The Apple You Don't Know

| About: Apple Inc. (AAPL)

Apple Inc. (NASDAQ:AAPL), well known for its iPhone, iPad, iMac, and iPod products, has led a secret life. While the masses focus on the next iteration of the iPhone and iPad, the company holds some mysteries.

Does Apple really have $145 billion in cash?

On April 24, 2013, Bloomberg published an article titled, Apple's $145 Billion in Cash Fails to Win AAA Debt Rating, where it references a $145 billion cash position. Two other articles - one from The Fiscal Times and the other from Techcrunch - coming around the same time, also reference this $145 billion in cash.

Surprise: According to Apple's March 30, 2013 10-Q SEC filing, the company does not have $145 billion in cash. Instead, Apple's "Cash, Cash Equivalents, and Marketable Securities" at fair value are worth $145 billion. The next question: what are these Marketable Securities? I created a chart below using Note 2 - Financial Instruments from the 10-Q SEC filing which shows the company's holdings in mutual funds, government securities, corporate securities, mortgage-backed securities, and etc. This fixed income portfolio clearly cannot be lumped under the general term "cash" without further analysis because cash implies security of principal and immediate liquidity.

According to Note 2, Apple's investments are mostly long-term marketable securities having maturities between one and five years generally invested in investment grade bonds. They total 73% of the Cash, Cash Equivalents, and Marketable Securities total of $145 billion which can be seen from the chart I created below. Short-Term marketable securities (19% of total) mature within 1 year which could involve both securities with maturities originally issued with up to a year's maturity or longer maturity securities that have a year or less before maturity date. What's surprising is true cash is $5.9 billion and cash plus cash equivalents are $12 billion or 4% and 8% of the total which is nowhere near the common myth of $145 billion in cash hoard.

The marketable securities portfolio with $100 billion in assets requires professionals to manage. Potential principal loss through credit events and rising interest rates are not a significant risk for the short-term marketable securities. Therefore we focus on the long-term marketable securities which predominately are fixed income securities which are more sensitive to rising interest rates and potential credit issues due to the longer maturity. I created a chart to better show the breakdown of what Apple has in its long-term marketable securities portfolio. In the worst case scenario we can assume all their investments are zero coupon bonds with a 5 year maturity. In that case, the modified duration of those bonds are 5 meaning if interest rates move one to two percent then the portfolio value will drop five to ten percent ($5 to $10.5 billion) which is a significant portion of this quarter's net income of $9.5 billion. Obviously most of these securities are not zeros, but even with a duration of two we can expect $2 to $4 billion dollars in unrealized losses if interest rates increase. These potential losses matter little as Apple's 2012 full year net income was $41.733 billion.

The last two things to consider is the market impact and income/capital gain taxes that which are not included in the fair value of Apple's investment. Market impact happens when large transactions influence the market. Selling an enormous position tends to depress selling prices and buying the same position tends to increase buying prices both increase the cost of a transaction. Fixed income securities generally pay interest which is taxed at income rates and selling securities above cost will result in capital gain taxes.

In this case whether Apple's "cash" is really cash does not matter. But an informed investor always conducts thorough research and analysis to determine the significance of his or her findings.

Is Apple's large marketable securities holding necessary?

Tim Cook either under pressure or having a change of heart is starting to believe in returning capital.

Last year on March 19, 2012 he announced plans to initiate dividend payments of $2.65 a share and a $10 billion share repurchase plan. As a sign of investor impatience David Einhorn, hedge fund manager and president of Greenlight Capital, filed a lawsuit in early February 2013 to force Apple to return the excess $137 billion in "cash" back to shareholders using the proceeds from a preferred stock issuance. Recently on April 23, 2013 coinciding with Q2 earnings release Apple increased dividend payments to $3.05 a share and the share repurchase plan to $60 billion. These statements can be found directly from Apple's website.

Before we chastise Apple for holding large amounts of capital we need to know why. The main reason is to fund growth. From their most recent earnings release in Note 6 - Commitments and Contingencies they have off-balance sheet commitments of $19.7 billion in contrast to the buildup to last year's holiday season Apple had a $26.5 billion in off-balance commitments. These mostly come from purchase and lease commitments which make up 93% of the total. Please see the chart I created below for better visualization.

Current assets which include cash, cash equivalents, and short-term marketable securities are sufficient to cover these commitments and current liabilities with $8 billion remaining. See the table I created below. Outside consideration for acquisitions, a $105 billion long-term marketable securities portfolio is unnecessary for organic growth and supports Apple's decision to return capital to shareholders.

Apple is no longer a growth company

The charts I created below illustrate the rapidly slowing net income growth starting in the June 2012 quarter and the historical annual growth rates from the company's 10-Q/K filings. Apple is rapidly transitioning to a mature company operating in a mature market where new features are less common and price competition accelerates. Barring any new product announcements it is difficult for the company to grow faster.

As a result, Apple stock has decline significantly and investors should not value the company based on its rapid growth. The recent massive stock price slide and the recent bounce back can be attributed to growth investors punishing the stock for poor earnings growth and declining margins and value investors stepping in due to compelling valuations and the new capital return program. The below table created illustrates the trailing 12 month diluted Price to Earnings subtracting the value of Long-Term Marketable Securities per diluted share. I used the highest/lowest price of the stock for the following quarter. For example the December 31, 2012 earnings information uses the stock prices from January 1, 2013 to March 31, 2013.

I assembled this information using a combination of sources: High/Low prices from Yahoo Finance, Morningstar and SEC 10Q/K for the rest. From the above table Apple's stock valuation should be a combination of both the value of its earnings and the value of long-term marketable securities. Growth investors focus on the company's earnings, margins, and products but forget to consider the company's treasure chest, which now accounts for 27% of the company's stock price.

The Apple you don't know will hurt you. First, Apple's $145 billion "cash" position is not cash but a massive investment-grade fixed-income portfolio. This error in classification is not material and won't hurt investors. Second, the impression that the existence of a large portfolio of long-term marketable securities is undesirable and should be promptly returned to shareholders is premature. Without analyzing the off-balance-sheet commitments, Apple's product rollout, and potential acquisition needs, it's better to have the company determine the appropriate time to return capital to shareholders. In this article we can make the case that the balance of long-term marketable securities can be considered returnable to shareholders. Third, many analysts continue to value Apple as a fallen growth company. Apple is now a value company, where its P/E, book value, and capital return program (dividends and stock buybacks) matter more than earnings and sales growth.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.