When adding debt is good

By Al and Mark Rosen | June 18, 2013 | Last updated on September 15, 2023
6 min read

Apple Inc. makes far too much money. And, as Apple’s cash stockpile grows, the money becomes a bigger drag on share value through decreased returns on equity.

The problem is the majority of Apple’s cash hoard is domiciled offshore (70% at the end of last quarter). The cash can’t simply be handed to investors through dividends or share buybacks. That would require repatriating the cash first and having to pay roughly $25 billion in taxes. Unwilling to surrender that money, Apple has instead been lobbying Congress for years to let it return the cash to shareholders without onerous consequences.

Meanwhile, investors were restless. At its recent low, cash represented 39% of Apple’s share price and activist investors were urging the company to do something. David Einhorn’s plan to issue perpetual preferred shares garnered media attention and might be what spurred Apple’s board to finally act.

Rather than resorting to arcane financial engineering, Apple decided to issue debt. With interest rates bottoming out, the time to borrow could not be better. More importantly, the debt gives Apple the U.S. domiciled cash it needs to boost its profile with shareholders by hiking the dividend and undertaking the largest share buyback plan in history.

The idea is not unique. Microsoft has issued roughly $15 billion in debt over several years to counterbalance its excess offshore cash reserves. Apple was already paying a dividend of $2.65 per quarter and created a $10-billion buyback plan, but the repurchases merely offset the dilution caused by share-based compensation.

The company’s new plan takes it to a different level of shareholder friendliness. Apple hiked its dividend 15% and increased its share repurchase plan to $60 billion. To facilitate this, the company issued $17 billion in bonds with maturities ranging from three to 30 years. The debt issue was one of the largest in history and reportedly two times oversubscribed.

Neither here nor Eire

Even with the debt offering, Apple still needs to deal with its repatriation tax dilemma. Other tech giants with large offshore cash hoards include Google, Oracle, Cisco and Qualcomm. Like Apple and Microsoft, these firms are hoping for a repatriation tax holiday—similar to the one extended in 2004 and 2005. While there are ongoing discussions with Congress and the current administration, the process is moving slowly.

One positive sign was when Apple CEO Tim Cook was invited to President Obama’s State of the Union Address in February. The president mentioned Apple would return manufacturing jobs to the U.S. One criticism of the last repatriation tax holiday was that it cost the Treasury billions and didn’t increase U.S. jobs.

More recently, Cook testified to a U.S. Senate subcommittee on the details of Apple’s offshore tax strategy centred in Ireland. While a congressional report revealed that Apple claimed tax residency in neither the U.S. nor Ireland (and did not pay taxes in either jurisdiction), the questions lobbed at Apple executives by the senators mostly highlighted deficiencies in the tax code, rather than imply the company cheated.

Success metrics

The market seems to approve of Apple’s plans, with shares rising 15% since April. Given its success, it hasn’t taken long for similar plans to emerge in Canada.

When news broke that U.S. activist investor Highfields Capital Management was in talks with Tim Hortons to increase shareholder value, Tim Hortons’ share price jumped 7%.

Highfields’ two-pronged plan involved halting investment in Tim Hortons’ U.S. expansion and recapitalizing the company through various means. All in, Highfields estimated Tim Hortons shares could rise to $100 in 12 to 18 months.

In its published letter, Highfields proposed converting Tim Hortons to a REIT similar to Loblaws or Canadian Tire (“REIT spinoffs create value, Advisor’s Edge Report, March 2013”). It argued that doing so would boost return on capital, return on equity and earnings per share. While finding it intriguing, Tim Hortons poured cold water on the idea, claiming many of its locations are leased and there’s not much hidden value.

Highfields’ letter also referenced a recapitalization plan that takes advantage of historically low interest rates. According to sources familiar with Highfields’ presentation to management, this would mean issuing $3.4 billion of debt to repurchase over one-third of Tim Hortons’ shares.

The buyback strategy is plausible and may have gained more credibility in the wake of Apple’s success.

Tim Hortons’ reaction

Tim Hortons management says there may be “value creation potential in adding leverage…in light of the historically low interest rate environment that has persisted for some time now and the financial flexibility afforded us by the strength of our balance sheet.”

But comments from Tim Hortons CEO Paul House, who is scheduled to step down in July, indicate current management doesn’t foresee leveraging to the level proposed by Highfields. The company covets its investment-grade credit rating, which is based on debt levels plus off-balance-sheet operating leases.

New CEO Marc Caira, who comes from global food giant Nestle, may be more open to increasing leverage since international companies aren’t as shy about doing so.

Investors may recall shareholder activists caused Tim Hortons to be spunoff from Wendy’s in the first place. Perhaps the Canadian icon is set to revisit its American roots.

Tim Cook testifies

A Senate panel says Apple Inc. is avoiding paying billions of dollars in U.S. taxes, but the world’s most valuable company says it is complying with the laws and pays “an extraordinary amount” in taxes to the U.S. government.

Apple Inc. CEO Tim Cook testified on Capitol Hill to explain the company’s tax strategy.

The Senate investigation found Apple employs a group of affiliate companies outside the U.S. to avoid paying taxes.

Apple is holding overseas some $102 billion of its $145 billion in cash, and an Irish subsidiary that earned $22 billion in 2011 paid only $10 million in taxes, according to a report issued by the Senate Permanent Subcommittee on Investigations.

The strategies Apple uses are legal, and many other multinational corporations use similar tax techniques to avoid paying U.S. income taxes on profits they reap overseas. But Apple uses a unique twist, the report found. The company’s tactics raise questions about loopholes in the U.S. tax code, lawmakers say.

Apple’s chief financial officer and its tax chief are also scheduled to testify and explain the company’s tax strategy.

They are expected to face tough questions. The subcommittee’s chairman, Sen. Carl Levin, D-Mich., and other panel members could hold up Apple as an example of a powerful company using its privileged position to avoid taxes while ordinary Americans must pay them. The subcommittee last fall derided executives from other technology giants over similar allegations.

Apple refuted the subcommittee’s assertions in testimony prepared for the hearing. Apple said it employs tens of thousands of Americans and pays “an extraordinary amount” in U.S. taxes, citing the roughly $6 billion it paid in fiscal 2012.

Apple “complies fully with both the laws and the spirit of the laws,” the testimony says.

“And Apple pays all its required taxes, both in this country and abroad. Apple does not use tax gimmicks.”

The company has made clear that, given current U.S. tax rates, it has no intention of repatriating its overseas profits to the U.S. Apple reiterated in its testimony its support for comprehensive tax reform as a way to support economic growth and boost U.S. companies’ competitiveness.

– Associated Press

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.

Al and Mark Rosen

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.