By Whitney Tilson, founder, Empire Financial Research
Every profitable company must make an important choice of what to do with all of that excess cash.
It could do nothing at all and simply watch its cash hoard grow. It could squander those profits… pay down debt… or reinvest in its business. It could reward stockholders through dividends or share repurchases.
The seventh and final choice companies can make with excess cash is to make acquisitions.
Corporate America has an even worse track record with acquisitions than it does with share repurchases.
Studies show that approximately two-thirds of acquisitions end up destroying value, primarily because companies tend to overpay. Similar to share repurchases, they tend to make expensive acquisitions when the economy is strong, cash flow is high, and optimism is peaking.
This is exactly what we’re seeing this year. In the pharmaceutical sector, AbbVie (ABBV) just announced a $63 billion deal for Allergan (AGN), and Bristol-Myers Squibb (BMY) acquired competitor Celgene for $74 billion earlier this year. In the biggest bank merger in a decade, BB&T (BBT) is buying SunTrust (STI) for $28 billion. And cloud-computing software company Salesforce (CRM) purchased business-analytics firm Tableau (DATA) for $16 billion.
We’ll see how those transactions work out in the years to come. But those are massive deals taking place 10 years into this historic bull market… which can’t go on forever.
Even a company buying a world-class asset can make a bad acquisition if it pays too much. Even worse is when companies buy lousy assets – for example, a cyclical business at what turns out to be peak earnings, or one that’s in decline, but that the seller has spruced up and flipped to a gullible buyer.
And then there are the routine problems of incompatible corporate cultures and “synergies” that fail to materialize.
To be clear, some acquisitions are brilliant – for instance, Alphabet’s (GOOGL) purchase of YouTube and Facebook’s (FB) purchase of Instagram have been grand slams.
And some CEOs and companies are able to consistently make good acquisitions. Warren Buffett has purchased hundreds of companies over time and nearly all have worked out beautifully. But he’s Warren Buffett!
Don’t be fooled, however, by these examples. They’re what I call “the tyranny of the anecdote.” When you see a company make an acquisition, your working assumption should be that it will end badly. And the bigger and more frequent the acquisitions, the more skeptical you should be. That’s what the research shows.
A Case Study in Capital Allocation
To understand how different companies can (and should) adopt different capital-allocation strategies, let’s look at what two of the greatest businesses of all time – Apple (AAPL) and Alphabet – are doing.
Apple was one of the greatest growth stocks of all time, growing its revenues and profits exponentially. Under the late Steve Jobs, it barely repurchased any shares and, as recently as 2011, paid no dividend at all. The cash just piled up.
Then, in August 2013, activist investor Carl Icahn announced that he had bought the stock and pushed the company to return cash to shareholders. Even though he owned fewer than 1% of the shares, other shareholders supported Icahn because he was right. The company did indeed have tens of billions of dollars of excess cash, so it began returning it to shareholders.
It increased its dividend to more than $14 billion annually. More important, seeing that its stock was cheap, it ramped up its share repurchases dramatically. It bought back between $24 billion and $46 billion annually from 2013 to 2017, and then more than doubled it to $75 billion in 2018.
This is a huge number, but Apple can do it because in 2018 it generated $64 billion of free cash flow (operating cash flow minus capex).
This capital-allocation strategy makes sense because Apple is no longer a growth stock. With $258 billion of trailing revenue, it’s now so large that any meaningful growth is impossible. More than half of its revenues come from selling iPhones. Pretty much everyone – not just in the U.S., but around the world – who wants an iPhone already owns one. It’s mostly a business of replacements and upgrades. Apple is trying to grow its services and other product offerings, but it will be hard to grow… Indeed, over the past two and a half years, revenue is up a mere 5% and operating income has actually declined somewhat.
But that’s OK, because Apple is the world’s greatest cash cow. As long as it gushes cash and returns it to shareholders, the stock will likely do well (though I’m not expecting it to outperform the market by much).
Alphabet, in contrast, is less than half Apple’s size, with “only” $142 billion in trailing revenue. It has robust growth prospects thanks to 2 billion low- and moderate-income people around the world who will be buying smartphones in Asia, sub-Saharan Africa, and Latin America in the coming years. These people are likely to be using numerous Alphabet products like Google search, YouTube, Gmail, Android, Chrome, and Maps.
In addition, it’s investing heavily in new technologies like self-driving car unit Waymo. It’s just beginning to monetize its Android operating system and YouTube. Essentially, Alphabet is where Apple was five or 10 years ago in terms of growth potential, so the company is investing heavily (nearly doubling its capex to $25 billion in 2018) to meet this opportunity.
Even after spending so much on capex, Alphabet still generated $26 billion in free cash flow over the past year. Plus, it’s sitting on more than $100 billion in net cash. Yet, like most growth companies, it isn’t yet returning much capital to shareholders. It doesn’t pay a dividend and its share repurchases have been modest to date (though they nearly doubled to $9 billion in 2018).
As Alphabet matures, I expect it to ramp up its dividend and, especially, share repurchases. This will likely be a major tailwind for the stock (as it was for Apple).
The decision not to return capital to shareholders is one big reason why I like Alphabet’s stock more than Apple’s… Because it reflects the likelihood that the company still has substantial growth ahead of it. Those growth prospects, combined with increasing return of cash to shareholders, should lead the share price to double over the next few years.