Apple's turnaround? As simple as I-B-M

A commitment to return cash to shareholders is a key reason IBM's shares have fared well even when the broader tech sector has fallen from favor. Apple should take heed.

By StreetAuthority Mar 8, 2013 8:49PM
IBM logoBy David Sterman
Apple (AAPL) CEO Tim Cook has often emphasized that the personal-technology pioneer still has aces up its sleeve, hinting at bold new products in the pipeline. So Apple could still surprise investors with better-than-expected growth.

But even if Cook is right and Apple is on the cusp of an impressive product-release cycle, he's wrong on one key point: Apple will never again be a great growth story.

The company's annual revenue base is fast-approaching the $200 billion mark, so even if the company is layered in tens of billions of dollars in new revenue, that would only offset some of the revenue declines Apple will experience from the maturation of key products and competitive pressures, which could lead to more price cuts.

Make no mistake, it is Cook's job to focus on product development and technology leadership. But Apple's board of directors now has a completely different task: Boost a stock price that remains in a free fall.

Luckily for Apple, tech stalwart IBM (IBM) once had a similar problem, and it pulled off a successful transition of its message to Wall Street.

"In 2005, IBM was telling the Street it could grow earnings double-digit, but the company was so complicated that analysts didn't believe it," wrote UBS analyst Steve Milunovich. He's actually been following technology stocks since 1997 and has seen a number of companies manage to reinvent themselves through changes in capital allocation.

Milunovich draws parallels between IBM and Apple for a more prosaic reason -- both companies produce stunning amounts of cash flow, thanks to returns on invested capital (ROIC) that exceed 30%. In fact, while IBM's free cash flow has remained fairly consistent in the past eight years, Apple's has been exploding.

Milunovich says it's time for Apple to join an emerging trend among technology companies. "IBM was one of the early vendors to deal with maturity and make a strength of it by consistently giving back up to 80% of its free cash flow to investors," the analyst saiid. 

He points out that Intel (INTC), Cisco Systems (CSCO) and, more recently, Dell (DELL) and Texas Instruments (TXN) have made strong commitments to returning cash to shareholders.

Returning cash to shareholders is indeed a key reason IBM's shares have always fared well, even when the broader tech sector has slipped out of favor. IBM has boosted its dividend by at least 13% for each of the past seven years, but the current yield is a fairly unimpressive 1.7%.

Caught Buffett's eye
Yet Big Blue's retirement of more than 500 million shares is more impressive. That has enabled IBM to more than triple its earnings per share during that time frame, even as sales growth has never exceeded 8% in any given year. This has attracted mega-investors such as Warren Buffett, whose stake in IBM is now valued at more than $14 billion.

So with Apple's free cash flow set to exceed $40 billion in the current fiscal year, it's time to assess what Apple can do for shareholders. Let's assume, as Miluvonich notes IBM has done, that Apple earmarks 80% of free cash each year (about $32 billion) to dividends and buybacks.

Allocating $8 billion each year to the dividend would translate into a roughly 2% dividend yield. Applying the remaining $24 billion into stock buybacks would shrink the share count by roughly 6% each year. Apple's board should actually show a great deal of flexibility on the matter. At times like this, when shares have fallen sharply in a short period of time, buybacks should be the main focus. When shares rebound (which they likely will if Apple pursues an IBM-style strategy), dividend growth should be the focus.

In fact, you could take this concept a step further. With nearly $140 billion in cash in the bank, Apple could return 100% of its annual free cash to shareholders and part with another $20 billion from its balance sheet each year. This works out to be $60 billion in play money, which could generate a 3% dividend yield and shrink the share count by 10% annually.

Risks to Consider: Buybacks can prove to be ill-timed if the market tumbles lower in subsequent quarters. Companies such as Nokia (NOK) spent billions on buybacks, only to find they could have bought back a lot more shares a few years later when share prices were lower. That said, judging by the metric of free cash flow, Apple's stock is already close to washed out.

Action to Take: Investors are clamoring for Apple to take bold action to boost its flagging stock. It should become increasingly clear to the company that promising a rebound in growth will not be the panacea for this stock.

If Apple decides to make bold moves such as big stock buybacks and dividend hikes, then shares could quickly regain altitude. Even in the absence of any near-term actions, shares look quite washed out at roughly 10 times free cash flow. This once-hot growth stock looks like a more compelling value stock with each passing day, making it safe to hop on board, even as others are heading for the exits.

Sterman does not hold positions in any securities mentioned in this article. StreetAuthority owns shares of INTC and CSCO in one or more "real money” portfolios.

More from StreetAuthority
Mar 14, 2013 10:41AM
Apple "was" Steve Jobs.  iPods, iPhones, and iPads brought them to where they are today but that is slipping away as they are doing nothing to further the evolution of those devices.  How likely is it for Apple to pull a rabbit from it's hat without Mr. Jobs?

This is history repeating itself for a second time with Apple.  Apple is the hare while Microsoft/Intel is the tortoise.  That's how this story is going to end.

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