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Five Reasons Apple Should Split Its Stock And Four Reasons It Shouldn't

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There are five advantages for Apple to do a five-to-one stock split:

The Math:  the stock doesn’t become cheaper, it just becomes affordable.     Expectations for Apple stock price are now around $1,000 per share within a couple years.  Although most investors, professional and retail, can understand intellectually that a $1,000 stock earning $100 per share is mathematically the same as 20 $50 stocks earning $5 per share.   And investors also understand that a $50 stock earning $5 per share and growing at 20% per year is more attractive than a $50 stock earning $5 per share but growing at 5% per year.  The first Price-to-Earnings ratio in this example is 10.0x with a growth rate of 20% versus a growth rate of 5%, or a PEG of 0.5x versus a PEG of 2.0x.  Again investors prefer the theoretical $50 stock with $5 earnings at 20% growth, because it is cheaper.   They “buy” more growth for the same P/E.  This is why Apple’s current PEG (FY13, excluding cash) of 0.6x is very attractive, but many investors can’t get over the size of the current price of $667.  By splitting the stock five-to-one, each new share is $133.40; and it now becomes more psychologically affordable to investors.  After all, investors want more than one share of stock for their $667, even though that $667 will produce the same total earnings.

A Five-to-One stock split puts Apple stock at $133, still a premium price point, but not unattainable…like its products.   Think of Apple’s product strategy in terms of computers and iPods.  Both competed in commoditized markets (PCs and MP3 players) where the basis of competition was price.  In both cases, Apple’s products remained priced at price-points that were higher than competing brands and Apple still was able to create buzz and desire for their products at higher points.  Then, in both cases, Apple brought the products to a larger audience by introducing “lighter” versions, like the white MacBook, or the iPod Shuffle.  While the functionality, size, memory were smaller than their MacBookPro or iPod Classic brethren, they opened up the market to more people who coveted the products but couldn’t afford the original price points.  By opening up the addressable audience, Apple has become a market leader in MP3 players world wide and has been able to grow its computer business at a pace 7.5 times the industry average.  Now, think of Apple’s stock.  It remains at a very high price point, and is only attainable to institutional investors, high net worth investors and some retail investors who can get over the previous argument.  By splitting the stock 5 to 1, the stock price becomes attainable to a larger audience.

More investors mean a wider investor base.  In Why is Apple’s P/E so Low? and the same Part 2, I make the case that Apple’s current institutional investor base may be “maxed” out on how much stock they can hold.  Traditional money managers, like State Street, may be limited in their charter of how much of one stock they can hold.   For example, a fund may be limited 3-5% of one stock for diversification.  Once they fill their position, they can’t buy more; and if the stock appreciates, it would exceed its limited proportion of the fund and the fund managers would have to sell.  So, in this world, perversely, a well-chosen investment may have to be sold out of a fund, not because its prospects have diminished but because it has performed too well.  This puts an artificial ceiling of how much demand can exist by traditional fund managers for Apple stock and an mechanism by which the stock remains “stuck” in a particular range.

A wider investor base unlocks value in the stock.  One benefit of Apple’s announcement in March to pay dividends was to increase the potential audience of fund managers who could buy Apple for their portfolios.   If you look at the trading chart of Apple before it announced the dividend, it appeared stuck in the range of roughly $330-$415; after the announcement, the stock popped up into a new range of $530-$640.  The wider the audience and greater demand for Apple stock, the closer the stock can come to parity with its PEG ratio.

A stock split will make the stock more attractive to retail investors who tend to hold stocks, rather than trade around them.   Should Apple split its stock to become more “affordable,” it opens up this investor base as well as creates a positive emotional benefit to the stock.  Stock splits are associated with growth companies whose earnings are expected to continue to expand.  Apple’s earnings continue to grow and accelerate.  For the past three fiscal years, Apple’s EPS have grown 34%, 67% and 83%.  Current estimates peg Apple’s earnings at a 69% growth over last year.

