November 13th, 2024. Apple’s Capex-Light Business Model, Apple’s Excess Cash Position, Apple Buyback vs. Apple Dividends
Hello everyone.
The initial plan was to begin going over Big Tech CY3Q24 earnings. There are a few new ideas worth trying out to get caught up quickly and efficiently. While we will still do that, a few incoming questions from members late yesterday led me to change the schedule around.
For the past two weeks, we have gone deep into Apple’s latest financial results. Yesterday, we went over everything share buyback. A somewhat simple question was raised. Is Apple doing the right thing?
The company is generating $100B+ of free cash flow per year and pouring it all into share buyback (and dividends). Is that the right strategy given where we are in the current generative AI / spatial computing environment?
It’s a worthy discussion to have in today’s update.
There are two topics in particular worth addressing:
- Is Apple investing enough in its business?
- Is Apple making the prudent decision with what is deemed excess cash?
Apple’s Capex-Light Business Model
Over the past year, one of the defining Big Tech debates on Wall Street has involved capex (capital expenditures). Generative AI mania put a spotlight on the amount of cash companies were spending on data centers, cloud infrastructure, and related assets.
Even before AI mania, capex was a hot button issue in Big Tech. Business models dependent on data-collection services were requiring increasing investment at unprecedented rates. Success for such business models was based on achieving scale in order to grab as much data as possible. Considering how several Big Tech business models were already capex-heavy in the sense of maintaining these data-collection services, the need for even more capex for AI came across as unnerving to some on Wall Street.
As 2024 progressed, there was evidence that Wall Street was warming to the capex situation. As discussed in the Inside Orchard essay "Big Tech Should Be Spending Big on AI," Wall Street began to agree with the philosophy that it is better for companies to invest now in capex because being late to the game would lead to more serious consequences. If generative AI buzz petered out, Big Tech could retrofit capex so that organic growth can utilize computing capacity already in place. It helped that companies also pursued aggressive cost cutting to partially offset the higher capex.
Apple finds itself in a very different situation. Instead of chasing scale with the goal of monetizing data or usage, Apple sells tools that management thinks people will want and are willing to pay for. For Apple, scale is considered a byproduct of a properly functioning business model. Such uniqueness dramatically reduces Apple’s need for capex. AI mania has not changed this dynamic.
Apple Intelligence offers a real-world example of Apple’s capex-light business model. While Apple is on the hook financially for handling Private Cloud Compute, billed as the private, cloud-based solution for more computational intense features offered through Apple Intelligence, the company has positioned much of Apple Intelligence as an on-device personal intelligence system. This greatly reduces the need for costly compute and cloud-related infrastructure. When it comes to third-party models, Apple is not on the hook financially to handle the corresponding compute and cloud-related infrastructure. An Apple Intelligence user engaging with ChatGPT (via the upcoming Apple Intelligence integration) will put OpenAI on the (financial) hook. If we extend this exercise to include future third-party model integrations with Apple Intelligence, Apple’s capex-light business model is further reinforced. This dynamic has been referenced by Apple on recent earnings calls as a hybrid approach to capex. Such an approach is also found with Apple relying on third-parties for product assembly, although Apple still dedicates funds to owning certain manufacturing machinery and equipment.
Thanks to its capex-light business model, Apple is spending approximately $10B per year on PP&E vs. $35B to $45B that Alphabet and Microsoft are spending per year on PP&E. One way of framing that capex delta: It can fund 30% to 35% of Apple’s annual buyback program.
Looking ahead, the question isn’t so much if Apple needs to do something different financially, like ramp cloud-related capex, to support its business model. Instead, it’s more about the business model itself. Would Apple need to change its business model to better compete against free services? Such a change would likely require a rethink on capex and spending.
There is little found with Apple’s capex-light model that puts the company at a disadvantage to capex-heavy peers. As long as users reward curation and design-first computing, Apple’s model is applicable.
Apple’s Excess Cash Position
Apple currently has $50B of what we can refer to as excess cash. Apple has used the phrase “net cash neutral” to help denote what it considers excess cash. Management wants to have its cash position equal to the amount of debt held on the balance sheet. Even though Apple has allowed debt holdings to fall a bit in the current high interest rate environment, declining debt does not impact Apple’s net cash position as a corresponding amount of cash is removed from the balance sheet when debt is repaid.
One way for Apple to reduce its excess cash position is to have capital return exceed free cash flow generation. Free cash flow is a measure of how much cash is generated after taking into account capex and other costs associated with running the business. Another option to get rid of excess cash is to pursue large price tag M&A, although there are a few reasons why such M&A isn’t in Apple’s DNA.
In terms of putting excess cash back into the business via organic means, Apple’s focus mantra results in the company using a heavy hand when determining funding needs. Apple isn’t built to support an ever-increasing R&D portfolio. While some may look at this as “Apple will always be behind competitors from a technology perspective,” Apple’s response would be they are focused on coming up with the best solution rather than the first solution. Such a goal would be congruent with focused R&D spending.
It is important not to lose context with Apple’s excess cash. Management is not penny pinching to hoard cash. Apple’s R&D will be up nearly 80% over the past five years. As Apple has grown its revenue base from $275B to $425B in five years, R&D as a percent of revenue will have gone up by about 100 basis points. Meanwhile, Apple’s SG&A reflects a company that never let go of a “hard times are ahead” mindset that dates to the late 1990s and early 2000s.
Apple Buyback vs. Apple Dividends
In terms of spending the $50B of excess cash on its balance sheet (i.e. cash that is not needed to fund growth) and the roughly $110B of free cash flow that will be generated over the next 12 months, Apple will utilize both share buyback and a quarterly cash dividend. However, the two vehicles aren’t close to being equal. Apple spends $15B/year on dividends and closer to $100B/year on buyback.
Apple can certainly increase the amount that is spent on dividends even if it meant slowing down its buyback pace as a result. This goes back to my long-standing view that Apple’s board is being downright frugal with the quarterly cash dividend, increasing it pretty much at the lowest amount possible each year. Last year, it was $0.24/share per quarter. This year, it was $0.25/share per quarter. When it comes to estimating next year’s dividend, $0.26/share per quarter would be the logical projection as $0.27/share would be too large of an increase.
The logic behind running with a lower dividend is that if management views its growth opportunities as strong, paying out a higher percentage of EPS in dividends isn’t the right move. Instead, management would keep more cash to invest back into the business. For Apple, it’s not so much that cash that would have gone to pay a dividend is instead spent on R&D or M&A. Instead, the cash is simply spent on more share repurchases.
Companies typically do get feedback from their largest investors as to preferences between buyback and dividends. It's certainly possible that Apple’s top shareholders don’t mind the current dividend payout ratio and aren’t clamoring for Apple to pay a higher payout as it means they would be paying more in tax (there’s no tax associated directly with share buyback).
As long as Apple’s finance team views AAPL shares as trading less than Apple’s intrinsic value, we should expect buyback to be heavily favored over dividends. (We can use discounted cash flow to value intrinsic value ourselves but there is such a degree of subjectiveness found in the exercise it’s futile to try to figure out Apple’s internal projections).
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