Apple deciding to simply keep all excess cash rather than distributing at least a portion to shareholders.

In order to evaluate each of these options, we started by calculating what we estimated to be Apple’s excess cash in 2012. Looking at the income statement and balance sheet, we first needed to calculate the required cash. This is a difficult figure to approximate however we chose to calculate it by adding the total operating expenses, change in accrued expenses, tax at the effective rate of 23%, change in inventory each year, repatriation tax (in 2012) and change in accounts payable each year. We chose these items as they vary proportionally with cash. We used growth rates provided in the case when possible but for operating expenses, we made the assumption that it had the same annual growth rate as sales, which is 10%. From there, we calculated the change in each item and added them together, giving us the required total cash of $66,467 in 2012 as shown in appendix 5. The excess cash was computed as a plug (total cash less required cash) which amounted to $54,764 billion in 2012. In order to predict the total cash in the following 5 years, we used the previous cash data from 2000 to 2012 to calculate the average growth rate of cash, which is around 32.8%.  By using this rate and the above calculations, we found that the total cash Apple would have after five years if they distributed all excess cash to shareholders in 2012 is $274,619 billion (appendix 5).

If Apple chose to commit to an annual dividend from 2012-2017, we would need to first determine free cash flow (FCF) to decide how much it could afford to distribute each year. FCF is an important measurement because it tells you how much a firm can afford to pay in dividends in a given year. We know Apple has no new debts issues and debts repayments for each year. We also assume depreciation, amortization and capital expenditure increase with sales at a 10% annual growth rate per year since the change of CAPEX is based on how the amount of fixed assets or investments would change. We also calculate working capital needs by using current assets less current liabilities. Using the FCF formula, we found Apple’s FCF per year in addition to the dividend they could afford to pay per share which is shown in appendix 6.

Another option Cook and Oppenheimer considered was a share repurchase. In order to calculate the effect, we first needed to determine excess cash which would be used to repurchase Apple’s shares. In order to make this determination, we employed a number of assumptions. The first assumption was that Apple’s capital expenditures in 2012 were roughly equivalent to their capital expenditures in future years. We used this figure as the amount that Apple would need to reinvest in their business each year. Another assumption made was that Apple would not be using any cash other than what they spent on capital expenditure in 2012 to invest in new projects, as they did not have any positive net present value (NPV) investment opportunities. From there, we started our calculation with cash from operating activities. We then subtracted payment to debtholders and cash for re-investment to arrive at an excess cash figure of $42.561 billion (appendix 7). After arriving at this excess cash figure of $42.561 billion, we assumed that Apple would buy back the 939.1 million shares at the current market price of $450.50 on September 29, 2012 to find the total value of the firm before the share repurchase which was equal to 423.1 billion (appendix 8).  Following a share repurchase, the number of shares outstanding dropped to 867.7 million and value of the firm dropped to 380.5 billion (appendix 8). There would be no effect on the share price which would remain at $450.50 however the earnings per share (EPS) for Apple would have increased from $44.43 to $49.41 (appendix 8).

Cook and Oppenheimer could have also chosen to issue a one-off dividend payment.  If total excess cash of $42,561 billion was used to issue a one-off dividend distribution to shareholders, then Apple would have distributed approximately $45.32 per share to each common shareholder. It is assumed that the share price would have been reduced by the amount of the dividend, going from $450.50 to $405.18. Therefore, the value of Apple would have reduced to $380.5 billion (see appendix 9).

Another possibility Cook and Oppenheimer considered was the issuance of iPref shares. iPrefs are perpetual preferred stock that has no maturity date and will continue paying a dividend indefinitely. Each iPref share has a face value of $50 and pays $2 in dividends annually. This is received as $0.5 every quarter, perpetually. iPrefs are distributed tax-free and at no cost to existing shareholders as the cost is covered by free cash flow. Preference shareholders can either hold the stock for the future or resell them to the market.