Note, Apple’s market capitalization is currently $625B.  Previously only oil companies, propelled by oil prices, and Cisco and Microsoft had market capitalizations in excess of $500B.  Interestingly, Cisco and Microsoft achieved their high market caps due to high P/Es.  Cisco’s P/E increased from 68x in October 1998 to over 200x in April 2000.  Microsoft’s P/E ranged from 56x to 81x in the same period.  On the same basis, Apple’s is currently 16x.  It has achieved its large market capitalization in spite of its P/E.

Lastly, a stock split would make its product fans happy.  Many Apple product owners feel priced out of investing in the stock, for the above reasons.  Apple should support the very customers that make them successful and let their customers benefit from Apple’s increased sales through stock ownership.

There are four arguments against Apple doing a stock split:

High stock prices keep out frivolous investors, argues Berkshire Hathaway.  Berkshire Hathaway is a different type of stock, more like fund of value investments than a single company stock.  Buffet wants his investors in for the long haul because he is often investing significant amounts in turnaround or bottom-of-the-cycle companies.  Often these investments are difficult for his investors to understand.  He needs investors to give him a longer runway to prove out his investment thesis.  Apple is not this situation at all:  retail investors can touch, feel and evaluate the product and its prospects.

It is more difficult to beat earnings after a stock split.   This is an argument for a company that has difficulty managing their earnings.  So, for example, if a company earns $1.00 per share before a five-for-one stock split, those earnings now become $0.20.  If it “beats” its earnings forecast by $0.05 that translates into $1.05 before the split and $0.21, only beating by one penny – far less glamorous and noteworthy.  Again, it doesn’t really apply in Apple’s case.  Apple has beat earnings estimates in nine of the last eleven reporting periods, six of those by $1.00 or more.  Even with a five-for-one stock spilt, Apple would be beating by $0.20 or more:  a very newsworthy beat with the split.

There is more trading around a lower-priced or split stock.  The academic research on this topic is abundant, and the theory is a company with a split stock gets more attention, and also attracts less-informed traders, both which will add to the trading.  In Apple’s case, it is not an undiscovered stock nor is it a stock without ample public information already, negating these effects after a stock split; after a split, more people could take advantage of the information that is available.  Moreover, Apple already supports healthy trading volume.  For the last three months, trading has averaged around 15M shares per day, out of 937M outstanding.   This represents healthy trading compared to other technology stocks (IBM, MSFT, GOOG) or the broader market.  Generally more trading can be positive because more buyers and sellers can converge to price discovery.  A wider audience in this case could lead to less volatility because retail investors tend to be buy and hold investors.

There are legal and administrative costs for a company to do a stock split.  Apple has $123B in cash, cash equivalents and short and long-term investments; therefore administrative costs would not be a burden to Apple.

Lastly, there is the Dow discussion.   Many speculate that Apple, at $667, is not included in the Dow because its price would give it a much heavier weighting in the index.  The Dow average is calculated based upon the prices of the stocks.  Therefore, those stocks with a higher stock price have a greater weight in the index.  Today, there are only two stocks in the Dow that have a dollar price over $100, and they are Chevron and IBM.  Therefore, should Apple split its stock, it may “qualify” to be included in the average.

On the other hand, Dow stocks are selected on the basis of their reflection of the economy as a whole.  Does Apple reflect the economy?  Apple has defied the economy as a whole for years and, in particular, the last recession.   Moreover, Apple does not trade like a tech stock or a retail stock.  For these reasons, even at a split-stock price, it may not make sense to include Apple in the Dow, and it should not be part of the argument for or against a stock split.

Bottom Line:  On the whole, it is very difficult to create a strong argument against Apple splitting its stock.  The consensus amongst analysts is that the stock will continue to appreciate, and price targets for the stock are much higher than the stock is trading now.  With this price appreciation comes more psychological difficulty of paying so much for one share of stock.  Against investor measures, Apple remains undervalued.  When Apple opened to a new investor audience by paying dividends, the stock range moved up to a new level.  A stock split would provide many benefits for Apple, unlock value, potentially reduce volatility and, most importantly, enable the very people who have propelled Apple to these levels to participate by investing, the Apple users.