The Time Has Come For Apple To Make This Bold Move

Years from now, Apple employees will look back on April 18, 2013, as the day the company awoke from its slumber.

That day, Apple's shares closed below $400 -- a price that was inconceivable seven months earlier, when the stock was making a bold run toward the $700 mark.

Why is a tumble below $400 a crisis for Apple? Because many of its employees receive stock options, and a lower stock price tends to make employees antsy. Apple can't afford a brain drain when rivals like Samsung (OTC: SSNLF) are getting stronger by the day.

The Balance Sheet Catalyst
Since he took the reins of Apple (Nasdaq: AAPL) in October 2011, CEO Tim Cook has insisted the company is doing just fine and that it will focus on product development and not its stock price.

That attitude was understandable when shares slipped below $500 this January. He was right that there was no need to panic. After all, that price still represented a 20% increase from where shares stood at the start of 2012.

Now, with shares falling into the $300s, it is time for action.

About six weeks ago, I argued that Apple should mimic IBM (NYSE: IBM) and embark upon a large and ongoing stock-buyback program. Radically reducing the share count was a masterstroke for Big Blue. Apple, with its stunning levels of cash and free cash flow, can do even more on this front.

Yet the buzz is building that Apple can go further than just a cash-fueled stock buyback. If the company takes action, shares could zoom to $600 -- 50% higher than current levels.

That action? Put some debt on the balance sheet, and use that money for buybacks, too.

The Right Time To Borrow
Typically, technology companies are debt-averse and like to carry lots of cash on the balance sheet. That's largely due to fears that an eventual economic slump might lead to a cash crisis, as happened with the dot-com bust of 2000.

In Apple's case, it's virtually impossible to envision a scenario in which sales plunge, free cash flows evaporate, and the company starts to bleed cash. It is plausible, however, to envision a slow-growth future in which Apple's revenues expand less than 10% a year and free cash flow remains stuck in its current range. (Free cash flow has exceeded $30 billion in each of the past two years.)

 

Slow top-line growth and healthy free cash flow are the factors behind many companies' decision to shift from cash-rich, debt-free balance sheets to moderate levels of debt. The tax advantages of carrying debt are the main reason, although the current environment of low interest rates certainly doesn't hurt.

Let's look at Apple's balance sheet to see how much debt it could take on, and what that would mean for the share count.

At the end of 2012, Apple had more than $135 billion in net cash. Thanks to robust ongoing free cash flow, that figure is likely closer to $145 billion now. (Apple will release fiscal first-quarter results April 23.) Second, let's conservatively assume that Apple will generate $25 billion in annual free cash flow in the years ahead. Third, let's assume Apple would be willing to take on $40 billion in net debt.

The $185 billion swing in the cash balance, coupled with the annual free cash flow forecast, would enable Apple to spend $60 billion on buybacks in 2013, 2014 and 2015, and roughly $20 billion on buybacks after that.

Spending $60 billion annually (assuming shares remain at $400) would buy back 150 million shares annually, or roughly 13% of Apple's current 934 million share count. (It stood at 947 million at the end of fiscal 2012 in September.)

As Apple's share count shrinks, the percentage reduction in the share count increases (assuming 150 million shares are bought back each year). That would have the effect of nearly doubling EPS, all other things being constant. If Cook has another plan to double earnings per share (EPS) in just three to four years, he should share it with investors.

Apple earns $40 to $50 a share every year. A massive share buyback could boost this figure toward the $75 mark. Slap a multiple of 8 on that EPS target, and shares would move up to $600.

The Quarters Ahead
In the near term, Apple's woes may appear to increase. Though the company will likely meet the consensus fiscal first-quarter EPS forecast -- which has already come down from $11.84 to $10.13 over the past three months -- this stock is vulnerable to tepid near-term guidance. For example, BMO Capital's Keith Bachman just lowered his second-quarter EPS forecast from $9.78 to $8.29, well below the $9.28 consensus.

Bachman sees trouble on a number of fronts. "We have lowered our unit estimates for iPhones, iPads, and Macs ... as well as our gross margins for iPhones, which lowers our consolidated gross margins," he recently wrote.

If his assumptions are correct, and Apple has to establish a lower bar for unit sales and gross margins, this stock could easily tumble lower. It's unclear whether the recent drop in the stock anticipates that possibility, but it highlights the fact that there's no reason to rush to buy this stock ahead of next week's earnings release.

Yet it's unwise to write Apple off. It is still the best consumer technology company in the world (though Samsung is a formidable rival). I'm keeping a close eye on Sony's (NYSE: SNE) turnaround plans as well.

However, no competitor -- not Sony, Samsung or any other company -- will knock Apple off its perch. The installed base of Apple disciples is too powerful. That's why this near-term weakness is so intriguing: If weak second-quarter guidance pushes this stock well below the $400 mark, then the long-term upside scenario starts to really strengthen -- especially when Apple puts its dormant balance sheet into action.

Risks to Consider: Apple has a very large retail investor base (individuals love this stock even more than hedge fund managers these days), and these retail investors may get spooked by Apple's recent sell-off, which could add to the selling pressure in the near term.

Action to Take --> At any price below $400, Apple should be buying back stock -- lots of it. It's absurd to sit idly by and watch shareholder value be destroyed. Though few may ponder the notion of a debt-fueled stock buyback, look for the idea to gain currency in coming quarters.

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