One of the more certain items found with Apple’s upcoming 2Q19 earnings is that the board will approve increases to the company’s share buyback authorization and the quarterly cash dividend. The two capital return initiatives continue to be polarizing topics as Apple holds more than $100 billion of excess cash on the balance sheet. A closer look at Apple’s buyback and dividend trends suggests the company’s board still has a strong incentive to increase Apple buyback authorization in a big way next week.

Capital Return Trajectory

Exhibit 1 highlights the amount of cash Apple has spent on capital return (buyback, cash dividends, and net share settlement) on an annual basis since 2012:

Exhibit 1: Apple’s Capital Return (Annual)

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Prior to U.S. tax reform, Apple had been spending approximately $50 billion annually on capital return initiatives. The total was funded by a mixture of free cash flow and debt issuance. Once Apple was able to bring its foreign cash back to the U.S. at a favorable tax rate, the pace of capital return increased materially. Last year, Apple spent $90 billion on share buyback, cash dividends, and net share settlement.

Assuming Apple doesn’t spend a significant amount of its excess cash on M&A, the company has enough cash to continue spending nearly $100 billion on capital return annually for at least the next two years. Kicking off between $50 billion and $60 billion of free cash flow annually, Apple ends up utilizing approximately $40 billion to $50 billion of its excess cash on capital return initiatives each year. Over the long run, Apple’s current business footprint supports an annual capital return budget of closer to $50 billion.

Share Buyback

Next week, Apple’s board will approve the seventh consecutive increase to the company’s share buyback authorization. Here are the changes to Apple’s share buyback authorization since the program launched in 2012:

2012: $10 billion buyback authorization
2013: $60 billion (increase of $50 billion)
2014: $90 billion (increase of $30 billion)
2015: $140 billion (increase of $50 billion)
2016: $175 billion (increase of $35 billion)
2017: $210 billion (increase of $35 billion)
2018: $310 billion (increase of $100 billion)

Last year, Apple’s board approved a substantial $100 billion increase in share buyback authorization. This was double the amount of the previous record increase in buyback authorization.

At the end of December, Apple had $63 billion of share repurchase authorization remaining. This is another way of saying that Apple had worked through $247 billion of its $310 billion share repurchase authorization. Assuming Apple bought back $20 billion of shares in FY2Q19 (January to March 2019), the company likely had closer to $43 billion of authorization remaining at the end of March.

When estimating the potential increase in Apple’s share buyback authorization, one has to look at the company’s intended buyback pace. Following U.S. tax reform, which opened the floodgates for Apple’s foreign cash being used to fund capital return initiatives, Apple had been on pace to buy back approximately $80 billion worth of shares annually. This elevated buyback pace was interrupted in FY1Q19 following the sudden and dramatic drop in product demand in China. In December 2018, Apple didn’t buy back any shares. However, based on Apple’s 1Q19 10-Q, it looked like Apple had begun buying back shares in January.

Assuming Apple continues to target a share buyback pace of approximately $80 billion per year, the implication is that Apple’s board will need to approve another substantial increase in share buyback authorization next week. An increase of less than $50 billion in additional share buyback authorization would imply a potential slowdown in Apple’s buyback pace. This would be a surprising move considering the significant amount of excess cash that remains on Apple’s balance sheet. In addition, management continues to reiterate its intention of reaching net cash neutral over time, which means the amount of cash on Apple’s balance sheet equals the amount of debt.

Accordingly, my expectation is that Apple’s board will approve an increase in buyback authorization in the range of $75 billion to $100 billion. This will bring Apple’s overall buyback authorization to approximately $400 billion. There isn’t much of a difference between a $75 billion and $100 billion increase in authorization. Both totals would give Apple plenty of flexibility to pursue an aggressive share buyback strategy. A $75 billion increase in authorization would provide Apple approximately $115 billion of available authorization for buyback while a $100 billion would equal more like $140 billion of available authorization. Both of those totals assume Apple repurchased $20 billion of shares in FY2Q19.

Quarterly Cash Dividend

Given how much press and attention is given to Apple’s share buyback, the company’s cash dividend story continues to fly under the radar. Apple’s board has approved six consecutive increases to the quarterly cash dividend. Next week, the company will announce its seventh consecutive increase.

Here is Apple’s dividend history since reinitiating the dividend in 2012:

2012: $0.38 per share
2013: $0.44 (15% increase)
2014: $0.47 (8% increase)
2015: $0.52 (11% increase)
2016: $0.57 (10% increase)
2017: $0.63 (11% increase)
2018: $0.73 (16% increase)

When gauging the magnitude of the upcoming quarterly cash dividend increase, a 10% increase likely represents a floor. There are two reasons behind such an assertion:

Dividend strategy. Apple follows a stable dividend policy characterized by a steady dividend payout that reflects its long-term earnings potential. Instead of dividends closely following near-term earnings swings, the two variables align when looking at long-term trends.
Apple’s share buyback pace. As Apple buys back shares, the company pays out less in the way of cash dividends. This is made possible because repurchased shares are retired, reducing the number of outstanding shares. For every 100 million shares that Apple repurchases, the company saves approximately $300 million on cash dividends per year. Since reinstating the dividend, the amount of cash that Apple has spent on dividends has increased by 30% while the quarterly cash dividend has increased by 92%. As long as Apple continues to buy back significant amounts of stock, the company will be able to increase the quarterly cash dividend by 10% and not actually incur additional dividend expense.

(For an in-depth examination into Apple’s dividend strategy, check out the Above Avalon Report: Apple Dividends: A Deep Dive into Apple’s Cash Dividend Strategy. The report is available exclusively to Above Avalon members. To read the report, become a member here.)

With the preceding two variables in mind, my expectation is that Apple’s board will approve a 14% increase in Apple’s quarterly cash dividend to $0.83 per share, up from $0.73 per share.

Cash Spend

With more than $100 billion of excess cash on the balance sheet, there continues to be a vocal group advocating that Apple spend the cash on something other than capital return. However, the item that is often ignored by those advocating that Apple cut back on buyback and dividends is that management is already spending tens of billions of dollars each year funding organic growth opportunities.

In FY2018, Apple funded the following items:

R&D: $14.2 billion
Capital expenditures: $13.3 billion
M&A: $0.7 billion
Total: $28.2 billion

After taking into account the preceding organic growth investments and expenditures, Apple was still left with approximately $50 billion of free cash flow. It is this free cash flow, in addition to the excess cash already on the balance sheet, that is funding the company’s capital return initiatives:

Buyback: $73.0 billion (in FY2018)
Cash Dividends: $13.7 billion
Net share settlement: $2.6 billion
Total: $89.3 billion

Piling additional cash into R&D simply as a means of spending excess cash doesn’t make any sense. The same philosophy applies to capex. Apple’s business model is capex light. There is no logic found in Apple moving away from this model just to spend more cash. Even if Apple doubled R&D and capex overnight, which isn’t going to happen, the company would still have tens of billions of dollars piling up on the balance sheet each year.

This leaves M&A as the only other way for Apple to spend the excess cash. While Apple is certainly in a position to fund additional M&A activity, including acquisitions with larger price tags, there is no logic in the company changing its M&A philosophy because it has excess cash. Acquisitions don’t suddenly become more rational simply because the acquirer has excess cash that it wants to remove from the balance sheet. Instead, Apple continues to look at M&A as a tool for acquiring technology and talent in order to plug crucial holes in its asset base.

Given the lack of attractive alternatives, Apple’s board still has the incentive to continue approving substantial increases to share buyback authorization and quarterly cash dividends.

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