Going into 2014, we're seeing a very different Apple (NASDAQ:AAPL) from the one we've seen historically. The company is now thinking about buying larger companies, and has been able to expand into China for the very first time. All of this leaves me with high conviction that Apple could return to continued top and bottom-line growth over the next five years.
While I'm optimistic of Apple's core operations; Apple's balance sheet hasn't been a source of wealth creation, which was why I hoped for bigger M&As to begin with.
By the time you finish reading this article; you will agree that Apple should look for strategic M&A opportunities rather than invest into bond/mortgage/stock securities.
Apple needs to invest into M&A as I have stated earlier
Earlier in the year I stated:
Considering the mounting pile of cash, and the slowing growth in Apple's core hardware business, adding a high-margin service business could be its winning ticket to becoming a resurgent growth investment. It's likely that investors will come to reward Apple's management for its ability to create cash generative businesses from scratch, and its savvy acquisitions.
Admittedly, I was hoping Apple would do something major, like a buyout of Comcast (NASDAQ:CMCSA) ($107 billion market cap).
In recent weeks, there have been rumors of a major Beats Audio acquisition, valued at approximately $3.2 billion. It's a high-margin business, which is great, and helps to validate my underlying thesis that Apple should be more aggressive on M&A.
Now I won't bore you with the details about the acquisition, because everything that could possibly be said about the potential M&A has been said by various journalistic sources. Instead, I'm going to talk about Apple's balance sheet. Well, more specifically, I'm going to talk about the sheer size of Apple's bond portfolio, and the instability of global currency exchange and interest rates.
It's because the underlying principal value of bonds can fluctuate so much, paired with currency that I'm starting to think Apple will instead accelerate the buyout of companies. This can transition the value of its assets into goodwill accounts, rather than report unrealized losses on investment securities.
Is the foreign investment risk well understood?
Source: Apple Annual Report
At the present moment, the company's adjusted cost basis on all of its investment positions totals to $147.143 billion. Whereas the fair value on all of its positions is $146.761 billion. This indicates that Apple's investments have failed to return an actual ROI, as the fair value is lower than the cost basis of its portfolio of investments. In 2013, Apple had $793 million in unrealized losses.
The unrealized losses primarily came from Non-U.S. government securities, and corporate securities. With the vast majority of Apple's profits in overseas segments, Apple's stock investment portfolio mostly consists of foreign equities. This is a problem, which I will try to explain in more detail later in the article.
The $252 million in unrealized losses most likely didn't come from U.S. stock exposure. I'm fairly certain of this, because the S&P 500 had one of its best years in 2013.
Looking over the details of its currency hedges, it looks like the notional principal amount even when combining non accounting hedges is inadequate to cover the balance sheet exposure that Apple has. In Apple's 2013 fiscal year, the company generated $108 billion in foreign revenue. Assuming net profit margins on that revenue were 21.42%, the company had $23 billion in cash that was probably invested into foreign stocks and foreign bonds. However, the invested cash may be larger than $23 billion, as foreign taxes are lower than in the U.S. Also, Apple's CAPEX spending, and R&D is primarily based in the United States, so the cash from foreign operations may in fact be significantly higher than cash from U.S. operations.
In Apple's 2013 fiscal year the company only held $54 billion in notional value on foreign exchange contract, and interest rate contracts. The notional value of these hedges is small when compared to the total exposure Apple has through its assets.
Furthermore, to avoid taxes, it's unlikely that Apple will bring the cash home, and will continue to invest the cash into foreign treasury bonds, stocks, and currencies. The foreign currency risk is what annoys me the most. This is because Apple's foreign currency hedges seem to be adequate enough to cover its business operations. However longer-term hedges would need to be made on assets assuming the holding period is longer-term. Apple's investment portfolio generated negative returns, leading me to the logical conclusion that Apple didn't hedge its investment portfolio appropriately.
Longer-term hedges cost more money. Anyone with some investment experience with derivative contracts knows this is the case. For example, a one-year option contract costs way more than a one-week option contract. Usually, international businesses hedge against foreign currency risks over the short-term. This is why; Apple's total fair value on derivative contracts pertaining to currency and interest rates is about $214 million. Shorter-duration contracts are cheap, which means these contracts are intended to cover short-term risks. If over the short-term the dollar increased in value against a basket of currencies by 10%, the foreign income would have devalued by 10%. This is because net income translated into dollars from xyz foreign currency would be worth less as the dollar increased in value.
