A Leveraged-Buy-Out of Apple Inc?

Posted on 12/05/2011

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Although such a transaction is unlikely to happen given the size of Apple’s market capitalisation ($319bn) and the huge equity requirement that such a deal entails, I still think it is a worthwhile exercise to consider Apple’s capital structure from the perspective of a private equity investor, who would be unlikely to stick with the current strategy of relying entirely on equity financing.

The first question to ask is: “How much debt can Apple’s operations reasonably support?”  There is no exact science to calculating a company’s debt capacity, as it is affected by both quantitative and qualitative factors.  However, I would argue that debt capacity is positively related to: business size; customer numbers; customer diversity; geographical diversity; product diversity; operating margins; product necessity; percentage of recurring revenues; and revenue stability.  Debt capacity is also negatively related to: prevailing interest rates; capital expenditure requirements; operating margin volatility; revenue cyclicality; degree of operating leverage; working capital requirements; and working capital volatility.  Apple scores highly on almost all of these factors, with the clearest exceptions being product necessity (most Apple products are a discretionary expense), recurring revenues (despite high customer loyalty, purchases are contractually a one-off), and revenue stability (ie. lenders feel more comfortable with a business which has grown at +1% for a long period than +50% for a short period).  I would therefore feel comfortable lending to Apple with a a relatively high degree of financial leverage.

The second question to ask is: “How much debt can Apple’s finances reasonably support?”  This question can be answered more quantitatively, as it is purely a calculation to determine the interest that can be serviced by Apple’s current cash flow.  In FY11e Apple is expected (by JP Morgan) to generate EBITDA of $31.9bn, receive a $3.6bn release of working capital, and spend $3.8bn on capital expenditures, leaving free cash flow of $31.8bn (cash conversion is excellent at near-100%).  The table below shows the forecast FY11e interest cash-cover ratio for various combinations of interest rates and debt balances.  We can see that even if Apple was to borrow $150bn at 6% per annum (BB bonds currently yield 5.73%), the interest costs would be 3.5x covered by FY11e cash flow.  More conservatively, Apple could perhaps borrow $100bn at 5%, giving debt/EBITDA of 3x and cash flow/interest of 6.3x with annual interest costs of $5bn.

What would be the effect of this on equity holders?  Well, with annual interest costs of $5bn, the expected tax bill would fall from $7.47bn to $6.24bn (assuming the rate remained constant at an expected 24.6%); however, net income would decline from a forecast $22.8bn to $19.1bn.  However, given that equity holders could potentially receive a special dividend, capital distribution or share-buyback of $166bn, as shown in the sources and uses table below, and I think this would overall be an attractive transaction for Apple shareholders.

Shareholders would receive $166bn up-front (equivalent to 52% of their current holdings by value), and still have an interest in a business which is expected to generate $19.1bn in net income this year.  Even at a 10x P/E multiple post-reorganisation, this would value Apple at $357bn (including the cash return), some 12% above the current valuation.  At a slightly more generous 13x P/E multiple Apple would be worth $414bn, 41% more than it is today.

How can this be the case?  Well, Apple would be replacing equity capital (expensive) with debt capital (a bargain at only 5% interest rates).  Also, Apple would be gaining the benefit of paying for a portion of its capital out of re-tax rather than post-tax income, thus reducing its ongoing tax expenses.  Thirdly, Apple would be returning cash to shareholders – on the purest valuation methodology, the dividend discount model, more distributions, bigger distributions and sooner distributions equals a higher valuation.

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