There's no question that technology company Apple (AAPL 1.07%) is one of the most influential companies on earth. It's an industry giant whose annual profits alone are larger than most companies could ever dream of generating as top-line revenue. It's also been one of the greatest investments over the past several decades.
Apple's nearly $3 trillion valuation has resulted in management spending billions of dollars to repurchase its stock, borrowing money at very low interest rates. However, the cost to borrow money seems poised to skyrocket, so Apple may struggle to continue on its buyback path. Here is what investors need to know.
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More money, more buybacks for Apple
Apple has been using excess cash to buy back its stock for most of the past decade. Share repurchases often happen when a company generates more cash profits than it needs to invest back into the business. Lowering the number of shares helps shareholders because there are fewer shares to spread profits over and it increases per-share metrics like earnings per share (EPS), which supports a higher share price.
You can see in the chart below that Apple has repurchased many billions' worth of stock over time, which has lowered the share count from approximately 26.4 billion to 16.7 billion. Over time, the dollars spent repurchasing shares have increased with Apple's free cash flow.
AAPL Stock Buybacks (TTM) data by YCharts
The result? Apple's revenue has grown 13% per year on average this decade, but EPS has grown an average of 19% per year because of the buybacks. A company growing earnings per share at nearly 20% annually over a decade is probably going to be a fantastic investment, and Apple's stock has crushed the S&P 500 for the past 10 years.
Impact on the balance sheet
But you need to look at the fine print regarding Apple's share repurchases. The company has leaned on its balance sheet to fund much of its buybacks, taking the balance sheet from zero debt to $122 billion within the decade. I'm not saying that Apple's in any sort of trouble, the company has a whopping $64 billion in assets like cash and securities it can quickly sell to raise cash. If you factor in non-current assets like bonds or real estate, Apple's war chest inflates to almost $190 billion.
AAPL Non-Operating Interest Expense (TTM) data by YCharts
If Apple has so much in assets, why is it borrowing? Simply put, debt has been very cheap for most of the decade, as monetary policy by the Federal Reserve Board has taken interest rates to near zero, making it cheap to borrow money. Apple's average interest rate on its debt is roughly 2.1%.
Headwinds on the horizon for Apple?
However, you shouldn't ignore debt, because it still adds risk to the balance sheet. Inflation is surging, and the monetary policy that created cheap debt seems to be changing course. The Federal Reserve raised the Federal Funds Rate in March and is expected to raise it several more times this year.
With a higher Federal Funds Rate, it will become more expensive for Apple to borrow because interest rates will be higher. Roughly $83 billion of Apple's debt comes due over the next five years, so management will need to decide whether to refinance the debt at higher rates or use its cash to begin paying it down.
Either way, there's a chance that it may force Apple to slow its share repurchases, which could, in turn, slow the company's EPS growth. Slower growth could put pressure on the stock's valuation.
Apple's valuation could take a hit
This is especially relevant when Apple's stock trades at a price-to-earnings ratio of 29, nearly twice what the stock's P/E has averaged over the past decade (about 15.5). The combination of slowing growth and a high valuation could mean that the market turns against Apple, selling the stock to a lower valuation.
Perhaps this doesn't happen, and Apple continues growing fast enough to juggle its debt and still fund massive repurchases. However, investors should look at the potential risk versus the potential reward of any investment. Apple's stock trades near the high end of its historical range while the company takes on debt and has to continue repurchasing shares to fuel EPS growth.
If you ask me whether I believe there's more room for the stock to go up or down over the next couple of years as interest rates rise, I think it's clear that there's more risk than reward in Apple at today's prices.
