Seeking Alpha
Long/short equity, medium-term horizon, value, growth
Profile| Send Message|
( followers)  

Apple (NASDAQ:AAPL) has cash, cash equivalents and marketable securities totaling $145 billion (as of March 30, 2013), compared to its market capitalization of $388 billion. The company has built up this cash stockpile by conservatively retaining all its earnings until 2012; when it finally began paying dividends and initiated a share repurchase program. However, despite this, Apple still has cash and cash-like assets at 37% of the value of where the company is currently trading at. With Apple trading at a P/E ratio of 9.36 (TTM), optimists believe that this cash stockpile is not properly represented in the market's valuation of the company.

AAPL Chart

AAPL data by YCharts

A short recap on what is going on at Apple

Analysts are divided over their opinions of where Apple is heading into its future. Apple's recent lackluster quarterly earnings releases have shown falling revenue growth and narrowing profit margins. Analysts see this as evidence that the smartphone and computer tablet industry is maturing and competition is becoming tougher. Pessimists see this as a cause for concern, and that Apple may fall into the footsteps on once proud manufacturers of consumer technology, such as Nokia (NYSE:NOK), BlackBerry (NASDAQ:BBRY), and Sony (NYSE:SNE). They share the view that Apple would, in the same ways, fail to innovate and adapt new products to suit the dynamic and demanding nature of consumers' tastes. On the other hand, optimists point to Apple's ability to maintain, what is still considered as, high operating margins, as evidence of strong consumer confidence in Apple's product quality and its ecosystem, which drives consumer loyalty. They also look at Apple's strong balance sheet, and low P/E valuations, to suggest that Apple is currently trading at a substantial discount to the market.

Whichever view turns out to be correct would certainly take a long time to tell. In the meantime, Apple has yet to launch any significant products in its mobile and tablet division. Apple has however updated its notebooks [both MacBook Air and MacBook Pro) with Intel's (NASDAQ:INTC) 4th generation Core processors. {For those of you who are interested in Apple's choice for adopting Intel's new processors, I recommend reading Ashraf Eassa's SA article, here}. But given the timing of the launch of the sale of these products, the impact on Apple's Q3 earnings should be small, but perhaps noticeable. However, analysts are more concerned with the mobile and tablet market, where Apple generates the overwhelming majority of its profits. Although it has promised a much needed revamp of its iOS (mobile) operating system, it has released few details to the public. In itself, the new operating system, iOS 7, has become a contentious issue, as any significant change always invites. Therefore, investors have been reluctant to preemptively judge whether Apple can maintain its lead over the smartphone industry; and they will continue to be cautious but attentive with investment decisions until the launch of new mobile devices, which is expected only in the fall of this year.

The cash stockpile

Many optimists believe that observers have not taken into account Apple's cash assets into its valuation. They say that if you remove the cash assets from Apple's market capitalization, then the company would trade at an adjusted P/E of 5.87 (and a forward P/E of 6.54). This is a significant discount to the industry. But should we accept such a form of valuation, as most of the cash is held offshore, and repatriating the cash to return to shareholders would incur taxation at 35%. Perhaps it would be more appropriate to assume a discount of 35% on its offshore cash assets and no discount on its US cash assets. That would still give a handsome adjusted P/E of 6.71 (and a forward P/E of 7.48).

(click to enlarge)Apple

Source: Apple's Q2 Financial Statements (10-Q)

Without any expectation of using the cash, the cash has largely been invested in long-term marketable securities, including US Treasuries, corporate debt, and mortgage-backed securities. According to its 2012 annual report, the 'cash-like' assets had a weighted average interest rate of "1.03%, 0.77%, and 0.75% during 2012, 2011, and 2010, respectively." This is pitifully low; and given that Apple has a return on equity (RoE) of 33% (which would have been much higher had Apple returned the cash to shareholders), this is a very inefficient use of capital. Instead of holding assets which yield just 1%, Apple should deploy the capital efficiently through investing within the firm, or on acquisitions which strengthen its businesses. And if it had other purpose for the cash, other than to save it for a 'rainy day', it should return the capital to shareholders. Its management, especially with Steve Jobs, had believed that it needed the cash to ensure that it could finance new product developments, or future acquisitions. This view has been too conservative, and has been a cause of the gross misallocation of capital. Apple has sufficient cash flow to fund most acquisitions it would consider undertaking; and if not, it could always go to the capital markets for funding and present its case to outsiders.

