Apple (AAPL) has taken a lot of flack lately for sitting on a cash hoard of approximately $137B (source: 10-Q dated 01/24/2013), all the while watching the stock price plummet. It is by far the largest cash and investment portfolio in U.S. corporate history outside of a financial institution. It earns a measly return for shareholders. Over the last 12 months, according to Apple's quarterly filings, the investment portfolio has generated $1.28B in investment income. Dividing that return by the average cash balance over the past 12 months ($121.4B), shows Apple shareholders earning an approximate return of 1.05 percent. It has another $864M in unrealized gains, which, if they are booked as gains, bump up the return to a slightly more palatable 1.76 percent. Considering Apple earned $41.75B in net income over the same period, the income earned on the cash balance is hardly a drop in the bucket.
How can Apple earn a greater return without putting undue amounts of capital at risk? First let's take a look at where Apple has allocated its cash and investments.
|dollars in millions||December 29, 2012|
|Level 1 Assets:|
|Money market funds||3,666|
|Level 2 Assets:|
|U.S. Treasury securities||22,890|
|U.S. agency securities||20,658|
|Non-U.S. government securities||4,684|
|Certificates of deposit and time deposits||2,370|
|Mortgage- and asset-backed securities||13,696|
|source: 10-Q dated 01/24/2013|
Clearly this is an extremely low risk portfolio. There is barely any equity exposure (maybe none - I am not sure if mutual funds are equity funds) and the debt securities must be very short duration for all these investments to only generate a 1.05 percent return. For comparison, Microsoft, at December 31, 2012, has $9.4B in equity investments, or approximately 12 percent of its cash and investment balance (source: 10-Q dated 01/24/2013).
If Apple were to take a minority portion of its investment portfolio ($20B or so) and bump up the risk profile, shareholders could, over time, through the magic of compounding, see a much more respectable return on their cash pile; the cash could actually work for them, instead of against them. Here are several alternatives Apple should consider.
1. Consider a total return mutual fund, such as PIMCO or Doubleline. PIMCO Total Return has not had a negative year since 1999; even then it only lost 28 basis points (Source: Yahoo! Finance ticker PTTRX). Its five year annualized return is 7.5 percent. While Doubleline has a much shorter track-record, it too can generate similar returns with considerable downside protection; both funds have expense ratios of about 50 basis points. They have top notch managers that know how to make money in any investment environment. The funds are predominately fixed income products.
2. Consider distressed debt or special situations hedge funds or private equity funds. My employer has been heavily invested in these types of funds for many years. Without naming names, there are many qualified managers that excel in this space. While there is no cookie cutter investments for one of these funds, they are equipped to provide capital up and down the capital structure for all different sized companies - typically in the U.S. and Western Europe. They are incredibly opportunistic and take what opportunities the markets provide. While these funds can take negative marks on their investments, the good managers almost always realize the value they aimed to achieve. In a bad year, these funds can go down 5-8 percent. In a good year, like 2012, they can go up 15+ percent, net of fees.
2. Consider some level of equity exposure. It could be in many different forms. It could be in long-only mutual funds, ETFs or long/short hedge funds, if the company is worried about too much directional exposure. Some level of equity exposure is appropriate for Apple considering the huge amount of excess cash it sits on.
In conclusion, Apple basically has a riskless investment portfolio today. As of December 29, 2012, Apple's investments had unrealized gains of $951M (mostly from corporate securities and non-U.S. government sovereigns) and $87M in unrealized losses. An $87M loss on a $137B portfolio creates an error message on my calculator; the number is so small. Apple has excessively more cash on its balance sheet than it will ever need to run its businesses. It continues to generate oodles of additional cash ($47B in free cash flow the last 12 months). The company can afford to take some risk with a small portion of its cash. Over the long term, cash has the potential to actually work for shareholders (instead of against them as it does) by adding a meaningful amount to net income.
How meaningful of a contributor to net income could it become? For assumption purposes, let's say Apple could earn, on average, an 8 percent return on the $20B it invests in higher yielding assets. That is the assumed rate of return that most pension funds use when calculating their obligations to their retirees. That is an additional $1.6B in pre-tax income in year 1. Assuming that $1.6B is reinvested, and the $20B of invested principal becomes $21.6B in year 2, Apple then earns $1.7B, and so on and so forth. If you get a bit more aggressive and assume a larger rate of return, the returns can be more attractive.
|Assumed Return||Year 1||Year 2||Year 3||Year 4||Year 5|
These annual returns assume the reinvestment of all prior year gross earnings. Of course, returns are not linear, so this is not an entirely realistic scenario, but it does illustrate the power of compounding returns. Again, for a company that many would argue has maxed out on its earnings potential with its current slate of products, this could become a meaningful source of income and contribute to EPS growth going forward. The more cash allocated to higher yielding assets, the larger this number could get. If Apple were to, after a number of years of utilizing this strategy, generate 5 to 10 percent of its net income solely by investing its cash, investors would be quite pleased.