In this case, Apple had 939.1 million shares outstanding and Apple issued five preference shares per ordinary share, meaning that a total of about 4.7 billion iPref shares would be issued. Assuming a constant P/E ratio of 10.0x, total dividend payments for iPref shares would have amounted to $9.4 billion. Current EPS were about $45.05. Under Einhorn’s proposal each common share would have been allocated five iPref shares. A total annual dividend payment of $10.00 for the five iPref shares (5 shares * $2.00 dividend payment) would have reduced Apple’s EPS from $45.05 to $35.05. After issuing iPref shares, the market price for each common share would have dropped to approximately $350.50 per share. However, each of these common shares would entitle the holder to five iPref shares, each with a face value of $50. Therefore, each common shareholder would see additional value of $250 per common share, bringing the total value for holding one common share to about $600.50, and unlocking a new value of $150 for each share. In this scenario, with the issuance of iPref shares, Apple’s value would have been $563.5 billion ($350 * 939.1 million + $50 * 4696 million) (see appendix 10).

While issuing iPref shares seems like a good option for Cook and Opppenheimer, there is no guarantee that after issuing iPref shares Apple would be able to maintain its current P/E ratio of 10. There may be an element of dilution (the dilution of EPS and constant cash outflow) that would lower the P/E of Apple and imply that investors were not expecting high earnings growth for the company. If the P/E ratio did go down to less than 4 after issuing iPref shares, then the market value of Apple will be less than the other two options (appendix 11).

The value of Apple following any of these options is uncertain. Apple wants to remain cash rich and debt free while continuing to maximize shareholder wealth. It is not possible to conclusively say that any one method would be the most beneficial to shareholders. Further, additional options that were not touched on in this paper need to be considered and assessed before a final decision is made, such as the option to take on some debt and lower its cost of capital. Additionally, we did not consider that after a share purchase the stock price would likely increase. However, based on the analysis in this paper, we believe that the best option for Cook and Oppenheimer is to authorize the issuance of iPref shares. We believe this is the best option for Apple for a number of reasons. Quantitatively, we can see that both a one-off dividend payment and share repurchase decrease the value of the firm from $423.1 billion to $380.5 billion. In both of these cases we also know that the shareholders would receive $45.32 per share. On the other hand, an iPref issuance increases the value of the firm to $563.2 billion.

Apple investors are more interested in the appreciation of the stock and Apple’s growth as it does not currently pay a dividend. However, issuing iPref shares would capture a new demographic that Apple does not currently capture: investors seeking safe, recurring income. Apple is an especially attractive stock if they were to pay a preference dividend because it is highly liquid and would be taxed at a favorable dividend rate. Therefore, the current shareholders who receive iPref dividends should not have any trouble selling the shares. Another benefit of iPref shares is that there is no risk of default because Apple would be issuing equity rather than debt. Apple would have the option to stop paying the iPref if absolutely necessary, though we do not see this happening in the foreseeable future.

While the issuance of iPrefs is a good sign, signaling that management in confident in Apple’s future earnings, one potential concern is that dividends are “sticky” and once Apple starts paying them, shareholders will expect it to pay either the same or more each year. In this case, issuing iPref dividends would cost Apple almost $9.4 billion per year. This needs to be taken into consideration when Apple is calculating required cash for upcoming years. However, we are not concerned about Apple being able to cover this cost. Apple is one of the most cash-rich companies in the world and at the time of the issuance Apple had $42,470 billion in domestic cash. This means that Apple had enough domestic cash to cover the iPref dividend for the next two years without repatriating any cash. Instead, this overseas cash can be used for further capital investment, research and development and other activities to create more value to shareholders.  On the other hand, if Apple were to engage in a share repurchase program using all excess cash, this may require it to repatriate some overseas cash for investment opportunities should they present themselves.

iPref issuance is also beneficial for current shareholders because they have the option to receive this dividend annually or sell the iPref share on if they do not wish to receive a dividend. Some shareholders such as those in the highest tax bracket may prefer not to receive a dividend whereas tax-free investors and corporations would prefer a dividend. A preference dividend gives investors the option to choose based on what works best for their individual situation. Another important aspect of this option is that while Apple will be distributing some excess cash which could not be reinvested, they will still maintain a healthy cash balance to reinvest in the business or invest in external projects with a positive NPV. If Apple had chosen to pay an annual dividend, this may have signaled to investors that Apple did not have any positive NPV investment opportunities which is not a good sign. If they had chosen to issue a one-off dividend, the stock price would have declined.