Apple covers short-term interest/currency exposure, but doesn't focus on long-term exposure, which helps to explain why fair value declined on the balance sheet line item referred to as long-term investment.
Apple's global investment portfolio likely to remain volatile
In the past year, the dollar has decreased in value (positive for Apple). However foreign equity markets have underperformed (negative for Apple). This whole conundrum of fluctuating equity/bond notes values makes it very difficult to be a global asset manager.
Apple barely escaped 2013 with a modest decline in fair value, but with further volatility comes the possibility that Apple could have another bad year on its investments. This is why Vanguard, in a research note to clients states "that it's a good idea to hedge fixed income from currency fluctuations." The two charts below represents investment returns on global fixed income with currency hedges, or without currency hedges.
As indicated in the above chart, whenever the U.S. dollar declined in value, the return on foreign bonds increases, but whenever the dollar increases in value, the value of foreign bonds decreases. This inverse relationship is why Apple needs to increase the size of its foreign currency hedge even further.
However, when currency exposure is hedged, foreign bond returns are slightly higher to U.S. bonds, and are more closely correlated. Apple didn't hedge its foreign bonds to currency exposure in fiscal year 2013, which is why Apple's unrealized losses on U.S. Treasuries were lower than on foreign treasuries.
Furthermore, the dollar is starting to gain in value against the euro. This puts additional pressure on U.S. foreign currency hedges as the flight to safer assets may prompt foreign investments to underperform on a currency adjusted basis. Not to mention, foreign investment funds tend to pull investments from foreign markets whenever the dollar is being bid up in value. The weakening foreign investment trade isn't just isolated to Europe there are some legitimate concerns in Asia investment exposure as well.
China's weakening GDP, which I highlight in a little more detail in a previous article, can have currency implications. However, the bigger challenge is that if GDP declines, interest rates will most likely go up. This will damage the value of Chinese Dim Sum bonds. The Chinese Yuan is strengthening against the U.S. dollar, which improves the principal value of the note on a currency basis. But because Apple isn't going to repatriate the cash to the United States, the cash vested in Chinese bonds will decline in value (the principal value of Chinese bonds decline when interest rates go up).
Vanguard discusses unhedged bonds in more detail:
Any allocation to unhedged international bonds represents a bearish view about the performance of the U.S. dollar, whether that is the investor's intended objective or not. An allocation to unhedged international bonds would be expected to increase a portfolio's average volatility over time.
Basically, in laymen terms, Apple needs to hedge its currency exposure. Even after a foreign currency hedge, the return profile of these foreign treasuries will make the return characteristics similar to U.S. bonds. The closely correlated return characteristic of hedged foreign bonds to U.S. bonds means that if U.S. interest rates go up, the foreign currency hedges won't soften the impact from higher interest rates.
Therefore, I'm just not convinced that owning a massive portfolio of paper assets is appropriate at the present time. Rather Apple should invest into strategic M&A opportunities.
Foreign M&A will move Apple's cash into goodwill accounts on its balance sheet. M&A activity will lower its sensitivity to foreign interest rates, and it will boost both revenue and net income assuming the company is able to find synergies from operations. Furthermore, additional revenue from foreign operations can be hedged with short-term derivatives rather than long-term derivatives. Short-term derivatives are a little less expensive, which adds to the appeal of foreign acquisitions.
For these reasons, I have great conviction that Apple will continue to use more of its cash flow to buyout companies rather than hold cash in foreign investment accounts. The global investment environment is not only hard to understand, it's also volatile at the present moment.
I think that Apple's unrealized losses in its 2013 fiscal year on its long-term/short-term investments can be viewed somewhat negatively. However, these losses can certainly be mitigated with some interest rate, and currency hedges. If Apple hedges aggressively, Apple will preserve the buying power of its cash and earn a modest yield on its investments.
However, an even more effective strategy would involve transitioning more of its assets into goodwill accounts through the use of strategic M&A. Strategic M&A will boost top and bottom line results immediately, and are easier to hedge from both interest and currency volatility. Furthermore, product synergies can unlock additional market share, or add to Apple's pre-existing competitive moat.
The unrealized losses were small when compared to annual revenue. It would be preferable if Apple's unrealized losses were unrealized gains of 5-6%. Considering Apple's foreign investment portfolio consists of $106 billion in long-term assets, an unrealized gain of 6% would have boosted Apple's balance sheet by an additional $6.36 billion dollars.
Based on the current investment environment, Apple shareholders should anticipate major foreign acquisitions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.