Despite concern that hoarding cash is inefficient, there is an even greater concern. That is, Apple's management now has to manage, what appear to be, two very different businesses: Apple computers, and the 'financial division' managing the cash-like assets. Apple's 'cash pile' has increasingly become migraine inducing for its management, as some shareholders demand for the cash to be returned or consider issuing preferred stock. This diverts management's attention from rightfully developing better products. That could hamper innovation, and lead to a poorer management of what is Apple's main business, which is making products and software development. Fortunately, and in an increasingly less reticent fashion, Apple's management is rightly moving towards returning capital to shareholders. This should refocus management's attention on what really matters.

As announced in its previous earnings release, Apple intends to return $100 billion to shareholders by 2015. It would raise debt by 'offsetting' its offshore 'cash-like' investments to obtain a low cost of funding. This is good news, but not enough capital is being returned. Apple should, on top of the $100 billion announced, return all future free cash flow not used in financing capital investment and acquisitions, to shareholders. Otherwise, Apple's cash stockpile will, once again, continue to rise, and end up generating a poor return as well as creating another row with shareholders.

Just when you thought the cash hoard problem was finally over

Apple is set to release its third quarter earnings on July 22, 2013. Analysts are forecasting EPS for the quarter to come in at $7.33, down from $9.32 on the previous year. Apart from a slow quarter, there is, however, an important question that this earnings release would address; that is, how Apple's long-term bond investments are affected by recent market fears with regards to the Fed 'tapering' its asset purchases. I recommend Stephen Rosenman's SA article, which explains that Apple would likely make significant unrealized losses on its portfolio of long-term bonds. To summarize, the interest rate for long-term bonds have risen sharply in recent weeks; and consequently, long-term bond assets have fallen in market value. This is as a result of investors demanding much higher yields on long-dated bonds to compensate for expectations of the Fed to tighten monetary policy.

With $106 billion of long-term assets, Apple is expected to lose a figure in the billions on its balance sheet; but so long as it holds its assets to maturity, it does not make a realized loss. Nonetheless, it has lost an opportunity to buy those same assets more cheaply today, or possibly at even better value in the future. From Apple's Q2 financial statement, the company states that the company holds long-term marketable securities that have maturities that "generally range from one to five years." This should offer some comfort, as bonds with shorter maturities have lost less value as a result of the steepening yield curve.

But for illustration, if we assumed that all of the $106 billion was invested in 5 year US Treasuries (which they are certainly not; see table above for the composition of Apple's investments), then the company would have lost a value of approximately $3 billion on its long-term investments, as yields have risen from 0.78% to 1.43%. Please take this illustration with a pinch of salt, because without knowing the exact maturity and composition of these assets, it is hard to estimate the value lost because of recent events. Nonetheless, this highlights the risks of holding long-term financial investments.

Apple is particularly affected because of the large proportion of long-term bond assets (including US Treasuries, corporate debt, and mortgage backed securities; which have all fallen in value in recent weeks) in Apple's cash and marketable securities (non-core financial assets it has 'tucked away'). Google, Microsoft, Cisco and many other non-financial corporations with significant cash or cash-like assets have them invested primarily in the form of cash or short-term investments. That is not to say, however, that holding longer-term investments is not in Apple shareholders' interest; as they typically offer (marginally) higher returns; but, obviously, also at higher risk. In a way, a part of Apple acts like a financial company through voluntarily taking on interest rate risk; and this is perhaps why investors discount the value of Apple's financial investments when valuing Apple's stock. I would, however, like to point out that Apple had raised $17 billion of long-term debt, since the Q2 earnings release; and this would offer some hedge against the recent increase in long-term bond yields. These bonds issued by Apple have similarly fallen in value because of investors' demand for higher yields in fear of the Fed tightening policy. In the future, with further long-dated bond issuances, Apple should become better protected against to monetary policy changes which affect long term interest rates.

What should Apple do?

Apple should avoid increasing its allocation of long-term marketable securities until it issues more long-term debt. It should try to match the maturities of the cash-like securities it holds with the maturity of the debt it issues. Together with holding only high investment grade assets, and maintaining the idea of returning free cash flow to shareholders, Apple can minimize the financial risks of its investments. After all, Apple is not a financial company and it should not take unnecessary financial risks unrelated to its main business. Doing this would allow management to focus on developing the products and seek to expand its markets. If Apple learns from this mistake, all we need to worry about now is whether Apple can deliver on developing new products which suit to consumer tastes.

Source: How Does Apple's Cash Stockpile Affect The Company - And Has The Market Undervalued It?