Ultimately, iPref’s would lower Apple’s cost of capital and increase the company’s financial flexibility. It is the best option for iPref shareholders who want a common dividend as well as common shareholders who simply wish for Apple to increase its growth.

Sources

• Blodget, H. (2013) These Two Charts Show Why Apple's Stock Price Is Collapsing, Available at: https://www.businessinsider.com/two-charts-show-why-apple-stock-dropped-2013-4?r=US&IR=T (Accessed: 21st September 2019).
• Brown, B. (2019) How Apple Stock Reacts After Every Major iPhone Reveal, Available at: https://www.ccn.com/apple-stock-iphone-launch/ (Accessed: 24th September 2019).
• Chick, C. (2013) The Rise and Fall (But Mostly Rise) of Apple Stock, Available at: https://www.chipchick.com/2013/03/rise-of-apple-stock.html (Accessed: 24th September 2019).
• Cohan, P. (2012) Apple Can't Innovate or Manage Supply Chain, Available at: https://www.forbes.com/sites/petercohan/2012/10/26/apple-cant-innovate-or-manage-supply-chain/#9b40de717b56 (Accessed: 21st November 2019).
• Evans, J. (2012) iPhone 5 component supply challenges could threaten Apple's empire, Available at: https://www.computerworld.com/article/2472882/iphone-5-component-supply-challenges-could-threaten-apple-s-empire.html(Accessed: 21st November 2019).
• Gross, D. (2012) Five user complaints about iPhone 5, Available at: https://edition.cnn.com/2012/09/26/tech/mobile/iphone-5-complaints/index.html (Accessed: 21st November 2019).
• Jackson, E. (2012) Here's Why All the People Freaking Out About Apple's Stock Crash Need To Take A Xanax, Available at: https://www.forbes.com/sites/ericjackson/2012/10/10/heres-why-all-the-people-freaking-out-about-apples-stock-crash-need-to-take-a-xanax/#2abf3cfe3ccc (Accessed: 22nd November 2019).
• Johnson, K., Yang, Li., Phan, H., Singer, J. and Trinh, H. (2012) 'The Innovative Success that is Apple, Inc.', Theses, Dissertations and Capstones, Paper 418 [Online]. Available at: https://mds.marshall.edu/cgi/viewcontent.cgi?article=1420&context=etd (Accessed: 23rd November 2019).
• Kollymeyer, B. (2018) Here’s how Apple’s stock performs around iPhone launch events, Available at: https://www.marketwatch.com/story/heres-how-apples-stock-performs-around-iphone-launch-events-2018-09-12 (Accessed: 24th September 2019).
• Ortutay, B. (2012) Apple Closes Above $700 For First Time, Available at: https://www.manufacturing.net/home/news/13197793/apple-closes-above-700-for-first-time (Accessed: 24th September 2019).
• Shanhong, L. (2019) Apple's gross margin as percentage of revenue from 1st quarter 2005 to 4th quarter 2019, Available at: https://www.statista.com/statistics/263436/apples-gross-margin-since-2005/ (Accessed: 22nd November 2019).
• Software AG Social Media A Team (2012) Supply Chain Lessons Learned from Apple's iPhone 5 Launch, Available at: http://www.b2b.com/blog/2012/09/28/apple-supply-chain-lessons/(Accessed: 21st November 2019).
• Trefis Team (2012) Apple's Well-Fortified Supply Chain Can Handle The Sharp Scare, Available at: https://www.forbes.com/sites/greatspeculations/2012/09/05/apples-well-fortified-supply-chain-can-handle-the-sharp-scare/#5319772451b3 (Accessed: 21st November 2019).
• Yarow, J. (2012) Tim Cook Told Everyone Why iPhone 5 Sales Were Worse Than Expected, Available at: https://www.businessinsider.com/tim-cook-iphone-5-sales-2012-9?r=US&IR=T (Accessed: 24th September 2019).