November 25, 2019
“Show Me The Money”
How Sensible Capital Allocation Helps Drive A Stock Higher
A reporter recently reached out to understand how we view the large cash balances that sit on some corporate balance sheets (namely Facebook’s). Capital allocation ranks high on the list of importance for what drives business and stock value. I think it is often underappreciated. Contrasting Facebook (FB) to Apple (AAPL) illustrates how constructive changes in capital allocation can drive significant value.
Amazingly, FB is cheaper than AAPL. FB trades for 11.7x 2020 EV/EBITDA versus AAPL at ~13x. It’s amazing because FB is growing much faster (2020 estimated rev growth for FB 22% and AAPL 5%) with better returns on capital (though AAPL is catching up by reducing the value-destroying capital sitting on its balance sheet). Why is FB, which has better visible fundamentals, cheaper? Yes, FB may be more squarely in the political/regulatory crosshairs but this issue affects both of them. I don’t think this alone explains the discrepancy. I think capital allocation is a key difference.
We purchased long-term Apple call options in early 2013 when the stock pulled back from $100 to the $60s mostly due to fears that growth had stalled out. It was right before Apple starting returning capital to shareholders (this change was an important consideration for us). Since then, the stock is up 4.4x with revenues up 60%, pretax profits up 36% and net income up 56%. Why has the stock way outperformed the fundamentals? A cheap starting point always helps! But the market has truly re-rated the stock. I recall it bottomed at ~7x earnings and it now trades for 20x earnings, a premium to the market (SPX 17x next year’s earnings)!
The shift in capital allocation explains much of it, in my opinion. They’ve dramatically increased their capital return to shareholders over the years. Net cash didn’t peak on their balance sheet until 2017 at around $150B and now its $100B – still enormous but down by a third. It now has a dividend. While the dividend is still small (1.2% yield), it’s grown at a nice clip (10.5% per year growth rate over the past 5 years). Diluted shares have fallen 32% from their 2012 peak. A key point: buying back stock below fair value INCREASES business value.
Having a sensible capital allocation policy is extremely important in our view. Roughly a third of market returns have been dividends since the 60s and the current demand for income is large. Also returning capital that sat on the balance sheet destroying value by earning a lower return than the cost of capital helped improve AAPL’s return on capital – an important driver of stocks.
Bill has always used Texas Instruments as the primary example of an optimal capital allocation policy. They explicitly tell you how they will return capital. They use both dividends and share repurchase. They target dividend growth in line with earnings/cash flow and they repurchase stock more aggressively at lower prices. The market has awarded Texas Instruments with a premium valuation to the market. This is a good approach for most companies to follow.
The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date published. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2019 Miller Value Partners, LLC