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By Jeremy Glaser and Brian Colello, CPA | 04-24-2013 08:30 AM

Market Too Pessimistic on Apple

Apple's gross margins likely will shrink over time, but the market is underestimating the long-term potential of the iPhone, says Morningstar’s Brian Colello.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Apple posted fiscal second-quarter results that were in line with our expectations. But their outlook was a little bit weak, and they also announced some big changes to their capital structure. I'm here with Brian Colello, our Apple analyst, to take a look at some of these changes.

Brian, thanks for joining me.

Brian Colello: Thanks for having me.

Glaser: So, let's start with those capital structure changes. They announced a pretty big increase to their stock-buyback program and increase to the dividend. What's your thinking behind these moves, and is the way they're going execute it something you think is going to add value for shareholders?

Colello: So they expanded the buyback. It was originally $10 billion and they upped to $60 billion. They said it was the largest buyback plan in U.S. history. We probably believe that. They increased their dividend by 15% and in between product cycles, because they launched a lot of new products in the December quarter, and there hasn't been any new refreshes. I think the big issue on investors' minds has been capital allocation and how do they put that cash to use.

The issue that Apple always has is they have $145 a share in cash, $99 of it is overseas. It can't be used for dividends or buybacks until they bring it back to the U.S. and pay repatriation taxes, which is probably an extra 30% haircut you would have to take. Instead, it looks like Apple will take on debt at probably really low rates, priced at something like 3%, probably less, in order to bring more cash into the U.S. to fund dividends, to fund the buyback.

So, the $60 billion plan, I think it's a good move because we think the stock is cheaper and are encouraged that Apple thinks the stock is cheap, too. I think it's been received positively by investors thus far. I also think it adds flexibility. If you were to go the other way and expand the dividend, rightly or wrongly, there is probably a perception that if you are a high dividend payer, that you can no longer innovate, you don't have good places for your cash. With the buyback, I think, it gets rid of that perception, and it's also more flexible. If something were to come along in terms of a big acquisition target, that's not necessarily what Apple does, but if something were to come along, Apple has a little more flexibility with the buyback. And with the stock being as cheap as we think it is, we think it's a good use of capital.

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