Thursday, March 29, 2012

Apple's Stash of Cash: What to Do With It

Time to Reward Shareholders?
Anyone who pays attention to the financials of Apple, Inc. or anyone who follows its stock and analyzes it knows Apple has a history of hoarding cash.  Its former CEO Steve Jobs wouldn't have it any other way. From the time he returned as CEO in the late 1990s until his death last year, he refused to allow  Apple to pay a dividend or repurchase stock. He and Apple had suffered through tough times in the early days of his return, and he had haunting memories of getting caught in a financial nightmare, being strapped for cash. He, too, endured financial setbacks with his early-1990s venture, NeXT, and was forced to inject new cash capital from his pocket to keep the failing business afloat.

So over the next decade after his return, Apple created all the gorgeous i-Products the world knows about, attracted a cult-like following of consumers, and generated cash--over $10 billion in cash reserves or over $20 billion in liquid securities, over $30 billion in all--and stockpiled it.

In this first year in the post-Jobs era, Apple continues to introduce modifications to popular products (the new iPad, e.g.) and continues to fascinate its worldwide following. But in this first year, Apple dared to do something else:  It decided that some of  the cash stockpile is better off in the hands of shareholders than in the coffers of Apple's treasury.  In recent weeks, it announced it plans to pay a dividend and will consider a stock-repurchase plan.

A first glance at its balance sheet shows the bulge of $10 billion in cash and $20 billion parked in safe securities. It also shows something else: A negligible amount of long-term debt, significantly noticeable for a firm that owns and operates industrial sites, supply and distribution channels, and hundreds of gleaming, white Apple stores, non-current assets that normally require long-term funding.

With its ability to generate gushes of cash flow in the last decade, if Jobs wanted to avoid debt to finance operations (even debt at low interest rates), he could. Apple financials show that with a surge in popularity in its products, the company generates "free cash flow" (after meeting operating expenses and other current obligations) at a pace of about $20-25 billion/year.  Each year, some of that supports new products, new stores and other research and expansion, but much of it is piled into cash accounts.

Apple, post-Jobs, has decided it's time to rethink its balance sheet.  While they ponder a new financial strategy, research analysts predict the company will continue to generate mountains of cash (likely  amassing "free cash flow" above $20 billion/year, likely to still have total reserves at or near $30 billion for years to come, some say, even with a new dividend program).

For the astute student of corporate finance, what should Apple do with its $30 billion stash?

If it chooses to pay a dividend and/or repurchase stock, how much should it deploy for this purpose and which strategy (a dividend or stock repurchase) is better for shareholders? How often should it do it? Perhaps this happy conundrum is an ideal finance exercise for the Consortium finance student at Tuck, Darden, Stern, Simon or Ross.

There are pros and cons. Much depends on Apple's vision for growth and products in the years to come.  No doubt investment banks have whispered and pitched to advise Apple's finance team, board and CEO. Apple will likely make the call.

Pros:  Why it makes sense to stash the cash, or why Jobs remained obstinate about not sharing  wealth with shareholders

1. Excess liquidity means there is  sufficient cash for emergency and unforeseen purposes. There is, too, cash to ensure that current liabilities can be paid down in an instant or cash to act as a cushion in a worst-case scenario (lawsuit, loss of property, product defect, or any unexpected event).

Excess liquidity helps CFOs sleep at night and allows the CEO and the board to focus on long-term objectives. Apple's balance sheet today shows it can erase all short-term liabilities and just about all of its long-term debt (what little it has), whenever it chooses. 

Excess liquidity also means it doesn't have to wait through product cycles (from product design to manufacture to shipping and sale)  before generating cash, especially  if new cash is necessary for new projects, new expenditures, or debt repayment.

2.  Excess reserves allow the company to avoid leverage (debt), avoid the anxiety of always having to generate just enough cash to pay down debt and interest expenses that are due and avoid having to be at the mercy of debt markets and lenders. 

3. When it chooses to invest in projects, facilities, new companies, or acquisitions, it need not rely on external bank, debt or equity markets to execute.  It can set its own timetable. This permits it to pounce on opportunities without delay, without permission from other stakeholders.

4.  With virtually no long-term debt, it doesn't subject itself to onerous covenants and requirements from debt-holders and bank lenders.  It doesn't require permission from banks or bond-holders to make investments, acquisitions or enter into new product lines.

5.  With cash residing in pockets all over the world, it need not repatriate funds back to the U.S. and subject them to taxes.

Cons:  Why it doesn't make sense to hoard too much cash, or what Jobs missed by not being more strategic in his use or deployment of cash

1.  The most obvious:  Cash and equivalents generate low returns for shareholders. Shareholders could argue they can generate similar returns or even better and would be happier to have the option of having control of cash better suited in their own treasure chest.

The low returns on cash also act as a drag on the company's overall return on equity. Apple in 2012 generated an ROE of about 16% last year. Billions of those cash reserves generating returns below 2-3% hampered returns.  If $5 billion cash had already been swept back into shareholders' pockets, the ROE might have climbed to 18%--about two percentage points in ROE gain and arguably a higher price for an already high-performing stock. 

2.  Corporate-finance experts argue leverage, when managed carefully, helps generate higher returns (and stock prices) for shareholders.  If leverage doesn't rise to burdensome amounts, an optimal amount of debt exists for any company.  The optimal amount, especially in current times when interest rates are low, (a) allows the company to continue with growth and expansion and (b) leads to higher returns without the debt becoming a balance-sheet burden.

Others argue the advantages of a varied, mixed capital structure and the advantages of having experience and discipline with debt markets well before the day the company decides it needs them.

Jobs may have understood the classical advantages of leverage, but never wanted to risk being unable to determine what that optimal debt-equity ratio should be for Apple. Or he just didn't want to fuss with debt-holders about restrictions, liens, covenants and required payments.

3.  Some have argued that Apple equity (stock) is unattractive to a segment of investors looking for income from dividends, especially from a company quite capable of paying dividends.  The absence of this investor group lessens the demand for Apple stock. Although with extraordinary increases in its stock price the past year (over 50%) and the company's way of impressing the world with impressive products, it's hard to observe slackened demand for the stock.

Apple faces the decision of whether to pay a dividend (on a one-time or regular basis) or  repurchase stock or do a little of both.

The finance culture and history of Apple suggest it will choose to remain financially conservative. Apple is accustomed to the comfort of excess liquidity and reserves. It won't suddenly tap debt markets, nor tamper with its pristine, safe balance sheet. And it will want to reward shareholders based on its own timetable. Apple will likely pay a teaser dividend and implement a modest stock-repurchase program. But don't get used to it.

Tracy Williams

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